Basic Microeconomics

Adapted from the original work by Professor R. Larry Reynolds, PhD Boise State University Publication date: ay !"##

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2004-2007 Editions asic -icroeconomics (http.//www&boisestate&edu/econ/lreynol/web/-icro&htm) by $rofessor %& 'arry %eynolds, oise State 0niversity& %eleased under Creative Commons license (CC- !) #pril 1212 by %& 'arry %eynolds& 2011 Editions (http !!opencolle"etextbooks#or") )extbook *+uity publishes this soft cover version using a CC- !-"C-S# license& "o content changes were made to original version& )extbook *+uity added a table of contents and index& 3ersions available at the 4pen College )extbook repository. PDF Version, (Chapters 1 15), 301 pages, Free Download Textboo !"#it$ Paperba% , (Chapters 1 15), 301 pages, &ist Pri%e '3()*5

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Table of Contents
1 Introduction to Microeconomics.......................................................8 1)1 !%ono+i%s as a ,t#d$ o- Pro.isioning))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))* 1)/ !%ono+i%s as a ,t#d$ o- the 0llo%ation o- ,%ar%e 1eso#r%es))))))))))))))))))))))))10 1)3 ,o%ial ,%ien%e and !%ono+i%s))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))10 1)3)1 1ole o- 2ndi.id#al in the Co++#nit$)))))))))))))))))))))))))))))))))))))))))))))))))))))))11 1)3)/ Cooperation, Co+petition and Cons%ription))))))))))))))))))))))))))))))))))))))))))1/ 1)3)3 The 3at#re o- an !%ono+i% ,$ste+ and Pro%esses within a ,$ste+)))))1( 1)3)( ,o%ial 2ntera%tion and Te%hnolog$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))15 1)( The Proble+ o- Pro.isioning))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))14 1)()1 ,o%ial 2ntera%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))15 1)()/ !%ono+i% 0%ti.ities))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/1 2 The Problem of Provisioning...........................................................25 /)1 2ntrod#%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/5 /)/ ,o%ial 2ntera%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/4 /)3 ,pe%iali6ation))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/4 /)( Di.ision o- &abor))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/7 /)5 Coordination o- !--orts)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/* /)4 !%ono+i% 0%ti.ities))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))30 /)4)1 Prod#%tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))30 /)4)/ Distrib#tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))31 /)4)3 Cons#+ption)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))3/ /)4)( Coordination, Co+petition and Cooperation))))))))))))))))))))))))))))))))))))))))33 /)5 Te%hnolog$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))3( /)7 !%ono+i% De%isions))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))35 /)7)1 1#les ))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))35 /)7)/ 2nt#ition))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))37 /)7)3 1eason and 1ational 8eha.ior)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))37 /)7)( 2n-or+ation)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))37 /)7)5 1ationalit$ and 2n-or+ation))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))(0 3 Introduction to Wa s of !no"ing....................................................#1 3)1 Fa%ts, 2n-or+ation, 9nowledge and :isdo+))))))))))))))))))))))))))))))))))))))))))))))))(/ 3)/ ;$potheses, Theories, &aws and <odels)))))))))))))))))))))))))))))))))))))))))))))))))))))))(3 3)3 Fo#ndations o- =,%ien%e>))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))(5

3)( !xplanation, Predi%tion and ,tor$telling )))))))))))))))))))))))))))))))))))))))))))))))))))))50 3)5 &ogi%)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))51 3)5)1 Ded#%ti.e 1easoning)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))5/ 3)5)/ 2nd#%ti.e 1easoning))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))5/ 3)5)3 0bd#%ti.e 1easoning)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))53 3)4 !piste+olog$ and !%ono+i% <ethodolog$)))))))))))))))))))))))))))))))))))))))))))))))))))53 3)4)1 0 Taxono+$ o- 9nowledge))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))5( 3)4)/ 8rie- ,#r.e$ o- !piste+olog$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))54 3)4)3 <ilton Fried+an)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))5* 3)4)( Deirdre <%Clos e$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))40 3)5 :hi%h <ethodolog$ is =Corre%t?>))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))43 3)7 The ,tandard View o- the ,%ienti-i% <ethod)))))))))))))))))))))))))))))))))))))))))))))))))4( # Individuals and $ommunit ............................................................%5 ()1 2nstit#tions))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))44 ()/ 2nstit#tions and Costs))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))47 ()3 <oralit$, @#sti%e and a ,table ,o%iet$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))51 ()( 0gents))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))5( ()5 Argani6ations and 0gents)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))54 ()4 AbBe%ti.es))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))55 ()5 !%ono+i% obBe%ti.es))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))5* 5 $riteria for &valuation.....................................................................81 5)1 Criteria to !.al#ate !nds and <eans)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))7/ 5)/ !thi%s)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))7/ 5)3 !--i%ien%$ ))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))75 5)3)1 Te%hni%al !--i%ien%$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))75 5)3)/ Prod#%tion Possibilities F#n%tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))75 5)3)3 Pareto !--i%ien%$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))*4 5)3)( ,o+e pra%ti%al ethi%s)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))103 5)3)5 !--i%ien%$ and ethi%s (againC)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))10( % Introduction to the 'ules of the (ame and &conomics ) stems....1*% 4)1 !%ono+i% ,$ste+s)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))104 4)1)1 Traditional !%ono+ies)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))105 4)1)/ Co++and !%ono+ies))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))110 4)1)3 <ar et)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))113 4)1)( 1ole o- Do.ern+ent)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))114 4)1)5 Propert$ 1ights)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))115

4)1)4 Do+esti% @#sti%e)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))115 4)1)5 3ational De-ense)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))115 4)1)7 Pro.ision o- %olle%ti.e or p#bli% goods )))))))))))))))))))))))))))))))))))))))))))))))))117 4)1)* Pro+ote Co+petition)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))11* 4)1)10 ,a-et$ 3et)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))1/0 4)/ Propert$ 1ights)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))1/0 4)/)1 Propert$ 1ights 0nd <ar ets))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))1// 4)/)/ 2ss#es 2n Propert$ 1ights))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))1/4 + &conomic Wa of Thin,ing.............................................................13* 5)1 <ar et !x%hange as an 0llo%ati.e <e%hanis+))))))))))))))))))))))))))))))))))))))))))))130 5)1)1 Vol#ntar$ !x%hange))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))13/ 5)1)/ !%ono+i% :a$ o- Thin ing))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))135 8 -emand and )u..l in a Mar,et ) stem........................................1#/ 7)1 De+and F#n%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))1(* 7)1)1 2ndi.id#al De+and F#n%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))150 7)1)/ <ar et De+and F#n%tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))151 7)1)3 Change in E#antit$ De+and ))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))153 7)1)( Change in De+and)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))15( 7)1)5 2n-erior, 3or+al and ,#perior Doods)))))))))))))))))))))))))))))))))))))))))))))))))))155 7)1)4 Co+pli+ents and ,#bstit#tes)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))154 7)1)5 !xpe%tations)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))155 7)/ ,#ppl$ F#n%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))155 7)3 !"#ilibri#+)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))140 7)3)1 <ar et 0dB#st+ent to Change))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))143 7)3)/ ,hi-ts or Changes in De+and))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))143 7)3)3 !"#ilibri#+ and the <ar et)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))145 / -emand and $onsumer 0ehavior..................................................1%8 *)1 Cons#+er Choi%e and Ftilit$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))147 *)1)1 Ftilit$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))147 *)1)/ 2ndi.id#alGs de+and -#n%tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))170 *)1)3 <ar et De+and )))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))171 *)1)( Cons#+er ,#rpl#s)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))17/ *)1)5 Prod#%er ,#rpl#s)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))17/ *)1)4 !lasti%it$ ))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))173 1* Production and $ost.....................................................................1// 10)1 Prod#%tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))1** 10)1)1 (1) Prod#%tion Fnit))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/01

10)1)/ (/) Prod#%tion F#n%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/0/ 10)1)3 (3) Ti+e and Prod#%tion))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/03 10)1)( (() Prod#%tion in the ,hortH1#n )))))))))))))))))))))))))))))))))))))))))))))))))))))))/0( 10)1)5 Cost))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/0* 10)1)4 Costs and Prod#%tion in the ,hortH1#n))))))))))))))))))))))))))))))))))))))))))))))/10 10)1)5 Draphi%al 1epresentations o- Prod#%tion and Cost 1elationships)))))/11 10)1)7 1elationship o- <C and 0VC to <P& and 0P&)))))))))))))))))))))))))))))))))))/15 10)1)* Prod#%tion and Cost Tables)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/15 10)1)10 Prod#%tion and Cost in the &ongHr#n)))))))))))))))))))))))))))))))))))))))))))))))//0 11 1.timi2ation and Mar,ets ...........................................................22% 11)1 AbBe%ti.e, %onstraints and alternati.es)))))))))))))))))))))))))))))))))))))))))))))))))))))))//4 11)/ Criteria to e.al#ate alternati.es))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))//5 11)/)1 <arginal 0nal$sis)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/3/ 11)/)/ <ar et !x%hange and !--i%ien%$ ))))))))))))))))))))))))))))))))))))))))))))))))))))))))/34 11)/)3 Pri%es as 2n-or+ation)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/35 12 Pure $om.etition.........................................................................23/ 1/)1 <ar et ,tr#%t#re)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/3* 1/)1)1 Chara%teristi%s o- P#re Co+petition))))))))))))))))))))))))))))))))))))))))))))))))))))/(1 1/)/ The Fir+ in P#re Co+petition))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/(1 1/)/)1 Pro-it <axi+i6ation in the ,hort 1#n)))))))))))))))))))))))))))))))))))))))))))))))))/(3 1/)/)/ Pro-its in &ong 1#n P#re Co+petition)))))))))))))))))))))))))))))))))))))))))))))))/(7 13 Firms With 3Mar,et Po"er4 ........................................................253 13)1 <onopol$ ))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/55 13)1)1 Pro-it <axi+i6ation 2n a <onopol$)))))))))))))))))))))))))))))))))))))))))))))))))))))/55 13)1)/ 2+per-e%t Co+petition and <onopolisti% Co+petition)))))))))))))))))))))/5* 13)1)3 De+and Fa%ed b$ <onopolisti%all$ (2+per-e%tl$) Co+petiti.e Fir+ )))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/40 13)1)( Pro-it <axi+i6ation in 2+per-e%t or <onopolisti% Co+petition)))))))/41 13)/ Aligopol$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/43 13)/)1 9in ed De+and <odel))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/4( 13)/)/ Per-or+an%e))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/44 1# Mar,ets for In.uts and -istribution of Income...........................2%8 1()1 0) The De+and -or 2np#ts))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/50 1()1)1 ,#ppl$ o- 2np#ts)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/5( 1()1)/ <ar et -or 2np#ts)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/55 1()1)3 2n%o+e Distrib#tion)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/54 15 Pro.ert 'ights and Mar,ets........................................................281 8

15)1 Pri.ate Propert$ 1ights)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/71 15)/ Trans-erabilit$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/7/ 15)3 !n-or%eabilit$))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/7/ 15)( !x%l#si.it$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/73 15)5 =<ar et Fail#re> and Propert$ 1ights)))))))))))))))))))))))))))))))))))))))))))))))))))))))/7( 15)5)1 !xternalities)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/7( 15)5)/ P#bli% or Colle%ti.e Doods))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/74 15)5)3 Co++on Propert$)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))/74 1% 'eferences...................................................................................288

1 Introduction to Microeconomics

1 $%T&'()*T$'%

T'

+$*&'E*'%'+$*,

Archeological

and written records of human existence suggest that

obtaining the material means to satisfy wants has been a perpetual problem& :ood and shelter are re+uirements of human life& 4ther goods satisfy a range of human desires and give pleasure or utility to individuals& )he study of ways that humans deal with these problems of provisioning is called ;economics&< )he evolution of processes to solve the provisioning problem takes place in a social context& #s a result, the economy is a subsystem and is interrelated with a variety of other social subsystems& )hese subsystems include (but are not limited to) economic, political, religious, social, geographic, demographic, legal, and moral systems& )he psychology of individuals is also fundamental to the social system& :rom the time of the =reeks (e&g& >enophon ?652-577 C*@, $lato ?619-569 C*@ and #ristotle ?5A6-511 C*@) through the Classical economists (e&g& #dam Smith ?1915-19B1@, )homas -althus ?1988-1A56@ and Cavid %icardo ?1991-1A15@), economics was treated as part of philosophy, religion and/or moral philosophy& Curing the 1Bth century, social science emerged and separate disciplines were carved out& *conomics, psychology, sociology, politics, anthropology and other branches of social science developed as separate fields of study& Dn the last part of the 1B th century, ;political economy< became ;economics&< Since that time, economics has been fre+uently defined as ;the study of how scarce resources are allocated to satisfy unlimited wants&< #s a professional discipline, economics is often regarded as a decision science that seeks optimal solutions to technical allocation problems& Dn this text, economics is presented from two perspectives& :irst, the process of provisioning will be

1 Introduction to Microeconomics

presented& )he second perspective is the technical analysis of the processes by which scarce resources are allocated for competing ends&

1.1 ECONOMICS

AS A

STUDY

OF

PROVISIONING

Provisioning treats economics as a social science& *conomics as a study

of provisioning includes the historical and philosophical foundations and context of economic behavior& )he tradeoffs between the economic and noneconomic goals are considered& )he interrelationships of economic life with Eustice, ethics, morality, creativity, security and aesthetic values are of concern& Fuman societies have attempted a broad array of alternative systems to deal with the problem of provisioning& Some have been more successful and other less so& Some systems have lasted for thousands of years with few changes& 4ther systems have come and gone +uickly& Dn some cases environmental problems have cause the demise of societies& Dn other cases, the societies ended abruptly with social revolution& Dn other cases, the societies adapted to changing circumstances and evolved over time& -ayan, *gyptian, %oman, Dncan are only a few of the societies that have come and gone& #rcheological studies continually find evidence of societies that flourished and ultimately failed& Dn some cases they were destroyed from outside forces. the Spanish ended the #,tec and Dncan societies& Dn other cases, the causes were environmental. there is a hypothesis a drought is responsible for a dramatic change in the -ayan society& *conomics as a study of provisioning is concerned with the relationships among individuals, between individuals and the community, and between individuals, society and natural and built environments& "atural environment refers to the geographic (cultural and physical) and meteorological and phenomena& )he built environment consists of the infrastructure

1.1 Economics as a Study of Provisioning

knowledge that a society has inherited and created& Dt should be noted that humans have the capacity to alter their natural environment in both positive and negative ways&

1.2 ECONOMICS RESOURCES

AS A

STUDY

OF T E

A!!OCATION

OF

SCARCE

-rom a technical perspective,

economics is the study of how various

alternatives or choices are evaluated to best achieve a given obEective& )he domain of economics is the study of processes by which scarce resources are allocated to satisfy unlimited wants& Ddeally, the resources are allocated to their highest valued uses& Supply, demand, preferences, costs, benefits, production relationships and exchange are tools that are used to describe the market processes by which individuals allocate scarce resources to satisfy as many wants as possible& )his increasingly narrow focus is the domain of modern, ;neoclassical,< microeconomic analysis& This introductor. chapter is intended to introduce so/e o0 the 0unda/ental issues in the stud. o0 econo/ics#

1." SOCIA! SCIENCE

AND

ECONOMICS

There is substantial evidence and general agreement that humans live in

social groups& )he Gestern tradition, as framed by the =reeks and the Hudeo/Christian tradition, holds that humans are social animals& $lato ?619-569 C*@ and #ristotle ?5A6-511 C*@ offer explanations of the

rise of the city-state& Dn The Repu !ic, $lato sees the origins of the city-state in the +uest for Eustice& $lato describes a conversation between Socrates and a group of students& )hey are pondering the nature of Eustice& )hey conclude that Eustice is each person doing that which they are best suited to do& )he

12

1." Socia! Science and Economics

person best suited to be a baker should be a baker. the person best suited to be a shepherd should be a shepherd& 4nce individuals speciali,e, the city-state arises to facilitate the interactions among the individuals& ?The Repu !ic, DD@ Dn Po!itics, $lato(s student, #ristotle, sees an organic composition of society& )he state becomes a natural community that is treated as an organism& )here is a natural progression from family to village to the citystate& )he city-state is then ;prior to the family and individual&< ?The Po!itics, ook D, Chapter B@ Ghile $lato and #ristotle take different approaches, both see economic behavior as an integral part of society& $lato(s focus is on Eustice and #ristotle(s is on the ;good life&< 4ne of the fundamental problems that both identify is the nature of the proper relationship between the individual and society& ook

1#1#1 &'2E

'-

$%($3$()A2

$% T4E

*'++)%$T5

$n economics (and social sciences more generally), the nature of the role
of the individual in the community or state has been a persistent +uestion& *very society must address the +uestion (either implicitly or explicitly), ;Fow can the autonomy (or freedom or liberty) of an individual be maintained and at the same time provide for the commonweal (social welfare)I< Dn some societies, the individual is regarded as more important than the community& Dn other societies, the community has priority over the individual& :rom a practical perspective, the problem is to balance the rights and freedom of the individual with the functions of the community&

11

1.".1 Ro!e of Individua! in the #ommunity

)here are several perspectives about the most appropriate ways to achieve that balance& Ghile dealing with this balance, the allocation or provisioning problem must be resolved&

1#1#2 *''PE&AT$'%6 *'+PET$T$'%

A%(

*'%,*&$PT$'%

$deally, each individual is free to make choices that are consistent with
their desires (preferences, values) and at the same time, these choices are consistent with the commonweal& Competition, cooperation and conscription may be used to coordinate individual actions& Cifferent societies have attempted different approaches at different times&

1#1#2#1 *''PE&AT$'%

A%( *'%,*&$PT$'%

*ooperation implies voluntary agreements and a coordinated approach to

the solution of a problem& Conscription implies a non-voluntary or forced behavioral choice in the allocation process& #n economic input (labor, capital, land) or good can be conscripted& Conscription implies the ability of one person or group to force another to make choices they would not prefer& Cooperation and coercion are opposite ends of a spectrum or range of behavioral patterns& )he degree to which a choice is voluntary or forced is not always clear& # group of Dnuits above the #rctic Circle may use cooperation as an important element of the coordination process& ;Cooperation< may be encouraged by strongly held common values or necessity& *ach member of the society understands that their chance for survival is reduced if she or he is not a member of the community& # behavior that is not sanctioned by be community (e&g& theft, murder, etc) may be result in the individual being ostraci,ed and expelled from the community, the result being death& Ds the acceptance of group values and activities voluntary or coercedI Df a

11

1.".$ #ooperation% #ompetition and #onscription

government (a formal social institution for allocating power and decision making authority in a community) uses sanctions to force behavior or choice it is clearly coercion or conscription& Df D threaten harm if you do not make a given choice or act in a specific way, that is coercion& Df a person(s mother says, ;!our go ahead but it will break my heartJ< is that coercionI 3oluntary cooperation and coerced conscription lie at opposite ends of a continuum& Dt is a variation of the arguments about whether individuals have free will& )he shift from voluntary coordinated behavior (cooperation) to coerced coordinated behavior (conscription) is a matter of degrees& Dn both cases, individuals have an incentive to coordinate their behavior& Dn the case of coercion, the incentive is the costs created and imposed by other individuals or groups of individuals& # student in high school may feel coerced by their peers, the class bully or the rules of the system& # worker may be coerced by other workers, the management of the firm or government regulations&

1#1#2#2 *'+PET$T$'%

+arket oriented societies focus on the use of competition to constrain

individual behavior& Dn Gestern industrial societies, competition is regarded as the optimal way to coordinate economic behavior& # market exchange is a contract between a seller and a buyer& )he seller competes to get the highest possible price (or best deal), while the buyer competes to by at the lowest possible price& )he competition between the buyer and seller is influenced by the tastes (or preferences) of buyer and seller, information that each has and alternatives that each has& )he word ;competition< has at least two meanings in economics& 4ne is to refer to rivalry& Dn rivalry, there is a winner and a loser& )he other is a structural notion of ;pure< competition where the sellers do not see

15

1.".$ #ooperation% #ompetition and #onscription

themselves as rivals (farmers are often thought of as being engaged in highly competitive markets but do not see themselves as rivals&) =enerally, societies use a mix of cooperation and competition& # firm is a form of cooperation& Dn 1B59, %onald Coase published an explanation of why business firms exist in a market economy (Coase, pp 55-77) Df a competitive market economy were the optimal way of allocating resources, why would firms be desiredI Coase argues that there are costs of using a market& Fe calls these costs ;transaction cost&< )here are also costs of creating and operating an organi,ation& Df the transaction costs exceed the cost of organi,ing a cooperative endeavor, a firm will be created to avoid the use of market transactions&

1#1#1 T4E %AT)&E ,5,TE+

'- A%

E*'%'+$* ,5,TE+

A%(

P&'*E,,E,

7$T4$% A

The study of economics can be approached at different levels& #t one

level economics is the study of how the economic provisioning, or economic systems, come into being and evolve over time& #t another level, economics studies the structure and ways in which a particular system deals with the allocation or provisioning problem& )he study of the structure and evolution of economic systems typically is interdisciplinary& Dt may use a good deal of history, psychology, sociology, law and philosophy in its analysis of the social process of provisioning& Ghen economics is the study of a particular system, it tends to be narrower and focus is on specific processes& Dn the Gestern industrial societies, the current focus is on market oriented economic processes and is referred to as ;"eoclassical< microeconomics or ;price theory&< Dts focus is on the

16

1."." The &ature of an Economic System and Processes 'ithin a System

competitive behavior of individuals and exchange transactions in a market context&

1#1#4 ,'*$A2 $%TE&A*T$'%

A%(

TE*4%'2'85

4umans have sought to solve the problem of provisioning through social

interaction and the use of technology& Social interaction is used to refer to the relationships between two or more individuals& Dn this context, an ;individual< has the ability to make a decision and carry that decision out& Dn legal terms, this individual is called an ;agent&< (4ne of the important concepts in law and economics is the relationship between a principal and an agent& )his concept will be addressed in more detail later in the text&) #n agreement between two individuals or agents is a contract& )he agreement may be influenced by social institutions as well as the preferences and values of the individuals& # social institution is a habitual pattern of behavior that is embedded in a social system& -arriage is an example of a social institution& Dt is a contract between two people& )he form of that contract is influenced by commonly held social values and laws of a society& #lmost all societies have some form of marriage& -arriage is a social creation that provides a solution to the problem of rearing children& #s a social institution, it may change over time as social values, technology, work and environment change& )hese institutions may vary from place to place& -oney, law (or the legal system), property rights and markets are examples of economic institutions& Dnstitutions simultaneously facilitate and constrain human activities& )echnology is the knowledge about the individuals( relationships with the natural and built environments& )his knowledge can be used to alter elements

17

1.".( Socia! Interaction and Techno!ogy

in the environments to satisfy human wants& )echnology involves knowledge about alternative ways of solving the problem of provisioning&

1.# T

PRO$!EM

OF

PROVISIONING

,ociety is confronted with a finite set of resources and a given state of

technology at any given point in time& #s a result, there is a finite amount of goods and services that can be produced in that time frame& =iven human desires and need for food, clothing and shelter, it is not always possible to produce everything that every one would like to have& Ghen individuals want more than can be produced they have the economic problem of scarcity& )he problem of scarcity might be resolved by reducing individuals wants or by increasing the output of goods and services& Df the solution is to reduce wants, which wants should be eliminated and which should be retained to be satisfiedI )he individual would necessarily be re+uired to make a choice& Df the solution was to produce more goods, which goods should be produced and how are they to be producedI #gain, the individual must make choices& Dn modern, neoclassical, economic analysis (we will call this ;orthodox< economics), the problem is structured so the wants are taken as given and the problem is to produce the goods that satisfy the greatest wants& Scarcity re+uires that the individual or agent make choices& #n individual in isolation (Cefoe(s %obinson Crusoe before :riday) would have to make choices since time and resources are limited& Dt would be necessary to choose whether time was to be spent catching fish, gathering coconuts, reading or building shelter& Df the choice were to catch fish, he/she would have to choose between making a net, a fishing pole or trying to catch fish by hand& )he choice to spend an hour fishing implies that that hour cannot be used to gather coconuts& )he sacrifice of coconuts is called ;opportunity cost&<

18

1.( The Pro !em of Provisioning

*ven %obinson Crusoe(s world of isolation did not last long& Ghen :riday came to the island, it became necessary to decide who did what and who got what& Dt is necessary to coordinate the preferences and activities of Crusoe and :riday& Since the story of %obinson Crusoe was written by an *nglishman, Caniel Cefoe (187B-1951), Crusoe is dominant and he has a greater influence on the decisions than :riday& Dn 191B, the perspective of an *nglish writer was that aboriginals of various lands were subordinate& Still, it is necessary to coordinate their activities&

1#4#1 ,'*$A2 $%TE&A*T$'%

$n a society, the behavior of the individuals must be coordinated through

social interaction& )his social interaction takes many forms ranging from cooperation to competition& Dn the process of resolving the allocation problem through social interaction, a set of institutions, organi,ations, beliefs, principles, perspectives and commonly held values are created& Society, guided by these values, perceptions and beliefs and constrained by institutions, technology and resource endowment, must solve the problem of provisioning& )he specific uses of goods and resources must be determined& )hese choices involve which resources to use, which goods to produce, who will bear the costs and who will benefit& )he basic problem is the coordination of the choices and behavior of individuals& :inding a way to protect the autonomy of the individual while coordinating their behavior to provide for the commonweal has been an important goal of most great writers on social topics&

19

1.(.1 Socia! Interaction

1#4#1#1 ,PE*$A2$9AT$'%

,peciali,ation and the division of labor are two important forms of social
interaction that allow two or more individuals to do what an isolated individual cannot do& oth are means to increase the production of goods and services& Speciali,ation is the case where an individual (firm, organi,ation or country) focuses on the production of a specific good (or group of goods)& Dt can increase the amount of goods that can be produced& Dt also re+uires some form of social institution to coordinate the process& Df one individual produces food and the other clothing, the two individuals must interact if both are to have food and clothing& )his interaction may be facilitated through an institution such as the market or a transfer based on kinship, marriage, religion or government authority& $lato suggests that the city-state is a social construct that is used to facilitate speciali,ation and to improve the welfare of the members of that state&

$n

The Repu !ic, $lato ?619-569

&C&@ suggests speciali,ation as an

explanation of the origins of the city-state& $lato describes a conversation between Socrates and a group of students& )hey are pondering the nature of Eustice& )hey conclude that Eustice is each person doing that which they are best suited to do& )he person best suited to be a baker should be a baker. the person best suited to be a shepherd should be a shepherd& 4nce individuals speciali,e, the city-state arises to facilitate the transfer of goods and the necessary interactions among the individuals& ? The Repu !ic, ook DD@

$lato tries to identify the characteristics of the ideal society& 4ne of the focal points is Eustice that is achieved by ;each person doing what they are best suited to do&< Social interaction is re+uired because each person depends on the other members of the community& Fe devises a meritocracy that is lead

1A

1.(.1 Socia! Interaction

by philosopher kings& )o prevent nepotism and greed from influencing these philosopher kings, $lato does not allow the philosopher kings to hold private property rights, all of their property is held in common&

1#4#1#2 ($3$,$'%

'-

2A:'&

The division of labor is another form of social interaction that allows

individuals to do what the isolated person cannot& Dn the division of labor, the production of a good is broken down into individual steps& 4ne person then performs one step in the process& "o single person produces the good alone& )he actions of each individual in the production process must be coordinated& Dn modern industrial societies, production often takes place in a business firm& ;-anagement< is regarded as the process of coordinating the activities of the individuals within the production process& # specific application of microeconomics to the process of production within a firm is called ;managerial economics&< #dam Smith ?1915-19B2@ in the )ea!th of &ations proposes that the division of labor is one of the maEor elements that contribute to economic growth (the increased ability to produce goods and services) ? The )ea!th of &ations, page 1@& )he division of labor is the process of dividing a task (work) into its component parts& Smith argues that the division of labor increases production through improved dexterity, saving time in moving from one task to another and improvements in tools& Smith cautions about the effects of unrestrained use of the division of labor,
In the progress of the division of !a or% the emp!oyment of the far greater part of those 'ho !ive y !a or% that is% of the great ody of the peop!e% comes to e confined to a fe' very simp!e operations% fre*uent!y to one or t'o. But the understandings of the greater part of men are necessari!y formed y their ordinary emp!oyments. The man 'hose

1B

1.(.1 Socia! Interaction

'ho!e !ife is spent in performing a fe' simp!e operations% of 'hich the effects too are% perhaps% a!'ays the same% or very near!y the same% has no occasion to e+ert his understanding% or to e+ercise his invention in finding out e+pedients for removing difficu!ties 'hich never occur. ,e natura!!y !oses% therefore% the ha it of such e+ertion% and genera!!y ecomes as stupid and ignorant as it is possi !e for a human creature to ecome-.But in every improved and civi!i.ed society this is the state into 'hich the !a oring poor% that is the great ody of the peop!e must necessari!y fa!!% un!ess government ta/es some pains to prevent it.

?Smith, )ea!th of &ations, p 956-957@ Smith, a professor of moral philosophy, constructed a system to explain a set of forces that would guide social and economic behavior& Dn The Theory of Mora! Sentiments ?197B@ he showed the need for Eustice and a system of morality& Dn 0n In*uiry into the &ature and #auses of the )ea!th of &ations ?1998@ he describes the role of self-interest and markets& Dn a third book that was destroyed at his re+uest at the time of his death, he describes the need for a system of Eurisprudence& )wo sets of students( notes have been used to show these basic arguments in 1ectures on 2urisprudence ?1981-85 and 1988 published in 1B9A@& Smith describes a social system that re+uires morality, markets and Eurisprudence to guide and constrain individual action in a social context&

1#4#1#1 *''&($%AT$'%

'-

E--'&T,

'nce humans use the division of labor and speciali,ation, it is necessary

for them to coordinate their efforts& )hey must interact on a variety of levels& Society is a complex set of interactions among groups and individuals& )hese interactions give rise to social institutions& )he study of these interactions and institutions is ;socia! science&< Fuman interaction can be studied from a variety of perspectives& Sociology, political science, law, history, psychology, religion, anthropology and economics are examples of social sciences& )hese are often studied as separate disciplines& Fowever, we should remain aware

12

1.(.1 Socia! Interaction

they are all interrelated perceptions of human behavior& Ghile economics speciali,es in the study of the processes that coordinate human behavior as it allocates scarce resources to satisfy unlimited wants, its relationship to other social sciences should not be overlooked&

1#4#2 E*'%'+$* A*T$3$T$E,

;ohn

Stuart -ill ?1A28-1A95@ divided economic activities into three

categories. production, distribution and exchange& Dt may be helpful to think of an economic system as a process that begins with a set of inputs (or resources) that are used for production that must be distributed for ultimate consumption& (-ill, Princip!es of Po!itica! Economy, )he Colonial $ress, 1B22) Dn :igure D&1, the economy is shown as a process of altering a set of inputs to satisfy individual wants& Dn this example, the steps in the economic process are production, distribution and consumption&

,np!t or Reso!rces ,-and, labour,

capital and entrepreneurial ability or energy, matter, time and tech.

*onsu/ption
Prod!ction (istribution or Allocation
'he ability of goods and services to satisfy wants is called )utility*+

:igure D&1

1#4#2#1 P&'()*T$'%

Production is the process of altering inputs to increase their ability to

satisfy human wants& Dnputs are sometime called ;factors of production< or resources& )ypically, economists will categori,e inputs as land, labor and capital& Superficially, labor is defined as human effort used to produce goods that satisfy human wants& #n input that is a ;gift of nature< is referred to as

11

1.(.$ Economic 0ctivities

;land&< Capital is usually considered as an input that is produced by labor but is used for the further production of goods and services& *ntrepreneurial ability was the last category of inputs to be added as a factor of production in market oriented economies& Dt is usually associated with the process of creating and innovating of new processes& )he taxonomy of inputs, its relation social structure and the nature of economics will be considered more carefully later in the text&

1#4#2#2 ($,T&$:)T$'%

(istribution usually describes the process of allocating the goods and

services that have been produced& Societies have used market exchange, reciprocity, eminent domain, inheritance, theft and philanthropy to distribute goods and services& )he primary means of distribution or allocative mechanisms that are used in most societies are market exchange, reciprocity and eminent domain&
+A&<ET E=*4A%8E

+arket exchange involves a *uid pro *uo, i&e& an exchange of private

property rights between individual agents& )he terms of the exchange are clearly specified. ;D will give you this if you will give me that&< )he goods to be exchanged are clearly specified, as are the terms of the exchange& )he participants in the exchange do not need to know each other. they only need to know the terms of the exchange& )he information re+uirements are +uite low& Dn many cases, the exchange may be made easier by social institutions& 'aws that protect buyers and sellers may facilitate the exchange& )rust may be an important element as well&

11

1.(.$ Economic 0ctivities

&E*$P&'*$T5

&eciprocity is a system of obligatory gift giving. D will do you a favor or give you a gift, but you are then obligated to do an unspecified favor or give me a gift at some (possibly unspecified) point in the future& %eciprocity re+uires a sense of community& Kinship ties or membership in the community is needed so that the obligation of returning a favor is enforced by social forces& Df a friend helped you move apartments one weekend and then helped you fix your car the next weekend, your refusal to help that person would have social repercussions& !our common friends might come to regard you as a freeloader& Social pressure may induce you to return the favor&
E+$%E%T ('+A$%

Eminent domain is a redistribution of private property rights through the authority of some organi,ation& )he individual is re+uired to give up their claims to private property by an authority& 0sually the process of eminent domain is legitimi,ed by government, religion or some other authority&
P4$2A%T4&'P5

The act of giving a gift with nothing expected in return is called philanthropy& )his is an important method of distribution in blood drives and the donation of organs for transplantation&
$%4E&$TA%*E A%( T4E-T

$nheritance is the process transferring private property rights from a dead person to an agent& )he form that the inheritance laws take may greatly influence the accumulation of wealth in a society& Theft is the process of transferring property rights by illegitimate force& :ew societies can function if theft is widely used&

15

1.(.$ Economic 0ctivities

1#4#2#1 *'%,)+PT$'%

The end purpose of economic activity is to provide goods and services

that can be consumed by individuals to satisfy needs and wants& -odern, neoclassical economists generally do not like to use the word ;needs&< )he use of the word ;wants< is an attempt to take subEective Eudgment out of the analysis&

16

$ The Pro !em of Provisioning

2 T4E P&':2E+
2.1 INTRODUCTION

'-

P&'3$,$'%$%8

,ociety is confronted with a finite set of resources and a given state of

technology at any given point in time& #s a result, there is a finite amount of goods and services that can be produced in that time frame& =iven human desires and need for food, clothing and shelter, it is not always possible to produce everything that every one would like to have& Ghen individuals want more than can be produced they have the economic problem of scarcity& )he problem of scarcity might be resolved by reducing individuals wants or by increasing the output of goods and services& Df the solution is to reduce wants, which wants should be eliminated and which should be retained to be satisfiedI )he individual would necessarily be re+uired to make a choice& Df the solution was to produce more goods, which goods should be produced and how are they to be producedI #gain, the individual must make choices& Dn modern, neoclassical, economic analysis (we will call this ;orthodox< economics), the problem is structured so the wants are taken as given and the problem is to produce the goods that satisfy the greatest wants& Scarcity re+uires that the individual or agent make choices& #n individual in isolation (Cefoe(s %obinson Crusoe before :riday) would have to make choices since time and resources are limited& Dt would be necessary to choose whether time was to be spent catching fish, gathering coconuts, reading or building shelter& Df the choice were to catch fish, he/she would have to choose between making a net, a fishing pole or trying to catch fish by hand& )he choice to spend an hour fishing implies that that hour cannot be used to gather coconuts& )he sacrifice of coconuts is called ;opportunity cost&<

17

$.1 Introduction

*ven %obinson Crusoe(s world of isolation did not last long& Ghen :riday came to the island, it became necessary to decide who did what and who got what& Dt is necessary to coordinate the preferences and activities of Crusoe and :riday& Since the story of %obinson Crusoe was written by an *nglishman, Caniel Cefoe (187B-1951), Crusoe is dominant and he has a greater influence on the decisions than :riday& Dn 191B, the perspective of an *nglish writer was that aboriginals of various lands were subordinate& Still, it is necessary to coordinate their activities&

2.2 SOCIA! INTERACTION

$n a society, the behavior of the individuals must be coordinated through

social interaction& )his social interaction takes many forms ranging from cooperation to competition& Dn the process of resolving the allocation problem through social interaction, a set of institutions, organi,ations, beliefs, principles, perspectives and commonly held values are created& Society, guided by these values, perceptions and beliefs and constrained by institutions, technology and resource endowment, must solve the problem of provisioning& )he specific uses of goods and resources must be determined& )hese choices involve which resources to use, which goods to produce, who will bear the costs and who will benefit& )he basic problem is the coordination of the choices and behavior of individuals& :inding a way to protect the autonomy of the individual while coordinating their behavior to provide for the commonweal has been an important goal of most great writers on social topics&

2." SPECIA!I%ATION

,peciali,ation and the division of labor are two important forms of social
18

$." Specia!i.ation

interaction that allow two or more individuals to do what an isolated individual cannot do& oth are means to increase the production of goods and services&

Speciali,ation is the case where an individual (firm, organi,ation or country) focuses on the production of a specific good (or group of goods)& Dt can increase the amount of goods that can be produced& Dt also re+uires some form of social institution to coordinate the process& Df one individual produces food and the other clothing, the two individuals must interact if both are to have food and clothing& )his interaction may be facilitated through an institution such as the market or a transfer based on kinship, marriage, religion or government authority& $lato suggests that the city-state is a social construct that is used to facilitate speciali,ation and to improve the welfare of the members of that state& Dn The Repu !ic, $lato ?619-569 &C&@ suggests speciali,ation as an

explanation of the origins of the city-state& $lato describes a conversation between Socrates and a group of students& )hey are pondering the nature of Eustice& )hey conclude that Eustice is each person doing that which they are best suited to do& )he person best suited to be a baker should be a baker. the person best suited to be a shepherd should be a shepherd& 4nce individuals speciali,e, the city-state arises to facilitate the transfer of goods and the necessary interactions among the individuals& ?The Repu !ic, ook DD@

$lato tries to identify the characteristics of the ideal society& 4ne of the focal points is Eustice that is achieved by ;each person doing what they are best suited to do&< Social interaction is re+uired because each person depends on the other members of the community& Fe devises a meritocracy that is lead by philosopher kings& )o prevent nepotism and greed from influencing these philosopher kings, $lato does not allow the philosopher kings to hold private property rights, all of their property is held in common&

19

$.( 3ivision of 1a or

2.# DIVISION

OF

!A$OR

The division of labor is another form of social interaction that allows

individuals to do what the isolated person cannot& Dn the division of labor, the production of a good is broken down into individual steps& 4ne person then performs one step in the process& "o single person produces the good alone& )he actions of each individual in the production process must be coordinated& Dn modern industrial societies, production often takes place in a business firm& ;-anagement< is regarded as the process of coordinating the activities of the individuals within the production process& # specific application of microeconomics to the process of production within a firm is called ;managerial economics&< #dam Smith ?1915-19B2@ in the )ea!th of &ations proposes that the division of labor is one of the maEor elements that contribute to economic growth (the increased ability to produce goods and services) ? The )ea!th of &ations, page 1@& )he division of labor is the process of dividing a task (work) into its component parts& Smith argues that the division of labor increases production through improved dexterity, saving time in moving from one task to another and improvements in tools& Smith cautions about the effects of unrestrained use of the division of labor,
In the progress of the division of !a or% the emp!oyment of the far greater part of those 'ho !ive y !a or% that is% of the great ody of the peop!e% comes to e confined to a fe' very simp!e operations% fre*uent!y to one or t'o. But the understandings of the greater part of men are necessari!y formed y their ordinary emp!oyments. The man 'hose 'ho!e !ife is spent in performing a fe' simp!e operations% of 'hich the effects too are% perhaps% a!'ays the same% or very near!y the same% has no occasion to e+ert his understanding% or to e+ercise his invention in finding out e+pedients for removing difficu!ties 'hich never occur. ,e natura!!y !oses% therefore% the ha it of such e+ertion% and genera!!y ecomes as stupid and ignorant as it is possi !e for a human creature to

1A

$.( 3ivision of 1a or

ecome-.But in every improved and civi!i.ed society this is the state into 'hich the !a oring poor% that is the great ody of the peop!e must necessari!y fa!!% un!ess government ta/es some pains to prevent it.

