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MICRO-

ECONOMICS AND

BEHAVIOR

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MICRO-

ECONOMICS AND

BEHAVIOR

Seventh Edition

ROBERT H. FRANK

Cornell University

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto fra7573x_fm_i-xxviii.qxd 9/20/07 7:21 PM Page iii

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MICROECONOMICS AND BEHAVIOR

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2008, 2006, 2003, 2000, 1997, 1994, 1991 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 WCK/WCK 0 9 8 7 ISBN 978-0-07-337573-1

MHID 0-07-337573-X Editorial director: Brent Gordon Executive editor: Douglas Reiner Developmental Editor: Angela Cimarolli Senior marketing manager: Melissa Larmon Project manager: Jim Labeots

Production supervisor: Gina Hangos Lead designer: Matthew Baldwin Photo research coordinator: Lori Kramer Senior media project manager: Susan Lombardi Cover design: Artemio Ortiz Jr.

Interior design: David Seidler Typeface: 10/12 Sabon Roman Compositor: Aptara, Inc.

Printer: Quebecor World Versailles Inc.

Library of Congress Cataloging-in-Publication Data

Frank, Robert H.

Microeconomics and behavior / Robert H. Frank. — 7th ed.

p. cm.

Includes index.

ISBN-13: 978-0-07-337573-1 (alk. paper) ISBN-10: 0-07-337573-X (alk. paper)

1. Microeconomics. 2. Economic man. 3. Self-interest. 4. Consumer behavior. I. Title.

HB171.5.F733 2008 338.5—dc22

2007033877

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For Dana

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vii

A B O U T T H E A U T H O R

Robert H. Frank is the Henrietta Johnson Louis Pro- fessor of Management and Professor of Economics at the Johnson Graduate School of Management at Cor- nell University, where he also teaches principles of microeconomics in the College of Arts and Sciences. His

“Economic Scene” column appears monthly in The New York Times. After receiving his B.S. from Geor- gia Tech, he taught math and science for two years as a Peace Corps volunteer in rural Nepal. After receiving his M.A. in statistics and his Ph.D. in economics from the University of California at Berkeley he began his teaching career at Cornell. During leaves of absence from the university, he served as chief economist for the Civil Aeronautics Board, a Fellow at the Center for Advanced Study in the Behavioral Sciences, and Professor of American Civilization at l’École des Hautes Études en Sciences Sociales in Paris. His research has focused on rivalry and cooperation in economic and so- cial behavior. His books on these themes, which include Choosing the Right Pond, What Price the Moral High Ground?, Passions Within Reason, and Falling Behind, have been translated into eleven languages. Other books include The Economic Naturalist and Principles of Economics, co-authored with Ben Bernanke. The Winner- Take-All Society, co-authored with Philip Cook, received a Critic’s Choice Award, was named a Notable Book of the Year by the New York Times, and was included on Business Week’s list of the ten best books 1995. His Luxury Fever was named to the Knight-Ridder Best Books list for 1999. He is past president of the Eastern Economic Association, a co-recipient of the 2004 Leontief Prize for Advancing the Frontiers of Economic Thought, and a recipient of the Merrill Scholars Program Outstanding Educators Citation. At the Johnson School, he was awarded the Russell Distinguished Teaching Award in 2004 and the Apple Distinguished Teaching Award in 2005.

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ix

P R E F A C E

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y goal in writing Microeconomics and Behavior was to produce an in- tellectually challenging text that would also be accessible and engaging to students. The more common approach in this market has been to emphasize one of these dimensions or the other. For example, some texts have done well by sacrificing rigor in the name of user-friendliness. But although such books sometimes keep students happy, they often fail to prepare them for upper- division courses in the major. Others texts have succeeded by sacrificing accessi- bility in the name of rigor, where rigor all too often means little more than mathematical density. These courses overwhelm many undergraduates, and even those few who become adept at solving well-posed mathematical optimization problems are often baffled by questions drawn from everyday contexts. I have al- ways believed that a text could at once be rigorous and user-friendly. And to judge by the breadth of Microeconomics and Behavior’s adoption list, many of you apparently agree.

I wrote this book in the conviction that the teaching of intuition and the teaching of technical tools are complements, not substitutes. Students who learn only technical tools rarely seem to develop any real affection for our discipline;

and even more rarely do they acquire that distinctive mindset we call “thinking like an economist.” By contrast, students who develop economic intuition are stimulated to think more deeply about the technical tools they learn, and to find more interesting ways to apply them. Most important, they usually end up liking economics.

Microeconomics and Behavior develops the core analytical tools with pa- tience and attention to detail. At the same time, it embeds these tools in a uniquely diverse collection of examples and applications to illuminate the power and versatility of the economic way of thinking.

ECONOMIC NATURALISM

In more than thirty-five years of teaching, I have found no more effective device for developing intuition than to train students to become “Economic Naturalists.”

Studying biology enables people to observe and marvel at many details of life that would otherwise have escaped notice. In much the same way, studying microeconomics can enable students to see the mundane details of ordinary existence in a sharp new light. Throughout the text, I try to develop intuition by means of ex- amples and applications drawn from everyday experience. Microeconomics and Behavior teaches students to see each feature of the manmade landscape as the reflection of an implicit or explicit cost-benefit calculation.

To illustrate, an Economic Naturalist is someone who wonders why the business manager of the economics department was delighted when I began putting the lecture notes for my course on the university’s intranet server, whereas the very same move troubled the associate dean in the management school, where I also teach. About a week into the term, I got an urgent letter from this dean telling me that henceforth I should make hardcopies of my lecture notes for dis- tribution to students free of charge. No similar instruction came from the business manager of the economics department. When I asked for clarification, the management school’s dean told me that students had been downloading my notes

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and printing them in the school’s computer labs at a cost of 5 cents a page, which was far more than the 1.25 cents the school’s copy center was charging at the time.

Fair enough. But then why was the economics department’s administrator not wor- ried about the same problem? (When I asked whether he wanted me to distribute hardcopies of my notes, he replied “Don’t you dare!”)

Their different viewpoints, I soon discovered, had nothing to do with the very different cultures of the two units. Instead, they stemmed from a small but important difference in economic incentives: In the management school, the same administrator pays for printing in both the computer labs and the copy center. The economics department administrator, however, pays only for printing on the department copier. When economics students print my lecture notes off the web in the various campus computer laboratories in the Arts College, the bills go directly to the College. From the economics department’s point of view, these copies were free.

Year in and year out, the most valuable assignments in my course are the two brief papers in which I ask students to report on their efforts to become economic naturalists. Their specific charge is to use microeconomic principles to answer a question prompted by a personal observation. In recent terms, students have grappled with questions like these: Why do the keypads of drive-up ATM machines have Braille dots?

Why do top female models earn more than top male models? Why do brides spend so much money on wedding dresses, while grooms often rent cheap tuxedos (even though grooms could potentially wear their tuxedos on many other occasions and brides will never wear their dresses again)? Why are child safety seats required in cars but not for air travel? Why do airlines charge their highest prices to passengers who buy at the last minute, while the practice is exactly the reverse for Broadway theaters?

The beauty of this assignment is not only that most students enjoy writing these papers, but also that few manage to complete them without becoming life- long economic naturalists. For those who would like to learn more about the assignment, my lecture on it is posted in the Authors@google series here: www.

youtube.com/watch?v⫽QalNVxeIKEE.

FOCUS ON PROBLEM SOLVING

Most economists agree that a critical step in learning price theory is to solve problems. More than any other text currently available in the marketplace, Microeconomics and Behavior prepares students for its end-of-chapter problems by taking them through a sequence of carefully crafted examples and exercises within each chapter. Because most of these examples and exercises are drawn from familiar contexts, and because students engage more readily with the con- crete than with the abstract, this approach has proven effectiveness. In the absence of such groundwork, many students would reach the end-of-chapter problems with little or no idea how to proceed.

OPTIMAL TOPIC COVERAGE

A guiding principle in the evolution of Microeconomics and Behavior has been that topics should be emphasized in proportion both to their importance and to the difficulty that students have in mastering them. Because the basic rational choice model is the building block for much of what comes later in the course, I have devoted considerably more attention to its development than competing texts do. I have also allocated extra space for elasticity and its applications in demand theory, and for the average-marginal distinction in production theory.

As an additional means for discovering which topics are most difficult to master, I have used research in behavioral economics that identifies systematic departures

x PREFACE

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from the prescriptions of the rational choice model. For example, whereas the model says that rational persons will ignore sunk costs, many people are in fact strongly influenced by them. (Someone who receives an expensive, but painfully tight, pair of shoes as a gift is much less likely to wear them than is someone who spent $400 out of his own pocket for those same shoes.) Especially in the chapters on consumer behavior, I call students’ attention to situations in which they themselves are likely to make irrational choices. Because student resources are limited, it makes sense to focus on precisely those issues for which knowing price theory is most likely to be helpful.

It may seem natural to wonder whether discussing examples of irrational choices might confuse students who are struggling to master the details of the rational choice model. It’s a reasonable question, but my experience has been exactly to the contrary. Such examples actually underscore the normative message of the traditional theory. Students who are exposed to them invariably gain a deeper standing of the basic theoretical principles at issue. Indeed, they often seem to take an almost conspiratorial pride in being able to see through the errors of judgment that many consumers make. For instructors who want to pursue how cognitive limitations affect consumer behavior in greater detail, there is an entire chapter devoted to this topic. When the first edition of Microeconomics and Behavior appeared in 1990, many in the economics profession were skeptical about the emerging field of behavioral economics. But as evidenced by U.C. Berkeley economist Matthew Rabin’s receipt of the John Bates Clark Award in 2000 (the honor bestowed every two years by the American Economics Association on the most outstanding American economist under the age of 40) and by Daniel Kahneman’s receipt of the Nobel Prize in Economics in 2002, the behavioral approach is now part of the microeconomics mainstream.

A BROADER CONCEPTION OF SELF-INTEREST

Another of my goals has been to incorporate a broader conception of preferences into models of individual choice. Most texts mention at the outset that the rational choice model takes people’s tastes as given. They may be altruists, sadists, or masochists; or they may be concerned solely with advancing their narrow material interests. But having said that, most texts then proceed to ignore all motives other than narrow self-interest. It is easy to see why, because economic research has scored its most impressive gains on the strength of this portrayal of human motiva- tion. It tells us, for example, why Ford discontinued production of its 7,500-pound Excursion SUV in the wake of gasoline price increases; and why thermostats are generally set lower in apartments that have separately metered utilities.