?Smith, )ea!th of &ations, p 956-957@ Smith, a professor of moral philosophy, constructed a system to explain a set of forces that would guide social and economic behavior& Dn The Theory of Mora! Sentiments ?197B@ he showed the need for Eustice and a system of morality& Dn 0n In*uiry into the &ature and #auses of the )ea!th of &ations ?1998@ he describes the role of self-interest and markets& Dn a third book that was destroyed at his re+uest at the time of his death, he describes the need for a system of Eurisprudence& )wo sets of students( notes have been used to show these basic arguments in 1ectures on 2urisprudence ?1981-85 and 1988 published in 1B9A@& Smith describes a social system that re+uires morality, markets and Eurisprudence to guide and constrain individual action in a social context&

2.& COORDINATION

OF

EFFORTS

'nce humans use the division of labor and speciali,ation, it is necessary

for them to coordinate their efforts& )hey must interact on a variety of levels& Society is a complex set of interactions among groups and individuals& )hese interactions give rise to social institutions& )he study of these interactions and institutions is ;socia! science&< Fuman interaction can be studied from a variety of perspectives& Sociology, political science, law, history, psychology, religion, anthropology and economics are examples of social sciences& )hese are often studied as separate disciplines& Fowever, we should remain aware they are all interrelated perceptions of human behavior& Ghile economics speciali,es in the study of the processes that coordinate human behavior as it allocates scarce resources to satisfy unlimited wants, its relationship to other social sciences should not be overlooked&

1B

$.4 Economic 0ctivities

2.' ECONOMIC ACTIVITIES

;ohn

Stuart -ill ?1A28-1A95@ divided economic activities into three

categories. production, distribution and exchange& Dt may be helpful to think of an economic system as a process that begins with a set of inputs (or resources) that are used for production that must be distributed for ultimate consumption& (-ill, Princip!es of Po!itica! Economy, )he Colonial $ress, 1B22) Dn :igure D&1, the economy is shown as a process of altering a set of inputs to satisfy individual wants& Dn this example, the steps in the economic process are production, distribution and consumption&
,np!t or Reso!rces ,-and, labour,
capital and entrepreneurial ability or energy, matter, time and tech.

*onsu/ption
Prod!ction (istribution or Allocation
'he ability of goods and services to satisfy wants is called )utility*+

:igure D&1

2#>#1 P&'()*T$'%

Production is the process of altering inputs to increase their ability to

satisfy human wants& Dnputs are sometime called ;factors of production< or resources& )ypically, economists will categori,e inputs as land, labor and capital& Superficially, labor is defined as human effort used to produce goods that satisfy human wants& #n input that is a ;gift of nature< is referred to as ;land&< Capital is usually considered as an input that is produced by labor but is used for the further production of goods and services& *ntrepreneurial ability was the last category of inputs to be added as a factor of production in market

52

$.4.1 Production

oriented economies& Dt is usually associated with the process of creating and innovating of new processes& )he taxonomy of inputs, its relation social structure and the nature of economics will be considered more carefully later in the text&

2#>#2 ($,T&$:)T$'%

(istribution usually describes the process of allocating the goods and

services that have been produced& Societies have used market exchange, reciprocity, eminent domain, inheritance, theft and philanthropy to distribute goods and services& )he primary means of distribution or allocative mechanisms that are used in most societies are market exchange, reciprocity and eminent domain&
+A&<ET E=*4A%8E

-arket exchange involves a *uid pro *uo, i&e& an exchange of private property rights between individual agents& )he terms of the exchange are clearly specified. ;D will give you this if you will give me that&< )he goods to be exchanged are clearly specified, as are the terms of the exchange& )he participants in the exchange do not need to know each other. they only need to know the terms of the exchange& )he information re+uirements are +uite low& Dn many cases, the exchange may be made easier by social institutions& 'aws that protect buyers and sellers may facilitate the exchange& )rust may be an important element as well&
&E*$P&'*$T5

%eciprocity is a system of obligatory gift giving. D will do you a favor or give you a gift, but you are then obligated to do an unspecified favor or give me a gift at some (possibly unspecified) point in the future&

51

$.4.$ 3istri ution

%eciprocity re+uires a sense of community& Kinship ties or membership in the community is needed so that the obligation of returning a favor is enforced by social forces& Df a friend helped you move apartments one weekend and then helped you fix your car the next weekend, your refusal to help that person would have social repercussions& !our common friends might come to regard you as a freeloader& Social pressure may induce you to return the favor&

2#>#2#1 E+$%E%T ('+A$%

*minent domain is a redistribution of private property rights through the authority of some organi,ation& )he individual is re+uired to give up their claims to private property by an authority& 0sually the process of eminent domain is legitimi,ed by government, religion or some other authority&
P4$2A%T4&'P5

)he act of giving a gift with nothing expected in return is called philanthropy& )his is an important method of distribution in blood drives and the donation of organs for transplantation&
$%4E&$TA%*E A%( T4E-T

Dnheritance is the process transferring private property rights from a dead person to an agent& )he form that the inheritance laws take may greatly influence the accumulation of wealth in a society& )heft is the process of transferring property rights by illegitimate force& :ew societies can function if theft is widely used&

2#>#1 *'%,)+PT$'%

The end purpose of economic activity is to provide goods and services

that can be consumed by individuals to satisfy needs and wants& -odern, neoclassical economists generally do not like to use the word ;needs&< )he use

51

$.4." #onsumption

of the word ;wants< is an attempt to take subEective Eudgment out of the analysis&

2#>#4 *''&($%AT$'%6 *'+PET$T$'%

A%(

*''PE&AT$'%

Each
patterns)

society must develop a set of social institutions (behavioral to coordinate the activities of production, distribution and

consumption& )here is a wide range of forms these institutions may take depending on the physical environment, state of technical knowledge, social values and other factors& )hese institutions and behavioral patterns may rely on competition, cooperation or some combination& -arket systems tend to focus on competition while other systems may have a larger role for cooperation& # bicycle race is a useful metaphor& Dn a road race the riders cooperate in the peleton (the large group of riders in a bicycle race) by drafting (using the rider in front to reduce the wind drag)& Ghen a group breaks away from the peleton, they typically form a pace line and each shares the work of riding in front of the group& *ventually, the structure of the pace line disintegrates and the riders compete in a sprint to the finish or they fall back into the group& )he race is a mixture of cooperation and competition& Hoan %obinson argues that an economic system ;L r e*uires a set of ru!es% an ideo!ogy to 5ustify them% and a conscience in the individua! 'hich ma/es him 6sic7 strive to carry them out.< (%obinson, p 15) $roduction, distribution and consumption are interrelated& Ghat to produce is influenced by what individuals want to consume& Ghat people want to consume is influenced by the distribution process and what can potentially can be produced& )his coordination may come in the form of cooperative activities, such as the creation of a business firm& )he firm usually organi,es production internally as a cooperative process but must compete externally& #lternatively,

55

$.4.( #oordination% #ompetition and #ooperation

the coordination of activities may be accomplished by competition or some combination of cooperation and competition&

2.( TEC

NO!OGY

Technology

is knowledge about how resources, individuals and social

organi,ation can be used to accomplish obEectives& )echnology is more than a set of skills to do things& Dt is a perspective about the relationships between humans and their world& )echnology is the sum total of the ways in which human societies interact with natural and built environments& Fumans seek to understand these interactions and develop technology by combining and reorgani,ing existing technologies& Dn economics, technology is the knowledge about the use of scarce resources to produce goods and services that satisfy human wants& )he knowledge about how we do things, ;technology,< is not limited to machines& )he discovery of a calendar or the reali,ation that crops can be planted on a three field rotation may be as important as the invention of the padded horse collar, the steam engine or the $C& Knowledge about the use of organi,ational structure to achieve an obEective is, in a sense, a form of technology& )he values and structure of society are connected to the state of technology& Society is shaped by technology and at the same time is an important force in the determination of the course of technological change& )his relationship between technology, society and the individual can be driven by curiosity and/or material gain& )echnological change is pervasive& Curing some periods of history, technology changes at a slow pace& #t other times, the rate of change is more rapid and more dramatic& Curing the medieval period, technological change was slow& Gith the development of mechanical clocks, the plague, moveable

56

$.8 Techno!ogy

type,

gunpowder, change&

new

techni+ues the by 19 th

in

art

and 1Ath

other

innovations, the ;age

the of

;%enaissance< (usually thought of as the 16 th-19th centuries) was a period of dramatic Curing and centuries, change& *nlightenment< was fueled technological )he ;Dndustrial

%evolution< (which is often dated as about 1972) is another term used to identify a period of rapid technological change& *ach of these periods involves changes in ideas, values, knowledge and social institutions& *ach altered economic and social processes& )here are opposing views as to the process of technological change& 4ne view is the )homas #& *dison perspective& Dn this case, technological development is driven by profits& Df a technology is profitable, it will be invented& )he other view is that technology is a self-generating process& "ew technology is the result of old technology(ies) being recombined in new ways and used for new purposes& Dn the second view, profits cannot create the development of technology but determine its uses& Ghat an individual perceives as a resource is influenced by the nature of technology& Dn the 1Ath century, obsidian was an important resource among the inhabitants of the western 0nited States. uranium was not& Dn the 11 st century, obsidian is not normally regarded as a very important resource while uranium has become a resource& :actor endowment may influence the direction that technology develops& Dn a society with an abundance or arable land and a shortage of labor may produce (and consume) different goods and seek different technologies to produce them& Dn the *dison view, the light bulb was invented because there was a demand for it and it could be developed and produced for a profit& Dn the second view, it is not possible to invent high-pressure steam engines, even

57

$.8 Techno!ogy

though they may be profitable, until the technology of metallurgy develops metals to contain the higher pressure& *ither view supports the argument that technology builds upon itself& )he creation of an internal combustion engine depended on its connections to cannons, oil, -aybach(s spray carburetor, levers and gears& *ach of these in turn depended on other technologies& Ghen Caimler and -aybach built the automobile, it was the result of a series of connections between technologies that had been developed by many people over a long period& (see urke, #onnections, pp 197-1A5)

Dt is useful to think about technological change as a process& :irst, a piece of knowledge emerges or an ;invention< occurs& Second, some one finds an application for the new knowledge (innovation) and uses it& )hird is the process of dissemination, i&e& the use of the idea is spread through out the social system& *ach stage of technological change may produce or re+uire significant changes in values and social institutions& Changes in social structure or the natural environment may encourage technological change& )echnology and the social system are interconnected& )echnology has a strong influence on the structure of society and individual behavior& )he Dndustrial %evolution may be thought of as a fundamental change in technology of production that altered society& )he development of the mechanical clock was driven by the clergy(s desire to satisfy the institution of prayers at specific times of the day& )he perception of and taxonomy of inputs or resources was influenced by social structure& 'and was associated with the nobility and the clergy while labor was associated with the serfs& #s trade developed, a merchant class arose and became associated with capital&

58

$.9 Economic 3ecisions

2.) ECONOMIC DECISIONS

$n a simple taxonomy, individual behavior may be influenced by rules

(command), intuition, emotion, habit, reason or some combination& $hilosophers and psychologists have struggled with the issue of fate and freewill& )he issue has not been resolved& Dt is not likely that it will be resolved here& )he +uestion for economics is to try to understand and explain how humans try to resolve the problems of provisioning and allocation&

2#?#1 &)2E,

$f behavior is constrained or influenced by rules, rules of thumb or habits,

the nature of those rules and the process by which the rules evolves is of interest to economists& Df the agent(s decision is constrained, the nature of those constraints is of concern& %ules may by implicit or explicit& *xplicit rules often take the form of law and maybe imposed by governments or organi,ations& =enerally, explicit rules are conscious creations and must be communicated and enforced& Social groups may also use explicit rules& usiness firms, churches, and other organi,ations may explicitly impose rules& Dmplicit rules may also be important constraints& Dmplicit rules are not consciously created but must still be communicated& Certain types of behavior are expected and influenced by such social constructs as ;manners,< mores, custom, rules of thumb and traditions& )hese rules are short cuts to problem solving& Df over time a particular problem is always or nearly always resolved by a specific approach, that approach becomes a habit or rule of thumb& )hese rules and habits provide ready made solutions that do not have to be derived by reason or intuition&

59

$.9.$ Intuition

2#?#2 $%T)$T$'%

$n recent years, there has been a growing interest in the interrelationship

between psychology and economics& Caniel Kahneman ("obel :oundation pri,e winner) has explored intuition and reason as thinking and decision processes& (Kahneman, pp 166B-1697) #ccording to Kahneman, intuition can be powerful and accurate, re+uires practice and is ; rapid and effortless&< )he reasoning process provides a check on the intuitive process&

2#?#1 &EA,'%

A%(

&AT$'%A2 :E4A3$'&

'rthodox, modern economic analysis is generally regarded as the study

of alternative uses of resources to achieve obEectives& #t a technical level, economic analysis is used to evaluate rational decisions& %ational behavior that the agent has identified an obEective or goal and has evaluated all feasible alternatives to select the alternative that best achieves the obEective&

2#?#4 $%-'&+AT$'%

7ithin any economic system, the agents must have information and
there must be a set of incentives to encourage appropriate actions& Ghether the economic system primarily uses market exchange, reciprocity, eminent domain or some other allocative mechanism, the agents must have information about preferences, inputs, technology and alternatives& Dn different economic systems, the decisions may be made by different agents& Dn a planned economic system, some type of planning authority would necessarily have to have information about the preferences of the members of the systems, all inputs, all technology and all alternatives that are feasible& )his is an enormous re+uirement& Dn a market-oriented system based on

5A

$.9.( Information

exchange between individual(s, the information re+uirement is altered& Dndividuals only need to know about their own preferences and feasible alternatives& Ghat is re+uired is a social system that provides for voluntary exchanges between agents with appropriate information& Dn the 1B12(s and 52(s there was a debate ()he Socialist Calculation Cebate) about the ability of socialist systems to ac+uire necessary information& 4ne side of the debate lead by the #ustrians ('udwig von -ises (1AA1-1B95) and :riedrich Fayek (1ABB-1BB1)) argued that it would be impossible for a centrally planned economy run by rules to have the necessary information to function& 4scar 'ange (1B26-1B87) and #bba $& 'erner (1B25-1BA1) argued that if planners were cost minimi,ers, the appropriate information could be calculated& )his is a simplistic description of the Socialist Calculation Cebate but emphasi,es the importance of information to the functioning of an economic system& Dn the Socialist Calculation Cebate, #ustrians argued that command economies could not be successful because there was insufficient information to guide decisions in the economic process& )hey believed that each individual had information about their preferences and what they were capable and willing to do& -arkets were seen as the social institution that could provide information about relative values through the voluntary, exchange interactions of individuals& )he market system was the process that provided the information for the agents to make decisions& )he #ustrians argued that the command system had no process by which information would be revealed& 'ange accepted this criticism and suggested, ;market socialism< as an alternative& Dncentives are the forces that encourage or induce agents to behave in particular ways& Cuty, authority or self-interest may guide an agent(s

5B

$.9.( Information

behavior& Since neoclassical economics is based on a conse+uentialist ethic that is expressed through markets, the incentive provided by self-interest is perceived as dominant& 4ther incentives may be e+ually as important& Smith believed that self-interest would be constrained by systems of morality and Eurisprudence&

2#?#@ &AT$'%A2$T5

A%(

$%-'&+AT$'%

The

allocation of scarce resources re+uires both information and

incentives for the agents& Dnformation about the obEectives and feasible alternatives is necessary if ;rational choices< are to be made& # rational choice re+uires that the alternative that ;best< satisfies the obEective be selected& )his re+uires criteria to evaluate each alternative with respect to the obEective& ased on the obEective, set of alternatives and the method of evaluation, the optimal or best alternative can be selected& )here are three fundamental steps to the process of making ;rational< economic choices.
/dentify the ob0ective of the agent* /dentify all feasible alternatives that are related to the ob0ective* Develop the criteria to evaluate each feasible alternative with respect to the ob0ective*

62

" Introduction to )ays of :no'ing

1 $%T&'()*T$'%

T'

7A5,

'-

<%'7$%8

<nowledge

about economic phenomena is imperfect& )he problem of

knowing is not uni+ue to economics& #n understanding of the methods by which knowledge is accumulated aids in the identification of potential biases and weaknesses of any discipline or field of study& #cademic disciplines, like individuals, can benefit from introspection& y examining our values, obEectives, and methods of achieving those goals, we better understand ourselves, consider other perspectives and hopefully improve the discipline& )he study of methodology and epistemology provides a process by which this introspection of economics as an academic discipline can proceed& #ny understanding of the methods used in economics re+uires some introduction to a few important contributions to the literature on the process of knowing& Dt is a fundamental part of cultural literacy in a world dominated by <science< and the ;scientific method&< # brief summary of some of the basic concepts and maEor contributors is presented here& )here is a long history of various approaches to the study of the economy& )hese approaches are not self contained, isolated bits of knowledge. they are extensions of and reactions to earlier approaches in economics and other fields& )he process of ;knowing< is difficult& )wo +uestions that should be paramount are. 87at do , know9 :ow do , know w7at , t7ink , know9 *pistemology is the study of the origin, nature, methods and limits of knowledge& )here are several approaches to the study of processes that contribute to knowing. the history of science and the sociology of knowledge are two closely related fields& -ethodology is one aspect of epistemology&

61

" Introduction to )ays of :no'ing

-ethodology is generally seen as the system of values, beliefs, principles and rules that guide analysis within a given discipline& )he methodology(ies) that prevails within a discipline plays a maEor role in the nature of +uestions that are asked as well as the answers that are offered& )here is a large and growing body of literature on methodology in philosophy and the sciences (both natural and social)& )his trend has also influenced economics& -any economists have participated in the explorations into methodology and epistemology& 4ne explanation for a renewed interest in methodology in economics is that the basic processes created to explain the development of market systems and mature industrial economies may need to be adEusted if there are significant structural changes in the economy& )he study of the history of economic thought and methodology adds the +uestions of ;87at do , belie%e9< ;87y do , belie%e w7at , belie%e9< 4ne of the most difficult tasks in any discipline is to understand the nature of knowledge and the process by which it is ac+uired within the discipline& Dn this matter, economics is no different from any other body of knowledge& )he methods used to study the phenomena influence the phenomena we select to study and the conclusions we draw&

".1 FACTS* INFORMATION* +NO,!EDGE

AND

,ISDOM

$n any period of history, there is a problem of determining the nature of

what we think we know& :acts, information, knowledge and wisdom are not the same things& Dt is possible to engage in long arguments about the meaning of these words& (:or our purposes, we will accept facts in the spirit of its 'atin roots& ;actum is something done. factus is done. facere is to do&) Sometimes

61

".1 ;acts% Information% :no'!edge and )isdom

data may be considered as facts& :acts alone do not tell us much& Dt is the organi,ation of those facts into patterns that provides information& )he recognition of patterns is aided by the way in which facts are ordered& Categori,ation (taxonomy) of facts is necessary to establish the relevant patterns and relationships& Dnformation may also include the communication of those facts& Knowledge implies an understanding of the nature of relationships (system of causation) among the facts and information& Gisdom is more complicated and suggests a system of values and the Eudgment to evaluate and apply knowledge& Gisdom re+uires a system of ethics& )he definitions of facts, information, knowledge and wisdom used here are superficial and subEect the reader(s interpretation&

".2

YPOT ESES*

EORIES*

!A,S

AND

MODE!S

-y.ot-e/i/ is a proposition or set of propositions that is an attempt

to explain an event or class of phenomena& Dt is usually thought of as provisional and a guide to further investigation& Fypotheses can be tested but never proven& Fypothesis testing re+uires the analyst to try to disprove the hypothesis& Df it can be shown to be false, then it can be reEected& Df it cannot be shown to be false then it is accepted as not yet proven false and may be retained until proven false& Dt is possible to reEect a true hypothesis as false. this is a )ype D error& Dt is also possible that a hypothesis is retained as probably true even when it is false. this is a )ype DD error& Dt is not possible to reduce these errors to ,ero& # t-eo0y is an explanation about a class of phenomena& Gebster(s Cictionary defines a theory as a ;as a coherent group of genera! propositions used as princip!es for e+p!aining a c!ass of phenomena &< 0sually a theory is considered as more reliable than a hypothesis& )heories are used to establish

65

".$ ,ypotheses% Theories% 1a's and Mode!s

relevant patterns in data and to explain the relationships within those patterns& "ewton(s theory of gravity or *instein(s theory of relativity are examples of explanations of relationships between masses or the relationships between energy and matter& )heories are used to make sense out of data and information& ;Githout theory facts are meaningless&< (#lfred -arshall) )he term 123 is used to represent a widely accepted premise or theory about a particular causal relationship& Dt is more widely accepted than a theory& Dn economics some writers refer to a ;law of demand&< ()he belief that demand functions are inverse relationships between price and +uantity that will be bought at each price, individuals buy more of a good at lower prices&) Dn economics, a 4o5e1 is a simplification of various relationships among economic variables and is used to explain or predict economic phenomena& Dt is a way to represent or call attention to a relevant order or pattern in a set of data& Dt is of necessity an abstraction and includes only the most important aspects of a relationship& )he nature of a model is dependent on the elements it is constructed of and the purposes it(s anticipated use& Df two groups are given the task of making a model airplane but one of the groups is given paper and the other clay, their models will not look alike& oth models will be abstractions from reality& )he elements of reality that are modeled may be different& )he shape of a wing to give lift is an important feature& )he color of the insignia on the rudder may not be significant (unless you are trying to demonstrate how air craft are identified by different insignia)& Ghich model is ;bestI< # paper model of an airplane may be useful to demonstrate the idea of flight to a third grade class& # clay model might be best in a wind tunnel to test aerodynamics of a 972 mph wind& Dn economics, models built using individuals may not be useful in describing the economic behavior of multinational corporations&

66

".$ ,ypotheses% Theories% 1a's and Mode!s

-odels using land, labor and capital may not ask and answer the same +uestions as models that are built with energy, matter, time and technology& -odels may take many forms. narrative, visual/graphic, tabular,

mathematical, Cartesian graphs are some of the forms that may be used to present models&

"." FOUNDATIONS

OF

6SCIENCE7

;acob

ronowski contends there are three creative ideas central to

science& )hese are the ideas of. 1) order6 2) causes and 1) chance# ( ronowski 1B9A)
'&(E&

ronowski states that, ;Science is not an impersona! construction &< ( ronowski& p 15) )his human construction of knowledge begins ordering of things and events or phenomena& #ristotle saw order in the ;nature of things&< )hings fall to the earth because it is in their nature to do so& #ges is that there is a hierarchy to the system of order& (Dbid& p 15) )he notion of order is implicit in the classification of phenomena& )axonomy (the art and/or science of identification, naming and categori,ation of phenomena) is fundamental to the process of science and the ac+uisition of knowledge& )o classify events or things re+uires the recognition of the way in which things are alike or different& )axonomy implies observation of the phenomena and some recognition of specific characteristics& Science looks for order or regularities among sets of facts& 4rder or regularities are patterns that are repeated in data or facts& :acts or data are ronowski mentions that one of the contributions made by the philosophers of the -iddle

67

"." ;oundations of Science

usually collected by empirical methods& 4bservation is a typical method of collection& Df we watch a ;magician< or a group of witnesses to a crime testify, we understand that what we observe is not always what is& Dt is important to be very careful about what we see as facts& Cifferent sets of ;facts< can lead to very different +uestions and conclusions& Cifferent ;facts< or data can be collected about the same set of events& )he taxonomy or the categori,ation of facts may lead to the recognition or belief that these facts are related in particular ways& # different taxonomy may result in the perception of different patterns Ghen inputs are categori,ed as land, labor, capital and entrepreneurial ability, the order recogni,ed may be different to a set of inputs categori,ed as energy, matter, time and technology& Cepending on the patterns (order) perceived within the data, different +uestions may be asked&
*A),E,

ronowski argues that both C# 3inci and "ewton were great inventors and mechanics& )hey both recogni,ed patterns of order in the universe and were able to describe these patterns& )he difference, according to ronowski, is that ronowski while C# 3inci was interested in variety and infinite adaptability, "ewton was focused on unity and the singleness of nature& ( ronowski, p 16) comments. ;)e cou!d say that the Midd!e 0ges sa' nature as striving to'ards its o'n inner order< and that the Scientific Revo!ution overthre' this order and put in its p!ace the mechanism of causes. - =n the one hand% a!! science% and indeed a!! thin/ing starts from and rests upon the notions of order< 'hat mar/s the Midd!e 0ges is that their order 'as a!'ays a hierarchy. 0nd on the other hand 'hat mar/s the scientific vie' is not that it turned to the mechanism of causes% ut that it sa' the 'or!d as a mechanism at a!! > a machine of events. ( ronowski, p 17)

68

"." ;oundations of Science

0nderstanding how one fact is related to another fact is the recognition of causes& )he recognition of order, regularities or patterns in a set of fact, raises the +uestion as to the nature of the patterns& )here are at least five possibilities. 1) event # may be caused by event 1) event . A A 8a(:)

may be caused by event #. : A 8b(A) may be caused by some (unobserved event

5) events # and C).

: A 8bcB and A A 0acB 6) event # may be caused by some interaction between events and C. A A 8h(:6 *) 7) events # and may be the result of coincidence

Statistical analysis is the typical method used to manipulate and analy,e data& -any technical tools can be used to describe and relate the facts in data sets& #verages, median, mode, range, domain, variance, standard deviation and other measures are descriptive statistics& Correlation, analysis of variance and regression can be used to relate different aspects (variables) in the data set& )he strength of the relationships that are recogni,ed in the data set can the tested using t-scores, :-ratios, Chi S+uare and other methods& #t the end of the day, none of these methods can prove causation. they can only show correlation& )he concept of causation depends on a theory (or hypothesis) about the relationship between the variables& Statistical methods allow a test of the hypothesis or theory& )he hypothesis cannot be proven it can only be disproven and the hypothesis reEected& Statistics can be used as evidence to support or reEect a perception of causation&

69

"." ;oundations of Science

*4A%*E

Df the world of events were truly a machine subEect to the law of causes, events would be deterministic& ronowski argues that the recognition of the law of chance is central to the method of science& Dt adds ; statistica! !a' to the concept of ;causa! !a'&< ( ronowski,& p A1) Causal law states that event is caused by event # and therefore, event will follow event # 122 time out of 122 occurrences of event #& Statistical law is based on the notion that event will ;pro a !y< follow event #& )he process is described as one where.
)e !oo/ for a trend or systematic difference. But the !ine of this trend 'i!! itse!f e !urred y the unsteady hand of chance or random f!uctuation. )e cannot get rid of this random scra'!. But 'e can from it determine a measure of random variation% and use that to dra' round the trend an area of uncertainty. If the area is sma!! enough y standards 'hich are agreed et'een us% then the trend is esta !ished% and 'e /no' the !imits 'ithin 'hich it is !i/e!y to !ie. ( ronowski, p

B1) )he concept of probability provides the method by which observations of an extraordinarily complex world can be interpreted& Dt gives us information and knowledge that may not be ;true< but is useful& Dn a complex world, there may be many reasons for a lack of certainty in causes& )here may be other hidden or unrecogni,ed forces that influence the relationship between event # and event event & Df event # results in event B2M of the time we may believe that # ;causes< & Df the occurrence of # results in may be more important&

52M of the time, other ;causes< of

$robability is a key idea in the understanding of causes& Statistics provides the means to state that with B7M confidence (or some other percentage) event # is correlated with event &

),E-)2%E,, A%( CT&)T4D

Knowledge held at any time may be ;true< or ;not true&< Knowledge that is true may or may not be useful& Knowledge may be useful whether it is ;true<

6A

"." ;oundations of Science

or not&

efore the Copernican %evolution, a common belief was that the *arth

was a stationary center of the universe& )his was the $tolemaic system attributed to Claudius $tolemy ?119-171 #C@, a =reek mathematician and astronomer who lived in *gypt& Dn this system, the sun, stars, planets and moon circled the *arth in repeated patterns& Complex models were constructed to explain and predict the paths of the obEects& )hese models worked with reasonable accuracy and were useful to plan for seasons, planting of crops, and to prepare for floods& )he models were useful, but ;wrong&< "ew information obtained through observation and measurement showed there were simpler explanations for the paths of the celestial bodies& )he Copernican or heliocentric view gained dominance& =alileo ?1786-1861@ verified the Copernican system with a new technology (the telescope)& Hohann Kepler ?1791-1852@ improved on =alileo(s findings and calculated e+uations to explain the elliptical orbits of the planets about the sun& #s we accept ;new knowledge< about the cosmos and subatomic matter, we replace old truths with new truths&

6B

".( E+p!anation% Prediction and Storyte!!ing

".# E9P!ANATION* PREDICTION

AND

STORYTE!!ING

Explanation and prediction are two of maEor obEectives of science& )hese

two goals are not symmetrical. it is possible to explain an event or phenomenon without being able to predict the probability of its occurrence. at the same time, it is possible to predict an event without being able to explain its nature or causes& -ark laug identifies two problems that arise from the ;Symmetry )hesis&< :irst is the problem. ; the history of science contains a num er of theories 'hich appear to e+p!ain natura! phenomena% 'ithout ho'ever predicting them even in a statistica! sense. ( laug, 1BA8, p 196) Carwin(s theory of evolution is cited as an example& Second is the problem. ;-science% and particu!ar!y socia! science% a ound in ru!es?of?thum that yie!d high!y accurate predictions a out oth natura! and socia! events despite the fact that 'e may have a so!ute!y no idea 'hy these ru!es?of?thum 'or/ as 'e!! as they do. (Dbid&) Ghether explaining or predicting, science places value on precision and rigor of the process& Fowever, one should avoid using the same criteria to evaluate scientific models with different obEectives& Dt is also necessary to avoid attempts at precision and rigor that are not possible& )homas -ayer cautions economists (the warning applies to all disciplines).
...'e shou!d dra' a much sharper distinction that is usua!!y done et'een t'o types of economic theory. =ne% forma!ist theory is a stract theory that is concerned 'ith high?!eve! genera!i.ation and !oo/s to'ards a+iomi.ation. The other% empirica! science theory focuses on e+p!aining past o servations and predicting future ones. )hi!e oth are perfect!y !egitimate% app!ying the criteria appropriate to one to eva!uate the other generates confusion and misunderstanding. 6Mayer@s oo/7...is a p!ea for a more modest economics that recogni.es the inherent difficu!ty of ma/ing precise and indu ita !e statements a out the actua! 'or!d% accepts that there is a trade?off et'een rigor and re!evance. I certain!y agree that one shou!d e as rigorous as one can e< I 5ust oppose trying to e as rigorous as one can not e. (-ayer, p

72

".( E+p!anation% Prediction and Storyte!!ing

9) #n emphasis on rigor and precision may result in attempts to develop theories or models that are esoteric and of little interest to anyone other than the scientist-author& Dn addition to explanation and prediction, science and the stories of science also create, shape and transmit individual and social values& 4ften this is an unintended effect rather than a conscious obEective& )he study of the evolution of methods in a discipline, such as economics, will hopefully create a greater awareness of this role and a greater understanding of one of the important effects&

".& !OGIC

,everal processes can be used in the discovery, creation and Eustification

of knowledge& Dnstinct, intuition, abduction, deduction, induction and authority are examples of sources of knowledge& #ppeals to authority as a Eustification for acceptance of knowledge is common but is not a reliable source& Dnstinct, intuition and introspection were once of great importance, but are not often seen as credible as ;science< when seeking Eustifications for ;knowledge< in Gestern, industrial societies& %esearch in the cognitive sciences and behavioral economics has recently been investigating intuition as a means of decisionmaking& Caniel Kahneman (a psychologist) received the "obel in economics for work in cognitive processes and intuition in economic decisions& Fowever, most discussions of methods in science place primary emphasis on inductive and deductive processes&

71

".A.1 3eductive Reasoning

1#@#1 (E()*T$3E &EA,'%$%8

Aristotle (5A6-511

C*) is usually credited with formali,ing syllogistic or

deductive reasoning& Ceductive reasoning is a process that starts with a set of premises (or a priori truths) or general principles and through rules of logic, ;deduces< a conclusion about a specific case& )here are usually two premises. a maEor premise and a minor premise& Df the general principle or maEor premise were that all the water in the lake was safe to drink, then deductive reasoning would conclude that a specific glass of water from the lake (the minor premise is the water is from the lake) is safe to drink& )he internal logic could be correct but if either of the premises were false, correct deductive logic would not yield true conclusions&

1#@#2 $%()*T$3E &EA,'%$%8

-rancis

acon

(1781-1818)

is

credited

with

formali,ing

inductive

reasoning& H&*& Creighton argues that

acon(s &ovum =rganum was to replace

#ristotle as the preeminent guide to the process of ac+uiring knowledge&

Bacon did for inductive !ogic 'hat 0ristot!e did for the theory of the sy!!ogism. It is of course% incorrect to say% as has sometimes een said% that Bacon invented the inductive method of reasoning. - )hat Bacon endeavored to do 'as to ana!y.e the inductive procedure% and to sho' 'hat conditions must e fu!fi!!ed in order that truth may e reached in this 'ay. ( acon, pps vii-viii)

Dnductive reasoning is the process of inferring information from empirical observations& Df several glasses of water were taken from a lake and each glass of water was shown to be safe to drink, it might be ;inferred< that the water in the lake is safe to drink& ecause all the water in the lake was not (and possibly could not) be tested there is some probability that all the water in the lake is not safe to drink& *mpiricism is rooted in the inductive process

71

".A.$ Inductive Reasoning

and is based on empirical observations& Statistical inference is an application of the inductive method& Ghile inductive methods are useful, there are pitfalls to avoid& 4bservations might be incomplete or the interpretation of the observation(s) could be incorrect& )he selection of which phenomena to observe and the se+uencing of the ;facts< can alter the conclusions reached& )he application of inference and inductive methods re+uires Eudgment and caution in the interpretation of data&

1#@#1 A:()*T$3E &EA,'%$%8

Abduction is a creative process from which hypotheses arise& #bduction is

similar to induction& )he differences are that abduction is less formal process that consists of a combination of intuition, experience, observation, deductive reasoning and generates hypotheses which could be wrong& #bduction is the insight that occurs with less conscious formal reasoning than either induction or deduction& Dt is the purpose of inductive and deductive reasoning to test the hypotheses that emerge from the process of abduction&