And yet, as students are keenly aware, our homo economicus caricature is patently at odds with much of what we know about human behavior. People vote in presidential elections. They give anonymously to public television stations and private charities. They donate bone marrow to strangers with leukemia. They endure great trouble and expense to see justice done, even when it will not undo the original injury. At great risk to themselves, they pull people from burning buildings, and jump into icy rivers to rescue people who are about to drown. Soldiers throw their bodies atop live grenades to save their comrades. Seen through the lens of the self- interest theory emphasized in most textbooks, such behavior is the human equivalent of planets traveling in square orbits. Indeed, many students are strongly alienated by our self-interest model, which they perceive as narrow and mean-spirited.

Microeconomics and Behavior freely concedes the importance of the self-interest motive in many contexts. But it also devotes an entire chapter to the role of unselfish

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motives in social and economic transactions. Employing elementary game theory, this chapter identifies circumstances in which people who hold such motives have a competitive advantage over pure opportunists. It shows, for example, that people known to have cooperative predispositions can often solve prisoner’s dilemmas and other commitment problems in ways that purely self-interested persons cannot.

Our theoretical models of human nature are important, not least because they mold our expectations about how others will behave. Economics is the social science most closely identified with the self-interest model of human behavior. Does this model color our expectations of others, and perhaps even our own behavior?

When Cornell psychologists Tom Gilovich, Dennis Regan, and I investigated this question, we found numerous indications that economists are much more likely than others to behave opportunistically in social dilemmas.¹For example, academic economists were more than twice as likely as the members of any other discipline we surveyed to report that they give no money at all to any private charity. In an experiment, we also found that economics majors were more than twice as likely as nonmajors to defect when playing one-shot prisoner’s dilemmas with strangers.

This difference was not merely a reflection of the fact that people who chose to major in economics were more opportunistic to begin with. We found, for example, that the difference in defection rates grew larger the longer a student had studied economics. Questionnaire responses also indicated that freshmen in their first microeconomics course were more likely at the end of the term to expect opportunistic behavior from others than they were at the beginning.

There are thus at least some grounds for concern that, by stressing only the narrow self-interest motive, economists may have undermined our students’ propensi- ties for cooperative behavior. The irony, as I attempt to show in Chapter 7, is that the internal logic of the economic model never predicted such narrowly self- interested behavior in the first place.

ADDITIONAL PEDAGOGICAL FEATURES

Unlike most intermediate texts, Microeconomics and Behavior contains no boxed applications, which tend to distract students from the thread of argument being developed. Instead, applications and examples are integrated fully into the text. Many of these have the added advantage of being drawn from experiences to which students can personally relate.

The chapter introductions and summaries are another innovative feature of Microeconomics and Behavior. Most chapters begin with an anecdote that poses a problem or question that the material developed in the chapter will enable the student to answer. These introductions have proved especially helpful for the many students who find that getting started is often the hardest step. The chapter summaries in most current texts consist of brief annotated lists of the topics covered.

The chapter summaries in Microeconomics and Behavior, by contrast, are written in a narrative form that carefully synthesizes the material covered in the chapters.

Each chapter concludes with a selection of problems that range in difficulty from routine to highly challenging. These problems have all been class-tested to as- sure their accuracy and effectiveness in helping students master the most important concepts in the chapters.

Answers to all in-text exercises appear at the end of the chapter in which they occur. Variations and extensions of these exercises are echoed in the end-of-chapter

xii PREFACE

1See R. H. Frank, T. D. Gilovich, and D. T. Regan, “Does Studying Economics Inhibit Cooperation?”

Journal of Economic Perspectives, Spring 1993.

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problems, which enables students to approach these problem sets with greater con- fidence. Detailed answers to all end-of-chapter problems are included in the instructor’s manual.

CHANGES IN THE SEVENTH EDITION

The two-color format of previous editions was once the norm for intermediate microeconomics textbooks. It was in that format that this book’s first edition appeared in 1990 and continued for five more editions. For users of those previous editions, then, the most striking change in the seventh edition of Microeconomics and Behavior will be the book’s new four-color format. If you’re familiar with other four-color texts in economics, you’ll notice that color is used more sparingly in this book than in most others. In my view, the cluttered look of many texts stems in part from using color to excess. What might drive publishers to do this? Here’s a behavioral hypothesis: The incremental printing cost in moving from two colors to four is the same no matter how much color is used, which may prompt many to use color wherever possible, if only to make sure they got their money’s worth. Onthat absurd logic, however, every sentencewould look like thisone!

Economic logic dictates that even if the marginal cost of additional color use is zero, it should be employed only when it enhances the appearance or clarity of the book. I am therefore grateful that McGraw-Hill and I were able to agree on a more spare design in which color’s primary role is to make it easier to interpret graphs that contain multiple curves. The marvelous illustrations that accompany the Economic Naturalist examples were drawn by the renowned New Yorker cartoonist Mick Stevens in black ink. That’s how they look best, and that’s how they again appear.