".' EPISTEMO!OGY

AND

ECONOMIC MET

ODO!OGY

Epistemology is the study of the nature and limits of knowing& *conomists

are confronted with an ocean of facts and data that are reputed to support a plethora of theories and laws that purport to be the ;truth< about economic behavior& #ny discipline, whether it is economics, physics, biology or L, advances because someone +uestions the received wisdom. both extensions of ideas and new ideas that are created as reactions against result from +uestions about the received wisdom& Df a scientist, economist or practitioner of any discipline has the ;truth,< their only task is to make sure others accept

75

".4 Epistemo!ogy and Economic Methodo!ogy

that ;truth&< # bit of humility about what one thinks they know is not a bad thing& # +uick survey of some of the basic ideas in epistemology provides an enlightened humility&

1#>#1 A TA='%'+5

'-

<%'72E(8E
knowledge as propositional and prescriptive

;oel

-okyr

classifies

knowledge& -okyr, an economic historian, relates the problem of human knowledge to economic growth and the economic problem& $ropositional knowledge is ;&&/no'!edge 6that is to say e!iefs7 a out natura! phenomena and regu!arities&< (-okyr, p 6) $rescriptive knowledge is instructional or knowledge about techni+ues about how to do something& (ibid)

1#>#1#1 P&'P',$T$'%A2 <%'72E(8E

$n -okyr(s taxonomy, propositional knowledge () can take two forms&

Fe describes these as (1) ;the o servation% c!assification% measurement% and cata!oging of natura! phenomena &< #nd (1) ;the esta !ishment of regu!arities% princip!es and Bnatura! !a's@ that govern these phenomena and a!!o' us to ma/e sense of them.< -okyr(s characteri,ation of propositional knowledge is.
Science% as 2ohn Ciman has emphasi.ed% is the *uintessentia! form of pu !ic /no'!edge% ut propositiona! /no'!edge is much more< the practica! informa! /no'!edge a out nature such as the properties of materia!s% heat% motion% p!ants and anima!s< and intuitive grasp of asic mechanics 6inc!uding the si+ B asic machines of c!assica! anti*uity< the !ever% pu!!ey% scre'% a!ance% 'edge and 'hee!7< regu!arities of the ocean currents and the 'eather< and fo!/ 'isdom in the Bapp!e?a?day? /eeps?the?doctor?a'ay@ tradition. Deography is very much a part of it< /no'ing 'ere things are is !ogica!!y prior to the instructions of ho' to go from here to there. (-okyr, p 7)

Fe argues that for the economic historian what matters is the collective knowledge of what society, as a whole, knows (the union of all statements of such knowledge)& Confidence and consensus about knowledge as well as

76

".4.1 0 Ta+onomy of :no'!edge

access to and transmittal of that knowledge is of great importance to how propositional knowledge is used& -okyr characteri,es the development of new propositional knowledge as ;discovery% the unearthing of a fact of natura! !a' that e+isted a!! a!ong ut 'as un/no'n to anyone in society.< (-okyr,, p 12)

1#>#1#2 P&E,*&$PT$3E

<%'72E(8E

Prescriptive knowledge () is the knowledge about how to do something.

it is techni+ue or instructional knowledge& )his prescriptive knowledge is defined as ;sets of e+ecuta !e instructions or recipes for ho' to manipu!ate nature.< (-okyr,, p 12) )he addition to this prescriptive knowledge is called an ;invention&< $rescriptive knowledge is not right or wrong it is successful or unsuccessful& -okyr argues that the industrial revolution and the associated economic growth began when prescriptive knowledge came to be based on proportional knowledge& Dndividuals can learn to do things without knowing why they work& 4nce you know why techni+ues (prescriptive knowledge) work, (propositional knowledge), it is easier to invent improvements to old techni+ues and develop of new ones&

1#>#1#1 A%

E=A+P2E

Knowledge about baking includes an understanding of the effects of altitude, leavening, moisture, temperature, gluten and a host of other phenomena on cakes& )his knowledge is propositional knowledge& # cake can be baked by someone in San :rancisco with a recipe (prescriptive knowledge) and no knowledge about the effects of altitude on cakes& )he recipe will work as long as person doesn(t try to bake a cake in Santa :e, "- (elevation 9122 feet)& )o modify the recipe so it will work at the new elevation re+uires propositional knowledge& )he development of new recipes ( ) re+uires some proportional knowledge ()&

77

".4.$ Brief Survey of Epistemo!ogy

1#>#2 :&$E- ,)&3E5

'-

EP$,TE+'2'85

Karl $opper ?1B21-1BB6@ is the primary architect of falsification as a method of science& Dn his The 1ogic of Scientific 3iscovery, 1B56, he outlines the basic approach taken in what is called the scientific method& Fe proposes that scientific knowledge grows through a process of making hypotheses abut the nature of problems and the falsification or testing of those hypotheses& $opper argues that it is the duty of every scientist to try to disprove or reEect his or her hypotheses& Df a hypothesis cannot be reEected by empirical evidence, it may be retained as ;probably true&< #ll knowledge then is probabilistic. it has not yet been falsified& )he process is subEect to what statisticians call )ype D and DD (or alpha and beta) errors& )ype DD errors occur when a false hypothesis is accepted as ;true&< Ghen a ;true< hypothesis is reEected as false a )ype D error has occurred& )homas Kuhn ?The Structure of Scientific Revo!utions , 1cd ed, 1B81,1B92@ offers another explanation for the evolution and change of scientific thought in the ;hard sciences&< Fis explanation is often applied to economics and social sciences& Kuhn used the concept of ;paradigms< and paradigm shifts to explain the process& )he term, paradigm, is often used and abused in discussions& Kuhn(s approach is essentially a ;truth by consensus< which is contained in the paradigm& )his paradigm (and its associated ;truth by consensus<) is practiced until there are ;anomalies< or problems that the existing paradigm cannot explain& )hen an alternative paradigm with greater explanatory powers replaces it& Fe argues that a science operates within a paradigm& )his paradigm is characteri,ed by,
the )community structure of science1 or the )disciplinary matri(+ which consists of symbolic generali2ations 3deployed without 4uestion5, shared commitments to a set of beliefs and a set of values*

78

".4.$ Brief Survey of Epistemo!ogy

)he members of the science use this paradigm to resolve anomalies& Ghen an anomaly of maEor significance or a large number of anomalies cannot be explained, the paradigm must be +uestioned and a new paradigm for that science developed& Dn this manner ;science progresses&< Dmre 'akatos( method is expressed in his book, Proofs and Refutations, ?Cambridge 0niversity $ress. Cambridge, 1B98@& 'akatos( approach, while in the tradition of one of his teachers, Karl $opper, is critical of both $opper and Kuhn& Fe advocated a more sophisticated form of falsification of ;groups of theories< and combined it with ;scientific research programmes (S%$(s)< which were more specific than paradigms& 'akatos( S%$ consists of two elements, the ;hard core, protective belt< and the ;positive heuristic&< ($heby, Hohn, Methodo!ogy and Economics< a #ritica! Introduction , -&*&Sharpe, 1BAA,, p 78) )he hard core is constructed of ;basic axioms and hypotheses< that are accepted without +uestion and is used as a defense mechanism& )he positive heuristic is the body of theories and problems that drive the research programmes& ($heby, p 78) Kuhn(s approach can be contrasted with that of Karl $opper and Dmre 'akatos& $opper saw the advancement of knowledge as the result of the falsification of testable hypotheses& )hose hypotheses that were not disproved were accepted as ;probably true&< 'akatos took the middle ground& %ather than falsifying a hypothesis or the whole paradigm, he felt that the process was based on ;scientific research programs&< # school of economic thought may represent a paradigm (in a Kuhnian sense) or a scientific research program (in a 'akatian sense)& # more extreme view is expressed in $aul :eyerabend(s book, 0gainst Method (3erso. 'ondon, 1BAA, originally published by "ew 'eft ooks, 1B97)& Fe advocates an approach to science that has been called ;theoretical

79

".4.$ Brief Survey of Epistemo!ogy

anarchism&< :eyerabend argues that the ;success of science cannot be used as an argument for treating yet unsolved problems in a standardi,ed way< and scientific achievements can ;be Eudged only after the event&< (:eyerabend, p 1) :eyerabend(s approach to the methodology of science is radically different because of his obEectives& Fe claims his purpose is ;humanitarian not intellectual< in that he wants ;to support people not advance knowledge&< Fe is ;against ideologies that use the name of science for cultural murder&< (:eyerabend, p 6@) Ghile he does not disavow the title of ;theoretical anarchist,< he does provide insights into the evolution of science and knowledge& :eyerabend summari,es some of his insights.
&either science nor rationa!ity are universa! measures of e+ce!!ence. They are particu!ar traditions% una'are of their historica! grounding.

(:eyerabend, p 151)
Eet it is possi !e to eva!uate standards of rationa!ity and to improve them. The princip!es of improvement are neither a ove tradition nor eyond change and it is impossi !e to nai! them do'n. (:eyerabend,

p 16A)
Science is a tradition among many and a provider of truth on!y for those 'ho have made the appropriate cu!tura! choice. (:eyerabend, p

178)
The entities postu!ated y science are not found% and they do not constitute an Bo 5ective@ stage for a!! cu!tures and a!! of history. They are shaped y specia! groups% cu!tures% civi!i.ations< and they are shaped from a materia! 'hich depending on its treatment% provides us 'ith gods% spirits% a nature that is a partner of humans rather than a !a oratory for their e+periments% or 'ith *uar/s% fie!ds% mo!ecu!es% tectonic p!ate. Socia! monotony thus imp!ies cosmic monotony ? or Bo 5ectivity%@ as the !atter is ca!!ed today. (:eyerabend, p 182)

Science (and economics) is not free from ideology& Dt is necessary to understand the prevailing ideology in a culture, society, group or corporation in order to interpret one(s own perspective& Dmagine a luxury train, the 4rient *xpress& !ou find your way to the club car and find a billiard table& !ou shoot the cue ball down the table (parallel to the tracks) in the direction the train is

7A

".4.$ Brief Survey of Epistemo!ogy

coming from at the same speed the train is traveling& !ou perceive that the ball is rolling toward the other end of the table& )o some one observing the train pass by, as they peer into the window they perceive that the cue ball is stationary and that the table, you and the train are moving away from the point where the ball is fixed& !our perspective determines your interpretation of the event&

1#>#1 +$2T'% -&$E(+A%

+ilton :riedman ?1B11-1228@ is one of the best-known economists of the

12th century& Fis article, ;)he -ethodology of $ositive *conomics< in Essays in Positive Economics ?1B75@ was one of the most important influences on economic thought& Dn this important piece, :riedman sets the standards for normative and positive economics as well as influencing several generations of economists& Fe argues that positive economics is ;independent of any ethica! position and its task is to provide ;a system of genera!i.ations that can e used to ma/e predictions a out the conse*uences of any change in circumstances< it deals with ;'hat is. (:riedman, p& 6) "ormative economics is dependent on positive economics and deals with ;'hat ought to e&< :riedman argues that economics can be a positive science& )he structure of this positive science, like all positive sciences, consists of two parts. first, is a language and second, is a ; ody of su stantive hypothesis designed to a stract essentia! features of comp!e+ rea!ity. < (Dbid& p& 9) #ccording to :riedman, language is a set of tautologies whose primary function is to organi,e and classify empirical material to facilitate our understanding& )his language has no substantive content& )his component or element in positive science may be evaluated by formal logic to determine if it is consistent and

7B

".4." Mi!ton ;riedman

complete& *mpirical or factual evidence and presumably the use of the language will reveal how well the analytical filing system functions& (Dbid&) )he body of ;substantive hypotheses< or theory is primarily to yield ; va!id and meaningfu! 6i.e. not truistic7 predictions a out phenomena not yet o served&< (Dbid&) )he only test of the validity of the hypotheses or theory is its ;predictive po'er for the c!ass of phenomena it is intended to Be+p!ain &(< Df there are alternative hypotheses that may be chosen, :riedman suggests two criteria. simplicity and fruitfulness& Simplicity is an echo of the work of Gilliam 4ckham ?11A7-1569 (6BI)@ or 4ckham(s ra,or& :ruitfulness reflects the precision of predictions as well as their relevance for wider or more generali,ed applications& # more ;fruitful< set of hypotheses would also suggest additional lines of research& )he validity of a theory cannot be evaluated on the basis of the reality of the assumptions, rather a
-hypothesis can e tested on!y y the conformity of its imp!ications or predictions 'ith o serva !e phenomena< ut it does render the tas/ of testing hypotheses more difficu!t and gives greater scope for confusion a out the methodo!ogica! princip!es invo!ved. More than other scientists% socia! scientists need to e conscious a out their methodo!ogy.

(:riedman, p 62)

1#>#4 (E$&(&E +**2',<E5

'f all the individuals whose views on methodology have been discussed,
:riedman and -cCloskey are the only writers who can be identified as ;economists&< -cCloskey(s book, The Rhetoric of Economics, (0niversity of Gisconsin $ress. -adison, 1BA7) has gained widespread attention among economists& -cCloskey argues that the method economists claim to follow is not the method that they follow in practice& -ost economists, as well as individuals in most other disciplines, claim to follow the ;scientific method< of falsification (i&e& hypothesis testing), usually in the format expressed by some

82

".4.( 3eirdre Mc#!os/ey

integration of $opper/'akatos/Kuhn& -cCloskey charges that as a result of attempts to create and follow a modern science, ;modernism< has become a dominant theme& #ccording to -cCloskey, modernism is a ;word that can be fully defined only in use&< (-cCloskey, 1BA7, p 7) She points out that modernism is not limited to economics but is also present in philosophy, architecture, music, and politics& )his list can be expanded to include management, accounting and a multitude of other fields& Ghile it may not be possible to give a precise definition of modernism, it is possible to characteri,e its nature& Some of its characteristics are identified in the following +uotes about modernism.
/no'!edge is to e mode!ed on the ear!y t'entieth century@s understanding of certain pieces of nineteenth?century and especia!!y seventeenth?century physics. (-cCloskey, 1BA7, p 7) ($resumably, Comte, Cescartes and "ewton are the seventeenth century physicists in the reference&) Dt is the notion that 'e can /no' on!y 'hat 'e cannot dou t and cannot rea!!y /no' 'hat 'e can mere!y assent to. (-cCloskey, 1BA7,

p 7)
It inc!udes the e!ief that on!y fa!sifia !e hypotheses are meaningfu!< the evidence is consistent 'ith the hypothesis< of tastes one ought not% of course% to *uarre!& (-cCloskey, 1BA7, p 8) Modernism vie's science as a+iomatic and mathematica! and ta/es the rea!m of science to e separate from the rea!m of form% va!ue% eauty% goodness% and a!! unmeasura !e *uantity& (-cCloskey, 1BA7, p 8) Dt is functiona!ist and given to socia! engineering and uti!itarianism% the modernist is antihistorica!% uninterested in cu!tura! or inte!!ectua! traditions. (-cCloskey, 1BA7, p 8)

-cCloskey advocates the use of classical rhetoric to advance economic theory through the same methods used in literary criticism& %hetoric, which includes the use of fact, logic, metaphor and story, provides the criterion and framework that guides the development of science& Ceirdre -cCloskey argues that,

81

".4.( 3eirdre Mc#!os/ey

6E7conomists do not fo!!o' the !a's of in*uiry their methodo!ogies !ay do'n. (-cCloskey, 1BA5, p 6A1)

%ather,
Economists in fact argue on 'ider grounds and shou!d. Their genuine 'or/aday rhetoric% the 'ay they argue inside their heads or their seminar rooms diverges from the officia! rhetoric. (-cCloskey, 1BA5,

p 6A1) -cCloskey proposes that the development of ;knowledge< about economic relationships and behavior is pushed forward by ;rhetoric&< ooth& %hetoric is.
the art of pro ing 'hat men e!ieve% rather than proving 'hat is true according to a stract methods. the art of discovering good reasons% finding 'hat rea!!y 'arrant assent% ecause any reasona !e person ought to e persuaded. carefu! 'eighing of more?or?!ess good reasons to arrive at more?or !ess pro a !e or p!ausi !e conc!usions ? none too secure ut etter than 'ou!d e arrived at y chance or unthin/ing impu!se. the art of discovering 'arranta !e e!iefs and improving those e!iefs in shared discourse. not to ta!/ someone e!se into a preconceived vie'< rather it must e to engage in mutua! in*uiry. (-cCloskey, 1BA5, pp& 6A1-6A5)

)he many

dimensions of rhetoric emerge from +uotes -cCloskey chooses from Gayne

-cCloskey argues that,

Each step in economic reasoning% even the reasoning of the officia! rhetoric% is metaphor. The 'or!d is said to e B!i/e@ a comp!e+ mode!% and its measurements are said to e !i/e the easi!y measured pro+y varia !e to hand. (-cCloskey, 1BA5 p 721)

*ven ;&&&mathematical theori,ing is metaphorical and literary&< (-cCloskey, 1BA5, p 727) Dn If Eou@re So Smart, published in 1BB2, -cCloskey argues that,
1i/e other arts and sciences% that is% economics uses the 'ho!e rhetorica! tetrad< fact% !ogic% metaphor% and story. Pieces of it are not enough. The a!!eged!y scientific ha!f of the tetrad% the fact and !ogic% fa!!s short of an ade*uate economic science% or even a science of roc/s or stars. The a!!eged!y humanistic ha!f fa!!s short of an ade*uate art of

81

".4.( 3eirdre Mc#!os/ey

economics% or even a criticism of form and co!or. (-cCloskey, 1BB2, p

1) )o consider the rhetoric and storytelling of economics does not mean that economics is or should be without method& %hetoric provides a framework and criterion that guides the development of economic theory& Dt is rhetoric that makes theory more relevant, identifies the ethical content and increases flexibility in the evolution of economic knowledge&

".( ,

IC

MET

ODO!OGY IS

6CORRECT:7

7hich
followedI

of the methodological arguments is ;correct< and should be )here is not a universally accepted answer in any academic

discipline nor among those who study the philosophy of science& )o understand and contribute to any field of knowledge, it is necessary to be aware of the methodology(ies) that have guided the development of accepted ideas, hypotheses, theories, concepts, tools, values and ideologies that are used within that discipline& Dgnorance of methodology dooms an individual to perpetual training and re-training rather than opening the door to education& -ethodological problems apply to all knowledge including "ewtonian mechanics, the theory of relativity and +uantum mechanics as well as economics& Dn economics, the methods used and ideological preconceptions of individual economists and schools of thought help to explain many of the differences in explanations of problems and policies advocated& -odern economic theory has a long tradition of following a ;modernist< methodology characteri,ed by a strong faith in empiricism and rationalism& Githin modern economics, knowledge is believed to be advanced by inductive or empirical investigations that can verify (or fail to falsify) ;positive< concepts, hypothesis, theories or models developed by deductive or rationalist logic&

85

".8 )hich Methodo!ogy is #orrectF

"ormative economics (or the study of what ;ought to be<) is seen as distinctly separate from positive economics& Ghen economics is studied as a process of provisioning, normative and positive issues become interrelated&

".) T

STANDARD VIE,

OF T E

SCIENTIFIC MET

OD

)he process by which knowledge is ac+uired is often called the ;scientific method&< )here are several variations of the way in which the scientific method are characteri,ed, but the steps usually are.
1) 1) 5) 6) 7) 8) recognition of a problem creation of a hypothesis about the nature of the problem collect relevant data to test the hypothesis propose a solution to the problem act on the proposed solution or policy to solve the problem monitor the results of the policy. collect and analy,e data on the application of the policy 9) make adEustments in the hypothesis and solutions as needed&

)he first step in the so-called scientific method re+uires an integration of positive and normative issues (normative and positive aspects of economics was discussed under the section on -ilton :riedman)& )he recognition of a problem is a recognition of a deviation between what should be and what is& Df my shoes do not hurt my feet (a positive statement), D probably don(t think about my shoes& Df my shoes hurt my feet (a positive statement) and D think they shouldn(t hurt my feet (a normative statement), D recogni,e a problem& Df there is unemployment (positive statement) and believe there should be unemployment (normative statement), a problem is not recogni,ed& Df there is unemployment and think that there should not be unemployment, a problem is recogni,ed&

86

( Individua!s and #ommunity

4 $%($3$()A2,

A%(

*'++)%$T5

community is made up of a group of individuals& 4ne of the

characteristics of a community is that there is an intersection of a set of shared values and obEectives held by the individuals& Social institutions (embedded patterns of behavior within a society) represent these shared values& 4nly under rare circumstances would a group of individuals have the same set of shared obEectives& ecause they are individuals, it is probable that some of their obEectives will be different and conflict or compete& Dt is necessary for the community to have a set of social institutions to coordinate competing values and ends& Social institutions both arise from human behavior and influence their behavior& )raditions, mores, customs and more formal institutions (such as laws), define the range of choices& -arkets are also a social institution& # voluntary contract between two individuals is a social mechanism to coordinate activities& -arkets re+uire a social infrastructure& )rust, expectations about buyers and sellers providing information (no fraud, deceit or duress), obligation to fulfill contracts and expectations that individuals will do no harm to others, facilitates the operation of markets& #dam Smith (1915-19B2) points out that markets are subEect to abuse.
Peop!e of the same trade se!dom meet together% even for merriment and diversion% ut the conversation ends in a conspiracy against the pu !ic% or in some contrivance to raise prices. It is impossi !e indeed to prevent such meetings% y any !a' 'hich either cou!d e e+ecuted% or 'ou!d e consistent 'ith !i erty and 5ustice. But though the !a' cannot hinder peop!e of the same trade from sometimes assem !ing together% it ought to do nothing to faci!itate such assem !ies% much !ess to render them necessary.(Smith )&, p 11A)

$articipants in markets may also use formal institutions (law, regulations) to benefit themselves.

87

( Individua!s and #ommunity

The interest of the dea!ers% ho'ever% in any particu!ar ranch of trade or manufactures% is a!'ays in some respects different from% and even opposite to% that of the pu !ic. To 'iden the mar/et and to narro' the competition% is a!'ays the interest of the dea!ers. To 'iden the mar/et may fre*uent!y e agreea !e enough to the interest of the pu !ic< ut to narro' the competition must a!'ays e against it% and can serve on!y to ena !e the dea!ers% y raising their profits a ove 'hat they natura!!y 'ou!d e% to !evy% for their o'n enefit% an a surd ta+ upon the rest of their fe!!o'?citi.ens. The proposa! of any ne' !a' or regu!ation of commerce 'hich comes from this order ought a!'ays to e !istened to 'ith great precaution% and ought never to e adopted ti!! after having een !ong and carefu!!y e+amined% not on!y 'ith the most scrupu!ous% ut 'ith the most suspicious attention. It comes from an order of men 'hose interest is never e+act!y the same 'ith that of the pu !ic% 'ho have genera!!y an interest to deceive and even to oppress the pu !ic% and 'ho according!y have% upon many occasions% oth deceived and oppressed it. (Smith )&, p 172)

#.1 INSTITUTIONS

(ouglass "orth argues that

Institutions are the ru!es of the game in a society or% more forma!!y% are the human!y devised constraints that shape human interaction. In conse*uence they structure incentives in human e+change% 'hether po!itica!% socia!% or economic. Institutiona! change shapes the 'ay societies evo!ve through time and hence is the /ey to understanding historica! change. ("orth, 1BB2, p 5)

"orth expands ;human exchange< to include human interactions that include ;political, social or economic< phenomenon& Fuman exchange is interpreted as ;human interaction on social, political and economic levels&< "orth(s broader definition will be used in this chapter even though the term ;exchange< is +uite specific.
E+change invo!ves a +uid pro +uo% i.e. an e+change of private property rights et'een individua! agents. The terms of the e+change are c!ear!y specified< I 'i!! give you this if you 'i!! give me that. The goods to e e+changed are c!ear!y specified% as are the terms of the e+change. 6#hapter $% p 1A7

"orth identifies the roles of these institutions.

88

(.1 Institutions

)/nstitutions reduce uncertainty by providing structure to everyday life*+ 36orth, p 75 )/nstitutions include any form of constraint that human beings devise to shape human interaction* Are institutions formal or informal8 'he can be either, and / am interested both in formal constraints 9 such as rules that humans beings devise 9 and informal constraints 9 such as conventions and codes of behavior*+ 36orth, p :5 )/nstitutional constraints include both what individuals are prohibited from doing and, sometimes, under what conditions some individuals are permitted to undertake certain activities*+36orth p :5 )A crucial distinction in this study is made between institutions and organi2ations* -ike institutions, organi2ations provide a structure to human interaction* 36orth, pp :;<: 6orth points out that organi2ations are considered as one of the players or actors while institutions are the underlying rules of the game*5 eings. They evo!ve and are a!tered

Institutions are a creation of human y human

eings< . . . Integrating individua! choices 'ith the constraints

institutions impose on choice sets is a ma5or step to'ard unifying socia! science research. ("orth, p 7)

"orth refers to some institutions as ;conventions and codes of conduct&< )raditions, customs, mores, rules of thumb are other examples of implicit institutions that are part of the rules of the game& )hese habitual patterns of behavior or embedded rules may arise spontaneously& Dndividuals seek solutions to problems& Ghen they find something that works (or provides a reasonable solution), they learn to try the same approach when the same or new problems arise& )hese institutions become short cuts to analy,ing and devising new solutions for every new problem& )hese implicit institutions may be transmitted to others in a variety of ways& Custom and traditions are the most obvious& Dt is possible to create codes of conduct that may be communicated through religious beliefs& %eligious law and Eurisprudence are common to almost all societies& Dn

89

(.1 Institutions

societies that depend on interpersonal relationships, these implicit institutions may be dominant in influencing behavior patterns& Dn cases where the community becomes complex, the effects of social values on individual choices may be weakened& Df implicit social institutions are weakened, force of law (formal explicit institutions) may be used to encourage some behavioral patterns and discourage others& #dam Smith had a manuscript on Eurisprudence destroyed at the time of his death (19B2)& Copies of students( notes on Smith(s lectures on Eurisprudence (1981-85, 1988) were found and published as 1ectures on 2urisprudence 6127& Dn these notes, Smith describes the role of law within a society& )he two traditions of common law and the "apoleonic code provide the framework for the legal systems in most Gestern industrial countries& Common law is based on stare decisis. i&e& laws emerge over time on the basis of precedence& #s society, technology, relationships, environment and other features of society change, laws are modified& )he "apoleonic code (dates from 1A26) is based on %oman 'aw& Dt establishes a clear legal framework on issues of property, inheritance, the family and individual freedom& explicit, formal institution& )he relationship between the legal and economic system is well oth approaches provide formal rules of the game and may be considered as an

established& Hohn %& Commons (1ega! ;oundations of #apita!ism, 1B16) and %ichard $osner (The Economic 0na!ysis of the 1a' , 1B95, sixth edition 1225) are foundations for two traditional approaches to law and economics&

#.2 INSTITUTIONS

AND

COSTS

The

provisioning process and the allocation process both involve the

ownership of resources and goods as well as the mechanisms by which the

8A

(.$ Institutions and #osts

rights of ownership are transferred& Gith in a society, the transfer of ownership of goods is not with out costs& Dn the case of eminent domain, there are costs (opportunity costs) to the authority that defines and enforces the transfer of ownership of goods (property rights)& Dndividuals who are affected by eminent domain incur costs as well& )here are also costs of using exchange& )hese costs are the effort (sacrifice) of individuals to obtain information about goods, other individuals who are willing to enter a contract and the effort to negotiate the contract or terms of exchange& Social institutions and organi,ations are a social response to reduce the costs of exchange and eminent domain& Social institutions also facilitate and enforce reciprocity& )he costs of using exchange are referred to as ;transaction costs&< (see Coase, ;"ature of the :irm<& 1B59) )he institutions define the rules of the game. provide individuals with information and some degree of certainty in their social interactions& )his reduces the time and effort (transaction costs) that individuals devote to the allocation problem& Dnstitutions and organi,ations are human creations that are intended to solve problems& Dt should be noted that these human creations might be intentional and explicit or unintentional and implicit& #s in all human endeavors, some attempts are more successful than others. i&e& some institutions are more successful at achieving obEectives than others& Dnstitutions arise as solutions to a given set of problems& Should the elements of the problem change (the actors, agents, technology, information, other institutions), the institutions may need to adapt& Fowever, any set of institutions is correlated with the interests of particular individuals& Some of these individuals benefit from the particular structure while others are not& )hose who benefit from a particular institutional structure have a vested

8B

(.$ Institutions and #osts

interest in preventing changes in the institutions& )hese vested interests may use their positions and power to prevent institutional change and to work to alter institutions (particularly explicit institutions such as law) in their interests& Conse+uently, the institutions that are prevalent at any point in time may lag behind environmental, technological and social changes& $atents, copyrights, regulations of communication industries (radio,

television, newspapers, internet and the like) determine the behavior of the agents and firms in those industries& =eorge Stigler (1B11-1BB1) described a ;capture theory of regulation&< (Stigler, 1B91, $ublished first in 1B81 with Claire :riedland) Fe argues that when an industry is regulated, it is in the interests of that industry to capture the regulatory agency and influence its policies& )he communication industries have a greater incentive to influence the policies of the :ederal Communications Commission (:CC) than the average person& %ecent actions by the :CC have allowed greater concentration of news media& Companies that publish music have more interest in the laws regarding the ownership (copyrights) and royalties to music than the public. the ;"apster< incident on downloading music files from the Dnternet is an example& )he insurance, pharmaceutical, hospital and medical industries have more interest in the social institutions that influence the delivery of health care than individuals& Fealth insurance emerged in the mid 1B52(s as a solution to the problems of random, catastrophic health care costs and how hospitals and doctors would receive financial payment& )he insurance and health care providers (doctors, pharmaceutical, hospitals and insurance industries and firms) have a vested interest in maintaining the system that maintains their sources of revenue&

92

(.$ Institutions and #osts

)he vested interests have an incentive to shape the formal and informal institutions that relate to their activities&

#." MORA!ITY* ;USTICE

AND A

STA$!E SOCIETY

$nstitutions

reduce the costs of the allocation process& #dditionally,

Eustice, an orderly society, tran+uility, security, peace are obEectives that are commonly held in many societies& #dam Smith (1915-19B2) is used to express these ideas here since he is generally regarded as one of the first writers to advocate a system based on morality, markets and law& Fe wrote the Theory of Mora! Sentiments in 197B to describe his view of the role of sympathy and empathy in human behavior& Fe argues that Eustice is essential for an orderly society& 4n the first page of Theory of Mora! Sentiments , Smith writes.
,o' se!fish man may e supposed% there are evident!y some princip!es in his nature% 'hich interest him in the fortune of others% and render their happiness necessary to him% though he derives nothing from it% e+cept the p!easure of seeing it. =f this /ind is pity or compassion% the emotion 'hich 'e fee! for the misery of others% 'hen 'e see it% or are made to conceive it in a very !ive!y manner. That 'e often derive sorro' from the sorro' of others% is a matter of fact too o vious to re*uire any instances to prove it< for this sentiment% !i/e a!! the other origina! passions of human nature% is y no means confined to the virtuous and humane% though they perhaps may fee! it 'ith the most e+*uisite sensi i!ity. The greatest ruffian% the most hardened vio!ator of the !a's of society is not a!together 'ithout it. (Smith, TMS, p 69)

Smith continues on the role of society in the formation of individual values.

)ere it possi !e that a human creature cou!d gro' up to manhood 6sic7 in some so!itary p!ace% 'ithout communication 'ith his 6sic7 o'n species% he cou!d no more thin/ of his o'n character% of the propriety or demerit of his o'n sentiments and conduct% of the eauty or deformity of his 6sic7 o'n mind% than of the eauty or deformity of his 6sic7 o'n face. 0!! these are o 5ects 'hich he cannot easi!y see% 'hich natura!!y he does not !oo/ at% and 'ith regard to 'hich he is provided 'ith no mirror 'hich can present them to his vie'. Bring him into society% and he is immediate!y provided 'ith the mirror 'hich he 'anted efore. It is p!aced in the countenance and ehavior of those he !ives 'ith% 'hich a!'ays mar/ 'hen they entered into% and 'hen they disapprove of his

91

(." Mora!ity% 2ustice and a Sta !e Society

sentiments< and it is here that he first vie's the propriety and impropriety of his o'n passions% the eauty and deformity of his o'n mind. (Smith, TMS, p 126)

Smith continues.
It is thus that man% 'ho can su sist on!y in society% 'as fitted y nature to that situation for 'hich he 'as made. 0!! the mem ers of human society stand in need of each other@s assistance% and are !i/e'ise e+posed to mutua! in5uries% )here the necessary assistance is reciproca!!y afforded from !ove% from gratitude% from friendship% and esteem% the society f!ourishes and is happy. 0!! the different mem ers of it are ound together y the agreea !e ands of !ove and affection% and are% as it 'ere% dra'n to one common centre of mutua! good offices. But though the necessary assistance shou!d not e afforded from such generous and disinterested motives% though among the different mem ers of society there shou!d e no mutua! !ove and affection% the society% though !ess happy and agreea !e% 'i!! not necessari!y e disso!ved. Society may su sist among different men% as among different merchants% from a sense of its uti!ity% 'ithout any mutua! !ove or affection< and though no man in it shou!d o'e any o !igation% or e ound in gratitude to any other% it may sti!! e uphe!d y a mercenary e+change of good offices according to an agreed va!uation. Society% ho'ever% cannot su sist among those 'ho are at a!! times ready to hurt and in5ure one another. (Smith TMS, p 188) . . . Society may su sist% though not in the most comforta !e state% 'ithout eneficence< ut the preva!ence of in5ustice must utter!y destroy it. . . . 2ustice% on the contrary% is the main pi!!ar that upho!ds the 'ho!e edifice. If it is removed% the great% the immense fa ric of human society% that fa ric% if I may say so% to have een the pecu!iar and dar!ing care of nature% must in a moment crum !e into atoms. (Smith TMS, p 189) 0s society cannot su sist un!ess the !a's of 5ustice are to!era !y o served% as no socia! intercourse can ta/e p!ace among men 6sic7 'ho do not genera!!y a stain from in5uring one another< the consideration of this necessity, it has been thought, was the ground upon which we approved the enforcement of the laws of Eustice, by

Smith recogni,es that beneficence and morality cannot be the only mechanism that creates order in society& Fe argues that.
This disposition to admire% a!most to 'orship% the rich and the po'erfu!% and to despise% or% at !east% to neg!ect persons of poor and mean condition% though necessary oth to esta !ish and maintain the

91

(." Mora!ity% 2ustice and a Sta !e Society

distinction of ran/s and the order of society% is% at the same time% the great and most universa! cause of the corruption of our mora! sentiments. That 'ea!th and greatness are often regarded 'ith the respect and admiration 'hich are due on!y to 'isdom and virtue< and that the contempt% of 'hich vice and fo!!y are the on!y proper o 5ects% is often most!y un5ust!y esto'ed upon poverty and 'ea/ness% has een the comp!aint of mora!ists of a!! ages. (Smith TMS, p 118)

Smith is not the only writer to argue the importance of Eustice and morality in the proper functioning of society& $lato, #ristotle, St )homas, and a host of writers argue the role of Eustice& #t the same time, most recogni,e that beneficence and cannot be the only motivating force in society& )he need for morality is based on biology and ecology. Hoan %obinson argues.
0 society cannot e+ist un!ess its mem ers have common fee!ings a out 'hat is the proper 'ay of conducting its affairs% and these common fee!ings are e+pressed in ideo!ogy. (%obinson, p 5) The io!ogica! necessity for mora!ity arises ecause% for the species to survive% any anima! must have% on the one hand some egoism?a strong urge to get food for himse!f 6sic7 and to defend his means of !ive!ihood< a!so?e+tending egoism from the individua! to the fami!y? to fight for the interests of his mate and young. =n the other hand% socia! !ife is impossi !e un!ess the pursuit of se!f?interest is mitigated y respect and compassion for others. 0 society of unmitigated egoists 'ou!d /noc/ itse!f to pieces< a perfect!y a!truistic individua! 'ou!d soon starve. There is a conf!ict et'een contrary tendencies% each of 'hich is necessary to e+istence% and there must e a set of ru!es to reconci!e them. Moreover% there must e some mechanism to ma/e an individua! /eep the ru!es 'hen they conf!ict 'ith his immediate advantage. (%obinson, p 6) & & & Since the egotistic impu!ses are stronger than the a!truistic% the c!aims of other have to e imposed upon us. The mechanism y 'hich they are imposed is the mora! sense or conscience of the individua!. (%obinson, p
7) & & &

But o serve% it is the honesty of other peop!e that is necessary for my comfort. (%obinson, p 8)

Hustice and concern for others is an important obEective that is often reflected in the golden rule. ;Co unto others as you would have them do unto you&< 4r to +uote Dvan Fill,

95

(." Mora!ity% 2ustice and a Sta !e Society

Men of many ages have considered the Do!den Ru!e to e the fundamenta! mora! imperative. #onfucius once 'as as/ed% BIs there one 'ord 'hich may serve as a ru!e of practice for a!! of one@s !ifeF@ ,e ans'ered% BIs not reciprocity such a 'ordF )hat you do not 'ant done to yourse!f% do not do to others. (Fill, p 6)

# Eust and moral society where humans can live in a peaceful environment is an obEective held by many philosophers through the ages& $erhaps for some, the history of conflict and war casts doubt on a human obEective of Eustice& #lternatively, perhaps conflicts and wars occur because of feelings or inEustice& )radition, customs, mores, and other social institutions are mechanisms through which individuals ac+uire common values& )he si,e of one(s family, forms of marriage, responsibility for children or parents, expectations about disposal of wastes, use of resources, obligations to care for less fortunate people, trust, theft, voting, creativity, duty to family (country, etc) attitudes about stewardship, are examples of values that may be generally held by the members of a community& )hese values influence the choices that individuals make&