Many college textbooks are too long. A natural solution would seem to be to publish shorter ones. Yet a short book usually fails because too many potential adopters cannot find their favorite topics in it. Most successful books are therefore big to begin with, and invariably grow longer with each edition. New developments have to be covered, after all, and it’s almost impossible to delete existing material that adopters have grown accustomed to using.

My McGraw-Hill editors and I agreed, however, that it would be a mistake to become completely paralyzed by this powerful bias toward the status quo. And so from this edition, I have continued the process, begun in the sixth edition, of elimi- nating significant blocks of material. Gone, for example, are the discussions of the evolution of hand-drying methods in public restrooms, arc elasticity, hedonic fram- ing, and contestable markets.

Also missing from this edition is the application of Hotelling’s model of spatial competition to positions taken by presidential nominees of the two major parties.

That analysis, which predicts nominees will edge ever closer to the political center, no longer seems to describe today’s highly partisan landscape. The largest deletion from this edition is in one respect not a deletion at all, but rather a relocation. Com- prehensive user surveys during the past several editions recorded a rapidly dwin- dling fraction of adopters who assigned the chapter on general equilibrium theory (Chapter 16 in the sixth edition). If including that chapter in the hard copy of the text were costless, we would have kept it there. But with production costs rising steadily, keeping it would have meant giving up other material that most instructors value more highly. So the general equilibrium chapter does not appear in the hard copy of this edition. But those who wish to continue assigning it can have their students download an updated version of it here: www.mhhe.com/frank7e.

A few things have been added. The list of empirical estimates of price elasticity of demand in Chapter 4 has been expanded, for example, as has the explanation in

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Chapter 5 of how automobile use decisions are affected by a gasoline tax whose revenue is returned to consumers through lump-sum reductions in other taxes.

Chapter 6 features a new example that illustrates how a risk-neutral plaintiff’s attorney might price his services to maximize their attractiveness to risk-averse potential clients.

Chapter 8 now contains a discussion of how errors in forecasting one’s own future preferences appear to affect consumer spending decisions. Following a sug- gestion by Professor Fred Moseley of Mount Holyoke College, I now treat intermediate products in Chapter 9 much like other factors of production, in line with the practice adopted by most other textbook authors.

On a careful reading of this edition, people familiar with earlier editions will also discover that I have continued my attempts to simplify the text and make it more concise. Of great help in this exercise has been my experience of having to ad- here to a strict word budget when writing my New York Times column the past sev- eral years. But shorter is not always better. Thus, for example, I have substantially expanded the discussion of Nash equilibrium in Chapter 13 of this edition, a con- cept that proves challenging to many students.

People familiar with earlier editions will also notice that in this edition I have at- tempted to call greater attention to the Economic Naturalist examples by running the Mick Stevens drawings that accompany them significantly larger. Why incur the additional cost? Again, my conviction is that the single most important service we can render to our microeconomics students is to instill in them an inclination to see the world around them in economic terms. Learning economics is like learning to speak another language. Reading about grammar helps, but the only way to succeed at a deep level is to actually do a lot of talking. The Economic Naturalist approach is the most effective device I’ve discovered for getting students to talk economics. Be- cause the drawings seem to help students remember the examples, they empower them to tell economic stories. Many of my students have described mid-semester trips home in which the Economic Naturalist examples discussed in class became the main topic of conversation at the family dinner table. Once students realize that they can pose and answer interesting economic questions on their own, they’re hooked.

A lifetime trajectory has begun in which their mastery of economic principles not only will not decay with each year following completion of the course, but will actually grow stronger as they continue to hone their craft.

The seventh edition is, in my view, by far the strongest edition of Microeconomics

& Behavior to date. It retains the essential character of the earlier editions that at- tracted such a loyal group of users. But it looks better and, in countless small ways, is better.

THE ANCILLARIES

The supplements package, which has been expanded and improved, now consists of the following materials:

Instructor’s Manual: James Halteman of Wheaton College thoroughly updated the Instructor’s Manual. Each chapter contains a Chapter Summary, a Chapter Out- line, Teaching Suggestions, a list of Stumbling Blocks for Students, Answers to Text Questions for Review, Problems, and Study Guide Homework Assignments. It is available on the Instructor’s Resource CD and in the Instructor’s Center of the book’s Web site (www.mhhe.com/frank7e).

Computerized Test Bank: The Test Bank has been revised for the Seventh Edi- tion by Jose Vazquez-Cognet of the University of Illinois-Champaigne. EZ Test is the most flexible and easy-to-use electronic testing program available in higher

xiv PREFACE

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education. It allows instructors to create tests from book-specific items and add their own questions. Multiple versions of a test can be created and any test can be exported for use with course management systems such as WebCT, BlackBoard, or PageOut. The program is available for Windows, Macintosh, and Linux environ- ments. This is available on the Instructor’s Resource CD.

PowerPoints: Professor Vazquez-Cognet also revised the PowerPoints, which guide students through the material and represent all the figures in the textbook.

They are available on the Instructor’s Resource CD and in the Instructor’s Center of the book’s Web site (www.mhhe.com/frank7e).

Instructor’s Resource CD: This disk contains the Instructor’s Manual, the Com- puterized Test Bank, and the PowerPoints. It also contains a program that allows teachers to create presentations from the components on the disk.

Study Guide: For each chapter, the guide provides these sections: Boiling Down (the chapter), Chapter Outline, Important Terms, A Case to Consider, Multiple- Choice Questions, Problems, and Homework Assignments. This invaluable study tool has been revised by Professor Halteman.

Web site: The Web site contains a great many features for both students and in- structors, including Quizzes, PowerPoints, and Career Opportunities for the student and the complete Instructor’s Manual and PowerPoints for the instructor (see www.mhhe.com/frank7e).

ACKNOWLEDGMENTS

I want to convey my sincere thanks and admiration to my editors at McGraw- Hill for their continued willingness to take steps that run counter to market trends. The biggest gambles, of course, were those taken by Scott Stratford, my editor for the first edition. (I hope he is pleased that subsequent developments in economics profession appear to have ratified the wisdom of those early decisions.) But even for this edition, Scott’s successors, Douglas Reiner and Angela Cimarolli, have been willing to innovate. I am extremely grateful for their enthu- siastic support.

I also want to thank the many reviewers who have been involved in the project, both in this edition and in earlier ones. Their insights and critiques have led to im- provements too numerous to list. I hope they are as happy as I am with their influ- ence on the final product.

PREFACE xv

Ronald Adams

California State University, Chico Susan L. Averett

Lafayette College Amitrajeet A. Batabyal

Rochester Institute of Technology Jeff Bauer

University of Cincinnati–Clermont David Bernotas

University of Georgia Tibor Besedes

Louisiana State University Pinaki Bose

University of Memphis

James Cardon

Brigham Young University Phoebe Chan

University of Michigan–Flint Ron Cheung

Florida State University Joy L. Clark

Auburn University Montgomery Ardeshir Dalal

Northern Illinois University Eric Dodge

Hanover College Robert R. Ebert

Baldwin-Wallace College

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As usual, I welcome further comments and suggestions.

Robert H. Frank

xvi PREFACE

Robert Fairlie

University of California Fred Foldvary

Santa Clara University David Garman Tufts University Satyajit Ghosh University of Scranton Adam Grossberg Trinity College Philip J. Grossman

Saint Cloud State University Susan He

Washington State University Steve Holland

Luther College E. James Jennings

Purdue University Calumet Robert Jerome

James Madison University Sumit Joshi

George Washington University Woodrow W. Hughes, Jr.

Converse College

Mark Kazarosian Stonehill College Jonathan Lanning Albion College Marc Law

University of Vermont Christopher McHugh Tufts University Stanley McMillen Trinity College Gyan Pradhan Westminster College Farahmand Rezvani Montclair State University Stephen Shmanske

California State University, East Bay Mark Steckbeck

Hillsdale College Kurtis J. Swope U.S. Naval Academy Michael Visser

Sonoma State University Mark D. White

College of Staten Island/CUNY

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PART 1 Introduction

1 Thinking Like an Economist 3 2 Supply and Demand 25

PART 2 The Theory of Consumer Behavior 3 Rational Consumer Choice 61

4 Individual and Market Demand 75 5 Applications of Rational Choice

and Demand Theories 139

6 The Economics of Information and Choice under Uncertainty 169

7 Explaining Tastes: The Importance of Altruism and Other Nonegoistic Behavior 211

8 Cognitive Limitations and Consumer Behavior 237

PART 3 The Theory of the Firm and Market Structure 9 Production 263

10 Costs 297

11 Perfect Competition 333 12 Monopoly 371

13 Imperfect Competition: A Game-Theoretic Approach 413

PART 4 Factor Markets 14 Labor 459

15 Capital 505

PART 5 Externalities, Public Good, and Welfare

16 Externalities, Property Rights, and the Coase Theorem 535

17 Government 567 Index 597

18W General Equilibrium and Market Efficiency

(online) 18W-1 xvii

B R I E F C O N T E N T S

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xix

C O N T E N T S

PART 1 Introduction 1

Chapter 1 Thinking Like an Economist 3

The Cost-Benefit Approach to Decisions 4 Example 1.1: Should I Turn Down My Stereo? 5

The Role of Economic Theory 5

Common Pitfalls in Decision Making 6

Example 1.2: Should I Go Skiing Today or Work as a Research Assistant? 7

Example 1.3: Should I Go Skiing Today or Scrape Plates? 7 Example 1.4: Should I Work First or Go to College First? 8 Example 1.5: Should I Drive to Boston or Take the Bus? 9 Example 1.6: The Pizza Experiment 10

Example 1.7a: Should You Drive to Wal-Mart to Save $10 on a $20 Clock Radio? 11

Example 1.7b: Should You Drive Downtown to Save $10 on a $1000 Television Set? 11

Example 1.8: Should Tom Launch Another Boat? 12 Example 1.9: How Many Boats Should Tom Launch? 13