#.# AGENTS

decision also implies the existence of an agent& #n agent is an

individual who has the authority to evaluate, select, and act on alternatives to achieve an end& )he agent may act for themselves or on the behalf of a principal& #gents choices may be based on intuition, habits (rules of thumb, institutions), explicit rules or reason& #ny decision implies that there is an end, obEective, or goal that an agent wishes to achieve& Fumans seek means to achieve ends& #s suggested above, decisions based on reason must have an obEective& Dntuition as a method for making decisions also implies that a result is desired& %ules and habits (or

96

(.( 0gents

social

institutions)

arise

because

there

is

some

desired

end

to

be

accomplished& )he +uestion is what is the origin and nature of the obEectives& oth the ends and means may be influenced or constrained by resource endowment, technology, or social institutions (such as customs, traditions, markets and law)& Dn the case of an agent or agents representing a principal, there may be a conflict or incompatibility among their obEectives& )his is referred to as the principal/agent problem& )he agent has a conflict of interest& # stockbroker acts as an agent for an investor. a doctor may act as the agent for a patient& )he lawyer acts as an agent for her client, the principal& )he goal or end of the investor may be to maximi,e earnings on their assets& )he end or obEective of the stockbroker may be to maximi,e their commission& Dn the short run, the broker may sacrifice the earnings of the investor to maximi,e commissions& Fopefully, in the long run the broker will recogni,e that the short term strategy will result in the loss of the investor as a client& )he principal must have some knowledge and information regarding the agent(s behavior& Dn a complex world, this does not always happen& *nron is an example of the principal/agent problem& )he interests (ends) of the C*4 and management (the agents) were inconsistent and had priority over the goals of the stockholders (principals)& Dn a complex world where it is difficult for principals to have information to evaluate all the action of the agents, a code of conduct or code of ethics may be important as a means to get the agent to act for the principal& )he Fippocratic oath is a social institution to insure the physician acts in the principals interests& #ccountants and lawyers are other examples of professions that rely heavily on codes of ethics to resolve conflicts between the principal and agent&

97

(.A =rgani.ations and 0gents

#.& ORGANI%ATIONS

AND

AGENTS
oth provide structure to

'rgani,ations are another way that the cost of economic activities& "orth
distinguishes between institutions and organi,ations& the costs of transferring ownership& (Coase, 1B59) )he crucial difference is that institutions are part of the rules of the game and organi,ations are participants in the game& )he firm (or any organi,ation) arises because there are costs to using the ;pricing mechanism&<
)hat the prices are have to e discovered. There are negotiations to e underta/en% contracts to e dra'n up% inspections to e made% arrangements to sett!e disputes% and so on. These costs have come to e /no'n as transaction costs. Their e+istence imp!ies that methods of co?ordination a!ternative to the mar/et% 'hich are themse!ves cost!y and in various 'ays imperfect% may nonethe!ess e prefera !e to re!ying on the pricing mechanism (marketI #uthor(s +uestion)% the on!y method of co?ordination norma!!y ana!y.ed y economists. It 'as the avoidance of the costs of carrying transactions out through the mar/et that cou!d e+p!ain the e+istence of the firm% in 'hich the a!!ocation of factors came a out as the resu!t of administrative decisions. In the &ature of the ;irm I argued that in a competitive system there 'ou!d e an optimum of p!anning since a firm% that !itt!e p!anned society% cou!d on!y continue to e+ist if it performed its co?ordination function at a !o'er cost than 'ou!d e incurred if co?ordination 'ere achieved y means of mar/et transations and at a !o'er cost than this same function cou!d e performed y another firm. . . . I argued in The &ature of the ;irm that the e+istence of transaction cost !eads to the emergence of the firm. 6#oase 1GGA% p 9?G7

human interactions& %onald Coase (1B12-) sees both as mechanisms to reduce

)he firm (or any organi,ation) comes into existence to create a small ;planned society< and to use administrative decisions to allocate resources because it would be more costly to use market exchange& :irms (or organi,ations) may be for profit, not-for-profit, cooperatives, sole proprietorships, partnerships or corporations& )here are many ways of categori,ing organi,ations&

98

(.A =rgani.ations and 0gents

Githin a firm the C*4,

oard of Cirectors, shareholders, 3ice-$resident of

-arketing, 3ice-$resident of $roduction and the assembly line workers may have competing obEectives that will be resolved by authority, contract, or some other social institution& )here are managerial techni+ues that might be used to coordinate the activities of the diverse groups in a firm& Dn a family, the parents may have different ends than the children& )here are parental ;instincts,< love and social expectations as well as laws that insure the parents act in the child(s interests& Githin an organi,ation, the principal/agent problem becomes important& 0sually a manager (C*4) makes administrative decisions that affect many other groups& )heir administrative decisions may be guided by general policies and guidelines established by a oard of Cirectors who in turn is constrained by the shareholders (or owners)& )he obEectives of the shareholders may or may not be reflected by the decisions of the manager& )he manager may have a different set of obEective and the shareholders may or may not have information (or control) over the decisions of the manager& Kenneth 'ay and the management of *nron is an example of the principal/agent problem&

#.' O$;ECTIVES

An obEective, goal or end is something that an individual or group of

individuals hopes to achieve& )here may be many alternatives that will potentially achieve the end or goal& Some alternatives have a higher probability of success& )he alternative that is selected, through reason, rules, habits or intuition, is the means& Dt is not always clear how humans create their obEectives or ends& 4ne hypothesis is that they are capable of thought and can imagine alternative states or conditions& Df the alternative state is perceived as preferable to the

99

(.4 = 5ectives

existing state, the alternative state becomes an end& )his process necessarily re+uires a subEective valuation or ranking of alternative states or conditions& D am hungry& D can perceive or imagine myself not being hungry& "ot being hungry is preferable to being hungry so the obEective or end is to reach the preferred state& )he mind is capable of recogni,ing an incongruity between what is and what D imagine can be& D may seek the means to satisfy my hunger through reason& Dntuition, rules or habitual patterns of behavior may also suggest means of satisfying my hunger& -any substances will satisfy hunger& =eographic differences and resource endowment may alter what people choose to eat& Dnuit people eat whale and sea lion& Dn the southwestern 0nited States pinto beans, corn and chili peppers are favorites& Dn :rance, escargot is a delicacy& Dndividuals often develop a ;taste< or preference for a food they ate as a child& #s a result, we often think of foods as representing different social of ethnic groups& Dtalian, Chinese, -exican, Dndian are examples of ethnic foods that represent different social groups from different locations& Funger is a physiological stimulus so it is easy to recogni,e the incongruity between being hungry and not being hungry& 4ther events are more complex& D have shelter that is ade+uate (a 922 s+uare foot shelter that has plumbing and heat) but can imagine a larger house (5222 s+uare foot with a den and multiple bathrooms) that D would prefer& Df the 922 s+uare foot house is ade+uate, why is the larger house preferredI Ds it because D perceive that my neighbors (the community) associate the bigger house with statusI Co the values of the community influence my preferencesI Df my obEective or end was to ac+uire status, the large house was the means to achieve that end& Df my obEective was to have enough room for a large family, the large house may be the means to achieve that end& )o the casual observer the ac+uisition of a large house may incorrectly be seen as the desired end&

9A

(.4 = 5ectives

*conomics is a study that is based on scarcity of the means to achieve obEectives& #s a result, choices must be made on the relative values that are placed on the competing obEectives& )o repeat from above, Garren Samuels argues that the ;economy is a process of va!uation L& That to ehave and to choose is to engage in va!uation and there y to participate in the socia!% or socioeconomic% va!uation process.< ?Samuels p ix@ Fe goes on to point out that, ;the economy encompasses more than the mar/et L< and ;that other nonmar/et va!uationa! processes e+ist&< )hese valuational processes are used to choose among competing ends, or obEectives&

#.( ECONOMIC

O$;ECTIVES

;ustice,

respect from others and creativity are not easily measured&

Dncome, +uantities of goods and prices are more easily measured& )here are many complexities in measuring incomes, +uantities of goods and prices& Dn spite of measurement problems, individuals tend to focus on phenomena that can be ranked or associated with a magnitude (or number)& )his is particularly a problem when +uantifiable obEectives are to be traded off for non+uantifiable obEectives& *xamples include an individual who sacrifices a larger salary for a Eob with more activities that are creative or to remain near a personal relationship& )he appreciation of environment or wildlife may be sacrificed for Eobs or timber production& *conomic obEectives are complex linkages& 0tilitarianism is the

philosophical foundation of modern economics& )he perceived obEective is to maximi,e the utility or welfare of the members of society& Dn a simplistic world, the welfare or utility of the community is the sum of the utilities or each member of that society& )herefore, if each individual maximi,es their utility it will maximi,e the utility of the group& )he maximi,ation of each individual(s

9B

(.8 Economic o 5ectives

utility is consistent with the maximi,ation of the utility of society& )his view re+uires a social mechanism or institution to coordinate or constrain the behavior of individuals& )he constraints may be social institutions such as moral rules, mores, customs, laws, or the market& Since it is not possible to measure utility, welfare or happiness, utility is connected to variables that can be measured& Dn orthodox economics, a person(s utility is a function of (or determined by) the +uantity of goods and services they consume& Since utility can(t be measured and is a function of the +uantity of goods, an increase in the +uantity of goods consumed is assumed to increase utility or welfare. more goods are preferred to fe'er goods & #s a result, economic growth, producing more goods (as measured by gross domestic product) becomes a perceived obEective& )he inability to measure utility also leads to the use of price as a proxy& )he price of a good is perceived as an indicator of its value& %elative prices are seen as information that can be used to rank the worth or value of goods& )he inability to measure utility directly leads to a focus on +uantities of goods and their relative prices as a substitute& )his process often leads to ignoring or minimi,ing the importance of non-market obEectives& Df prices are distorted by lack of information or imperfections in the social institutions, the rankings based on relative prices may be misleading& Dn the modern world our obEectives and behavior may be altered by advertising& :ashion and fads populari,ed in the media also shape our obEective and the means we choose to achieve them&

A2

A #riteria for Eva!uation

@ *&$TE&$A

-'&

E3A2)AT$'%

$ndividuals must make choices about their obEectives (or ends) and the
alternatives (means) they choose to achieve those obEectives& )o make these choices, it is necessary to value or prioriti,e ends and means& )he process of ranking and the ultimate selection of priorities re+uire criteria to value the alternatives& oth ends and means can be ranked on the basis of tradition& Communities often develop traditional solutions to economic problems& Dn some societies, the solution to the problem of food ac+uisition may be hunting& Funting a given specie or species of animals provides a workable solution given technology, natural and built environments& %eligion and other social institutions may develop to support these solutions& 0se of tradition and institutions (and rules of thumb) to choose ends and means is a way of minimi,ing the use of analysis and reasoning to make choices. there are a set of ready-made choices& )hese traditional ends and means are created and evolve as workable solutions to problems& Dn many cases, traditional solutions may be very effective& Fowever, traditions by their nature persist over time (tend to maintain the status +uo) and may become less effective as circumstances change& Ghen natural or built environments change society may still cling to the traditional solutions in the face of declining success& %eligion, the vested interests, desire for the old ways and human resistance to change are examples of forces that inhibit the search for new solutions& )he ranking of ends and means by tradition may lag behind the changes in knowledge, technology and environmental circumstance& Df traditions and existing institutions result in increasingly less successful results, new solutions that are more consistent with individual values and expectations may emerge&

A1

A.1 #riteria to Eva!uate Ends and Means

&.1 CRITERIA

TO

EVA!UATE ENDS

AND

MEANS

The

evaluation and ranking of both ends and means re+uires the

application of ethical principles& #t another level, the choices of means to achieve a given end may appear to be based on efficiency& *thics is the study of the process by which an obEective (and/or the means used) is Eudged ;right or wrong&< *fficiency is a measure of the extent to which an obEective is achieved& *fficiency can only be used to evaluate the means used to achieve a goal or end& 0ltimately, efficiency rests on a foundation of ethics& #n immoral obEective can be achieved ;efficiently&< "a,i =ermany sought ;efficient< means to achieve the annihilation of an ethnic group& -odern, neoclassical economics is often perceived as a study of efficiency with in the context of a very specific ethical system. ;utilitarianism&<

&.2 ET

ICS

Ethics is the branch of philosophy that studies the nature of ;right and
wrong< and the criteria used to evaluate the moral +uestions about ends, choices, means and behavior& #lbert Schweit,er is +uoted,
In a genera! sense% ethics is the name 'e give to our concern for good ehavior. )e fee! an o !igation to consider not on!y our o'n persona! 'e!!? eing% ut a!so that of others and of human society as a 'ho!e.

6*uoted in ,i!!% p (7 Fumans tend to rationali,e and Eustify their values, beliefs and behavior. they like to think that what they believe and do is ;the right thing to do&< :or our purposes, there are two broad approaches to Eudging right and wrong& 4ne approach is to Eudge the moral +uality of an end or action based on duty& )his is called deontological ethics& )he second approach is to Eudge the rightness or wrongness with regard to the conse+uences or outcomes of

A1

A.$ Ethics

actions& )his approach is referred to as axiological ethics& # third approach is teleological ethics that presumes that each person or community has some uni+ue purpose and that the moral obEective should be the attainment of that purpose&
(E'%T'2'8$*A2 ET4$*,

Dn deontological ethics, right and wrong are Eudged on ;duty&< Dndividuals often engage in activities and make choices that are based on a sense of duty& )hese duties may be based on tradition, expectations or more formal rules& )he rightness of behavior is can be seen as compliance with these rules& Dt should be noted that these rules may be implicit or explicit& )he belief that individuals have an obligation to tell the truth, not to kill, to vote or to serve their country are examples of rules that specify duties& Dn an exchange relationship the seller (or buyer) may have a duty to provide information to the buyer (or seller)&
A=$'2'8$*A2 '& *'%,EE)E%T$A2$,T ET4$*,

%ight and wrong (or goodness and badness) of an act (or choice) is based on the value of the outcome of that act (or choice) in axiological ethics& 4ne subset of axiological ethics is conse+uentialist ethics& Dn conse+uentialist ethics, the conse+uences of actions determines what an individual ought to do and will do& 0tilitarianism is a conse+uentialist ethic that provides the ethical foundation of orthodox microeconomics& "eoclassical economics is based on 0tilitarianism, a system of ethics that was formali,ed by Heremy entham ?196A-1A51@& entham believed that seeking pleasure (happiness, satisfaction, welfare or utility) and avoiding pain determined what individuals do and should do& Dt is based on the goal of maximi,ing the welfare or utility of the people ;whose interests are of concern&< )he rightness or wrongness of a choice is based on the outcome or the utility that results from that choice& Df the total utility of the group is

A5

A.$ Ethics

increased, the choice was ;right&< Df utility is decreased, the choice was unEustified by this ethical standard& Dn the Introduction to the Princip!es of Mora!s and 1egis!ation (19AB), entham makes the following observations&

)6ature has placed mankind under the governance of two sovereign masters, pain and pleasure* /t is for them alone to point out what we ought to do, as well as what we shall do*+ 3Bentham, Principles, &hapter /5 )By utility is meant that property in any ob0ect, whereby it tends to produce benefit, advantage, pleasure, good, or happiness or to prevent the happening of mischief, pain, evil, or unhappiness to the party whose interest is considered: if that party be the community in general, then the happiness of the community: if a particular individual, then the happiness of that individual*+ 3/bid*5 )'he interests of the community then is, what8 ;;the sum of the interests of the several members who compose it*+ 3/bid*5 )he conse+uentialist ethic of 0tilitarianism and neoclassical economics is based on the maximi,ation of each individual(s utility& Dt provides the criteria that are used to Eudge what we should do and it is the stimulus that directs what we do& )he interest or welfare of the community is the sum of the interests of individuals therefore the sum of individuals( utilities is the community or social welfare& #nything that increases the utility or welfare of an individual or society is perceived as ethically correct& entham tried to create a method to calculate the utility or welfare of a community. a ;felicific calculus&< Fis approach re+uired that each individual(s utilities be independent other individuals utility functions so that they could be added& )his process is a form of ;reductionism,< the overall system is simply the sum of its parts& entham considered seven characteristics of each act to calculate the conse+uences& )hese included. intensity (of pleasure or pain), the duration, the certainty, propin+uity (nearness in place or time), fecundity (capacity to produce similar results), purity and the extent or number of persons affected& entham argues the process is to

Sum up a!! the va!ues of a!! the p!easures on the one side% and those of

A6

A.$ Ethics

a!! the pains on the other. The a!ance if it e on the side of p!easure% 'i!! give the good tendency of the act upon the 'ho!e% 'ith respect to the interests of that individua! person< if on the side of pain% the ad tendency of it upon the 'ho!e. ( entham, p 5B)

entham(s utilitarianism is a benefit-cost analysis of pleasure and pain& Df the pleasure associated with an act exceeds the pains associated with that act, the act is Eustified by conse+uentialist ethics& Dn economics, finance, accounting and policy analysis, benefit/cost analysis is often used in decision making. if the benefit/cost ratio exceeds one, the proEect is Eustified& )he difference between entham and modern benefit/cost analysis is that entham(s approach is much broader& Dn modern benefit/cost analysis, prices of goods are substituted for pleasure and pain& 4nly market pleasures (utiltity) and pain (cost) are used in the analysis& $leasure and pain encompass emotional and non-market values held by individuals&

&." EFFICIENCY

Efficiency is a measure of the extent to which an obEective has been

achieved& Df an obEective is immoral or unethical, efficiency can still be used to evaluate the extent to which the obEective is met& Consider the construction of ovens& Df an oven is ;too small<, there is inefficiency in the loss of energy because the door is opened and closed more fre+uently& Df an oven is ;too large< it is inefficient in heating too much space& )he choice of using a toaster oven or a full si,e oven is a Eudgment about their efficiency at different tasks& Df the task were to dispose of human bodies during genocide, efficiency would be important in determining the si,e of the ovens even though the obEective is clearly immoral& Dt is possible to have obEectives that are unethical or wrong and still achieve those obEectives with different degrees of efficiency& Df an obEective were good, moral or ethically correct, then greater efficiency would be

A7

A." Efficiency

desirable& Df the obEective is immoral or bad, then greater efficiency is not necessarily desirable& Df there are alternative means to achieve an ethical obEective, the means may have different levels of efficiency& Dt is also possible that the different means will be more or less ethical than others& Dn this case, it may be necessary to Eudge between an efficient less ethical means and a less efficient more ethical one& )he idea of efficiency was borrowed from physics& *nergy efficiency is often measured as.
M efficiency N useful energy produced total energy used x 122

-echanical efficiency is defined as.

M efficiency N output power input power

H 122

Dn economics, efficiency can be thought of as a ratio of outputs to inputs& )he resources used in production are the inputs and the goods (and services) that are produced are the output& *fficiency is not in and of itself an obEective& Dt is possible to efficiently pursue immoral obEectives& Dt is also possible to pursue ethical ends with unethical means& Several variations of efficiency are relevant in economics. technical efficiency, allocative or economic efficiency and $areto efficiency& )hese concepts of efficiency are straightforward. the difficulty lies in measurement of output, value of outputs, inputs and the value of inputs& Dn neoclassical microeconomics, utilitarian ethics is the foundation of the concepts of efficiency& %elative prices of inputs and outputs are used as proxies or surrogates for relative values& #gain, remember the warning of 4scar Gilde.

A8

A." Efficiency

;# cynic is someone who knows the price of everything and the value of nothing&< $rice and value are not the same thing, but prices may be used as an approximation of value& $rices may not reflect all the benefits or costs associated with a choice& )hey may be distorted in a variety of ways. exchange may not be voluntary. agents may engage in deception, institutions may be inconsistent with technical and environmental circumstances, regulations and other problems&

@#1#1 TE*4%$*A2 E--$*$E%*5

'ne

of the functions of an economic system is to coordinate the

production of goods (and services)& )he technical efficiency of a productive process is the ratio of the outputs (or resources used) to the input (of goods and services)& Df an economic system produced two goods. >ebecs (O >) and !awls (O!), the output could be measured as O > P O!& )he inputs would be the sum of the resources used ('and Q, labor (') and capital (K))& *fficiency can be expressed as.
)echnical efficiency N O> P O ! % P' PK

output input

@#1#2 P&'()*T$'% P',,$:$2$T$E, -)%*T$'%

Efficiency as a market phenomenon can be illustrated using a production

possibilities model& (Sometimes called a $roduction possibilities function, production possibilities curve, production possibility frontier, $$: or transformation function)& )he $$: is a model that identifies all the production alternatives that are possible for two goods given a set of inputs and a state of technical knowledge& 0sing the e+uation from above.

A9

A.".$ Production Possi i!ities ;unction

$utput is => ? =@ or the 4uantity of good > 3(ebecs5 plus the 4uantity of good @ 3@awls5, there are alternative 4uantities of = > and =@ that can be produced* By limiting the outputs to two goods, the model can be constructed in two;dimensional space 3on a graph5* /f three goods are considered, the model re4uires a thee;dimensional space* /nputs are: A 3natural resources5 ? - 3labor5 ? B 3capital5, these resources are finite and given at any point in time* 'he state of technology is the information the agents have about the various ways of producing different 4uantities of goods > 3(ebecs, or = >5 and @ 3yawls, or =@5* Df all inputs and the best technology available were allocated to the production of xebecs (O>), a finite +uantity could be produced& Dn :igure 7&1 this is shown at point = on the > axis when 51 units are produced& Since no inputs are allocated to the production of yawls (O !), none are produced& Df the agents decided that some yawls were desired, they would have to take some of the inputs from the production of xebecs to use in the production of yawls& Since all the inputs (and best technology) were used to produce 51 xebecs in our example, any reallocation of inputs from the production of xebecs to yawls would re+uire a sacrifice, or the production and availability of fewer units of xebecs& )his can be shown as a move from point = (O > N 51. O! N 2) to point : (O> N 51. O! N 12)& )he production of 12 units of yawls re+uires the sacrifice of 1 units of xebecs (51-51N1)& )he inputs that are least effective in producing xebecs would be reallocated to the production of yawls& )he sacrifice of xebecs would be minimi,ed& (!ou would not shift the best resources to produce xebecs into the production of yawl. that would maximi,e the sacrifice&) #t point # (O> N 2. O! N 75), all inputs are allocated to the production of yawls so no xebecs are produced& %esources can be reallocated from the production of yawls to produce xebecs. the first five units of xebecs can be produced by sacrificing the output of 5 yawls& #gain, the least effective inputs in the production of yawls would be shifted to the production of xebecs& )his can be shown as a movement from point # to point & Sacrifice of one good to produce more of the other is called ;opportunity cost&< Ge can locate other

AA

A.".$ Production Possi i!ities ;unction

output alternatives along the $$:. points #,

, C, C, *, :, = all represents

alternative outputs of xebecs and yawls& #ny point that lies on the $$: is an output alternative that represents a combination of O > and O! that can be produced given inputs and technology& #ny output combination inside the $$: is possible but, would not be the maximum amounts of > and ! that could be produced& 4utput combinations that lie outside the $$: are not attainable or feasible given the inputs and technology available& )he output combination at point F (O >N18. O!N12) is clearly not efficient. more > or ! or both can be produced given the inputs and technology& (%emember, %, ', K and technology, inputs are fixed&) %esources can be reallocated to produce more xebecs (a move to point *), to produce more yawls (point C) or more of both (any point in the triangle F*C& #ny output combination that can be shown as a point on the $$: can be considered as ;technically efficient&< #ny output combination that falls inside the $$: is technically inefficient. there are unused inputs or inputs are not being used for the most appropriate purpose& Clearly there is a problem. there are an infinite number of output combinations (any point on the $$:) which are technically efficient& )here are also an infinite number of output combinations that lie inside the $$: that are technically inefficient& Df we expand the model to include the ratio of output to inputs, an increase in technical efficiency could be the result of. an increase in the output of either good while the other good and inputs are held constant an increase in both goods while inputs are held constant a decrease in the inputs while the output is held constant an increase in output and a decrease in inputs*

# movement from a point inside the $$: to a point on the curve is can be regarded as an ;increase in efficiency&< #n improvement in technical

AB

A.".$ Production Possi i!ities ;unction

knowledge can also be regarded as an ;increase in efficiency< since the same output combination could be produced with fewer inputs& )he technological improvement can also be envisioned as a shift of the $$:, more output can be produced if the same +uantities of inputs are used& )his is shown in :igure 7&1& )here are an infinite number of technically efficient solutions to the allocation problem& Fowever, there is only one allocation that achieves economic or allocative efficiency&
A22'*AT$3E '& E*'%'+$* E--$*$E%*5

Since >ebecs (good O>) and !awls (good O!) are not the same things, it does not make sense to add them together (case of adding apples and oranges, O> PO!)& Df the values of the two (or more) goods were known or there were an acceptable proxy for the value, it would be possible to add their values& %emember that one of the tasks of the economic process is to allocate resources to their highest valued use& )echnical efficiency is a prere+uisite for allocative efficiency& *conomic or allocative efficiency takes into account the value of both the inputs and outputs& *conomic efficiency is measured by a ratio of the value of the output to the value of the inputs& 3alue is a complex notion and market prices are often used as an indicator of exchange value& (%emember the warning of 4scar Gilde. ;0 cynic is some one 'ho /no's the price of everything and the va!ue of nothing&<) 'acking a better proxy for value, price is often used& Df the price of good > ($ >) and good ! ($!) are proxies for their value and the wage or price of labor (G ' or $') and capital ($K or M) were proxies for their values then allocative or economic efficiency might be represented as.
#llocative efficiency N value of output value of input N $> O > P$! O ! $'' P $KK

B2

A.".$ Production Possi i!ities ;unction

='

I
=uantity of @awls

4 &

=iven the original $$: as line %#& #n improvement in technology that impacts only the production of xebecs can be seen as a shift from %# to % & #n improvement in technology that influences only the production of !awls would be a shift from %# to F#& )echnology that impacts the production of both goods would be a shift from %# to F & )hese outward shifts are sometimes called ;economic growth&< A change in inputs could also be shown as shifts in the PPC, a decrease in inputs would shift the PPC inward toward the origin* An increase in inputs would shift the PPC outward*

B =6 A
=uantity of >ebecs

Cigure <*!

#llocative efficiency is not only influenced by the +uantities of the goods produced and +uantities of the inputs used, but the relative values of the inputs and outputs are also important& )he benefits or value of an alternative can be expressed as $>O> P$!O!& )he costs of the alternative could be expresses as $'' P $KK& =iven a set of inputs and technology the solution that achieves allocative efficiency is the highest valued output possible given the inputs and prices&
Eiven inputs and a state of technology, the alternative sets of outputs are shown by the production possibilities function* /f all inputs are used to produce @awls 3good @, or =@5, a ma(imum of <7 units can be produced* /f the inputs are reallocated to produce < >ebecs 3good >, or =>5, it will be possible to only produce <" yawls* At the output shown by point &, #F units of (ebecs and :" units of yawls are produced* /f all inputs are used to produce >ebecs 3=>H 7! at point E5, a ma(imum of 7! units of > can be produced* Eiven technology and inputs, all possible output combinations are shown by all points that lie along and inside the line AB&DDCE* A change in inputs or technology will shift the production possibilities frontier* <7 <" =uantity of @awls 3 = @5 :" 7" !" #" D A

B &

D C E

<

#F

!:

!G

7!

Cigure <*#

=uantity of >ebecs 3=>5

B1

A.".$ Production Possi i!ities ;unction

0sing the same production possibilities function as in :igure 7&1, allocative efficiency can be described in :igure 7&5# Dn this example, the optimal output alternative is that with the highest value& Since value cannot be measured directly, neoclassical economists use market price as an approximation of value& Dn order for market price to be a reasonable approximation, exchanges must be voluntary exchanges of goods with exclusive property rights& Df the price of xebecs were R6 and the price of yawls were R1 the ;value< of each alternative identified in :igure 7&1 can be calculated& #lternative # is worth R128, alternative is worth R112, C is worth R166, C is worth R178, * is also ;valued< at R178& )he output at alternative : is worth R166 and at = is worth R11A& )hese calculations can be seen in )able 7&5& )he highest valued output, based on market prices will lie on the $$: between alternatives C (valued at R178) and C (also R178)& Df the prices of the goods are accepted as the value of the goods, the calculation of each alternative are shown in )able 7&1 Df the price of good ! should rise to R5&72 (and the price of > stay at R6) the alternative with the ;highest value< is at point C as shown in )able 7&1& )he alternative that is allocatively or economically efficient is dependent on a set of prices that measures value& Ge will explore the ability of the market to accurately reflect values of outputs& Dt is also important to note that there are many things that humans value that cannot be expressed as a market price&

B1

A.".$ Production Possi i!ities ;unction

3J#"F5 'he PPC is determined by the finite 4uantity of inputs and technology* /f the price of (ebecs is J: 3P>HJ:5 and the price of yawls is J! 3P@HJ!5, at point A the )value+ of good > is " and the )value+ of good @ is J#"F, the )value+ of the output 3given prices5 is J#"F* #t point the value of the output of good > is R12 (R6x7 units >), the value of good ! is R122 (R1x72 units !)& )he value of output of good > and ! is R112& At D and D the value of the output is J#<F* Some where between alternatives D and D on the PPC the value of the output will reach a ma(imum* /t is where the slope of the PPC is e4ual to <7 <" =uantity of @awls 3 = @5 :" 7" 3J#":5 !" #" A B 3J#!"5 3J#::5 & 3J#<F5 D

3J#<F5 D 3J#::5 C 3J#!K5 E

$>

$!

Any alternative inside the PPC will be valued at less than the ma(imum value*

<

#F

!:

!G

7!

Cigure <*7

=uantity of >ebecs 3=>5

B5

A.".$ Production Possi i!ities ;unction

)able 7&1 #llocative *fficiency and 3alue of 4utput

3alue of output of > ($> O>) 3alue of output of ! ($! O!) 75 R1&22 72 R1&22 62 R1&22 52 R1&22 12 R1&22 12 R1&22 2 R1&22 R128&22 R122&22 RA2&22 R82&22 R62&22 R12&22 R2&22 R62&22 3alue of output ($>O> P $!O!) R128&22 R112&22 R166&22 R178&22 R178&22 R166&22 R11A&22 R126&22

O>
#lternative

$>

O!

$!

2 7

R6&22 R6&22

R2&22 R12&22 R86&22 RB8&22 R118&22 R116&22 R11A&22 R86&22

C C * : = F

18 R6&22 16 R6&22 1B R6&22 51 R6&22 51 R6&22 18 R6&22

12 R1&22

B6

A.".$ Production Possi i!ities ;unction

)able 7&1

#llocative *fficiency and 3alue of 4utput

3alue of output of > ($>O>) 3alue of 3alue of output output of ! ($!O!) 75 R5&72 72 R5&72 62 R5&72 52 R5&72 12 R5&72 12 R5&72 2 R5&72 R1A7&72 R197&22 R162&22 R127&22 R92&22 R57&22 R2&22 R92&22 ($>O> P $!O!) R1A7&72 R1B7&22 R126&22 R121&22 R1A8&22 R17B&22 R11A&22 R156&22

O>
#lternative

$>

O!

$!

2 7

R6&22 R6&22

R2&22 R12&22 R86&22 RB8&22 R118&22 R116&22 R11A&22 R86&22

C C * : = F

18 R6&22 16 R6&22 1B R6&22 51 R6&22 51 R6&22 18 R6&22

12 R5&72

B7

A."." Pareto Efficiency

@#1#1 PA&ET' E--$*$E%*5

At a technical level, economics provides a set of tools to aid in choosing

among competing alternatives& Dn 1B28 an Dtalian, :rench, Swiss, engineer, sociologist, economist 3ilfredo $areto (1A6A-1B15) introduced the concept of $areto optimality as a means to undermine the role of utilitarianism in economics& Dnstead, it became the foundation for what is now called benefit cost analysis and its derivative measures of allocative performance such as rate of return on investment and cost effectiveness& Consider a community of individuals& !our task is to choose an alternative to maximi,e the welfare or utility of the group& Df there were an alternative that would improve the welfare (or increase the utility) of at least one person in the group without making any one worse off (decrease their welfare or utility), you should choose to that alternative& Fowever, if all the alternatives that would make at least one person better off would also make at least one other person worse off, you cannot know if that alternative would improve the wellbeing (utility) of the group& Pareto e00icienc. is the condition where all alternatives that would increase the welfare of at least one person without decreasing the welfare of others have been exhausted& )here is nothing that can be done to improve the welfare of anyone without making someone else worse off& Dn the $$: model (:igure 7&6), $areto efficiency exists at any point on the $$: once you have attained that point&

B8

A."." Pareto Efficiency

=uantity of @awls 3

Eiven the PPC, point I is not Pareto efficient: more > 3@5 can be produced with no sacrifice of good @ 3>5* A move to any output combination identified in the triangle ID& is a Pareto improvementL some one 3or everyone5 is better off and no one is any worse offL this area is Pareto Safe* A move to any point in the Pareto Safe area is a Pareto improvement or is Pareto superior* $nce on the PPC 3point D for e(ample5 any change to improve the welfare of an individual 3or group5 who prefers good @, would make those who prefer good > )worse off*+ 'o increase the 4uantity of @, from point D to point &, would re4uire that less > would be produced*

<7 <"

B &

= @5

:" 7" !" #" D

D C E

<

#F

!:

!G

7!

Cigure <*:

=uantity of >ebecs 3=>5

Pareto e00icienc. can be used as a criterion to decide whether to chose an alternative& Df a choice makes some one better off and no one any worse off, it is a choice that will increase the achievement of the goal or end of maximi,ing the utility or welfare of the group& )his can be ;Pareto ,a0e,< i&e& the output can be altered so someone is ;better off< and no one is worse off& #ny change that increases the welfare of one person or persons that does not reduce the welfare of another is a ; Pareto i/prove/ent< or $areto Safe and will clearly increase the welfare or utility of the community& #ny alternative that results in a greater utility of at least one person and no decrease in the utility of anyone can be referred to as ; Pareto superior&< )he problem is that this criterion tends to support the status +uo& #lmost all choices that increase the utility of an individual or group will make others worse off& Since a $areto efficiency criterion is very restrictive, Pareto Potential is may be used& )his is the same as the benefit/cost criterion& $areto potential holds that if a choice or alternative makes one person or

B9

A."." Pareto Efficiency

group better off but others are worse off, if the ;winners< or those who gain can hypothetically reimburse those who are ;losers< (or are worse off) and still be better off, the alternative will increase the utility of the group& Dn a more simplistic way, the benefits associated with the choice exceed the costs&
PA&ET' P'TE%T$A26 :E%E-$T!*',T A%( +A&8$%A2 A%A25,$,

)he $areto potential criterion for decision making is the foundation of analysis that use benefit/cost, cost effectiveness and rate of return for decision making& +ar"inal Anal.sis )he process of making decisions is like the proverb ;)he longest Eourney begins with the first step&< 4r like the +uestion posed by #lbert Camus (1B151B82) about the individual deciding each day about suicide or continuing life& )he individual taking a Eourney must make the decision about taking the first step before they decide on the second& Dn Camus( case, one must decide not to committee suicide before you tackle the rest of the day& Cecisions in economics are always made at the ;margin&< # decision to change one variable will cause a change in some other related variable& #n act or choice will have benefits and costs associated with that act& #n increase in the production of xebecs may re+uire a reduction in the production of !awls. the benefit is more xebecs, the cost is fewer yawls& # change in the price of a good will change the +uantity sold, a change in the +uantity sold will change the total revenue collected& )he change in total revenue caused by a change in units sold is called marginal revenue& )he marginal concept is applied to a wide variety of relationships& Dn principles of economics, these are usually described as a ;one unit< change in the variables& )he =reek letter delta, is used to identify a change calculated by

BA

A."." Pareto Efficiency

subtraction& Dn other cases, a derivative (d) or partial derivative (S) will be used to denote a change that approaches 2& )he use of marginal is applied to many economic relationships& Dn fact, the early period of the development of microeconomics (mid to late 1B th century) was called the ;margina!ist revo!ution&< useful marginal relationships& +ar"inal *ost (+*) -C is defined as the change in )otal Cost ()C) or variable cost (3C) caused by a one unit change in the +uantity produced, output (O)& -C represents opportunity cost& elow are some definitions of several

MC =

TC VC = Q Q

Equ2tio< &."

+ar"inal :ene0it (+:) is defined as the change in total benefit () ) caused by a one unit change

in +uantity consumed (O)&

MB =

TB Q

Equ2tio< &.#

+ar"inal )tilit. (+))

MU =

TU Q

Equ2tio< &.&

-0 is the change in utility caused by a change in +uantity consumed (O)

*4'$*E A%( +A&8$%A2 A%A25,$,

BB

A."." Pareto Efficiency

Df $areto $otential or the

enefit/Cost criteria are to be used for decision-

making, the rule is +uite simple. if the benefits associated with a choice (or alternative) exceed the costs associated with that choice, then the choice will increase net benefits& Df the costs of an alternative exceed the benefits of that alternative, then that alternative is not a good choice&
E=A+P2E :E%E-$T!*',T ),$%8 +A&8$%A2 A%A25,$,

0sing the example $$: presented in :igure 7&7 (Same $$: as in 7&1, 7&5, 7&6 ) Consider the $$: in :igure 7&7. >ebecs are priced at R6 ($>N R6) and

yawls are R5&72 ($! N R5&72)& Df the initial output were where O>N 18 and O! N 12, which is represented at point F& #t these prices, the output of xebecs is ;worth< R86 and yawls are worth R92& )he ;value< of the output alternative identified at point F is R156&

$riginal allocation is at I 3=>H#F, =@H!"5L P> H J: and P@ H J7*<" Alternative D 3&, D or any choice in triangle ID&5 has no &, the output of > or @ or both > and @ increases so the B is positive* 'he BM& ratio of any alternative is grater than one, the BN &* /f production were at point D 3=>H!:, =@H7"5, a choice of alternative & would result in =>H#F, =@H:", K units of > are traded for #" units of @* Si( fewer units of > at J: each is a & of J!:* 'he B is #" additional units of @ at J7*<" each or JJ7<* 'he BN &, 'he BM& ratio N#, the net benefits will increase by J## by selecting alternative & over D* Alternative & is worth

<7 <"

B &

= @5
=uantity of @awls 3

:" 7" !" #" D

D C E

<

#F

!:

!G

7!