Using Marginal Benefit and Marginal Cost Graphically 14

Example 1.10: How Much Should Susan Talk to Hal Each Month? 15

The Invisible Hand 15

Example 1.11: Should I Burn My Leaves or Haul Them into the Woods? 16

Would Parents Want Their Daughter or Son to Marry Homo economicus? 17

The Economic Naturalist 17

ECONOMIC NATURALIST 1.1:Why Is Airline Food So Bad? 18

ECONOMIC NATURALIST 1.2:Why Do Manual Transmissions Have Five Forward Speeds, Automatics Only Four? 19

Positive Questions and Normative Questions 19

Microeconomics and Macroeconomics 19 Summary 20

Questions for Review 20 Problems 20

Answers to In-Chapter Exercises 23 Chapter 2 Supply and Demand 25

Chapter Preview 25

Supply and Demand Curves 26

Equilibrium Quantity and Price 29

Adjustment to Equilibrium 30

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Free Markets and the Poor 32

Example 2.1: Denied Boarding Compensation 32 Example 2.2: Rent Controls 34

Price Supports 36

The Rationing and Allocative Functions of Prices 37

Determinants of Supply and Demand 37

Predicting and Explaining Changes in Price and Quantity 40

ECONOMIC NATURALIST 2.1:Why Do the Prices of Apples Go Down during the Months of Heaviest Consumption While the Prices of Beachfront Cottages Go Up? 40

Example 2.3: How Does a Price Support Program in the Soybean Market Affect the Equilibrium Price and Quantity of Beef? 41

The Algebra of Supply and Demand 41 Summary 42

Answers to In-Chapter Exercises 45

PART 2 The Theory of Consumer Behavior 53 Chapter 3 Rational Consumer Choice 55

The Opportunity Set or Budget Constraint 56

Example 3.1: Quantity Discount Gives Rise to a Kinked Budget Constraint:

Graphing the Budget Constraint for a Consumer’s Electric Power 61 Example 3.2: Budget Constraints Following Theft of Gasoline or Loss of Cash: Should Gowdy Buy More Gas? 62

Consumer Preferences 63

The Best Feasible Bundle 69

Example 3.3: Equilibrium with Perfect Substitutes:

Jolt Cola vs. Coca-Cola 72

An Application of the Rational Choice Model 73

Example 3.4: Is It Better to Give Poor People Cash or Food Stamps? 73 ECONOMIC NATURALIST 3.1:Why Do People Often Give Gifts Instead of Cash? 75 Summary 76

Appendix 3 The Utility Function Approach to the Consumer Budgeting Problem 83 Chapter 4 Individual and Market Demand 95

The Effects of Changes in Price 96

The Effects of Changes in Income 98

The Income and Substitution Effects of a Price Change 100

Example 4.1: Income and Substitution Effects for Perfect Complements:

Skis and Bindings 104

Example 4.2: Income and Substitution Effects for Perfect Substitutes:

Tea and Coffee 105

Consumer Responsiveness to Changes in Price 106

Example 4.3: Deriving Individual Demand Curves for Perfect Complements:

Car Washes and Gasoline 108 xx CONTENTS

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Market Demand: Aggregating Individual Demand Curves 109

Example 4.4: The Market Demand Curve: Beech Saplings in a Vermont Town Example 4.5: The Market Demand Curve: Ten Consumers 111

Price Elasticity of Demand 111

Example 4.6: Price Elasticity of Demand: Should the Transit System Raise or Lower Bus Fares? 118

The Dependence of Market Demand on Income 120

Example 4.7: How Does Income Affect the Market Demand Curve for Food? 120

ECONOMIC NATURALIST 4.1:Why Has the Nature of Outdoor Cooking Appliances Changed Dramatically in Recent Decades? 123

Application: Forecasting Economic Trends 124

Cross-Price Elasticities of Demand 125 Summary 126

Appendix 4 Additional Topics in Demand Theory 133

Chapter 5 Applications of Rational Choice and Demand Theories 139

Using the Rational Choice Model to Answer Policy Questions 140

Application: A Gasoline Tax and Rebate Policy 140

Application: School Vouchers 142

Consumer Surplus 144

Example 5.1: What Is the Loss in Consumer Surplus from an Oil Price Increase? 145

Application: Two-Part Pricing 146

ECONOMIC NATURALIST 5.1:Why Do Some Tennis Clubs Have an Annual Membership Charge in Addition to Their Hourly Court Fees? 146

ECONOMIC NATURALIST 5.2:Why Do Some Amusement Parks Charge Onlya Fixed Admission Fee? 147

Overall Welfare Comparisons 147

Example 5.2: Price Changes: Was Jones Better Off This Year or Last Year? 148

Application: The Welfare Effects of Changes in Housing Prices 149

Application: A Bias in the Consumer Price Index 150

Using Price Elasticity of Demand 153

Application: The MARTA Fare Increase 153

Application: The Price Elasticity of Demand for Alcohol 154

The Intertemporal Choice Method 155

Example 5.3: Will an Increase in the Interest Rate Cause You to Save More? 159

Application: The Permanent Income and Life-Cycle Hypotheses 160 Summary 162

Chapter 6 The Economics of Information and Choice under Uncertainty 169

The Economics of Information 170

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ECONOMIC NATURALIST 6.1:Why Do “Almost New” Used Cars Sell for So Much Less Than Brand New Ones? 175

ECONOMIC NATURALIST 6.2:Why Is Coyness Often an Attractive Attribute? 176 ECONOMIC NATURALIST 6.3:Why Do People in Small Towns Spend Less on Clothes Than People in Big Cities? 178

Choice under Uncertainty 179

Example 6.1: Maximizing Expected Utility: Smith and Gambling 181 Example 6.2: Will You Always Accept a Favorable Bet? 183

Example 6.3: The Lemons Principle: In a Certain Country, What Fraction of Personal Computers Is Defective? 184

Example 6.4: Should Sarah Become a Teacher or an Actress? What Is the Most She Would Pay for Smith’s Evaluation? 185

Example 6.5: Should Smith Sue the Manufacturer? 186

Insuring against Bad Outcomes 187

Application: Always Self-Insure against Small Losses 193 Summary 193

Appendix 6 Search Theory and the Winner’s Curse 199

Chapter 7 Explaining Tastes: The Importance of Altruism and Other Nonegoistic Behavior 211

An Application of the Present-Aim Standard: Altruistic Preferences Example 7.1: A Utility-Maximizing Altruist: Should Smith Give Some of His Wealth to Jones? 214

The Strategic Role of Preferences 214

The Commitment Problem 219

Illustration: The Cheating Problem 220

A Simple Thought Experiment 226

Tastes Not Only Can Differ, They Must Differ 228

ECONOMIC NATURALIST 7.1:Why Do People Vote in Presidential Elections? 228

Application: Predicting Variations in Voter Turnout 229

Application: Concerns about Fairness 229

Example 7.2: Will Hatfield and McCoy Work Together? 231

The Importance of Tastes 232 Summary 233

Chapter 8 Cognitive Limitations and Consumer Behavior 237

Bounded Rationality 238

The Asymmetric Value Function 239

Sunk Costs 242

Out-of-Pocket Costs versus Opportunity Costs 242

Affective Forecasting Errors 243

Choice under Uncertainty 245

Judgmental Heuristics and Biases 247 xxii CONTENTS

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ECONOMIC NATURALIST 8.1:Why Does the Rookie of the Year In Baseball Often Have a Mediocre Second Season? 250

The Psychophysics of Perception 251

The Difficulty of Actually Deciding 252

ECONOMIC NATURALIST 8.2:Why Do Real Estate Agents Show Two Houses That Are Nearly Identical, Even Though One Is Cheaper and in Better Condition? 254

The Self-Control Pitfall 255 Summary 256

PART 3 The Theory of the Firm and Market Structure 261 Chapter 9 Production 263

The Input-Output Relationship, or Production Function 264

Production in the Short Run 266

ECONOMIC NATURALIST 9.1:Why Can’t All the World’s People Be Fed from the Amount of Grain Grown in a Single Flowerpot? 268

Example 9.1: Maximizing Total Output (I): Should the Allocation of Boats of a Fishing Fleet Be Altered? 273

Example 9.2: Maximizing Total Output (II): How Should the Allocation of the Boats of a Fishing Fleet Be Altered? 274

Example 9.3: What Is the Optimal Amount of Time to Spend on Each Exam Question? 275

Production in the Long Run 275

Returns to Scale 278

ECONOMIC NATURALIST 9.2:Why Do Builders Use Prefabricated Frames for Roofs but Not for Walls? 279

Summary 281

Appendix 9 Mathematical Extensions of Production Theory 287 Chapter 10 Costs 297

Costs in the Short Run 298

Example 10.1: Graphing the Total, Variable, and Fixed Cost Curves 301 Example 10.2: Graphing the Average Fixed, Average Variable, Average Total, and Marginal Costs 305

Example 10.3: Graphing the Average Total Cost, Average Variable Cost, Average Fixed Cost, and Marginal Cost Curves 307

Allocating Production between Two Processes 308

Example 10.4: What Is the Least Costly Way to Produce a Total of 32 Units of Output? 309

The Relationship among MP, AP, MC, and AVC 310

Costs in the Long Run 311

ECONOMIC NATURALIST 10.1:Why Is Gravel Made by Hand in Nepal but by Machine in the United States? 314

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ECONOMIC NATURALIST 10.2:Why Do Unions Support Minimum Wage Laws So Strongly? 315

ECONOMIC NATURALIST 10.3:Why Would a Bathroom Equipment Manager Bake the Image of a Housefly onto the Center of Its Ceramic Urinals? 316

Long-Run Costs and the Structure of Industry 319

The Relationship between Long-Run and Short-Run Cost Curves 321 Summary 322

Appendix 10 Mathematical Extensions of the Theory of Costs 327 Chapter 11 Perfect Competition 333

The Goal of Profit Maximization 334

Example 11.1: Should the Owner of Valdosta, Georgia’s, Miniature Golf Course Move the Operation to Manhattan? 335

The Four Conditions for Perfect Competition 337

The Short-Run Condition for Profit Maximization 339

The Short-Run Competitive Industry Supply 343

Example 11.2: What Is the Industry Supply Curve for an Industry with 200 Firms? 344