Cigure <*<

=uantity of >ebecs 3=>5

122

A."." Pareto Efficiency

&ankin" o0 Alternative 4 Fith Alternative E Df alternative * were chosen over alternative F, 15 additional units of xebecs would be produced (1B-18N15)& )his is the marginal benefit (- ) of the choice of reallocating resources from alternative F to *& Df xebecs were valued at R6 each, that would be a of R71 in monetary terms& )his can be viewed as a move from row F to row * in )able 7&5

)able 7&5 #llocative *fficiency and 3alue of 4utput

#lte rnat ive

O>

$> R6&22 R6&22 R6&22 R6&22 R6&22 R6&22

3alue of output of > ($>O>) R2&22 R12&22 R86&22 RB8&22 R118&22 R116&22

O! 75 72 62 52 12 12

$! R5&72 R5&72 R5&72 R5&72 R5&72 R5&72

3alue of output of ! ($!O!) R1A7&72 R197&22 R162&22 R127&22 R92&22 R57&22

3alue of output ($>O> P $!O!) R1A7&72 R1B7&22 R126&22 R121&22 R1A8&22 R17B&22

# 2 7 C 18 C 16 * 1B : 51

)his reallocation of resources would not reduce the output of yawls, so the marginal cost of the reallocation is 2& Since the T -C, the reallocation or inputs to move the output alternative from F to * would be an improvement in the achievement of the obEective (producing the highest valued output)& )he output of xebecs and yawls at point * is R1A8 (156 P 71. the value of the output at F added to the of reallocation of inputs)

)he relative prices of xebecs and yawls are irrelevant since the marginal cost (-C) is ,ero& #ny increased production of xebecs at any positive price would be a $areto improvement& # reallocation to point C, C or any output combination that lies in the triangle F*C would be a $areto improvement (or $areto superior to the allocation at point F)&

121

A."." Pareto Efficiency

&ankin" o0 Alternative E Fith Alternative Df the current output were at point * (O >N 1B and O! N 12), and alternative : (O>N 51 and O! N 12) is considered& )he marginal benefit (the benefit associated with reallocating resources to point :) would be an additional 5 units of xebecs (51-1BN5)& #t R6 each this is a of R11 in monetary terms& Fowever, the reallocation of resources from F to : re+uires a sacrifice or -C of 12 units of yawls (12-12N12)& #t a price of R5&72 the -C is R57 in monetary value& )he -C N 57. N 11& # reallocation of inputs to move from point * to point : would be trading R11 for R57. not a good idea& &ankin" o0 Alternative E and Alternative ( # reallocation of resources from alternative * to alternative C would result in an increased output of 12 yawls& #t a price of R5&72, the units of xebecs& #t R6 each this is a -C of R12& Since the is R57& )his reallocation reduces the output of xebecs from 1B to 16, a marginal cost of 7 T -C (57 T 12), the reallocation of inputs from the production of the output at point * to point is Eustified by our benefit/cost criterion& "otice that the net gain to society is R17, so point C is ;worth< R17 more than the output at point *& C is ;valued< at R121 and * is ;valued< at R1A8 (1A8 P17 N 121)& Can a reallocation of inputs from the production of the output at point C to point C be Eustified using the $areto potential criterionI *o/plications )his analysis is simplified& )here are a number of +uestions& Ghen the ;winners< gain more than the losers, the reallocation is Eustified& )he winners can hypothetically reimburse the losers but the reimbursement may never occur& )he alternative at point C is preferable to that at point C& )he net marginal benefit of a reallocation form C to C is R5& )he individuals

121

A."." Pareto Efficiency

who have a preference for xebecs are ;worse off< (losers) )hose who prefer yawls are ;better off< (winners)& Can the redistribution of benefits from one group to another be Eustified on ethical groundsI Consider a reallocation of water from storage behind a dam to a free flowing river& Drrigators and power users may incur significant costs while the fishermen and white water rafters gain& # tax cut clearly benefits some individuals but may impose costs on others& )here may be no mechanism by which the losers can be compensated by the winners& #nother issue is that if the move from C to C involves fewer xebecs and more yawls& )he increase in yawls might cause the price for yawls to fall while the decrease in xebecs could feasibly result in a price increase for xebecs& Df the winners of an action can hypothetically compensate the losers and still be better off, the benefits exceed the cost of the action& )he benefit/cost ratio is greater than one and is Eustified by the $areto $otential criterion& )here are still ethical +uestions involved&

@#1#4 ,'+E

P&A*T$*A2 ET4$*,

The

ideas of Eustice and ethics are often considered a matters of

individual preference and therefore impossible to evaluate& Ghat D consider Eust, someone else may perceive as unEust& Dt has been a perplexing problem that has been addressed by philosophers over the ages& $lato and #ristotle both were concerned with Eustice& #dam Smith saw Eustice as a necessary re+uirement for a civil society& *thics is important& 4ne of the approaches that is applicable in economics is the ;veil of ignorance< as described by Hohn %awls&
It is assumed% then% that the parties do not /no' certain /inds of particu!ar facts. ;irst of a!!% no one /no's his p!ace in society% his c!ass position or socia! status< nor does he /no' his fortune in the distri ution

125

A.".( Some practica! ethics

of natura! assets and a i!ities% his inte!!igence and strength% and the !i/e. &or% again% does anyone /no' his conception of the good% the particu!ars of his rationa! p!an o !ife% or even the specia! features of his psycho!ogy such as his aversion to ris/ or !ia i!ity to optimism or pessimism. More than this% I assume that the parties do not /no' the particu!ar circumstances of their o'n society. That is% the do not /no' its economic or po!itica! situation% or the !eve! of civi!i.ation and cu!ture it has een a !e to achieve% the persons in the origina! position have no information as to 'hich generation they e!ong. These roader restrictions on /no'!edge are appropriate in part ecause *uestions o socia! 5ustice arise et'een generations as 'e!! as 'ithin them% for e+amp!e% the *uestion of the appropriate rate of capita! saving and of the conservation of natura! resources and the environment of nature. There is a!so% theoretica!!y any'ay% the *uestion of a reasona !e genetic po!icy% In these cases too% in order to carry through the idea of the origina! position% the parties must not /no' the contingencies that set them in opposition% They must choose princip!es the conse*uences of 'hich they are prepared to !ive 'ith 'hatever generation they turn out to e!ong to. (%awls, $ 159)

Dndividuals must be prepared to be placed in a society and no matter the circumstances, say ;)hat(s fair&<

@#1#@ E--$*$E%*5

A%( ET4$*, (A8A$%G)

$f

the obEective is to maximi,e the welfare or utility of a group, an

alternative with a benefit/cost ratio that exceeds 1 will increase the utility of that group& )he winners can hypothetically reimburse the losers and still be better off& Df the hypothetical reimbursement is not actually made, the distribution of wealth, income and the level of goods that each person can potentially consume will be altered& Some people are better off and other people are worse off& )his change in relative welfare of individuals is an ethical +uestion, not one of efficiency, although it often mas+uerades as a +uestion of efficiency& Consider a case of a society& 0nder the present conditions, there is a distribution of income and wealth that results in different individuals consuming differed +uantities of goods& )hese individuals probably have

126

A.".A Efficiency and ethics 6againI7

different preferences and derive different levels of utilities from the given good& # tax cut will make some people better off. they pay fewer taxes& Since the government has less revenue, they must cut some programs. grants for low income students to attend college, road construction, etc& Students, employees at universities, movie theaters near the university, trucking companies, and consumers who must pay higher prices because it costs more to transport goods may be worse off& )axpayers with lower taxes, firms where these taxpayers spend their increased incomes and workers who are hired by the firms are better off than before& Df the benefits exceed the costs, the winners could hypothetically reimburse the losers& Df the reimbursement is not actually made (which it probably will not), there is an ethical +uestion about taking from one group to benefit another&

127

4 Introduction to the Ru!es of the Dame and Economics Systems

> $%T&'()*T$'% T' T4E &)2E, 'E*'%'+$*, ,5,TE+,

T4E

8A+E

A%(

7hether

a society emphasi,es the use of exchange, reciprocity or

eminent domain to allocate resources, ; 0ny economic system re*uires a set of ru!es% an ideo!ogy to 5ustify them% and a conscience in the individua! 'hich ma/es him strive to carry them out &< (%obinson, p 15) )his set of rules includes informal institutions and values held by individuals as well as formal law& )he structure of the rules of the games shapes the society(s economic system& "eoclassical microeconomics does not often explicitly consider the nature of these rules and their relation to economic behavior&

'.1 ECONOMIC SYSTEMS

,ocieties

that fail to meet minimum subsistence re+uirements for its

members become relics of the past& Ddeally, an economy will produce more than necessary for subsistence and apply the additional output to improving the lives of the members of society through development and/or economic growth& )he ideas of ;progress,< economic development and economic growth came with the development of the commercial world that replaced the feudal society of the medieval world& #n economic system consists of a matrix of social institutions (law, political institutions, religion, etc), agents (individuals or actors), organi,ations (corporations, unions, charitable org, not-for-profit firms, etc) and society& )he principles, beliefs and values held by individuals are included in the structure of society& )he function of an economic system is to coordinate the activities of agents in the processes of provisioning and allocation& "onmaterial

128

4.1 Economic Systems

characteristics of life (social stability, low crime rates, a sense of community, etc) are related to the economic processes and should be included& %obert Feilbroner identifies thee basic types of economic systems& )hese are classified as markets, command, and tradition& Dn practice, most economies are a mixture that includes elements of all three& Fowever, the economic system is usually classified by the dominant approach& -arkets and command exist in traditional economies& )radition and markets exist in command economies& Gestern industrial societies categori,ed as ;marketoriented< economies rely primarily on exchange, but contain elements of tradition and command& Dn market economies tradition is important to such decisions regarding values, expectations about behavior (trust, loyalty, etc&), fashion, preferences about housing, choices about occupations and geographic preferences& Command is also found in market economies as regulations and laws regarding the allocation or resources and goods&

>#1#1 T&A($T$'%A2 E*'%'+$E,

Traditional economic systems are based the repeated use of solutions that
have worked in the past& Solutions to problems in the processes of production, distribution and consumption are embedded in the customs, mores and cultural patterns of social life& )hese solutions have been established through trial and error. those activities that result in ade+uate production and an acceptable distribution are retained and used often without +uestion& #gents in traditional societies may engage in exchange transaction but these are peripheral to the provisioning and allocation problems& )he traditional economic system tends to be found in non-industrial societies that are engaged in hunting, gathering, pastoral, or basic agriculture& 4ften these are subsistence economies. there is little or no growth or

129

4.1.1 Traditiona! Economies

progress& )he aboriginal culture in #ustralia is an example of an economy that has flourished for thousands of years (62,222 years by some estimates) as a traditional economy& )raditional economies tend to depend upon a deontological ethic& Cuties to other members of the family, tribe or clan and ;reciprocity< are the primary allocative mechanisms& )he forms of production that individuals engage in are based on the processes that have worked in the past& Social institutions, such as religion, may evolve to reinforce the traditional ways& )hese societies must communicate behavioral expectations to each new generation& )he most important form of knowledge may be contained in stories and myths& -ythology and story telling are important aspects of the creation as.
an unproved co!!ective e!ief that is accepted uncritica!!y and is used to 5ustify a socia! institution.

and

communication

of

cultural

values&

Websters

Encyclopedic

Unabridged Dictionary of the English Language gives one of the definitions of myth

Keen and 3alley-:ox describe myths as.

- an intricate set of inter!oc/ing stories% ritua!s% rites and customs that inform and give the pivota! sense of meaning and direction to a person% fami!y% community or cu!ture. (Keen, p xii)

-ythology

is one

of

the

processes

by which

cultural values

and

expectations about behavior are transmitted from generation to generation& *ven in modern societies, stories are fundamental to the process of creating, and perpetuating culture in societies& %eciprocity is often a key element in traditional economies& %emember that reciprocity is based on duty and involves obligatory gift giving. D do you a favor and both you and D (and other members of society) expect that you will return some unspecified favor at some unspecified time in the future& Dt

12A

4.1.1 Traditiona! Economies

re+uires a sense of duty, social values and a community to enforce reciprocation& Social institutions give structure to the values, duties and expectations about economic behavior& Dn many societies, reciprocity becomes an important element of the social process& Dn a ranching community %ancher Smith goes to the other ranchers and says. ;D need some help branding my calves next )uesday, D(d appreciate some help&< 4n )uesday, the ranchers show up at %ancher Smith(s place and help with the task& Df %ancher Hones does not come to help, it may be for a good reason& Fowever, if he or she is perceived as shirking his or her duty, it may be difficult for Hones to get neighbors to help with future tasks& Similarly, if everyone helps %ancher Smith but then at some point in the future %ancher Smith does not reciprocate by helping someone else fix his or her fence, then %ancher Smith may find it difficult to get anyone to help in the future& )here is a community that expects that the other members will help when needed and will reciprocate in the future& )he community must communicate the willingness of its members to participate in mutual aid and to sanction members who do not fulfill their obligatory duties& "otice that the substance of the event is different if %ancher # says. ;D(ll pay you R12 per hour to help me brand my calves&< Shifting the process from reciprocity to a market exchange significantly alters the relationships and the nature of the event& Dn the case of reciprocity, there is a sense of community& )he relationship between the members of the community may be of value in and of itself& lood and organ donations are examples& -oving a good or activity into a market transaction may significantly alter its meaning or value& # market exchange can take place between anonymous individuals& #s communities become larger, more complex and social relationships are altered. tradition may be less useful as an allocative mechanism& Dt is more

12B

4.1.1 Traditiona! Economies

difficult for the members of the community to communicate the extent to which the members fulfill their duties& Social pressure to enforce obligations of reciprocity and duty may become less effective since each person has more relationships that may be more valued& #nother weakness of a traditional economy is that it does not adapt +uickly to changes in technology or the environment& So long as there are no (or few) changes in the environment, technology or external forces, the traditional economy is stable or static& Fowever, if there are sudden changes in the environment, the traditional solutions may no longer suffice& Croughts, desertification, over hunting specific animals are examples of events that traditional societies may not be able to deal with& "ative #mericans in the plains developed societies that were dependent upon the bison& )heir economies, social structure, politics and religions were based on bison& Gith the advent of *uropeans, firearms, railroads and a demand for hides, the bison were hunted almost to extinction& -any of the native societies found it difficult to adapt to a system without bison& Ghaling, fishing, hunting, agriculture based on single (or limited) crops are other examples of the difficulty that traditionally based economies have in adapting to change&

>#1#2 *'++A%( E*'%'+$E,

Eminent domain is the primary allocative mechanism used in a command

economy& #n economic system based on command re+uires an agent or organi,ation with the authority to make allocation decisions& )his authority may be based on religion, military strength, political position, birth or wealth& Command economies often rely on traditions as part of the allocative process& )his traditional process is subordinated to eminent domain& )he %oman society is an example of a command economy& :ascist =ermany, the

112

4.1.$ #ommand Economies

former Soviet 0nion and -aoist China are other examples of attempts to use command& )hese economies are often thought of as ;planned economies&< Curing Gorld Gar DD many allied countries relied on command systems to coordinate the war effort& Dn both traditional and market economies command may play a significant role& Dn modern, market economies there are regulations and laws that mandate particular actions, behavior, production techni+ues and/or characteristics of products& # command economy re+uires an overall obEective or goal for the governing body. individuals( goals become subordinate& Since command economies are often represented by nation states, these can be thought of as national goals& Some organi,ations act as small communities with organi,ational goals and use command and eminent domain as the primary allocative mechanism& Curing the medieval era, the Church and the secular state both operated as command economies that were interrelated& Dn the modern industrial world, the multinational corporation uses a command system internally. its decisions are made administratively& =oals may include. economic growth, full employment, industriali2ation, military strength, con4uest, ac4uisition of specie 3goldM silver5, land, political control religious conversions control over markets where they sell, control of resources,

111

4.1.$ #ommand Economies

or any thing else that the governing authority chooses*

4ne of the important +uestions in a command economy how the overall obEective is selected& Dt may be an administrative choice& )he authority may simply select the obEective& Df this is the case, the intentions of the authority become crucial. are they benevolent or notI Dn some cases, it may be possible to have the obEectives of the members of the community reflected in the overall obEective& -arket socialism in the former !ugoslavia is an example& )he task of the command system is to coordinate individual behavior with the national or organi,ational goal& # command system relies on administrative decisions that flow from the authority down& )his re+uires that the decisions be communicated to the individuals and enforced& )his may re+uire a complex system of rules and institutions to communicate and create the appropriate incentives to act on that information& )he authority that is responsible for the administrative decisions that are imposed on the members of the organi,ation or state, must have information about the goals, the members of the community, the availability of inputs, all potential technologies, all alternative outputs and potential distribution patterns& )his is an enormous information re+uirement that was debated in the ;socialist calculation debate&< 4ne of the strengths of a command system is that it can alter its obEectives +uickly& Dn a wartime economy, it may be useful to be able to command the allocation of resources into the development and production of munitions and military hardware& )he weakness of a command system is that the authority would need an enormous amount of information about individuals( preferences and the production re+uirements of all goods and services& Command systems may also be flawed by the nature of the authority that may or may not be

111

4.1.$ #ommand Economies

benevolent& #nother maEor problem of a command system is the loss of individual autonomy&

>#1#1 +A&<ET

+arket based economies depend on individual exchange contracts that

occur in the context of a social contract& #n exchange contract is based on *uid pro *uo, ;I 'i!! give you this if you give me thatI< )he nature of the goods (include money) to be exchanged as well as the conditions and time is clearly specified& Dt is necessary that both parties engage in the contract or exchange voluntarily& Df the exchange is voluntary, the presumption is that a person would engage in the exchange if and only if they are better off or no worse off after the exchange& )herefore, a voluntary exchange results in $areto improvements and ultimately a $areto superior solution to the allocation problem& "eoclassical microeconomics uses ;supply and demand< as a representation of a market& )he demand function represents the behavioral patterns of the buyers (both actual and potential) of a specific good& )he supply function represents the behavior of actual and potential sellers (producers) of a good& )he strength of market system is that is capable of +uickly adapting to changes in preferences and technology& )he information re+uired by any one agent is minimal& )he weakness is that when exchanges are not voluntary or property rights are attenuated (weakened), outcomes may be less than optimal& "eoclassical microeconomics tends to be a study of contracting and voluntary exchanges between individuals& )he context in which these contracts

115

4.1." Mar/et

occur is usually ;the market&< )he structure of the markets is perceived to influence the behavior or the individuals who participate in voluntary exchanges or contracts& Dn its most ideal form, the market is characteri,ed as ;pure competition&< Dn pure competition, there are a large number of buyers and sellers, none of which can influence the price or the behavior of others. they can only contract to exchange goods (and money)& )he purely competitive market is characteri,ed by goods that are homogeneous. i&e& buyers perceive these goods as identical or perfect substitutes& uyers have no preference for one seller(s good over another(s& )he exchange or contract is made on the basis of price& Dn this way, sellers compete for buyers by lowering the price to the minimum they will accept& uyers compete to purchase by offering the highest price they are willing to pay& Dn a market such as this the e+uilibrium price. the price at which the last (or marginal) unit is exchanged will optimi,e the welfare of the buyers and sellers& Dn the least desirable market form, a seller has a monopoly where there is only one seller of a good& )he effects of market structure on the behavior of buyers and sellers are an important topic in neoclassical microeconomics that is covered in $art DD of this text& )he social context of economic behavior is often not made explicit& $eople perceive that individual exchange in competitive markets is the only consideration& )his leads to the perception that the government and community have little or no role in economic activity& -any !aisse. faire advocates fail to recogni,e that economic behavior is a part of social behavior& :riedrich #& Fayek (1899-1992) is a well-known advocate of the market system& Fe identifies the social infrastructure that must exist to support individual market exchange& )he following +uotes are long because they are important and must be considered in the context of Fayek(s ideas.

116

4.1." Mar/et

)hi!e it 'ou!d e an e+aggeration% it 'ou!d not e a!together untrue to say that the interpretation of the fundamenta! princip!e of !i era!ism as a sence of state activity rather than as a po!icy 'hich de!i erate!y adopts competition% the mar/et% and prices as its ordering princip!e and uses the !ega! frame'or/ enforced y the state in order to ma/e competition as effective and eneficia! as possi !e?and to supp!ement it 'here% and on!y 'here% it cannot e made effective?is as much responsi !e for the dec!ine of competition as the active support 'hich governments have given direct!y and indirect!y to the gro'th of monopo!y. It is the first genera! thesis 'hich 'e sha!! have to consider that competition can e made more effective and more eneficient y certain activities of government than it 'ou!d e 'ithout them. )ith regard to some of these activities this has never een denied% a!though peop!e spea/ sometimes as if they had forgotten a out them. That a functioning mar/et presupposes not on!y prevention of vio!ence and fraud ut the protection of certain rights% such as property% and the enforcement of contracts% is a!'ays ta/en for granted. )here the traditiona! discussion ecomes so unsatisfactory is 'here it is suggested that% 'ith the recognition of the princip!es of private property and freedom of contract% 'hich indeed every !i era! must recogni.e% a!! the issues 'ere sett!ed% as if the !a' of property and contract 'ere given once and for a!! in its fina! and most appropriate form% i.e.% in the form 'hich 'i!! ma/e the mar/et economy 'or/ at its est. It is on!y after 'e have agreed on these princip!es that the rea! pro !ems egin. (Fayek, pp 112-111)

Fayek continues.
If I am not mista/en% the main headings under 'hich the measures re*uired to insure an effective competitive order ought to e considered are the !a' of property and contract% of corporations and associations% inc!uding% in particu!ar% trade?unions% the pro !ems of ho' to dea! 'ith those monopo!ies or *uasi?monopo!istic positions 'hich 'ou!d remain in a other'ise sensi !y dra'n?up frame'or/% the pro !ems of ta+ation% and th pro !ems of internationa! trade% particu!ar!y% in our time% of the re!ations et'een free and p!anned economies. 0s far as the great fie!d of the !a' of property and contract are concerned% 'e must% as I have a!ready emphasi.ed% a ove a!! e a'are of the error that the formu!as of private property and freedom of contract so!ve our pro !ems. They are not ade*uate ans'ers ecause their meaning is am iguous. =ur pro !ems egin 'hen 'e as/ 'hat ought to e the contents of property rights% 'hat contracts shou!d e enforcea !e% and ho' contracts shou!d e interpreted or% rather% 'hat standard forms of contract shou!d e read into the informa! agreements of everyday transactions. (Fayek, pp 111-115)

117

4.1." Mar/et

#dam Smith also saw a positive role for government& #s implied in the +uotes from Fayek, it is the content of the laws of property and contract that is crucial& Dt is important to identify the role of the state in structuring the allocative process that society depends upon&

>#1#4 &'2E

'-

8'3E&%+E%T

'ne of the maEor controversies is the proper role of government (and the
use of command) within a market based economic system& -any of the issues in this controversy are ideological in nature and result in the existence of different ;schools of economic thought&< )he Chicago School and the #ustrian School of economic thought argue that the role of government in the economy should be minimi,ed& (Fayek taught at the 0niversity of Chicago and was an #ustrian economist&) )he #merican or ;4ld< Dnstitutionalists and much of "eoclassical microeconomics (in the Cambridge tradition) sees a more positive or active role for government in many areas& )he :rench $hysiocrats ?led by :rancios Ouesnay, 18B6-1996@ advocated a minimal role for government& Hac+ues Claude 3incent de =ournay ?1911-197B@ is usually credited with the phrase !aisse. faire% !aisse.?passerI Some advocates of an extreme !aisse. faire doctrine argue that there is no or almost no role for government& -ost argue for limited government action in the economy& 4thers, such as #dam Smith and :& # Fayek (above) see a positive role for social institutions and government participation& #dam Smith ?191519B2@, who was familiar with the work of the $hysiocrats, advocated a social system based on ethics, markets and Eurisprudence with a minimal role for government&

118

4.1.( Ro!e of Dovernment

)here are many arguments about the proper role of government& Some of the arguments are based on ideology while other disagreements arise on pragmatic grounds& Fere are several possible roles for government.

>#1#@ P&'PE&T5 &$84T,

'ne

of the functions of government is to define and protect property

?1851-1926@

rights& Hohn 'ocke Karl -arx

argues the social contract is for the purpose of

?1915-19B2@

protecting property rights& Such diverse writers as #dam Smith

?1A1A-1AA5@

and

argue that this is one of the primary functions of

governments& $roperty rights may also be defined and enforces by informal rules such as social institutions, civility, tradition, custom, mores and systems of ethics&

>#1#> ('+E,T$* ;),T$*E

Adam

Smith included the enforcement of property rights under the

establishment of domestic Eustice when he defined the role government& Comestic Eustice is broader and includes ; protecting% as far as possi !e% every mem er of society from the in5ustice or oppression of every mem er of it & & & ;
(Smith, )ea!th of &ations, p 88B)

>#1#7 %AT$'%A2 (E-E%,E

7hile leaders and policy makers may argue about the level and nature of
national defense, there are few who would argue that there is no reason for the state to provide protection from attack by other nations& )he debate takes the form of the nature and extent of that national defense& "ational defense is

119

4.1.8 &ationa! 3efense

one of the best examples of a public or collective good& Dn the case of a public good, it is impossible to exclude a person from the consumption of the good and the marginal cost of an additional user is ,ero& Dn these conditions, the state often provides the good&

>#1#? P&'3$,$'%

'- *'22E*T$3E '& P):2$* 8''(,

Public goods are those goods whose property rights are not exclusive. it
is not possible to exclude anyone from their use and the additional cost (marginal cost) of an additional user is ,ero& "ational defense is a case of a public good& Df a baby is born in the country, it is not necessary to increase national defense& Clean air is another example of a public good& #dam Smith included other public goods in this category& Fe referred to them as public institutions and public works& Dn the terminology of modern economics, these goods are often called +uasi-public goods. the marginal cost of additional uses may be ,ero, but it is possible to exclude users& %oads, bridges, canals, navigational devices and the like could be paid for by tolls or financed by government& Smith includes education in this category of activities& Fe discusses specifically education of youth& Fe also says.
In the progress of the division of !a or% the emp!oyment of the far greater part of those 'ho !ive y !a or% that is% of the great ody of the peop!e% comes to e confined to a fe' very simp!e operations% fre*uent!y one or t'oJ But the understandings of the greater part of men KsicL are necessari!y formed y their ordinary emp!oyments. The man 'hose 'ho!e !ife is spent in performing a fe' simp!e operations% of 'hich% the effects too are% perhaps% a!'ays the same% or very near!y the same% has no occasion to e+ert his understanding% or to e+ercise his invention in finding out e+pedients for removing difficu!ties 'hich never occur. ,e natura!!y !oses% therefore% the ha it of such e+ertion% and genera!!y ecomes as stupid and ignorant as it is possi !e for a human creature to

11A

4.1.9 Provision of co!!ective or pu !ic goods

ecome. (Smith, Gealth of "ations, p 956)

Smith continues on the next page.

But in every improved and civi!i.ed society this is the state into 'hich the !a ouring poor% that is the great ody of the peop!e% must necessari!y fa!!% un!ess the government ta/es some pains to prevent it.

)he role of government in the provision of education and arts for individuals in society is controversial& Currently, there are a variety of debates ranging from voucher systems to the appropriate level of funding for *nglish as a second language and special education&

>#1#H P&'+'TE *'+PET$T$'%

The models of purely competitive markets show that the behavior of the
individual sellers (and buyers) will be consistent with social welfare in the long run& Ghen there are impediments to competition, the prices are distorted and incorrect signals encourage behavior that is less than socially optimal& #s a result, governments often try to regulate the behavior or to promote competition& -ost industrial nations have laws that make monopoli,ation of markets, price fixing, collusion, tying contracts and other anti-competitive practices illegal& )he Sherman #ntitrust #ct of 1AB2, the Clayton #ct of 1B16 and the %obinson-$atman #ct of 1B58 are examples& Dnformation is important to any allocative system& Dt is necessary for agents in a market exchange to have information to value goods and negotiate contracts& -ost societies see that one of the roles of government (if not a moral system) is to prevent fraud, deceit, and other methods of distorting information provided by buyers and sellers& )he Securities *xchange Commission attempts to regulate financial information provided to the financial markets, insider trading is illegal, there are truth in advertising laws and agencies that regulate the content and +uality of goods (food, drugs, etc&)&

11B

4.1.G Promote #ompetition

)he development of policy and law in these areas is often controversial and vested interests attempt to manipulate the regulations in their favor& (%emember =eorge Stigler(s capture theory of regulation&)

>#1#10 ,A-ET5 %ET

+ost civili,ed societies try to provide a safety net for individuals who are
unable to care for themselves& )here are many disagreements about the criteria to be used to decide which people should be included in this group&

'.2 PROPERTY RIG

TS

The concept of property rights is essential to any economic system& )he

analysis of property rights is complicated by several factors& :irst is the fact that when the term ;property rights< is used, the listener usually subconsciously inserts the word ;private&< Dn addition to private property, rights there are also public property rights and common property rights& $rivate property rights, in theory should apply to individuals but often private property rights is applied to publicly chartered organi,ations& Second, property rights can be Eustified by ;natural rights< or by logic and pragmatism& Hohn 'ocke ?1851-1926@, a natural law philosopher argues that humans have a natural right to the ownership of private property& )his natural right to property stems from the fact that the individual has a right to their own labor and therefore a property right to the fruits of that labor when mixed with un-owned resources& 'abor is the Eustification for property& 'ocke places two limitations on this right& Fe argues that the individual has a right to ac+uire property so long as nothing is wasted and there are sufficient resources left for others& ('ocke, pp 117-118) )he emotional context of property

112

4.$ Property Rights

rights associated with the natural rights approach that also complicates the discussion and analysis of the structure of property rights in a social system& # pragmatic Eustification of property rights is based on defining property rights to achieve an obEective& )hat obEective could be an optimal allocation or to maximi,e the monetary value of assets& $roperty rights Eustified on natural rights tends to be static while pragmatism tends to Eustify property rights that evolve to meet the needs of changing circumstances (population, technology, environment, etc&)& Fayek, a market oriented economist, seems to focus on a pragmatic approach to property rights.
)here the !a' of property is concerned% it is not difficu!t to see that the simp!e ru!es 'hich are ade*uate to ordinary mo i!e things or chatte! are not suita !e for indefinite e+tension. )e need on!y turn to the pro !ems 'hich arise in connection 'ith !and% particu!ar!y 'ith regard to ur an !and in modern !arge to'ns% in order to rea!i.e that a conception of property 'hich is ased on the assumption that the use of a particu!ar item of property affects on!y the interests of its o'ner rea/s do'n. . . . . The pro !em of the prevention of monopo!y and the preservation of competition is raised much more acute!y in certain other fie!ds to 'hich the concept of property has een e+tended on!y in recent times. I am thin/ing here of the e+tension of property to such rights and privi!eges as patents for inventions% copyright% trademar/s% and the !i/e. It seems to me eyond dou t that in these fie!ds a s!avish app!ication of the concept of property as it has een deve!oped of materia! thins has done a great dea! to foster the gro'th of monopo!y and that here drastic reforms may e re*uired if competition is to e made to 'or/. (Fayek, pp115-116) & & & It seems to me that% in genera!% the freedom of the individua! y no means need to e e+tended to give a!! these freedoms to organi.ed groups of individua!s% and even that it may on occasion e the duty of governments to protect the individua! against organi.ed groups. It appears to me a!so as if historica!!y in the fie!d of the !a' of corporations 'e had a situation rather ana!ogous to that in the fie!d of the !a' of property to 'hich I have a!ready referred 0s in the !a' of property the ru!es deve!oped for ordinary mo i!e property 'ere e+tended uncritica!!y and 'ithout appropriate modifications to a!! sorts of ne' rights< and thus the recognition of corporations as fictitious or !ega! person has had the effect that a!! the rights of a natura! person 'ere automatica!!y e+tended to corporations. (Fayek, p 118)

111

4.$ Property Rights

Fayek is +uoted at length because he is a market-oriented economist who recogni,ed that property rights must evolve with changes in the economy and technology& Fe also recogni,es that the form the property rights laws take is crucial to the operation of a market system&

>#2#1 P&'PE&T5 &$84T, A%( +A&<ET,

The operation markets and market exchange is facilitated by strong or

;nonattenuated< property rights& )he benefits and costs of exchange and use of resources and goods affect only the parties to the exchange& )he welfare of individuals who are not engaged in the transaction or use of economic goods is not altered& :urubotn and $eEovich define property rights as.
Property rights are understood as sanctioned ehaviora! re!ations among men KsicL that arise from the e+istence of goods and pertain to their use. These re!ations specify the norms of ehavior 'ith respect to goods that each and every person must o serve in his dai!y interactions 'ith other persons% or ear the cost of non?o servance. The term good is used here for anything that yie!ds uti!ity or satisfaction to a person. Thus% and this point is important% the concept of property rights in the conte+t of the ne' approach app!ies to a!! scarce goods. The concept encompasses oth the rights over materia! things 6to se!! my type'riter7 as 'e!! as Bhuman@ rights 6the right to vote% pu !ish etcetera7. The prevai!ing system of property rights in the community is% then% the sum of economic and socia! re!ations 'ith respect to scarce resources in 'hich individua!s stand to each other. (:urubotn, p 5)

)hese ;sanctioned behavioral relations< include both the formal sanction of legal systems and informal sanctions of social institutions& # sense of community, social values, religion, politeness and respect for others are probably more efficient ways to enforce property rights than the enforcement of laws by the state& $roperty rights may be ;private< property rights or ;public< property rights&

111

4.$.1 Property Rights 0nd Mar/ets

Strong or non-attenuated property rights that facilitate the effective use of market exchange have three basic characteristics.