Short-Run Competitive Equilibrium 344

The Efficiency of Short-Run Competitive Equilibrium 346

Producer Surplus 347

Example 11.3: Should the Legislature Ban Fireworks? 349

Adjustments in the Long Run 350

The Invisible Hand 353

Application: The Cost of Extraordinary Inputs 354

The Long-Run Competitive Industry Supply Curve 356

ECONOMIC NATURALIST 11.1:Why Do Color Photographs Cost Less Than Black- and-White Photographs? 359

The Elasticity of Supply 360

Applying the Competitive Model 361

ECONOMIC NATURALIST 11.2:Why Did 18-Wheel Cargo Trucks Suddenly Begin Using Airfoils in the Mid-1970s? 365

Summary 366

Answers to In-Chapter Exercises 369 Chapter 12 Monopoly 371

Defining Monopoly 372

Five Sources of Monopoly 373

The Profit-Maximizing Monopolist 377

Example 12.1: Finding a Marginal Revenue Curve for a Given Demand Curve 383

Example 12.2: What Is a Monopolist’s Profit-Maximizing Price, and How Much Economic Profit Is Earned? 385

A Monopolist Has No Supply Curve 388

Adjustments in the Long Run 389 xxiv CONTENTS

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Price Discrimination 389

Example 12.3: Finding and Graphing the Monopolist’s Quantity and Price in the Home Market 390

ECONOMIC NATURALIST 12.1:Why Do Some Doctors and Lawyers Offer Discounts to People with Low Incomes? 392

ECONOMIC NATURALIST 12.2:Why Do Theater Owners Offer Student Discounts on Admission Tickets but Not on Popcorn? 392

The Efficiency Loss from Monopoly 397

Public Policy toward Natural Monopoly 398

Example 12.4: Will the Monopolist Introduce a New Lightbulb That Lasts 10,000 Hours? 406

Summary 407

Chapter 13 Imperfect Competition: A Game-Theoretic Approach 413

An Introduction to the Theory of Games 414

ECONOMIC NATURALIST 13.1:Why Do Cigarette Companies Advertise

“Too Much”? 417

ECONOMIC NATURALIST 13.2:Why Might a Company Make an Investment It Knew It Would Never Use? 424

ECONOMIC NATURALIST 13.3:Why Would a Firm Build a Factory with More Capacity Than It Would Ever Need? 426

Some Specific Oligopoly Models 426

Example 13.1: Deriving the Reaction Functions for Cournot Duopolists 429 Example 13.2: Finding the Equilibrium Price and Quantity for Bertrand Duopolists 430

Example 13.3: Finding the Equilibrium Price and Quantity for a Stackelberg Leader and Follower 431

Competition When There Are Increasing Returns to Scale 433

Chamberlin Model of Monopolistic Competition 435

A Spatial Interpretation of Monopolistic Competition 440

ECONOMIC NATURALIST 13.4:Why Are There Fewer Grocery Stores in Cities Than There Were in 1930? Why Do Neighborhoods in Manhattan Have More Grocery Stores Than Neighborhoods in Los Angeles? 445

Historical Note: Hotelling’s Hot Dog Vendors 449

Consumer Preferences and Advertising 450 Summary 452

PART 4 Factor Markets 457 Chapter 14 Labor 459

The Perfectly Competitive Firm’s Short-Run Demand for Labor 460

The Perfectly Competitive Firm’s Long-Run Demand for Labor 462

The Market Demand Curve for Labor 462

An Imperfect Competitor’s Demand for Labor 463

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The Supply of Labor 464

Example 14.1: The Labor Supply Curve for Someone with a Target Level of Income 466

ECONOMIC NATURALIST 14.1:Why Is It So Hard to Find a Taxi on Rainy Days? 467 Example 14.2: The Optimal Leisure Demand for Someone Who Views Income and Leisure as Perfect Complements 467

Is Leisure a Giffen Good? 469

The Noneconomist’s Reaction to the Labor Supply Model 469

The Market Supply Curve 470

Example 14.3: How Do Rising MBA Enrollments Affect the Salaries and Employment of Economists in Liberal Arts Colleges? 470

Monopsony 472

Minimum Wage Laws 476

Labor Unions 478

Discrimination in the Labor Market 480

Statistical Discrimination 482

The Internal Wage Structure 485

Winner-Take-All Markets 488 Summary 489

Appendix 14 The Economics of Workplace Safety 497 Chapter 15 Capital 505

Financial Capital and Real Capital 506

The Demand for Real Capital 506

The Relationship between the Rental Rate and the Interest Rate 507

The Criterion for Buying a Capital Good 508

Interest Rate Determination 508

Real versus Nominal Interest Rates 510

The Market for Stocks and Bonds 510

ECONOMIC NATURALIST 15.1:Why Is Owning Stock in a Monopoly No Better Than Owning Stock in a Perfectly Competitive Firm? 514

The Anomaly of the Investment Newsletter 514

Tax Policy and the Capital Market 516

Economic Rent 517

Peak-Load Pricing 518

Exhaustible Resources as Inputs in Production 519 Summary 521

Appendix 15 A More Detailed Look at Exhaustible Resource Allocation 525

PART 5 Externailities, Public Goods, and Welfare 533 Chapter 16 Externalities, Property Rights, and the Coase Theorem 535

The Reciprocal Nature of Externalities 536 xxvi CONTENTS

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