D(clusivity Dnforceability 'ransferability

E=*2),$3$T5

Dt is impossible for the property rights to any good or resource to be completely exclusive& Fowever, the greater the exclusivity the more likely market exchanges will produce improvements to the welfare of society& #n exclusive property right is one where all the benefits and cost associated with a choice fall on the person(s) making the choice& Df "igel drinks a cup of tea, the costs and benefits of that act fall (for the most part) on "igel& # case of nonexclusive property rights occurs when Farold smokes a cigar in church& )he smoke may impose significant costs on other members of the congregation& Dt might be possible that #unt -abel and others in the congregation could contract (or pay) with Farold not to smoke& Df a voluntary contract is made, Farold is better off because he prefers the payment to smoking& #unt -abel and the congregation are better off because they were willing to pay Farold not to smoke& )his assumes that Farold had a property right to smoke& #n alternative view is to ban smoking in the church by assigning the property rights to smoke free air to #unt -abel and the others& Df Farold wanted to smoke, he would have to contract with the congregation for the right to do so&
E=TE&%A2$T5

)he failure of exclusive property rights results in three problems in the market& :irst is the problem of ;externalities&< )he example of second hand

115

4.$.1 Property Rights 0nd Mar/ets

smoke in the previous paragraph is an example& $ollution from a steel mill or odor from a pig farm are other examples& # negative externality results in ;too much< or over use of a resource or good since the marginal costs to society exceed the marginal cost to the economic agent who makes the decision& )he *nvironmental $rotection #gency was created to deal with many of the problems of negative externalities& *xternalities may also be positive& )he marginal benefits to society are greater than the marginal benefits to the decision maker or economic agents engaged in an exchange& Df D landscape my front lawn, it may increase the property values of my neighbor& )he benefits to my neighbor are not taken into account by my decision& Dn general, the market signals an under utili,ation of goods and resources that have positive externalities
P):2$* 8''(,

# second problem is that of ;public goods&< # public good is one in which the marginal cost of an additional user is ,ero and it is impossible to exclude anyone from its use& "ational defense is often used as an example of a public good& )here are other goods like roads, bridges, etc& that may be treated as public goods even though it is possible to exclude users& )hese are sometimes referred to as ;+uasi-public goods&
*'++'% P&'PE&T5 &E,')&*E,

)he third property rights problem is ;common property resources&< # common property resource is one where users are not excluded but the marginal cost of users is positive& =arret Fardin(s 1B8A article, ;)ragedy of the Commons< argues that common property tends to be overuse and can be driven to extinction& $assenger pigeons, whales, #merican bison, and fisheries are often cited as common property resources& )he property rights for these common property resources are not clearly defined and are ;fugitive< resources. whoever captures the resource has ownership rights& Dt is in the

116

4.$.1 Property Rights 0nd Mar/ets

interests of the economic agents to capture as much as possible as +uickly as possible& )he result is the market signals an overuse of the resource& )reaties and government regulation may be used to establish property rights that will result in a more economic use of the resource& Dnternational treaty protects whales& State fish and game departments may sell license and regulate the capture of game& *xternalities, public goods and common property resources are fodder for debates between pro and anti market advocates& )he economics of nonexclusive property rights will be covered in more detail in later chapters&
E%-'&*EA:$2$T5

)he establishment of property rights is fundamental to society& Social institutions and a sense of community (with a respect for others) establish the nature of property rights& Hohn 'ocke, #dam Smith Karl -arx and many other writers have argued that one of the functions of government (or the ;state<) is to define and enforce property rights& Dn a world of chattel and real property, property rights can be defined and enforced& Dn a world of intellectual property rights, computers, copy machines and all manner of devices to copy and transmit intellectual property with 2(s and 1(s, the enforcement of property rights is more problematic& #s the society has shifted to greater emphasis of an ;information< economy, intellectual property has become more important& -usic, computer software, books, and knowledge of how to do things has made the enforcement of property rights and market exchanges difficult in many cases& )he development of technology to electronically copy and transmit information has increased the problems of enforcing property rights to that information& Copyright and patent laws are examples of attempts to define and enforce property rights& $harmaceuticals, C"# and knowledge are often the source of

117

4.$.1 Property Rights 0nd Mar/ets

legal action& #s the technology to develop, copy and transmit information improves, the enforcement of intellectual property rights will become more difficult and expensive to enforce& -any interesting economics +uestions will accompany these changes&
T&A%,-E&A:$2$T5

Dn many cases, it is technically impossible to transfer property rights& )he property rights to a person(s height or athletic skill cannot be transferred& D cannot become a professional basketball player by purchasing a player(s height or skill& D might hire some one to coach me but there is no way to transfer property rights to height and skill& Fowever, with the ;advances< in science it may be possible to genetically modify a fetus with C"# from a person who has some physical characteristic that is desired& 4ften society will choose to prevent the transfer of property rights by making an exchange illegal& uying and selling children is technically possible but societies usually choose to make it illegal& )he 4rgan )ransplantation #ct of 1BA6 is another example& Ghile it is technically feasible to transplant organs (heart, kidney, lung, pancreas, liver, etc&), the law makes it illegal to sell an organ for transplantation& Fowever, it is now possible to travel to other countries to ;buy< a kidney& )here is some evidence that a black market (or illegal market) has been developing& )here are also advocates of creating a market for transplantable organs&

>#2#2 $,,)E, $% P&'PE&T5 &$84T,

Technological

change and structural changes in the modern economy

pose great challenges for society and the evolution of property rights& Conventional thought holds that the industrial economies are undergoing a structural change& )here is a shift from manufacturing to information and

118

4.$.$ Issues In Property Rights

services& )his shift has implications for the way in which property rights are assigned& #s Fayek has pointed out, property rights cannot be static. the property rights that apply to chattel property of individuals may not apply e+ually well to intellectual property& $roperty rights that work for individuals may not work for organi,ations such as corporations& )he nature of property rights is a maEor concern for modern society& $rivate property rights have long been seen as an important incentive for good stewardship& Df chattel or land is ;mine< D am more likely to use it wisely& )his perspective is based on property rights that are exclusive and enforceable& # version of this view has been extended to intellectual property rights& Df the property rights to ideas, inventions, patents, trademarks, copyrights are held privately, the owners will use them to the greatest advantage& )hese property rights also insure that individuals with have a strong incentive to create new ideas and inventions& #t the same time, all new ideas and inventions are founded on prior knowledge& )he material in this text is a conglomeration of ideas that have been debated for as long as humans have communicated& )here is little new material presented here& Dt consists of old ideas that have been restructured and combined with other ideas in new ways& #cademic tradition and law provides for the use of these ideas& Df authors do o appropriately cite sources of ideas, they are guilty of plagiarism& Fowever, it is impossible to know the origins of all ideas that authors use& )he evolution and creation of knowledge and technology depends on the availability knowledge from the past& Df intellectual property rights are not flexible enough that the existing ideas and knowledge cannot be used to create new knowledge, progress and economic growth are impeded& 'awrence 'essig argues that property rights must be balanced between provision of

119

4.$.$ Issues In Property Rights

incentives and to allow others to use intellectual property to extend knowledge& Culture and knowledge progresses by building on the past.
#reators here and every'here are a!'ays and at a!! times ui!ding upon the creativity that 'ent efore and that surrounds them no'. That ui!ding is a!'ays and every'here at !east partia!!y done 'ithout permission and 'ithout compensating the origina! creator. &o society% free or contro!!ed% has ever demanded that every use e paid for or that permission for )a!t 3isney creativity must a!'ays e sought. Instead% every society has !eft a certain it of its cu!ture free for the ta/ingMfree societies more fu!!y than unfree% perhaps% ut a!! societies to some degree. ('essig, ;ree #u!ture, p 1B)

)he +uestions become. Ohat form should intellectual property rights take if creativity is to be promoted8

Iow can property rights be structured to provide incentives for creators to continue to develop new ideas8
0 free cu!ture is not a cu!ture 'ithout property< it is not a cu!ture in 'hich artists don@t get paid. 0 cu!ture 'ithout property% or in 'hich creators can@t get paid% is anarchy% not freedom. 0narchy is not 'hat I advance here. Instead% the free cu!ture that I defend in this oo/ is a a!ance et'een anarchy and contro!. 0 free cu!ture% !i/e a free mar/et% is fi!!ed 'ith property. It is fi!!ed 'ith ru!es of property and contract that get enforced y the state. But 5ust as a free mar/et is perverted if its property ecomes feuda!% so too can a free cu!ture e *ueered y e+tremism in the property rights that define it. ('essig, ;ree #u!ture, p xvi) There is a history of 5ust such a property system that is 'e!! /no'n in the 0ng!o?0merican tradition. It is ca!!ed feuda!ism. Nnder feuda!ism% not on!y 'as property he!d y a re!ative!y sma!! num er of individua!s and entities. 0nd not on!y 'ere the rights that ran 'ith that property po'erfu! and e+tensive. But the feuda! system had a strong interest in assuring that property ho!ders 'ithin that system not 'ea/en feuda!ism y !i erating peop!e or property 'ithin their contro! to the free mar/et. ;euda!ism depended upon ma+imum contro! and concentration. It fought any freedom that might interfere 'ith that contro!. 0s Peter 3rahos and 2ohn Braith'aite re!ate% this is precise!y the choice 'e are no' ma/ing a out inte!!ectua! property. )e 'i!! have an information society. That much is certain. =ur on!y choice no' is 'hether that information society 'i!! e free or feudal& The trend is to'ard the feuda!. ('essig, ;ree #u!ture, p 189)

11A

4.$.$ Issues In Property Rights

#s changes in technology pushes us into the age of information, the +uestion of property rights will become more difficult&

11B

8 Economic )ay of Thin/ing

7 E*'%'+$* 7A5
(.1 MAR+ET E9C
ANGE AS AN

'-

T4$%<$%8
ANISM

A!!OCATIVE MEC

Ex=-2<>e is a voluntary transaction between two or more persons& )he

conditions of the transfer are clearly specified& Dt is a qui5 .0o quo arrangement& -arket exchange is a contract or agreement between the parties to the transaction& )hese agreements or contracts may be implied or explicit, formal or informal& )here is no need for one party of the exchange to know the other& *ach party only needs to know the terms of the exchange and that the other party will fulfill the agreement& )here is no need for any relationship between the parties other than the exchange& Dn many ways anonymity of the parties to the exchange may make the exchange less complicated& 4ften it is more difficulty to sell your used car to a relative or friend than to a stranger& Dn other cases some of the features of reciprocity and redistribution may facilitate or improve the process of market exchange& Dn the diamond trade in "ew !ork City or on the farm in Dowa, participants may know and trust each other to meet the conditions of the market exchange& )his reduces the effort or transaction cost of negotiating the agreement& Dn other cases redistribution by an authority may facilitate market exchange& #n individual who fails to comply with the terms of the contract or exchange may by sued in a system of courts that has the authority to enforce the exchange& # maEor advantage of market exchange as an allocative mechanism is that once you have found others to contract or exchange with, each actor only needs information about their own preferences and what they are willing and able to do& Dt is not necessary that all information be available in a central

152

8.1 Mar/et E+change as an 0!!ocative Mechanism

location or to a planner& Dt may be useful to think of a market as a communication system& )he preferences and feasible alternatives available to each agent or individual are communicated through the market& %elative prices and +uantities are pieces of information that may be used by the actors& )he buyer of a good demonstrates that they prefer the good they purchase to the money or the other things that an e+ual amount of money would buy& Similarly, the seller demonstrates a preference for the money (or what it will buy) to the good they sold& # good sold for a price of U7 is valued at or is ;worth< at least U7 to the buyer or the buyer would not have purchased the good& %isk and uncertainty are a part of virtually all human choices& Ghile an individual may think they will receive some level of benefit or utility from a purchase, they may fail to do so& # second advantage attributed to the market is that it is flexible and provides information and incentive to encourage agents to adapt +uickly to changes in technology, supplies of inputs and environmental conditions& Dn order for individuals and society to benefit from market exchange, there are two fundamental conditions that must hold& 4ne is that exchanges must be voluntary& )he other is that property rights must be ;nonattenuated&<

151

8.1.1 Oo!untary E+change

7#1#1 3'2)%TA&5 E=*4A%8E

In neoclassical economics, the obEective of an economy is to increase the

welfare or utility of the individuals who make up the society& 4ne of the basic concepts described in Chapter D Dntroduction was ;$areto *fficiency or $areto 4ptimality&< )o review, remember that a $areto efficient or optimal solution to the allocation problem exists when all the alternatives that will improve the welfare (utility) of a least one person, without making anyone else ;worse off< have be exhausted& #ny alternative that will improve the welfare or utility of at least one person without decreasing the welfare or utility of another person would increase the welfare of society& )his improvement is called a $areto improvement and the result is said to be $areto superior to the initial alternative& =enerally, a person would enter into a voluntary exchange if they can improve their welfare or increase their utility& Dt is assumed that an individual who voluntarily enters into an exchange would not make himself or herself ;worse off&< )herefore, any voluntary exchange will increase the welfare of one or both parties and neither will be any worse off& Heremy entham
?196A-1A51@

attempted to make ;utilitarianism< the operative

mechanism to improve the welfare of society& Fe and many of his followers attempted to find a way to +uantify utility and use it for decision-making& entham proposed a felicific calculus to make be used& Fowever, it is not possible to make interpersonal comparisons of utility, i&e& if each of 122 persons is given one *uro () each there is no reason to believe that they would all get the same utility& "or is it possible to assume that the utility or welfare of the group would be maximi,ed by that distribution& Consider a distribution where every member of society is given 1 case of cola and 1 box of tea bags& Since individuals do not have the same preference

151

8.1.1 Oo!untary E+change

for cola and tea, there is no guarantee this e+ual distribution of cola and tea would maximi,e the utility or welfare of the group& Dnformation on the preferences of all individuals is not held in one central place, utility cannot be measured and summed, so it is impossible to redistribute cola and tea by eminent domain and insure an increase in total utility& 3oluntary exchange is believed to increase the utility of the members of society& Dndividuals who prefer cola to tea should trade (or exchange) cola for tea with those individuals who prefer tea to cola& )he utility of all individuals, whether they prefer tea or cola would increase (or at least not go down)& )he parties to the exchanges must have information about their own preferences and who the others are that are willing to trade& Dt would be helpful to have information about the preferences of others before one offers to trade& Df D knew you liked tea did not like cola, D would offer to trade a small amount of tea for a large amount of cola& Dt would be to your advantage that D not know your true preferences& Dnformation is valuable& !ou might try to convince me that you liked cola to get a ;better deal&< )his is called ;haggling or bargaining&< )he negotiations for a contract often include the process of discovering the preferences and the maximum amount the other person will trade for a good, i&e& ;the best deal&< #s trades are negotiated among the members of a society, information about these transactions becomes valuable& Df you wish to buy or sell a used car you may consult the Kelly lue ook or *dmunds to find out the average prices that other exchanges& $roviding false information may be regarded as fraud or deceit& Dn communities where others often know one another, one(s reputation is often based on ;honest< dealings& Dn more complex societies, law and legal suits may be used to prosecute fraud and deception& )he maximum price the buyer is willing and able to pay for a good is called the ;reservation price of the buyer (%$ )< and the minimum price the seller

155

8.1.1 Oo!untary E+change

will accept for the good is the ;reservation price of the seller (%$S)&< So long as the %$ is greater than the %$S, a trade can take place& Df the %$S is greater than the %S , no trade will occur& "either the buyer nor seller wants the other party to know their reservation price& Faggling is the process by which a mutually agreeable price can be determined& )he price at which the exchange will occur will be greater than the %$S and lower than the %$ (%$ST$T%$ )& Dn the case of a single transaction, the price will be closer to the reservation price of the seller or buyer with the most information and the greatest skills in negotiation& )he degree to which individuals adhere to a pure +uid pro +uo and conse+uentialist ethic may give individuals an advantage over individuals who are constrained by a deontological ethic& 4ver time an expected pattern of trade emerges& # given amount of cola is expected to trade for a specific number of tea bags& )he ratio at which cola and tea trade can be called the exchange ratio& )he exchange ratio is the price of one good in terms of another& )his exchange ratio is determined by the preferences of the individuals, the relative amount and distribution of cola and tea& Df it is established that on average, 1 cola trades for 7 tea bags, individuals who do not like cola will be willing to accept cola on trade because they know its will trade for tea& Df 1 cola (1c) trades for 7 tea bags (7t), money can be used to facilitate the exchanges& )he use of money results in monetary prices rather than prices in terms of other goods& )he monetary price of cola will be labeled, $C, the price of tea $t& )he relative prices of cola and tea are established by the exchange ratio& Df one cola will trade for 7 tea bags,
1c N 7t, if $c N R1 implies $t N R&12 if $t N R1 implies $c N R7

156

8.1.1 Oo!untary E+change

Dn microeconomics it is the relative prices that are important& Df the exchange ratio is 1c N 7t, the ;correct< set of prices can be either
$c N R1 and $t = R&12 or $c N R7 and $t N R1

#ny voluntary exchange reflects the preferences of the parties to the exchange& Df Hoan buys a cola for 1, she must prefer the cola to 1 or she would have kept her money. If John sells Joan a cola for 1, he must prefer the 1 to the cola or he would have kept the cola. Therefore if Joan voluntarily buys a cola from John (who voluntarily sells it) they are both better off! or have increased their utility. )he problem arises as to what is meant by ;voluntary&< Some actions, such as ;duress< clearly violate the concept of voluntary& #ny contract concluded under duress is unenforceable in most countries& Contracts or exchanges with minors are also unenforceable& Df Hoan holds a gun to Hohn(s head to force him to sell the cola, that would clearly be duress or coercion and violate the conditions of voluntary exchange& Df the instructor of a class suggests you buy his or her book, is that coercionI Df your mother says, ;!ou go ahead and do what you want to do but it will break my heartJ< Ds that coercionI ;3oluntary< exchange is often a matter of degree& 4ften the only ;voluntary< choice open to an individual in a pure market is to ;exit&< )he person may choose to participate or not&

7#1#2 E*'%'+$* 7A5

'-

T4$%<$%8

Economic theory provides a ;map< or structure to aid in the interpretation

of economic data or information& )he nature of the map (economic theory) determines the nature of the +uestions asked& Hoan %obinson(s
?1B25-1BA5@

157

8.1.$ Economic )ay of Thin/ing

comment was, ;Df you don(t ask the right +uestion, you won(t get the right answer&< &eoclassical microeconomics is based on the belief that individuals are rational and that they attempt to optimi,e&

7#1#2#1 $%($3$()A2,

A&E &AT$'%A2

#* ob0ectives are known !* all feasible alternatives are known 7* each alternative is evaluated with respect to the ob0ective

7#1#2#2 :E%E-$T -

*',T -'&+AT

IPA&ET'

E--$*$E%*5!P'TE%T$A2J

Most

of economic theory is based on individuals making ;optimal

choices&< 4bEectives or goals are usually based on the maximi,ation or minimi,ation of some variable, i&e& the maximi,ation of utility, output or profit or the minimi,ation of cost per unit& enefit/cost analysis is a basic approach that is used& Df the benefits associated with a choice (alternative) exceed the costs incurred with the choice, there is an increase in net benefits& Df the costs exceed the benefits of a choice, it will not increase net benefits& "otice that it is the cost and benefit associated with a choice& )his re+uires ;marginal analysis&< variation of the $areto $otential criterion& /C analysis is a

7#1#2#1 +A&8$%A2 A%A25,$,

Decisions in economics are always made at the ;margin&< # decision to

change one variable will cause a change in some other related variable& # change in the price of a good will change the +uantity sold, a change in the +uantity sold will change the total revenue collected& )he change in total revenue caused by a change in units sold is called marginal revenue& )he marginal concept is applied to a wide variety of relationships& Dn principles of

158

8.1.$ Economic )ay of Thin/ing

economics these are usually described as a ;one unit< change in the variables& )he =reek letter delta, is used to identify a change calculated by subtraction& Dn other cases a derivative (d) or partial derivative (S) will be used to denote a change that approaches 2& )he use of marginal is applied to many economic relationships& Dn fact, the early period of the development of microeconomics (mid to late 1B th century) was called the ;margina!ist revo!ution&< useful marginal relationships& elow are some definitions of several

#*

arginal &ost 3 &5

& is defined as the change in 'otal &ost 3'&5 or variable cost 3P&5 caused by a one unit change in the 4uantity produced, output 3=5* opportunity cost* & represents

MC =
!* arginal Benefit 3 B5

TC VC = Q Q

B is defined as the change in total benefit 3'B5 caused by a one unit change in 4uantity consumed 3=5*

MB =

TB Q

7*

arginal Utility 3 U5
U is the change in utility caused by a change in 4uantity consumed 3=5

MU =

TU Q

:*

arginal Aevenue 3 A5
A is the change in 'otal Aevenue 3'A5 caused by a one unit change in the 4uantity sold 3=5*

159

8.1.$ Economic )ay of Thin/ing

MR =

TR Q

<*

arginal Product 3 P5 'he marginal product is the change in output 3=5 caused by a change in a variable input 3- or B5*

MP L =

Q Q , MP K = L K

7#1#2#4 +A&8$%A2 A%A25,$,

#*

A%(

':;E*T$3E,

'o ma(imi2e utility

So long as the U N &, consume the ne(t unit* /f UQ & reduce the level of consumption* Ohere UH & ma(imum utility is attained*

/f there are two or more goods that have a price 3or cost5, the process of utility ma(imi2ation re4uires that each additional e(penditure be made on the good that has the highest marginal utility* 'o ma(imi2e utility with several goods that have economic prices, the )e4uimarginal principle,+ is used*

UX

PX PY PN Sub0ect to B P X Q X + P Y Q Y + * * * + P N Q N Ohen P i = price of good i , B = budget, Q i = =uantity of good i

!* 'o ma(imi2e profit 35

UY

==

UN

So long as the ne(t unit of output can be produced at a cost that is less than it can be sold for, do itR 87en MR >M$, prod!ce 87en MR ?M$ red!ce o!tp!t, Maxim!m profits w7en MR @ M$

15A

8.1.$ Economic )ay of Thin/ing

7*

a(imum welfare of buyers and sellers

'he market is a social institution that provides information to guide the allocation process in a society* Buyers should purchase additional units of a good so long as the B N P*

'he producers 3sellers5 of a good should continue to produced and sell more of a good so long as the P N &*

'he welfare of buyers and sellers will be ma(imi2ed when M& @ P @ M$

7#1#2#@ APPE%($= $

,*4''2,

'-

E*'%'+$* T4')84T

uman behavior can be viewed from many different perspectives& Sociology, political science, psychology, anthropology, history, and economics are Eust a few of the basic approaches to the study of the individuals and society& Githin each of these disciplines there are differences in perspectives& Dn economics, there are ;schools of thought< that have alternative approaches to the analysis of economic processes& )hese schools of thought may ask different +uestions and use different methods in their attempts to answer them& Githin microeconomics the mainstream view is ;"eoclassical economics< which is the topic of this outline& 4ther approaches include, #ustrians, ;4ld< Dnstitutionalists, ;"ew< Dnstitutionalists, Galrasians, -arxists, $ublic Choice theorists, law and economics, Chicago, Keynesian and social economics& Some of these schools focus on macroeconomics while others are primarily deal with microeconomic issues& Ghile many of these schools have different approaches, there is often overlap& Dt is useful to know a little about some of these alternative approaches to understand how mainstream economics has developed and which aspects of "eoclassical economics might be subEect to criticism and how it may be adapted& =eorge Stigler (1B11-1BB1), described a school of economic thought,

15B

8.1.$ Economic )ay of Thin/ing

0 schoo! 'ithin a science is a co!!ection of affi!iated scientists 'ho disp!ay a considera !y higher degree of agreement up on a particu!ar set of vie's than the science as a 'ho!e disp!ays. It is essentia! to a schoo! that there e many scientists outside it% or the schoo! 'ou!d have no one 'ith 'hom to argue. Schoo!s have received !itt!e study% and the fo!!o'ing remar/s are on!y casua! impressions. 0 schoo! must have a !eader% ecause of the consensus of its mem ers 'i!! norma!!y e achieved and maintained y ma5or scientific entrepreneurs. If the schoo! is united on methodo!ogy rather than su stantive doctrines% its !ife 'i!! e !onger% ut a!so !ess inf!uentia!-. 0 schoo! may e ased on po!icy vie's rather than upon economic ana!ysis or scientific method-. ?Stigler, The Economist as Preacher,

asil

lackwell, 4xford, 1BA1, p118@

'-

7#1#2#> +$*&'E*'%'+$* ,*4''2,

E*'%'+$* T4')84T

Economics, as an identifiable discipline, began with the $hysiocrats& )he

$hysiocrats, led by :ranois Ouesnay (18B6-1996), emphasi,ed a natural order and coined the phrase ;1aisse. faire% !aisse. passer&< )hey were strong advocates of free trade& Ouesnay recogni,ed the idea of a flow or circular flow of goods and money in the ta !eau& )he $hysiocrats were concerned with the relationship of the individual to society& )hey believed that free trade with minimal intervention by the state would allow a state of harmony to exist& )hey were reacting against the nationalistic policies of an economic policy called ;Colbertism&< Colbertism was a set of mercantilist policies that emphasi,ed national power that could be enhanced by strong regulation of economic activities& 7#1#2#>#1 (1) *2A,,$*A2 E*'%'+$*, #dam Smith ?1915-19B1@ knew some of the $hysiocrats and used many of their ideas in the development of what was to become Classical economics& Smith(s ideas are to be found in The Theory of Mora! Sentiments (197B), 0n In*uiry into the &ature and #auses of the )ea!th of &ations (1998), and

162

8.1.$ Economic )ay of Thin/ing

1ectures on 2urisprudence ('ectures 1981-85 and 1988)& Smith believed that social harmony would be the result of a system of morality, free markets and a set of laws& Fis primary concern was economic growth that was the result of speciali,ation and the division of labor& -uch of Classical economics was macroeconomics in its concern about economic growth and the division of income among the various factors of production (land, labor, and capital& *ntrepreneurial ability as a factor was identified by %ichard Cantillon and populari,ed by H& & Say
?1989-1A51@) ?18A2-1956@

Self-interested behavior within free markets, constrained by morality and law were the basis of the Smithian system& )he )ea!th of &ations provided the foundations for the Classical school of economics& Some members (such as Cavid %icardo and H& & Say) of the school argued for free trade based on comparative advantage& 4thers (such as )homas -althus) argued for trade restrictions in the form of the ;corn laws&< )he corn laws had the effect of restricting the importation of grains& )hese restrictions reduced the supply and increased the price of grains used as food& :rom a microeconomic perspective, this changes the relative prices of goods& :rom a macroeconomic perspective, the functional distribution of income and economic growth are altered& )he Classical economists tended to focus on the functional distribution of income ()he functional distribution refers to the distribution of income to the factors of production, land, labor and capital& )hese were aligned with social classes&), economic growth (or stagnation in a stationary state), and social harmony& Smith saw the division of labor, increase in population and the accumulation of capital as the forces that promoted economic growth& %icardo, -althus, -ill and other classical economists believed that decreasing returns in agriculture and population growth would result in a stationary state&

161

8.1.$ Economic )ay of Thin/ing

Smith (as well as %icardo and most Classical *conomists) noted that there was a ;value in use< and a ;value in exchange&< Consistent with the Classical focus on the use of markets as the primary allocative mechanism, value in exchange was considered as the topic of economic analysis& =enerally, their approach began with a labor theory of value& Smith argued that
The rea! price of every thing% 'hat every thing rea!!y costs to the man 'ho 'ants to ac*uire it% is the toi! and trou !e of ac*uiring it. ?Smith, )&, page 52@

Smith and %icardo were aware that utility was an necessary prere+uisite for a good to be exchanged, but believed that the costs of production determined value& # cost of production theory of value is a broader approach that was ultimately accepted by Smith& Heremy entham ?196A-1A51@ is credited with contributing the foundation entham presumed that human behavior was entham(s words.

of ;utilitarianism< to economics&

rational and was directed by ;felicific calculus,< an evaluation of the pains and pleasures associated with each choice& Dn

Nature a! "#a$e% &a'ki'% u'%er t e (o)er'a'$e o* t+o !o)erei(' &a!ter!, "ai' a'% "#ea!ure, -t i! *or t e& a#o'e to "oi't out + at +e ou( t to %o, a! +e## a! to %eter&i'e + at +e ! a## %o, .' t e o'e a'% t e !ta'%ar% o* ri( t a'% +ro'(, o' t e ot er t e $ ai' o* $au!e! a'% e**e$t! are *a!te'e% to t eir t ro'e, T ey (o)er' u! i' a## +e %o, i' a## +e !ay, i' a## +e t i'k/ e)ery e**ort +e &ake to t ro+ o** our !ub0e$tio', +i## !er)e but to %e&o'!trate a'% $o'*ir& it, -' +or%! a &a' &ay "rete'% to ab0ure t eir e&"ire/ but i' rea#ity e +i## re&ai' !ub0e$t to it a## t e + i#e, T e "ri'$i"#e o* uti#ity re$o('i1e! t i! !ub0e$tio', a'% a!!u&e! it *or t e *ou'%atio' o* t at !y!te&, t e ob0e$t o* + i$ i! to rear t e *abri$ o* *e#i$ity by t e a'%! o* rea!o' a'% #a+, , , By t e "ri'$i"#e o* uti#ity i! &ea't t at "ri'$i"#e + i$ a""ro)e! or %i!a""ro)e! o* e)ery a$tio' + at!oe)er/ a'% t ere*ore, 'ot o'#y o* e)ery a$tio' o* a "ri)ate i'%i)i%ua#, but o* e)ery &ea!ure&e't o* (o)er'&e't, By uti#ity i! &ea't t at "ro"erty i' a'y ob0e$t, + ereby it te'%! to "ro%u$e be'e*it, a%)a'ta(e, "#ea!ure, (oo%, or a""i'e!!, , ,or, , , to "re)e't t e a""e'i'( o* &i!$ ie*, "ai', e)i#, or u' a""i'e!! to t e "arty + o!e i'tere!t i! $o'!i%ere%/ i* t at "arty be t e $o&&u'ity i' (e'era#, t e' t e a""i'e!! o* t e $o&&u'ity/ i* a "arti$u#ar i'%i)i%ua#, t e' t e a""i'e!! o* t at i'%i)i%ua#,

161

8.1.$ Economic )ay of Thin/ing

T e $o&&u'ity i! a *i$titiou! bo%y, $o&"o!e% o* t e i'%i)i%ua# "er!o'! + o are $o'!i%ere% a! $o'!tituti'( a! it +ere it! &e&ber!, T e i'tere!t o* t e $o&&u'ity t e' i!, + at2 33 t e !u& o* t e i'tere!t! o* t e !e)era# &e&ber! + o $o&"o!e it, -t i! )ai' to ta#k o* t e i'tere!t o* t e $o&&u'ity, +it out u'%er!ta'%i'( + at i! t e i'tere!t o* t e i'%i)i%ua#, 4 t i'( i! !ai% to "ro&ote t e i'tere!t , , , o* a' i'%i)i%ua#, + e' it te'%! to a%% to t e !u& tota# o* i! "#ea!ure!/ or, + at $o&e! to t e !a&e t i'(, to %i&i'i! t e !u& tota# o* i! "ai'!,

entham offered utility as an alternative explanation for value& Hohn Stuart -ill ?1A28-1A95@ can be regarded as a transitionary writer. he connects the Classical economists and 0tilitarianism to the development of market-oriented microeconomics& -ill was an admirer and proponent of both entham and Cavid %icardo& -uch of -ill(s work seems to be an effort to integrate %icardian economics with 0tilitarianism& )he classical school of economics tended to advocate markets as the primary allocative mechanism& )hey followed the concept of natural liberty and are associated with the concept of ;classical liberalism&< 7#1#2#>#2 (2) +A&=$,T Karl -arx ?1A1A-1AB5@ was a critic of the capitalist system and of most of the classical economists who Eustified the market system& -arx built on the labor theory of value as expressed by Cavid %icardo& -arx(s criti+ue of capitalism can be found in a variety of his books and articles but perhaps the Economic and Phi!osophica! Manuscripts ?1A66@ and 3as :apita! ?1A89, 1AA7,1AB6@ are the best sources& -arx used ;dialectical materialism( to build a system to explain the historical process& Fis focus was on struggles between the workers (proletariat) and the capitalists (bourgeoisie)& Fe believed that the surplus created by the workers would be appropriated by the capitalists because they owned the means of production& )his is what is meant by ;exploitation& Dn the attempts to capture the surplus the capitalists would increase the amount of capital per worker and the rate of exploitation& #s more and more capital was added, capital became less productive and

165

8.1.$ Economic )ay of Thin/ing

generated less profit& )he problem was a falling rate of profit that increased the unemployed and reduced the number of ;petty bourgeoisie&< 0ltimately the capitalist system would fail due to contradictions within the system& -arx believed that the ;modes of production< (the technical way that society produced the material re+uisites) determined the structure of society& Fowever, there was a lag between changes in the modes of production and the social structure& 7#1#2#>#1 (1) +A&8$%A2$,T &E3'2)T$'% # combination of forces encouraged the application of mathematics (particularly calculus) to the analysis of economic behavior& entham(s utilitarianism and classical economics coupled with the ideology and politics that accompanied the development of the industrial revolution brought about new perspectives and new problems& Dn seeking to explain relative prices, a utility theory of value emerges& )he rate of change in total utility associated with a change in consumption (marginal utility) becomes the basis of value& Hohann Feinrich von )hVnen ?19A5-1A72, =erman@ was one of the early writers who began to apply mathematical methods in the economics of location theory and wages& Fermann Feinrich =ossen ?1A12-1A7A@ clearly stated the principle of diminishing marginal utility and the e+uimarginal principle by 1A76& =ossen(s approach was utilitarian and argued that value was primarily linked to subEective Eudgments about utility rather than the costs of production& # group of :rench engineers, developing criteria for making choices about roads, bridges and canals were influenced by both mathematics and the $hysiocrats& Hules Cupuit ?1A26-1A88, :rench@, along with colleagues, had worked out the importance of marginal benefits and marginal costs in making decisions& #ugustin Cournot ?1A21-1A99, :rench@, a :rench mathematician,

166

8.1.$ Economic )ay of Thin/ing

independently developed the use of marginal analysis in determining the behavior of firms who were competing in a market& )he :rench engineers were +uite advanced in the development of their analysis& ?*klund and FWbert, Secret =rigins of Modern Microeconomics, 0niversity of Chicago $ress, 1BBB@ Ghile the :rench probably developed marginal analysis before others, their work was not translated until later& Gilliam Stanley Hevons ?1A57-1AA1, *nglish@ and Carl -enger (1A62-1B11, #ustrian) and 'on Galras ?1A56-1B12, :rench@ independently developed concepts of marginal utility to explain value and behavior& )he differences among the :rench, *nglish and #ustrian economists are subtle but important& )he :rench were attempting to use economic theory to evaluate choices at a public or social level& )he *nglish and the #ustrians focused on individual choice& 7#1#2#>#4 (4) %E'*2A,,$*A2 E*'%'+$*, "eoclassical economics grew out of Classical *conomics and the -arginalist %evolution& #lfred -arshall
(1A61-1B16, *nglish *conomist),

'Won Galras (1A56-1B12,

:rench/Swiss) and 3ilfredo $areto (1A6A-1B15, Dtallian/:rench/Swiss) were among the writers who were instrumental in the development of "eoclassical economics in the basic form that persists& #lfred -arshall is best known for his use of partial e+uilibrium that re+uires the concept of ceteris pari us& Fis focus is on individual and firm behavior in markets& 'Won Galras developed the concept of general e+uilibrium that includes the interdependence of all markets& -arshall synthesi,ed the cost of production theory of value of the classical school with the marginal utility of the marginalists& )he cost of production theory of value suggests that supply determines price& )he marginal utility approach attributes value to subEective choices and holds that price is determined by utility& -arshall argued that

167

8.1.$ Economic )ay of Thin/ing

supply and demand interact to determine price& Fe used the metaphor of a pair of scissors to emphasi,e his argument&
5e &i( t a! rea!o'ab#y %i!"ute + et er it i! t e u""er or t e u'%er b#a%e o* a "air o* !$i!!or! t at $ut! a "ie$e o* "a"er, a! + et er )a#ue i! (o)er'e% by uti#ity or $o!t! o* "ro%u$tio',6 , arshall, Pri'$i"#e! o* E$o'o&i$!, Kth edition, page !G".

3ilfredo $areto, :rancis !sidro *dgeworth ?1A67-1B18@ and Fenry Sidgwick ?1A5A-1B22@ were all instrumental in developing the idea of indifference functions that allows the use of ordinal concepts of utility& -ost of the materials in modern principles of microeconomics have evolved from the framework of "eo classical economics& #nd that is the focus of this outline& 7#1#2#>#@ (@) A),T&$A% E*'%'+$*, Carl -enger and a group of followers (such as *ugen von

Xhm- awerk

?1A71-1B16@, :riedrich von Gieser ?1A71-1B18@, 'udwig von -ises ?1AA11B95@ and :riedrich Fayek ?1ABB-1BB1@) have developed an alternative view of microeconomic behavior& )he #ustrian approach views human behavior as ;purposive,< (as opposed to rational)& -arkets are viewed as dynamic processes rather than the comparative statics of e+uilibrium outcomes in neoclassical economics& focus of many #ustrians& 0ncertainty and lack of information play an important role in #ustrian economics& #s a conse+uence, the role of information and learning becomes an important aspect of economic behavior and participation in markets& :or the #ustrians, value is subEective and is determined by the individual& -any of the ideas of the #ustrians have been incorporated into neoclassical or mainstream economics& Gieser is credited with coining the term ;opportunity cost&< Dmputing a value for inputs from the valuation of outputs has been ehavior in conditions of dise+uilibria and processes by which individuals and systems might move toward e+uilibrium has been the

168

8.1.$ Economic )ay of Thin/ing

integrated into mainstream economics& #ustrian economics supports the ideas of individual choice and a minimal role for government& 7#1#2#>#> (>) $%,T$T)T$'%A2 E*'%'+$*, )horstein 3eblen (1A79-1B1B) is

regarded

as

the

founder

of

the

Dnstitutionalist school of economics& 3eblen reacted against the sterile, individualism of neoclassical economics and coined the term ;neoclassical&< Fe argued that neoclassical economics is static (it primarily uses comparative statics) and is limited in its ability to deal with dynamic forces such as technology& )he Dnstitutionalists argue that human behavior is not ;rational< but rather is social behavior and is guided by ;habitual patterns of behavior< which are expressed as social institutions& Ddle curiosity, desire to be a parent and respect for workmanship are three of the forces that influence human behavior& 3eblen ;Ldeve!ops the idea that institutions are inhi itory and to'ard change&< ?)ilman, 0 Oe !en Treasury% page ++iii@ ac/'ard

!oo/ing% 'hi!e science and techno!ogy are themse!ves dynamic and oriented

)ilman finds five ideas in 3eblen that are representative of his contribution. economists& the emancipatory potential of the machine process antithesis between business and industry legal and political institutions as representing the vested interests the compulsive force of idea patterns the bankruptcy of commercial values

)he Dnstitutionalists, like the #ustrians are regarded as ;heterodox<

169

8.1.$ Economic )ay of Thin/ing

7#1#2#>#7 (7) 'T4E&, -odern microeconomics is characteri,ed by a variety of perspectives& )he Chicago School, the $ublic Choice/$roperty %ights view, and the "ew Dnstitutionalists represent variations on "eoclassical economics& )hese approaches tend to use "eoclassical economics to explain human behavior and the nature and structure of social institutions and organi,ations& Social economists offer alternative views and argue that modern

microeconomics has become ;imperialistic< in its attempts to explain all human and social behavior in terms of economics& Dn recent years, there has been a small group of economists who have been trying to place economic theory within a social context& %ichard Swedberg and #mitai *t,ioni are characteristic of some of the writers who hold a social perspective& )he focus is on the role of society and its influence on the individual& Society is seen as more than the summation of individual utility functions and behavior&

16A

9 3emand and Supp!y in a Mar/et System

? (E+A%(

A%(

,)PP25

$% A

+A&<ET ,5,TE+

The market system is an interrelated set of markets for goods, services

and inputs& # market is defined as the interaction of all potential buyers and sellers of a good or class of goods that are close substitutes& )he economic analysis that is used to analy,e the overall e+uilibrium that results from the interrelationships of all markets is called a ;general e+uilibrium< approach& $artial e+uilibrium is the analysis of the e+uilibrium conditions in a single market (or a select subset of markets in a market system)& Dn principles of economics, most models deal with partial e+uilibrium& Dn a partial e+uilibrium model, usually the process of a single market is considered& )he behavior of potential buyers is represented by a market demand function& Supply represents the behavioral pattern of the producers/sellers&

).1 DEMAND FUNCTION

demand function that represents the behavior of buyers, can be

constructed for an individual or a group of buyers in a market& )he market demand function is the hori,ontal summation of the individuals( demand functions& Dn models of firm behavior, the demand for a firm(s product can be constructed& )he nature of the ;demand function< depends on the nature of the good considered and the relationship being modeled& Dn most cases the demand relationship is based on an inverse or negative relationship between the price and +uantity of a good purchased& )he demand for purely competitive firm(s output is usually depicted as hori,ontal (or perfectly elastic)& Dn rare cases,

16B

9.1 3emand ;unction

under extreme conditions, a ;=iffen good< may result in a positively sloped demand function& )hese =iffen goods rarely occur& Dt is important to identify the nature of the ;demand function< being considered&

?#1#1 $%($3$()A2 (E+A%( -)%*T$'%

The behavior of a buyer is influenced by many factors. the price of the

good, the prices of related goods (compliments and substitutes), incomes of the buyer, the tastes and preferences of the buyer, the period of time and a variety of other possible variables& )he +uantity that a buyer is willing and able to purchase is a function of these variables& #n individual(s demand function for a good (=ood >) might be written. E= A 0=(P=6 Prelated "oods6 inco/e (+)6 pre0erences6 # # # ) => H the 4uantity of good > P> H the price of good > Prelated goods H the prices of compliments or substitutes /ncome 3 5 H the income of the buyers Preferences H the preferences or tastes of the buyers
Price
JK JS JF J< J: J7 J! J# ! : F K #" #! #: #F #K Cigure ///*A*#

)he demand function is a model that ;explains< the change in the dependent variable (+uantity of the good > purchased by the buyer) ;caused< by a change in each of the independent variables& Since all the independent variable may change at the same time it is useful to isolate the effects of a change in each of the

Demand =uantityMut

172

9.1.1 Individua! 3emand ;unction

independent variables& )o represent the demand relationship graphically, the effects of a change in $> on the O> are shown& )he other variables, ($related representation of demand& Since ($related and O> in a given unit of time (ut)& )he demand function can be viewed from two perspectives&
'he demand is usually defined as a schedule of 4uantities that buyers are willing and able to purchase at a schedule of prices in a given time interval 3ut5, $eteri! "aribu!* =6 @ f(P6), given incomes, price of related goods, preferences, etc* Demand can also be perceived as the ma(imum prices buyers are willing and able to pay for each unit of output, $eteri! "aribu!* P6 @ f(=6), given incomes, price of related goods, preferences, etc*
goods

-, preferences, & & & ) are held constant& :igure DDD&#&1 shows the graphical
goods

, -, preferences, & & & ) are held

constant, the demand function in the graph shows a relationship between $ >

Dt is important to remember that the demand function is usually thought of as O N f($) but the graph is drawn with +uantity on the >-axis and price on the !-axis& Ghile demand is fre+uently stated O N f($), remember that the graph and calculation of total revenue ()%) and marginal revenue (-%) are calculated on the basis of a change in +uantity (O)& )% N f(O) )he calculation of ;elasticity< is based on a change in +uantity (O) caused by a change in the price ($)& Dt is important to clarify which variable is independent and which is dependent in a particular concept&

?#1#2 +A&<ET (E+A%( -)%*T$'%

,hen

property rights are nonattenuated (exclusive, enforceable and

transferable) the individual(s demand functions can be summed hori,ontally to obtain the market demand function& Dn :igure DDD&#&1 and )able DDD&#&1, a market demand function is constructed from the behavior of three people (the participants in a very small

171

9.1.$ Mar/et 3emand ;unction

market& #t a price of $1, #nn will voluntarily buy 1 units of the good based on her preferences, income and the prices of related goods& :igure DDD&#&1& ob and Cathy buys 5 units each& )heir demand functions are represented by C #, C and CC in

Price

Cigure ///*A*!

P. DA d PB P#

DB d

Market Aemand

AM D& d

=Mut

)he total amount demanded by the three individuals at $ 1 is A units (1P5P5)& #t a higher price each buys a smaller +uantity& )he demand functions can be summed hori,ontally if the property rights to the good are exclusive. #nn(s consumption of a unit precludes ob or Cathy from the consumption of that good& Dn the case of public (or collective) goods, the consumption of national defense by one person (they are protected) does not preclude others from the same good& )he behavior of a buyer was represented by the function. E= A 0=(P=6 Prelated "oods6 inco/e (+)6 pre0erences6 # # # )# :or the market the demand function can be represented by adding the number of buyers (Y , or population), E= A 0=(P=6 Prelated "oods6 inco/e (+)6 pre0erences6 # # # K:)

171

9.1.$ Mar/et 3emand ;unction

Ghere Y

represents the number of buyers&

0sing ceteris paribus the

market demand may be stated

=6 @ f(P6), "i%en incomes, price of related "oods, preferences, C& etc.

?#1#1 *4A%8E

$%

E)A%T$T5 (E+A%(

,hen demand is stated O N f($) ceteris pari us, a change in the price of
the good causes a Cchan"e in Luantit. de/anded#D )he buyers respond to a higher (lower) price by purchasing a smaller (larger) +uantity& Cemand is an inverse relationship between price and +uantity demanded& 4nly in unusual circumstances (a highly inferior good, a =iffen good) may a demand function have a positive relationship& # change in +uantity demanded is a movement along a demand function caused by a change in price while other variables (incomes, prices of related goods, preferences, number of buyers, etc) are held constant& # change in +uantity demanded is shown in :igure DDD&#&5&

JK JS JF J< J: J7 J! J# ! : F K #" #! #: #F #K Cigure ///*A*7

An increase in 4uantity demanded is a movement along a demand curve 3from point A to B5 caused by a decrease in the price from JS to J:*

Price

A decrease in 4uantity demanded is a movement along the demand function 3from point B to A5 caused by an increase in price from J: to JS*

&
Demand =uantityMut

175

9.1.( #hange in 3emand

?#1#4 *4A%8E

$%

(E+A%(

A change in demand is a ;shift< or movement of the demand function& #

shift of the demand function can be caused by a change in.
incomes the prices of related goods preferences the number of buyers* Dtc * * *

#;change in demand< is shown in :igure DDD&#&6& =iven the original demand (Cemand), 12 units will be purchased at a price of R7& #n increase in demand (CD"C%*#S*) is to the right and at every price a larger +uantity will be purchased& #t R7, eighteen units are purchased& # decrease in demand is a shift to the left& #t a price of R7 only 6 units are purchased& # smaller +uantity will be bought at each price&
Eiven a demand function 3Demand5, an increase in demand is shown as D/6&ADASD* At each price a larger 4uantity is purchased* A decrease in demand is shown as DDD&ADASD* At each possible price the 4uantity purchased is less* Price

JK JS JF J< J: J7 J! J# ! : Aecrease

,ncrease

: F E A,)RD+*D AAD$RD+*
D F K #" #! #: #F #K Cigure ///*A*:

Demand =uantityMut

176

9.1.A Inferior% &orma! and Superior Doods

?#1#@ $%-E&$'&6 %'&+A2

A%(

,)PE&$'& 8''(,

change in income will usually shift the demand function& Ghen a good

is a ;normal< good, there is a positive relationship between the change in income and change in demand. an increase in income will increase (shift the demand to the right) demand& # decrease in income will decrease (shift the demand to the left) demand& #n inferior good is characteri,ed by an inverse or negative relationship between the change in income and change in demand& #n increase in the income will decrease demand while a decrease in income will increase demand&
Price

JK JS JF J< J: J7 J! J# ! : Aecrease

,ncrease

: F E A,)$RD+* AAD$RD+*
D F K #" #! #: #F #K Cigure ///*A*!

Demand D =uantityMut

# superior good is a special case of the normal good& )here is a positive relationship between a change in income and the change in demand but, the percentage change in the demand is greater than the percentage change in income& Dn :igure DDD&#&1 an increase in income will shift the Cemand function (;Cemand<) for a normal good to the right to CD"C%*#S*& :or an inferior good, a decrease in income will shift the demand to the right& :or a normal good a decrease in income will shift the demand to CC*C%*#S*&

177

9.1.4 #omp!iments and Su stitutes

?#1#> *'+P2$+E%T,

A%(

,):,T$T)TE,
> >

The demand for >ebecs (O ) is determined by the $ , income and the

prices of related goods ($ %)& =oods may be related as substitutes (consumers perceive the goods as substitutes) or compliments (consumers use the goods together)& Df goods are substitutes, (shown in :igure DDD&#&5) a change in $ ! (in $anel
Price

) will shift the demand for good > (in $anel #)&
Price P'B A' *!bstit!tes Eoods > and @ are substitutes, An increase in P@ 3from P@# to P@!5 decreases the 4uantity demanded for @ from @# to @!* 'he demand for good > increases to D>%* At P> the amount purchased increases from >! to >7* A decrease in P@ shifts D> to D>%% 3Amount of > decreases to >#5*

P6

A6* P'A6** ># >! >7 A6 => Mut 'B

Cigure ///*A*7

'-

=@ Mut
Panel B

Panel A

#n increase in $! (from $!1 to $!1) will reduce the +uantity demanded for good ! (a move on C !)& )he reduced amount of ! will be replaced by purchasing more >& )his is a shift of the demand for good > to the right (Dn $anel #, this is shown as a shift from C > to C>Z, an increase in the demand for good >)& #t $> a larger amount (>5) is purchased # decrease in $! will increase the +uantity demanded for good !& )his will reduce the demand for good >, the demand for good > will shift to the left (from C> to C>ZZ, a decrease)& #t $> (and all prices of good >) a smaller amount of > (>1) is purchased& Dn the case of compliments, there is an inverse relationship between the price of the compliment ($[ in $anel , :igure DDD&#&6) and the demand for

178

9.1.4 #omp!iments and Su stitutes

good >& #n increase in the price of good [ will reduce the +uantity demanded for good [& Since less [ is purchased, less > is needed to compliment the reduced amount of [ ([ 1)& )he demand for > in $anel # decreases for C > to C>ZZ& #n decrease in $[ will increase the +uantity demanded of good [ and result in an increase in the demand for good > (from C > to C>Z in $anel #)&
Price Price PGB P6 AG $ompliments Eoods > and T are compliments, An increase in PT 3from P T# to P T!5 decreases the 4uantity demanded for T from T# to T!* 'he demand for good > decreases to D>%%* At P > the amount purchased decreases from >! to >#* A decrease in PT shifts D> to D>% 3Amount of > increases to >75*

A6* PGA6** ># >! >7 A6 => Mut GB

Cigure ///*A*:

G-

=T Mut
Panel B

Panel A

?#1#7 E=PE*TAT$'%,

Expectations about the future prices of goods can cause the demand in
any period to shift& Df buyers expect relative prices of a good will rise in future periods, the demand may increase in the present period& #n expectation that the relative price of a good will fall in a future period may reduce the demand in the current period&

).2 SUPP!Y FUNCTION

supply function is a model that represents the behavior of the

producers and/or sellers in a market&

E=, N fS(P=, $D"$0)S, technology, number of sellers, laws,

taxes, expectations & & & YS)
P> H price of the good,

179

9.$ Supp!y ;unction

P/6PU'S H prices of the inputs 3factors of production used5 'echnology is the method of production 3a production function5, laws and regulations may impose more costly methods of production ta(es and subsidies alter the costs of production US represents the number of sellers in the market*

'ike the demand function, supply can be viewed from two perspectives.
Supply is a schedule of 4uantities that will be produced and offered for sale at a schedule of prices in a given time period, $eteri! "aribu!* A supply function can be viewed as the minimum prices sellers are willing to accept for given 4uantities of output, $eteri! "aribu!*

?#2#1#1 (1) 8&AP4

'-

,)PP25
TA:2E $$$#A#@ ,)PP25 -)%*T$'% $%DC* R7 R12 R17 O0#")D)! 2 12 12 52

The

relationship between the +uantity produced

and offered for sale and the price reflects opportunity cost& =enerally, it is assumed that there is a positive relationship between the price of the good and the +uantity offered for sale& :igure DDD&#&7 is a graphical representation of a supply function& )he e+uation for this supply function is OsuppliedN -12 P 1$& )able DDD&#7 also represents this supply function&

?#2#1#2 (2) *4A%8E

$% E)A%T$T5 ,)PP2$E(

Given

the supply function, Oxs N fs($x, $inputs,

R12

)ech, & & &), a change in the price of the good ($ >) will be reflected as a move along a supply function& Dn :igures DDD&#&7 and DDD&#&8 as the price increases from R12 to R17 the +uantity supplied increases from 12 to 12& )his can be visuali,ed as a move from point # to point on the supply

17A

9.$ Supp!y ;unction

function& # ;chan"e in Luantit. supplied is a /ove/ent alon" a suppl. 0unction&< )his can also be visuali,ed as a movement from one row to another in )able DDD&#&7&
*!pply
& B

?#2#1#1 (1) *4A%8E

$%

,)PP25

iven the supply function, Oxs N fs($x, $inputs, )ech, & & &, YS), a

J!" J#< J#" J< A

change in the prices of inputs ($ inputs) or technology will shi0t the supply function& # shift of the supply function to the right will be called an increase in supply& )his means that at each possible price, a greater +uantity will be offered for sale& Dn an

Price

#"

!"

7"

=Mut

Cigure ///*A*<

e+uation form, an increase in supply can be shown by an increase in the +uantity intercept& # decrease in supply is a shift to the left. at each possible price a smaller +uantity is offered for sale& Dn an e+uation this is shown as a decrease in the intercept&

Price

*!pply
&

J!" B

J#< A

J#" J<

A c7an"e in !antity s!pplied is a movement along a supply function that is )caused+ by a change in the price of the good* /n the graph to the right, as price increases from J#" to J#< the 4uantity supplied increases from #" to !"* 'his can be visuali2ed as a move from point A to point B along the supply function* A decrease in supply would be a move from point B to point A as price fell from J#< to J#"

#"

!"

7"

=Mut

Cigure ///*A*F

17B

9.$ Supp!y ;unction

A c7an"e in s!pply is a )shift+ of the supply function* A decrease in supply is shown as a shift from *!pply to *decrease in the graph* At a price of J#< a smaller amount is offered for sale* 'his decrease in supply might be )caused+ by an increase in input prices, ta(es, regulations or, * * * An increase in supply can be visuali2ed as a movement of the supply function from *!pply to *increase*

Price

*!pply

*decrease R D
A B

J!" J#< J#" J<

&

*increase

#"

!"

7"

=Mut

Cigure ///*A*S

)." E?UI!I$RIUM

,e ster@s Ency!opedic Nna ridged 3ictionary of the Eng!ish 1anguage

defines e+uilibrium as ;a state of rest or opposing forces,< and ; e*ua! e+uilibrium.
D4uilibrium as a )balance of forces+ D4uilibrium as )a point from which there is no endogenous Vtendency to change1+ D4uilibrium as an ) outcome which any given economic process might be said to be Vtending towards1, as in the idea that competitive processes tend to produce determinant outcomes*++

a!ance due to the e*ua! action of

a!ance

et'een any po'ers% inf!uences% etc. <

The &e' Pa!grave< 0 3ictionary or Economics identifies 5 concepts of

Dn "eoclassical microeconomics, ;e+uilibrium< is perceived as the condition where the +uantity demanded is e+ual to the +uantity supplied. the behavior of all potential buyers is coordinated with the behavior of all potential sellers& )here is an e+uilibrium price that e+uates or balances the amount that agents want to buy with the amount that is produced and offered for sale (at that price)& )here are no forces (from buyers or sellers) that will alter the

182

9." E*ui!i rium

e+uilibrium price or e+uilibrium +uantity& =raphically, economists represent a market e+uilibrium as the intersection of the demand and supply functions& )his is shown in :igure DDD&#&A&
/n the graph to the left, e4uilibrium is at the intersection of the demand and supply functions* 'his occurs at point B* 'he e4uilibrium price is J#< and the e4uilibrium 4uantity is !" units* At the e4uilibrium price the 4uantity that buyers are willing and able to buy is e(actly the same as sellers are willing to produce and offer for sale* Aemand
#" !" 7"

Price

*!pply
& B

J!" J#< J#" J< A

=Mut

Cigure ///*A*K

)his notion of e+uilibrium is one of the fundamental organi,ing concepts of neoclassical economics )his is a mechanical, static
Price

conception of e+uilibrium& "eoclassical economics uses ;comparative statics< as a method by which different states can be analy,ed& Dn this approach to e+uilibrium in a market the explanation about how e+uilibrium is achieved does not consider the possibility that some variables change at different rates of time&
*
W B & J!" J#< J#" J< #7

A
!" 7"

=Mut

Cigure ///*A*G

181

9." E*ui!i rium

)he process of achieving a state of e+uilibrium is based on buyers and sellers adEusting their behavior in response to prices, shortages and surpluses& Dn :igure DDD&#&B& Df the price were at R12& the price is ;too high< and the market is not in e+uilibrium& )he amount of the good that agents are willing and able to buy at this price (+uantity demanded) is less than sellers would like to sell (+uantity supplied)& #t R12 buyers are willing and able to purchase 15 units while sellers produce and offer for sale 52 units& Sellers have 19 units that are not sold at this price& )his is a surplus& Dn order to sell the surplus units, sellers lower their price& #s the price falls from R12 the +uantity supplied decreases and the +uantity demanded increases& ("either demand nor supply are changed&) #s the price falls, the +uantity supplied falls and the +uantity demanded increases& #t a price of R17 the amount that buyers are willing and able to purchase is e+ual to the amount sellers produce and offer for sale& Ghen the market price is below the e+uilibrium price the +uantity demanded exceeds the +uantity supplied& #t the price below e+uilibrium, buyers are willing and able to purchase an amount that is greater than the suppliers produce and offer for sale& )he buyers will ;bid up< the price by offering a higher price to get the +uantity they want& )he +uantity demanded will fall while the +uantity supplied rises in response to the higher price& #n economic system has many agents who interact in many markets& =eneral e+uilibrium is a condition where all agents acting in all markets are in e+uilibrium at the same time& Since the markets are all interconnected a change or dise+uilibrium in one market would cause changes in all markets& 'eon Galras ?1A21-1A88@ was a maEor contributor to the concept of general e+uilibrium& Kenneth #rrow ?1B11- @ and =Wrard Cebreu ?1B11- @, show the conditions that must be met to achieve general e+uilibrium&

181

9." E*ui!i rium

#ntoine #ugustin Cournot, ?1A21-1A99@ adopted the concept of partial e+uilibrium in 1A5A out of mathematical expediency& ( The &e' Pa!grave) #lfred -arshall ?1A61-1B16@ approach was to introduce the concept of time and the process of analy,ing one market at a time& "eoclassical microeconomics tends to focus on partial e+uilibrium& Dt was -arshall who introduced the concept of ceteris pari us as a means to isolate and analy,e each market separately& -arshall understood that all markets were interconnected but chose to analy,e each market individually& )he concept of partial e+uilibrium is used in introductory economics courses and for some analysis&

?#1#1 +A&<ET A(;),T+E%T

T'

*4A%8E

Market systems are favored by "eoclassical economists for three primary

reasons& :irst, agents only need information about their own obEectives and alternatives& )he markets provide information to agents that may be used to identify and evaluate alternative choices that might be used to achieve obEectives& Second, each agent acting in a market has incentives to react to the information provided& )hird, given the information and incentives, agents within markets can adEust to changes& )he process of market adEustment can be visuali,ed as changes in demand and/or supply&

?#1#2 ,4$-T,

'&

*4A%8E,

$%

(E+A%(

The demand function was defined from two perspectives.

A schedule of 4uantities that individuals were willing and able to buy at a schedule of prices during a given period, $eteri! "aribu!* 'he ma(imum prices that individuals are willing and able to pay for a schedule of 4uantities or a good during a given time period, $eteri! "aribu!*

185

9.".$ Shifts or #hanges in 3emand

Dn both cases the demand function is perceived as a negative or inverse relationship between price and the +uantity of a good that will be bought& )he relationship between price and +uantity is shaped by other factors or variables& Dncome, prices of substitutes, prices of compliments, preferences, number of buyers and expectations are among the many possible variables that influence the demand relationship& )he demand function was expressed. Ex A 8x(Px6 Pc6 Ps6 +6 Pre0erences6 Kbu.ers6 # # # ) $c is the price of complimentary goods& $s is the price of substitutes& - is income& Such proxies as gender, age, ethnicity, religion, etc represent preferences& %emember that a change in the price of the good ($ x) is a change in +uantity demanded or a movement along a demand function& # change in any other related variable will result in a shift of the demand function or a change in demand& Dn :igure DDD&#&12 the effects of a shift in demand are shown& Df supply is constant, an increase in demand will result in an increase in both e+uilibrium price and +uantity& # decrease in demand will cause both the e+uilibrium price and +uantity to fall&

186

9.".$ Shifts or #hanges in 3emand

Price

Eiven the supply 3*5 and the demand 3A5, the e4uilibrium price in the market is Pe,. 'he e4uilibrium 4uantity is =e* An increase in demand is represented by a shift of demand from A to A-* 'his will cause and increase in e4uilibrium price from Pe to P# and e4uilibrium 4uantity from =e to =#* AA decrease in demand to D! will cause e4uilibrium price to fall to P ! and 4uantity to =!*

P# Pe P!

AB =! =e =#

=H!t Cigure ///*A*#"

?#1#2#1 ,4$-T

'-

,)PP25

Remember that the supply function was expressed,

Exs A 0s (Px6 Pinputs6 Tech6 re"ulations6 K sellers6 # # # K,), # change in the price of the good changes the +uantity supplied& # change in any of the other variables will shift the supply function& #n increase in supply can be visuali,ed as a shift to the right, at each price a larger +uantity is produced and offered for sale& # decrease in supply is a shift to the left. at each possible price a smaller +uantity is offered for sale& Df the supply shifts and demand remains constant, the e+uilibrium price and +uantity will be altered& #n increase in supply (while demand is constant) will cause the e+uilibrium price to decrease and the e+uilibrium +uantity to increase& # decrease in supply will result in an increase is the e+uilibrium price and a decrease in e+uilibrium +uantity&

187

9.".$ Shifts or #hanges in 3emand

Price

*B

* *-

Eiven the demand 3A5 and the supply 3*5, the e4uilibrium price in the market is Pe,. 'he e4uilibrium 4uantity is =e* An increase in supply is represented by a shift of supply from * to *-* 'his will cause and decrease in e4uilibrium price from Pe to P# and an increase in e4uilibrium 4uantity from =e to =#*

P! Pe P#

A =! =e =#

A decrease in supply to *B will cause e4uilibrium price to increase to P! and e4uilibrium 4uantity to fall to =!*

=H!t Cigure ///*A*##

?#1#2#2 *4A%8E,

$%

:'T4 ,)PP25

A%(

(E+A%(

,hen supply and demand both change, the direction of the change of
either e+uilibrium price or +uantity can be known but the effect on the other is indeterminate& #n increase in supply will push the market price down and +uantity up while an increase in demand will push both market price and +uantity up& )he effect on +uantity of an increase in both supply and demand will increase the e+uilibrium +uantity while the effect on price is dependent on the magnitude of the shifts and relative structure (slopes) of supply and demand& )he effect of an increase in both supply and demand is shown in :igure DDD&#&11&
Price Eiven supply 3*5 and demand 3A5, the e4uilibrium price is Pe and 4uantity is =e* An increase in supply to *- results in a drop in price from Pe to P# while 4uantity increases from =e to =#*

* *-

P! Pe P#

=e =-I

=*

/f demand then increased to A-, the e4uilibrium 4uantity would increase to =** 'he price however, is pushed up* /n this case the price is returned to Pe. /f the shift in demand were Agreater of less 3or the slopes of * and A5 were different, the e4uilibrium price might rise, fall or A remain the sameL the change is indeterminate 188 until we have more information* =H!t
:igure DDD&#&11

9.".$ Shifts or #hanges in 3emand

Ghen supply and demand both shift, the direction of change in either e+uilibrium price or +uantity can be known but direction of change in the value of the other is indeterminate&

?#1#1 EE)$2$:&$)+

A%( T4E

+A&<ET

,hether

e+uilibrium is a stable condition from which there ;is no

endogenous tendency to change,< or and outcome which the ;economic process is tending toward,< e+uilibrium represents a coordination of obEectives among buyers and sellers& )he demand function represents a set of e+uilibrium conditions of buyers given the incomes, relative prices and preferences& *ach individual buyer acts to maximi,e his or her utility, ceteris pari us& )he supply function represents a set of e+uilibrium conditions given the obEectives of sellers, the prices of inputs, prices of outputs, technology, the production function and other factors& )he condition of e+uilibrium in a market, where supply and demand functions intersect (;+uantity supplied is e+ual to the +uantity demanded<) implies e+uilibrium conditions for both buyers and sellers&

189

G 3emand and #onsumer Behavior

H (E+A%(

A%(

*'%,)+E& :E4A3$'&

Demand is a model of consumer behavior& Dt attempts to identify the

factors that influence the choices that are made by consumer& Dn "eoclassical microeconomics, the obEective of the consumer is to maximi,e the utility that can be derive given their preferences, income, the prices of related goods and the price of the good for which the demand function is derived& #n individual(s demand function can be thought of as a series of e+uilibrium or optimal conditions that result as the price of a good changes& )here are two approaches that may be used to explain an individual(s demand function. utility analysis and indifference analysis& )he two approaches are compatible&

@.1 CONSUMER C

OICE AND

UTI!ITY

Utility is the capacity of a good (or service) to satisfy a want& Dt is one

approach explain the phenomenon of value& 0tilitarianism is the ethical foundation of "eoclassical microeconomics& Heremy entham ?196A-1A51@ entham formali,ed ;utilitarianism&< 0tility is a subEect evaluation of value&

seemed to intuitively grasp the notions of total an marginal or incremental utility& Fowever, it was not until 1A66 that Cupuit ?1A26-1A88@ linked marginal utility to the concept of demand& Feinrich =ossen ?1A12-1A7A@ developed the ;law of satiable wants< which is considered to be a forerunner of the ;law of diminishing marginal utility& Dn 1A91 Gilliam Stanley Hevons ?1A57-1AA1@ used the term ;final degree of utility< and Carl -enger ?1A62-1B11@ recogni,ed that individuals rank order their preferences& Dt was :riedrich von Gieser, ?1A711B18@ who first used the term ;marginal utility&<

H#1#1 )T$2$T5

18A

G.1.1 Nti!ity

Since utility is subEective and cannot be observed and measured directly,

it use here is for purposes of illustration& )he obEective in microeconomics is to maximi,e the satisfaction or utility of individuals given their preferences, incomes and the prices of goods they buy&
A# T'TA2 )T$2$T5 (T)) A%( +A&8$%A2 )T$2$T5 (+))

Total utilit. (T)) is defined as the amount of satisfaction or utility that one derives from a given +uantity of a good& +ar"inal utilit. (+)) is defined as the change in total utility that can be attributed to a change in the +uantity consumed&

'otal Utility = 'U = f ( =, preferences, ) X'U arginal Utility = U = X=

#s a larger +uantity of a good is consumed in a given period we expect that the )0 will increase at a decreasing rate& Dt may eventually reach a maximum and then decline& %emember the last time you went to an all you can eat pi,,a place and ate too muchI )his is shown in :igure D3&#&1& #s the +uantity of pi,,a/day consumed increases, the )0 derived from the pi,,a increases at a decreasing rate until the maximum or 19 is reached at the 7th pi,,a&

18B

G.1.1 Nti!ity

)0 is a function of the individual(s preferences and the +uantity consumed& Dn the illustration to the right, 12 units of utility are obtained by consuming 1pi,,a/day& )he consumption of 1 pi,,as/day results in a total of 1A units of satisfaction& )he maximum satisfaction that can be derived from the consumption of pi,,a is 19& )his occurs at 7 pi,,as& Df the individual eats more than 7 pi,,as their total satisfaction declines&

TKP B0 B3 B2 -1

TKP

-5

Fi"!re ,J.+.-

PiLLaHday

)otal 0tility can be displayed in table form& )he information contained in :igure D3&#&1 is shown in )able D3&1 -arginal utility (-0) is the change in )0 that is ;caused< by a change in the +uantity consumed in the particular period of time& -0 was defined.

U=

'U Q

)# '* D3&1

T'TA2 M +A&8$%A2 Dn )able D3&1 marginal utility is calculated by subtraction& )he change in )T$2$T5 +uantity from row to row is 1 ( O N 1)& )herefore the change in total utility Euant T) +) it. with each +uantity from can be calculated be subtracting the )0 associated that associated with the next +uantity& Dn )able 0D3&1 the 0 total utility -()0) 1 10 10 derived from 1 unit of the good is 12& )he )0 derived from 1 units is 1A. the 2 1? ? change in total utility ()0) attributable to a one unit change in +uantity ( O) 1 24 > is A& 4 2> 2 @ 27 1 > 2> -1

192

G.1.1 Nti!ity

U=

'U K = =K Q #

)he -0 of the third unit is 8

U7 =

X'U !: #K F = = =F X= # #

Ghen the -0 is calculated by subtraction, it can be visuali,ed as the slope of the )0 between two points& )his is shown in :igure D3&#&1
'he U can be visuali2ed as the slope of the 'U between successive units of the good* /n the graph to the right the U of the third unit of Pi22a is the slope of the 'U between points A and B* 'hink of the slope of a line as rise over run* 'U rise and = is the run* /n this e(ample the = is # 3 from the third to the fourth unit is #5* 'he 'U is F 3!:;#K5* rise over run or the slope of 'U between points A and B is F*
TKP

MK @
B0 B3 B2 -1

TK =
TKP

TK + =

&

-5

Fi"!re ,J.+.B

PiLLaHday

-arginal utility can be graphed, however remember that the -0 calculated by subtraction is ;between< successive units of the good& Dt is the slope of an arc defined by two points on a total utility function& )his is shown in :igure D3&#&5

191

G.1.1 Nti!ity

/n the graph to the right, one unit of the good yields #K units of satisfaction while ! units of the good result in 7" units of satisfaction* arginal Utility 3 U = X'U 5 can be shown
X=

'U :" 7< 7" !< !" #< #" < # ! 7 =Mut E B run TK @ -B A rise = @E1

as the slope of a line from point A to B* this is the red )arc+ between the two points* 'he actual 'U is shown by the curved blue line between A and B*
U= rise X'U #! = = = slope of 'U run X= #

-0 can be calculated as a derivative& #t 1 units of the good the -0 will be the slope of the line ==( tangent to )0 at point &

Cigure /P*A*7

)he relationship between total utility ()0), marginal utility (-0) and average utility can be shown graphically& Dn :igure D3&#&6 the )0 function has some peculiar characteristics so all-possible circumstances can be shown& Dn this example the total utility ()0) first increases at an increasing rate& *ach additional unit of the good consumed up to the OZ amount causes larger and larger increases in )0& )he -0 will rise in this range& #t OZ amount there is an inflection point in )0& )his is consistent with the maximum of the -0& Ghen #0 is is a maximum, -0 N #0& Ghen )0 is a maximum, -0 is 2& )his is shown in :igure D3&#&6

191

G.1.1 Nti!ity

'U

TK

/n the graph to the right, 'U increases at an increasing rate from " to =% units of the good* At =% there is an inflection point in 'U* 'his is consistent with the ma(imum of the U* Beyond =% amount the 'U increases at a decreasing rate* U 3the slope of 'U5 decreases* =% is the )point of diminishing U*+ Ohen U N AU, AU is )pulled up*+ Ohen U Q AU, AU is )pulled down*+ Ohen U H AU, AU is a ma(imum* 3AU is unchanged, its slope is ", AU is a ma(imum5 At = the 'U is a ma(imum* At this output the slope of 'U is "* U is the slope of 'U U H "*

=Mut U AU

+K =* = Cigure /P*A*: =M =Mut MK

:# ($+$%$,4$%8 +A&8$%A2 )T$2$T5

Dt is believed that as an individual consumes more and more of a given commodity during a given period of time, eventually each additional unit consumed will increase )0 by a smaller increment, -0 decreases& )his is called ;diminishing marginal utility&< #s a person consumes larger +uantities of a good in a given time period, additional units have less ;value&< #dam Smith recogni,ed this phenomenon when he posed this ;diamond-water paradox&< Gater has more utility than diamonds& Fowever, since water is plentiful, its marginal value and hence its price is lower than the price of diamonds that are relatively scarce&

195

G.1.1 Nti!ity

*#

:)(8ET *'%,T&A$%T

Ghen goods are ;free,< an individual should consume until the -0 of a good is 2& )his will insure that total utility is maximi,ed& Ghen goods are priced above ,ero and there is a finite budget, the utility derived from each expenditure must be maximi,ed& #n individual will purchase a good when the utility derived from a unit of the good > (-0>) is greater than the utility derived from the money used to purchase the good (-0 R)& 'et the price of a good ($>) represent the -0 of money and the -0> represent the marginal benefit (the $> T > >

) of a purchase& Ghen
>

, the individual should buy the good& Df the $ > \ >

, they should

not buy the good& Ghere $> N change their purchases&

, they are in e+uilibrium, they should not

=iven a finite budget ( ) and a set of prices of the goods ($ > , $!, $") that are to be purchased, a finite +uantity of goods (O >, O!, O") can be purchased& )he budget constraint can be expressed,

B P X Q X + P Y Q Y + + P N Q N Ohere B = budget P N = price of N th good Q N = 4uantity of N th good

:or one good the maximum amount that can be purchased is determined by the budget and the price of the good& Df the budget were A2 and the price was 7, it would be possible to buy 18 units& )he amount that can be purchased is the budget ( ) divided by the price of the good ($ >)&

Q X that can be purchased =

Budget B = Price PX

)he combinations of two goods that can be purchased can be shown graphically& )he maximum of good > that can be purchased is &

196

G.1.1 Nti!ity

B B , the amount of good Y is PX PY

#ll possible combinations of good > and ! that can be purchased lie along (and inside) a line connecting the > and ! intercepts& )his is shown in :igure D3&#&7

Dn the graph to the right, the budget is A2& Ghen the price of good ! ($!) is 6, a maximum of 20 units of good Y can be purchased !his is sho"n as point # on the Y-axis $f the price of good % is &, a maximum of 18 units of > can be purchased& )his is point F on the >-axis& )he line #F represents the maximum combinations of goods > and ! that can be bought given the budget and prices& #ny combination of goods that lies in the triangle 4#F (yellow area) can be purchased& #n increase in the budget will ;shift< the budget constraint out& # decrease in the budget will shift it in& # change in the relative prices will ;rotate< the constraint (change its slope)&

=@
Budget constraint when B H K", P> H < 'Y ( )

B K" = = !" P@ :

: M Cigure /P*A*<
B K" = = #F P> <

=>

Dn order to maximi,e the utility derived from the two goods, the individual must allocate their budget to the ;highest valued use&< )his is accomplished by the use of marginal analysis& )here are two steps to this process& :irst, the marginal utility of each unit of each good is considered& Second, the price of each good (or the relative prices) must be taken into account& Dt is believed that as a person consumes more and more of a (homogeneous) good in a given period of time, that eventually the total utility ()0) derived from that good will increase at a decreasing rate. the point of diminishing marginal utility (-0) will be reached&

197

G.1.1 Nti!ity

Ghen there are two (or more) goods (with prices) and a budget, the individual will maximi,e )0 by spending each additional dollar (euro, franc, pound or whatever monetary unit) on the good with the greatest marginal utility per unit of price & Consider the two goods in )able D3&1&

[ ]
UX PX
udget ( N R7) 5aFls (8ood 5) P5 A N1

TA:2E $3#2 -aximi,ing )0 of )wo =oods =iven $rices and =ebecs (8ood =) P= A N1 - P=1 A N#@0
U>

E=

T)=

U>

P>

U>

P>#

E5

T)5

+)5

U@

P@

2 1 1 5 6 7 8

2 12 1A 16 1A 52 52

-12 A 8 6 1 2

-12 18 11 6 1 -1

2 1 1 5 6 7 8

2 18 1A 58 62 62 58

-18 11 A 6 2 -6

-18 11 A 6 2 -6

Dn )able D3&1 the preferences for two goods (good >, xebecs and good !, yawls) is shown& )he preferences determine the )otal 0tility ()0) and marginal utility (-0) that is derived from various units of the two goods& # change in preferences will change the utility as expressed by )0 and/or -0& #

198

G.1.1 Nti!ity

preference state is one table& # change in preferences would be shown as a different table& %emember that for demand analysis preferences are subEect to ceteris pari us. )he effects of a change in price (of either good) or the budget can be shown within the given table& Dn )able D3&1 the preferences are given, the budget is R7, the $> is R1 and $! is R1& )he marginal utility per dollar (price) is calculated

[ ]
UN PN

for each good& )he agent then spends each monetary unit (R, U, ]

or& & & ) on the good that has the highest -0 "/$"& Dn )able D3&1 the individual would first buy a unit of good ! (yawls) to get 18 units of satisfaction& Df they had bought a unit of good > (xebecs) they would have gotten 12 units of satisfaction for the dollar expenditure& )he consumer decides on their next purchase& )hey can by an additional unit of yawls (for R1) and get 11 units of satisfaction or a unit of xebecs to get 12 units of satisfaction& )hey will by the second unit of yawls& )he third dollar is spent on xebecs (12 units of satisfaction is preferred to A)& )he fourth dollar is spent on either xebecs or yawls. the buyer is indifferent between the second xebec and third yawl& )hey have the same satisfaction& Df the second xebec is purchased, the fifth dollar will be spent on the third unit of yawls& =iven the preferences, $> N R1, $! N R1 and a budget of R7. the consumer will purchase 1 units of xebecs and three of yawls& )he +uantity of > purchased at R1 given $!, budget and preferences can be shown as point = in :igure D3&#&8&)his is an e+uilibrium point for the consumer& Ghen they buy two units of good > (1>) and three unit of good ! (5!), they obtain 76 units of satisfaction ()0> for 1> is 1A and )0! of 5! is 58)& Df they bought 1> and 6!

199

G.1.1 Nti!ity

their )0 would be 72& Df they bought 5> and 1! their )0 is 71& Clearly they cannot increase their utility by altering their purchases&
Eiven the individual1s preferences shown in 'able /P*!, a budget of J< and P> HJ# and P@ H J#, the individual will buy ! units of good >* 'his is a point on the demand function for good >* A point on the demand for good @ could be shown on another graph* Iere we will develop the demand for good >* 6ote that point E 3! units of > at J#5 represents an e4uilibrium condition for the consumer* 'hey cannot alter their purchases without reducing the total utility they derive from the J< budget* Point O is derived by lowering the price of (ebecs to J*<"

-.45

Price

-.55

F
8

.45

:igure D3&#&8

N6ebecsO

=6H!t

# second point on the demand for good > can be derived by changing the price of good > while holding preferences, budget and $y constant& Cecrease the price of xebecs ($>) from R1 to ($>1)R&72& )his will increase the marginal utility per dollar spent on good >& )his is shown in )able D3&1 in the column ?-0>/$>1@& :ollowing the same logic above the consumer would purchase 6 units of xebecs and 5 units of yawls with their R7 budget& "ote that this results in 86 units of satisfaction& %educe the amount of > by 1 units to buy one more unit of good ! and utility falls to 7A& Df the consumer tried to buy more > and less ! we will interpolate so 1&7 units of ! and 7 units of > can be purchased to yield 81 units of satisfaction&
=iven preferences in )able D3&1, N R7, $ ! N R1 and $>1 N R&72, the consumer will

purchase 6>& )his can be shown as point G in our graph for the demand of xebecs in :igure D3&#&8& # portion of the demand function for xebecs has been mapped and is shown as the line segment between points = and G&

19A

G.1.1 Nti!ity

Dt is important to note that the demand function represents a series of e+uilibrium conditions for the consumer as the price of xebecs changes while other parameters remain constant& Df $!, shift& (# EE)$+A&8$%A2 P&$%*$P2E udget or preferences changed, the demand for xebecs would

)he process demonstrated in the previous section may be referred to as the e+uimarginal principle& Dt is a useful tool and can be used to optimi,e (maximi,e or minimi,e) variables in marginal analysis& Dt will be used again to find the minimum cost per unit combination of inputs into a production process& )he rule for maximi,ing utility given a set of price and a budget is straightforward. if the marginal utility per dollar spent on good > is greater that the marginal utility per dollar spent of good !, buy good >& Df the marginal utility per dollar spent on good > is less that the marginal utility per dollar spent of good !, buy good !& 0tility is maximi,ed when the marginal utility per dollar spent is the same for all goods& )his can be expressed for as many goods as necessary& Since there is a budget constraint, if the marginal utility per dollar of one good is greater than the -0/R of another and the budget is all spent, the individual should buy less of one to obtain more of the other& )he e+uimarginal principle can be expressed.

Ux H Px

Uy U' == Py P'

19B

G.1.1 Nti!ity

subOect to the constraint, T $xOx P $yOy P &&& P $nOn Ghere $ni N price of ith good, Oni N +uantity of ith good and N budget

H#1#2 $%($3$()A2P,
(E+A%( -)%*T$'%

The individual will tend to

purchase more of a good at lower prices& )his was shown in a graph as a negatively

Price
JK JS JF J< J: J7 J! J# ! : F K #" #! #: #F #K Cigure /P*A*S

Demand =uantityMut

sloped function, E A 0(P)& )his is shown in :igure D3&#&9 ()his graph was introduced in Section DDD)& )he inverse relationship between price and +uantity is caused by the income and su stitution effects&
$ $%*'+E E--E*T

Ghen the price of a good that the individual buys increases and the income or budget remains constant, the ;real income< goes down and the individual can(t buy as much as they did before the price change& Df the price of a good goes down the real income goes up, therefore they effectively have more money and can buy more& )his is called the income effect& #t higher prices the real income is less so people buy fewer units of a good& #t lower prices the real income is greater (even though the nominal income is constant) and they can buy more&
$$ ,):,T$T)T$'% E--E*T

Dndividuals react to higher prices by looking for relatively lower priced substitutes& 4r, conversely they will react to lower prices of a good by substituting it for a relatively higher priced good&

1A2

G.1.$ Individua!@s demand function

)he income and substitution effects may be greater of smaller depending on the good being considered& Some goods may have a large income effect& #utos, computers and the like may have great income effects& Dn other cases the substitution effect may be larger& Ghen considering the demand for soft drinks the substitution effect may be important&

H#1#1 +A&<ET (E+A%(

If the good has nonattenuated property rights (they are exclusive), the
individuals( demand functions can be summed hori,ontally to obtain the market demand function& )his was described in Section DDD to review the idea note :igure D3&#&A (Cisplayed originally as :igure DDD&#&1)&

Price

Cigure /P*A*K

DB d P. DA d PB
Market Aemand

AM P# ! 7

D& d

=Mut

1A1

G.1.( #onsumer Surp!us

H#1#4 *'%,)+E& ,)&P2),

The demand function can be viewed as the maximum that someone is

willing an able to pay for each unit of a good& Dn :igure D3&#&B someone is
/n the graph to the right, the supply and demand functions establish the e4uilibrium price at J<* &onsumers are willing and able to pay more than J< for all units up to the #"th unit* 'he difference between the market price and what the consumers are willing and able to pay is called consumer surplus* 'he area PDA 3in yellow5 can be visuali2ed as consumer surplus* /f the market price were J<, note that the sellers are willing to produce and offer for sale the first #" units at a cost less than J<* 'his is called producer surplus* /t is area &DP 3in blue5* 'he sum of consumer surplus and producer surplus is a measure of social welfare* 'he market has ma(imi2ed the well being of both consumers and producers*

R
Price

Supply

JK JS JF J< J: J7 J! J# ! : F

$ =
K #" #! #: #F #K Cigure /P*A*G

Demand =uantityMut

willing and able to pay RB or more for the first 1 units& Df the market price were at e+uilibrium (R7 in this graph), the consumer would pay R7 while they were willing to pay in excess of RB for each of the two units& )herefore, they received more utility (that they were willing and able to pay for) than they had to pay& )he difference between the reservation price of the buyer (the maximum the buyers are willing and able to pay for each unit) and the market price is called consumer surplus&

H#1#@ P&'()*E& ,)&P2),

The welfare of the producers can be shown in a similar manner& )he

supply function represents the minimum price the sellers will accept for each unit& )herefore, the difference between the market price and the reservation price of the seller (the minimum the seller will accept for each unit) represents producer surplus& )his is represented by area C*$ in :igure D3&#&B&

1A1

G.1.4 E!asticity

H#1#> E2A,T$*$T5

Elasticity is a tool that is used to describe the relationship between two

variables& Cecision makers would like to describe how a change in price might alter the +uantity demanded& # measure of this relationship is called the ;o3<7 .0i=e e12/ti=ity of demand& Dt is also useful to describe how a change in buyers( income shifts the demand function for a good. this measure is called i<=o4e e12/ti=ity& Ghen the price of a related good (substitute or compliment) changes, the demand for a good will shift& C0o// e12/ti=ity is a measure of the responsiveness of buyers of a good to changes in the prices of related goods& *lasticity is defined as

E =

"er$e'ta(e $ a'(e o* t e %e"e'%e't )ariab#e "er$e'ta(e $ a'(e o* t e i'%e"e'%e't )ariab#e

)his is the percentage change in the dependent variable caused by a percentage change in the independent variable&

1A5

G.1.4 E!asticity

(A) C'7%D P&$*E E2A,T$*$T5 '- (E+A%( IEP '& P J $# (E-$%$T$'% '- EP

)he ;own< price elasticity of demand is sometimes called price elasticity or price elasticity of demand& )he price elasticity of demand
J #" Price
G K S F < : 7 ! # # ! 7 : < F S K G

measures the responsiveness of buyers to changes in the goods ;own< price& Dt reflects a movement along a given demand function or a change in +uantity demanded& :or illustrations of

= H #" 9#P P H #" 9 #=

& $ Demand
#"

=Mut

Cigure /P*A*#"

elasticity the demand function will be a linear function. O N 12 ^ 1$& )his simple demand function can also be expressed $ N 12 ^ 1O& Dt is important to note that less simple functions may not have this property& )he graphical representation of this demand function (O N 12 ^1$) is shown in :igure D3&#&12&
$$# *A2*)2AT$'% '- EP

$rice elasticity measures the percentage change in the +uantity demanded ;caused< by a percentage change in the price& Dn :igure D3&#&12, when the price of the good is R6 (at point ), six units will be purchased& Should the price increase to RA (point #), the +uantity purchased will decrease to 1 units& # decrease in price to R1 will cause an increase in the +uantity demanded to A units of the good (point C)& "otice that as the price increases from R6 to RA (a P 122M _$), there is a change in +uantity from 8 units to 1 units (a - 89M _O)& 0sing the definition of price elasticity,

1A6

G.1.4 E!asticity

EP =

7Q FS = = * FS 7P +#""

#t the price of R6, the coefficient of ;own< price elasticity of demand is -&89& )his is the elasticity at a point on the demand (point (R6) and +uantity (8 units)& ) for a specific price

# formula for calculating point price elasticity is.

EP

Q# 3 Q 9 Q# 8 P# 3 P 9 P#

Q Q# Q P # 8 = x P P Q # P#

Q# = F u'it!, P # = : : Q ! = K u'it!, P ! = : ! Q = + !, P = ! Q P # + ! : : EP = = = # = *FS P Q# ! F F

Calculating the *$ for a price change from R6 to R1 in :igure D3&#&12 , a move from point to point C.

"ote that the *$ is the same whether the price is increased from R6 to RA or decreased from R6 to R1& )he magnitude of the change does not affect the * $ either& )he coefficient of ;own< price elasticity is uni+ue to each point on the demand function& )o calculate *$ as the price falls from RA to R6 (a move from point # to point in :igure D3&#&12).

1A7

G.1.4 E!asticity

Q# = ! u'it!, P # = : K Q ! = F u'it!, P ! = : : Q = + :, P = : Q P # + : K : EP = = = # = +! P Q# : ! #

*$ at RA is ^1, at R6 it is -&89& )he coefficient is different at every point on the demand function even though the slope of the demand function is the same at every point& *$ is determined by the slope of the demand

[ QP ] and

the

location on the demand

[ P # Q# ] &

)he demand, *$ at every price, and total revenue ()%) are displayed in )able D3&5& Table $3#1 E A 10 Q 1P (e/and6 EP and Total &evenue (T&)
$rice Ouantity *$ )%

R2 R1 R1 R5 R6 R7 R8 R9 RA RB R12

12 B A 9 8 7 6 5 1 1 2

2 -2&11 -2&17 -2&65 -2&89 - 1&22 - 1&72 - 1&55 - 6&22 - B&22 undefined

2 RB R18 R11 R16 R17 R16 R11 R18 RB 2

1A8

G.1.4 E!asticity

)he information in )able D3&5, )he absolute value of *$ can be categori,ed by its relationship to 1& )able D3&6 shows the categories of elastic, unitary elasticity and inelastic coefficients& Ohen Yp YN #, we call demand e#a!ti$, the percentage change in 4uantity is greater than the percentage change in price* Ohen demand is elastic price and total revenue 3'A5 move in opposite directions* Ohen P N #, 'A will decrease: when P Q #, 'A will increase* Ohen Yp YQ #, we call demand i'e#a!ti$, the percentage change in 4uantity is less than the percentage change in price* Ohen demand is inelastic, price and 'A move in the same direction* Ohen P N #, 'A will increase: when P Q #, 'A will decrease* Ohere YpYH #, 'A will be a ma(imum* 'his is called u'itary e#a!ti$ity

1A9

G.1.4 E!asticity

Table $3#4 E A 10 Q 1P (e/and6 EP and Total &evenue (T&)

$rice Ouantity `*$` )%

R2 R1 R1 R5 R6 R7 R8 R9 RA RB R12

12 B A 9 8 7 6 5 1 1 2

2\1
(inelastic)

2 RB R18 R11 R16 R17 R16 R11 R18 RB 2

&11\1
(inelastic)

&17\1
(inelastic)

&65\1
(inelastic)

&89\1
(inelastic)

1N1
(unitary)

1&72T1
(elastic)

1&55T1
(elastic)

6&22T1
(elastic)

B&22T1
(elastic)

undefine d

)o solve the problem of a different coefficient of price elasticity at every price, average or ;arc< elasticity between two prices will be used& )he two prices should represent reasonable upper and lower bounds that the price might be expected to fall between& )he average or ;arc< price elasticity is calculated by.

1AA

G.1.4 E!asticity

E P arc =

P# + P ! X= XP Q# + Q !

Df the price of the good in the example were expected to generally be between R1 and R6, the average elasticity would be calculated.

)he average elasticity between R1 and R6 is - &65 and is inelastic& #n increase in the price in this range will increase )%& # decrease in price will decrease )%&

Q# = F u'it!, P # = : : Q ! = K u'it!, P ! = : ! Q = + !, P = ! Q P # + P ! + ! : + ! F EP = = = # = * :7 P Q# + Q ! ! F + K #:
$$$ +$(-P'$%T A%( EP

useful

short the

cut

to

understanding

relative
J #"
G

elasticity along a demand function is to use the mid-point& :or any linear demand function the midpoint can be located by dividing the O-intercept (or $-intercept) by 1& Dn :igure D3&#&11 the midpoint is at 7 units and R7& #t this +uantity (and price), *$ will be unitary or its absolute value is 1& )his will also be the maximum of

`*$` T 1, elastic range

Price

K S F < : 7 ! #

`*$` N 1 `*$` \ 1, inelastic range

# ! 7 : < F S K G

A
#"

=Mut

Cigure /P*A*##

the total revenue ()%)& )he ;top< half the linear demand function (at higher

1AB

G.1.4 E!asticity

prices) will be elastic& )he ;lower< half the demand function (lower prices) will be inelastic& @

$3 P&$*E E2A,T$*$T5 A%( T'TA2 &E3E%)E

'

)he demand function is a relationship between price and +uantity& $rice elasticity is determined by the slope of the demand function and the location (price and +uantity) on the demand function& )otal %evenue ()%) is the product of price and P1 P1 / ; D J 01 T1

E1 E1 EI#t / Fig#re 2V)0)11)5

+uantity& ()% N $O)& #s a conse+uence, demand, * $ and )% are related& )able D3&6 shows the relationships& )he demand function is elastic in the upper portion& #t the mid-point of a linear demand function, * $ is unitary (*$ N -1)& Dt is also at this mid-point that )% will be at a maximum& Dn :igure D3&#&11&7, the demand (or average revenue, #%) has a O-intercept of O1 and a $-intercept of $1& #t point F (the mid-point of the demand at one half $1 and O1) the value of *$ is ^1& )he upper portion of the demand is elastic& "ote that the demand has a negative slope and )% has a positive slope& )his will help you remember that price and )% move in the opposite directions& #s price rises, )% will decrease& #s price decreases, )% will increase& Dn the lower portion, the demand is inelastic& oth )% and demand have negative slopes& #s price increases, )% will rise& #s price falls, )% will decrease& )he maximum value of )% will occur at the +uantity were * $ is unitary& )he maximum value of )% is at point H& )he slope of )% at this point is 2& $rice elasticity is useful to explain the relationship of price and )%& Dt does not provide information about profits& $rofits () are defined as total revenue

1B2

G.1.4 E!asticity

minus total costs ( )% ^ )C)& )o determine the output and price that result in maximum profits, we must know both )% and )C& Cemand (C) is a functional relationship between price and +uantity that will be purchased& )otal revenue ()%) is the product of price and +uantity& ()% N $O)& )herefore, the demand for a firm(s product determines the revenues the firm

Average Aevenue = AA =
obtains from the sale of its output&

'A Q

)he average revenue (#%) and marginal revenue (-%) are also of interest in the analysis of a firm(s behavior& #% is the revenue per unit sold& Dt is calculated by dividing the total revenue by the +uantity, -arginal revenue (-%) is the change in )% caused by a (1 unit) change in the +uantity sold&
$, R1 2

arginal Aevenue =

A=

'A Q

:igure D3&#&11&7a

+&

Consider an example demand function $ N 12-1O (shown in :igure D3&#&11&7a)& )otal revenue is )% N $O, and $N12-1O&

A& (e/a nd 1 O/ 2 ut

y substitution, )%N(12-1O)O N 12O-1O1 #verage revenue the revenue per unit,

1B1

G.1.4 E!asticity

AA =

'A !"= !=! = = !" != = =

"otice that the #% is the same as the demand function& )his will always be true&

-arginal revenue (-%) is defined as the change in )% caused by a one unit

A=
change in the +uantity&

X'A d'A = !" := X= d=

"otice that the -% function (-% N 12 ^ 6O) has twice the slope as the demand (C) and #% functions& Since -% decreases twice as fast as #% (or C), it will intersect the O axis halfway between the origin and the intercept of the #% function& "ote that if the slope of the Cemand were 2, and the -% fell at twice the rate, the slope of -% would also be 2 (1 times 2 is still 2)& #s a result when the demand is perfectly elastic (has a slope of 2, demand is hori,ontal) the #% and -% will coincide& $rofits (a) are defined as the difference between the total revenue ()%) and total cost ()C), a N )% ^)C& )he relationship between demand an revenue

3 (ETE&+$%A%T, '- EP

$rice *lasticity of demand is influenced by.

1B1

G.1.4 E!asticity

#*

Availability of substitutes Eenerally, the more substitutes that are available, the more elastic the demand for a good* 'he demand for a class of goods 3soft drinks5 is usually more inelastic than the demand for a specific brand of the good 3Pepsi or &oca;&ola5* A Cirm may try to differentiate their product to make the demand relatively more inelastic*

!*

Proportion of item in budget Ohen the e(penditures on a product are a relatively small portion of a budget, the demand is relatively more elastic*

7*

'ime available to adapt 'he longer that consumers or buyers have to make ad0ustments in their behavior, the more elastic the demand is likely to be* 'he absolute value of the short run price elasticity of demand for gasoline would be smaller than the absolute value of the long run price elasticity of demand* 'he longer time allows consumers more opportunity to ad0ust to price changes*

3$ $%TE&P&ETAT$'% '- EP

Some examples of price elasticities of demand reported in Microeconomics for Today,

?)ucker, p 115, South-Gestern College $ublishing, 1BBB& Sources #rchibald and =illingham, Fouthakker and

)aylor, 3oith@

are presented in )able D3&7& "ote that the demand is relatively more

elastic for longer periods& Some goods, like movies, are inelastic in the short run and elastic in the long run& )he coefficient or price elasticity can be used to estimate the percentage change in the +uantity that consumers are willing and able to buy given a percentage change in the price& Dt is important to understand that this measure does not apply to the e+uilibrium conditions in the market&

1B5

G.1.4 E!asticity

Table $3#@ ,elected Price Elasticities Dtem #utomobiles -ovies -edical Care =asoline Short %un *$ -1&A9 -&2A9 -&51 -&12 'ong %un *$ -1&16 -5&89 -&B1 -&92

Dn )able D3&7 the short run * $ for gasoline is -&1& )his suggests that a 1M increase in price will reduce the +uantity demanded by &1M& # 12M decrease in price would increase the +uantity demanded by 1M& Dn the case of movies, a 1M increase in the price would change the +uantity demanded by 5&89M in the long run&
(:) $%*'+E E2A,T$*$T5 '- (E+A%(

)he responsiveness of buyers to changes in their incomes is measured by income elasticity& Ghile *$ measures a movement along a demand function as the price changes, income elasticity (* -) measure a shift of the demand function caused by a change in income& Dncome elasticity (*-) is defined.

EM

Q /ncome

Dn :igure D3&#&11 the original demand function is represented as (& (1 represents a decrease in demand (at each price a smaller +uantity is purchased& Ghen a larger +uantity is purchased at each price, this will represent an increase of demand to (2&

1B6

G.1.4 E!asticity

J #"

=iven demand

the function

original
Price

G K S F < : 7 ! # # ! 7 : <

(A) = @ -5 P -P (A-) =- @ 0 ( -P (AB) =B @ -. P -P

((),

consumers are willing and able to purchase 7 units of the good& by the Df income and to increased ;caused< 72M demand

&

AF S K

A
G #"

AB
=Mut

shift to (26 where A units are purchased at R7& )his is

Cigure /P*A*#!

a 82M increase in demand& Dncome elasticity (*-) is calculated.

EM =

7Q +F" = = +# * ! 7M +<"

Dn this case, an increase in income resulted in an increase in demand& # decrease in income might decrease the demand (to (1)& Dn this case income

EM =
elasticity would be

7Q F" = = +# * ! 7M <"

Ghen *- is positive, the good is called a normal good& Df an increase in income reduces demand (or a decrease in income increases demand), *- will be negative and the good is categori,ed as an inferior good& a& *- \ 2 means the good is inferior, i&e& for an increase in income the

+uantity purchased will decline or for a decrease in income the +uantity purchased will increase

1B7

G.1.4 E!asticity

b& 1 T -T 2 means the good is a normal good, for an increase in income the +uantity purchased will increase but by a smaller percentage than the percentage change in income& c& :or *- T 1 the good is considered a superior good&
*&',, E2A,T$*$T5

Cross elasticity (*>!) is used as a measure of the relationship between two goods& *>! is defined as.

E XY

7 Qx 7 Py

Consider two goods that are substitutes. butter and margarine& Cross elasticity cam be used to measure the relationship between the price of butter and the demand for margarine (* -argarinebutter

) or the relationship between the

demand for butter and the price of margarine (* butter-margarine)& )he value of *>! is not the same as or e+ual to *!>& Dn :igure D3&#&15 the concept of *>! is shown&
$-

P+4 P+ E+4 (:4 CE+ O /ut E:4 C

O /ut

Panel A

-i"ure $3#A#11

Panel :

1B8

G.1.4 E!asticity

Dn panel #, the demand for margarine (C -) is shown& #t a price of $ -, the +uantity demanded is O-& Dn $anel , the demand for butter (C ) is shown& #t a price of $ , the +uantity demanded is O & Df the price of margarine increased to $-F (in $anel #), the +uantity of margarine demanded decreases to O -F& Since less margarine is purchased, the demand for butter increases to C $anel
F

(in

)& =iven the higher demand for butter the butter demanded (given the

higher price of margarine) has increased& # decrease in the price of margarine would shift the demand for butter to the left (decrease)& )he coefficient of cross elasticity would be positive& Dn the case of complimentary goods, an increase (decrease) in the price of tennis balls would reduce (increase) the demand for tennis rackets& )he coefficient of cross elasticity would be negative& Df * >! is close to ,ero, that would be evidence that the two goods were not related& Df * >! were positive or negative and significantly different from ,ero, it could be used as evidence that the two goods are related& Dt is possible that * >! might be positive or negative and the two goods are not related& )he price of gasoline has gone up and the demand for $C(s has also increased& )his does not mean that gasoline and $C(s are substitutes&

1B9

G.1.4 E!asticity

Ohen xy > 5, ,a positive number. this suggests that the two goods are substitutes

Ohen xy ? 5, ,a negative number. this suggests that the two goods are compliments

H#1#>#1 E2A,T$*$T5

A%(

:)5E& &E,P'%,E

Elasticity is a convenient tool to describe how buyers respond to changes

in relevant variables& $rice elasticity (*$) measures how buyers respond to changes in the price of the good& Dt measures a movement along a demand function& Dt is used to describe how much more of less the +uantity demanded is as the price falls or rises& Dncome elasticity (*-) is a measure of how much the demand function shifts as the income(s) of the buyer(s) changes& Cross elasticity (*>!) measures how much changes in the price of a related good will shift the demand function& *lasticity can be calculated to estimate the relationship between any two related variables&

1BA

1P Production and #ost

10 P&'()*T$'%

A%(

*',T

Decisions about production re+uire individual agents to make decisions

about the allocation and use of physical inputs& 4bEectives of agents, technology, availability and +uality of inputs determine the nature of these decisions& Since the obEectives are often pecuniary, it is often necessary to relate the decisions about the physical units of inputs and outputs to the costs of production& Df the prices of the inputs and the production relationships are known (or understood), it is possible to calculate or estimate all the cost relationships for each level of output& Dn practice however, the decision maker will probably have partial information about some of the costs and will need to estimate production relationships in order to make decisions about the relative amounts of the different inputs to be used&

1A.1 PRODUCTION

Production is the process of altering resources or inputs so they satisfy

more wants& efore goods can be distributed or sold, they must be produced& $roduction, more specifically, the technology used in the production of a good (or service) and the prices of the inputs determine the cost of production& Githin the market model, production and costs of production are reflected in the supply function& $roduction processes increase the ability of inputs (or resources) to satisfy wants by.
a change in physical characteristics a change in location a change in time a change in ownership

1BB

1P.1 Production

#t its most simplistic level, the economy is a social process that allocates relatively scarce resources to satisfy relatively unlimited wants& )o achieve this obEective, inputs or resources must be allocated to those uses that have the greatest value& Dn a market setting, this is achieved by buyers (consumers) and sellers (producers) interacting& Consumers or buyers wish to maximi,e their utility or satisfaction given (or constrained by) their incomes, preferences and the prices of the goods they may buy& )he behavior of the buyers or consumers is expressed in the demand function& )he producers and/or sellers have other obEectives& $rofits may be either an obEective or constraint& #s an obEective, a producer may seek to maximi,e profits or minimi,e cost per unit& #s a constraint the agent may desire to maximi,e ;efficiency,< market share, rate of growth or some other obEective constrained by some ;acceptable level of profits& Dn the long run, a private producer will probably find it necessary to produce an output that can be sold for more than it costs to produce& )he costs of production ()otal Cost, )C) must be less than the revenues ()otal %evenue, )%)& =iven a production relationship (O N f (labor, land, capital, technology, L)) and the prices of the inputs, all the cost relationships can be calculated& 4ften, in the decision making process, information embedded in cost data must be interpreted to answer +uestions such as.
)Iow many units of a good should be produced 3to achieve the ob0ective58+ )Iow big should may plant be81 or Iow many acres of land should / plant in potatoes8+

4nce the +uestion of plant si,e is answered, there are +uestions,

)Iow many units of each variable input should be used 3to best achieve the ob0ective58+ )'o what degree can one input be substituted for another in the production process8+

122

1P.1 Production

)he +uestion about plant si,e involves long run analysis& )he +uestions about the use of variable inputs relate to short-run analysis& Dn both cases, the production relationships and prices of the inputs determine the cost functions and the answers to the +uestions& 4ften decision-makers rely on cost data to choose among production alternatives& Dn order to use cost data as a ;map< or guide to achieve production and/or financial obEectives, the data must be interpreted& )he ability to make decisions about the allocation and use of physical inputs to produce physical units of output (O or )$) re+uires an understanding of the production and cost relationships& )he production relationships and prices of inputs determine costs& Fere the production relationships will be used to construct the cost functions& Dn the decision making process, incomplete cost data is often used to make production decisions& )he theory of production and costs provides the road map to the achievement of the obEectives&

10#1#1 (1) P&'()*T$'% )%$T

In the circular flow diagram found in most principles of economics texts,

production takes place in a ;firm< or ;business&< Ghen considering the production-cost relationships it is important to distinguish between firms and plants& # plant is a physical unit of production& )he plant is characteri,ed by physical units of inputs, such as land Q or capital (K)& )his includes acres of land, deposits of minerals, buildings, machinery, roads, wells, and the like& )he firm is an organi,ation that may or may not have physical facilities and engage in production of economic goods& plant at all& Dn some cases the firm may manage a single plant& Dn other instances, a firm may have many plants or no

121

1P.1.1 617 Production Nnit

)he cost functions that are associated with a single plant are significantly different from those that are associated with a firm& # single plant may experience economies in one range of output and diseconomies of scale in another& #lternatively, a firm may build a series of plants to achieve constant or even increasing returns& =eneral -otors Corp& is often used as an example of an early firm that used decentrali,ation to avoid rising costs per unit of output in a single plant& Civersification is another strategy to influence production and associated costs& # firm or plant may produce several products& #lfred -arshall (one of the early "eoclassical economists in the last decade of the 1Bth century) considered the problem of ;Eoint costs& ; # firm that produces two outputs (beef and hides) will find it necessary to ;allocate< costs to the outputs& 0nless specifically identified, the production and cost relationships will represent a single plant with a single product&

10#1#2 (2) P&'()*T$'% -)%*T$'%

A
O N

production function is a model (usually mathematical) that relates levels f of physical outputs to various sets of & inputs, & & eg& )&

possible

('abor,

Kapital,

'and,

technology,

)o simplify the world, we will use two inputs 'abor (') and Kapital (K) so, O N f (', K, technology, &&&)& Fere we will use a Cobb-Couglas production function that usually takes the form.

E A A2a<b& Dn this simplified version, each production function or

process is limited to increasing, constant or decreasing returns to scale over the range of production& Dn more complex production processes, ;economies of scale< (increasing returns) may initially occur& #s the plant becomes larger (a larger fixed input in each successive short-run period), constant returns

121

1P.1.$ 6$7 Production ;unction

may be expected& *ventually, decreasing returns or ;diseconomies of scale< may be expected when the plant si,e (fixed input) becomes ;too large&< )his more complex production function is characteri,ed by a long run average cost (cost per unit of output) that at first declines (increasing returns), then is hori,ontal (constant returns) and then rises (decreasing returns)&

10#1#1 (1) T$+E

A%(

P&'()*T$'%

As the period of time is changed, producers have more opportunities to

alter inputs and technology& =enerally, four time periods are used in the analysis of production.
)market period+ ; A period of time in which the producer cannot change any inputs nor technology can be altered* Dven output 3=5 is fi(ed* )*7ort(r!n+; A period in which technology is constant, at least one input is fi(ed and at least one input is variable* )Lon"(r!n+ ; A period in which all inputs are variable but technology is constant* )T7e %ery Lon"(r!n+ ; During the very long;run, all inputs and technology change*

-ost analysis in accounting, finance and economics is either long run or short-run&

125

1P.1.( 6(7 Production in the Short?Run

10#1#4 (4) P&'()*T$'%

$% T4E

,4'&T-&)%

In the short-run, at least one input is fixed and technology is unchanged

during the period& )he fixed input(s) may be used to refer to the ;si,e of a plant&< Fere K is used to represent capital as the fixed input& Cepending on the production process, other inputs might be fixed& :or heuristic purposes, we will vary one input& #s the variable input is altered, the output (O) changes& )he relationship between the variable input (here ' is used for ;labor<) and the output (O) can be viewed from several perspectives&

)he short-run production function will take the form

= @ f (L), B and technology are fi(ed or held constant

# change in any of the fixed inputs or technology will alter the short-run production function&

=
Dn the short run, the the several
$r

TP

B 'P A

relationship be describes

between from )he

physical inputs and output can perspectives& relationship

can be described as the total product, the output per unit of input (the average product, #$) or the change in output that is attributable to a change in the variable input (the marginal product, -$)&

-A

Cigure P*#

-B ,np!t 3-5

126

1P.1.( 6(7 Production in the Short?Run

Total prod!ct 3TP or =5 is the total output* = or 'P H f3-5 given a fi(ed si2e of plant and technology* +%era"e prod!ct 3+PL5 is the output per unit of input* AP H 'PM- 3in this case the output per worker5* +PL is the average product of labor*

AP L =

output 'P Q = = /nput L L

Mar"inal Prod!ct 3MPL5 is the change in output )caused+ by a change in the variable input 3-5,

PL =
(A) T'TA2 A%( +A&8$%A2 P&'()*T

X' P X= = XX-

4ver the range of inputs there are four possible relationships between O and ' (1) )$ or O can increase at an increasing rate& -$ will increase, (Dn :igure 3&1 this range is from 4 to '#&) (1) )$ may pass through an inflection point, in which case -$ will be a maximum& (Dn :igure 3&1, this is point # at ' # amount of input&) )$ or O may increase at a constant rate over some range of output& Dn this case, -$ will remain constant in this range& (5) )$ might increase at a decreasing rate& )his will cause -$ to fall& )his is referred to as ;diminishing -$&< Dn :igure 3&1, this is shown in the range from '# to ' & (6) Df ;too many< units of the variable input are added to the fixed input, )$ can decrease, in which case -$ will be negative& #ny addition of ' beyond ' will reduce output. the -$ of the input will be negative& Dt would be foolish to continue adding an input (even if it were ;free<) when the -$ is negative& )he relationship between the total product ()$) and the marginal product (-$) can be shown& Dn :igure 3&1, note that the inflection point in the )$ function is at the same level of input (' #) as the maximum of the -$& Dt is also important

127

1P.1.( 6(7 Production in the Short?Run

to understand that the maximum of the )$ occurs when the -$ of the input is ,ero at ' &
(:) A3E&A8E6 +A&8$%A2 A%( T'TA2 P&'()*T

)he average product (#$) is related to both the )$ and -$& Construct a ray (4% in :igure 3&1) from the origin to a tangent point (F) on the )$& )his will locate the level of input where the #$ is a maximum, ' F& "ote that at 'F level of input, #$' is a maximum and is e+ual to the -$ '& Ghen the -$ is greater than the #$, -$ ;pulls< #$ up& Ghen -$ is less than #$, it ;pulls< #$ down& -$ will always intersect the #$ at the maximum of the #$&

128

1P.1.( 6(7 Production in the Short?Run

Fi"!re J.B
/n Fi"!re J.B, the total product 3'P5 function is shown in the upper panel* 'P H f 3-5 'his is a short run function which implies that there is a set of fi(ed inputs 3a scale of plant5 and a given state of technology* 'he 'P initially increases at an increasing rate* 'his may be caused by speciali2ation and division of labour* At point A there is an inflection point in the 'P function* Beyond -A amount of labour, the 'P increases at a decreasing rate until it reaches a ma(imum at point B* /f additional units of labour are used beyond -B, the output 3= or 'P5 will decline* /n the lower panel of Cigure P*! the average product 3AP5 and marginal product 3 P5 are shown* At -A amount of labour 3determined by the inflection point in 'P at point A in the top panel5, the P will reach a ma(imum at point A1* Ohen the 'P increases at an increasing rate, P rises* Ohen 'P increases at a decreasing rate, P decreases* Ohen 'P is a ma(imum, P is 2ero at point B1 in the lower panel* P is the slope of the 'P function* At -I amount of labour the AP will be a ma(imum at point I1* this is consistent with the tangency of the ray from the origin with the 'P function in the top panel* Ohen the AP is a ma(imum it will be e4ual to the P*

=
$r

A B I 'P

TP

$ MPL

-A -I

-B ,np!t 3-5

A1 MP I1 +PL B1 -A -I
Cigure P*!

Ohen P NAP, AP will increase* Ohen the AP will decrease*

PQAP,

-B ,np!t 3-5

Te$ 'i$a# E**i$ie'$y =

.ut"ut -'"ut

)echnical efficiency was defined as a ratio of output to input,

4P =

TP out"ut ( Q ) = L i'"ut ( L, (i)e' K )

129

1P.1.( 6(7 Production in the Short?Run

)he #$ is a ratio of )$ or O or output to a variable input and a set of fixed input(s)& )he maximum of the #$ is the ;technically efficient< use of the variable input (') given plant si,e& %emember that K is fixed in the short-run&
(*) &E3$E7 '- P&'()*T$'% &E2AT$'%,4$P,

Dn the short-run, as a variable input is added to a fixed input (plant si,e) the )$ may increase at an increasing rate& #s )$ increases at an increasing rate -$ for the variable input will rise& So long as the -$ is greater than the #$ of the variable input, #$ will rise& )his range is caused by a more ;efficient mix< of inputs& Dnitially, there is ;too much< of the fixed input and not enough of the variable input& *ventually, as more variable inputs are added there may be an inflection point in the )$& Dt is also possible that the )$ might increase at a constant rate in a range& #n inflection point in the )$ is where the ;curvature< of the )$ changes. it is changing from increasing at an increasing rate (concave from above or convex from below) to increasing at a decreasing rate (convex from above or concave from below)& #t this point, the -$ of the variable input will be a maximum& #$ will be rising& #t some point, the )$ will begin to increase at a decreasing rate& )here is ;too much variable input< for the fixed input& $roductivity of each additional input will be less. -$ will fall in this range& #$ of the variable input may be greater or less than the -$ in this range& Df -$ is greater than #$, #$ will be increasing& Df -$ is less than #$, #$ will be decreasing& # ray from the origin and tangent to the )$ function (line 4% in :igure 3&1) will identify the level of variable input where the #$ will be a maximum& #t this point -$ will e+ual #$& Since the fixed input is constant, #$ is the

12A

1P.1.( 6(7 Production in the Short?Run

e+uivalent of out measure of technical efficiency for a given scale of plant determined by the fixed input.

Te$ * E**i$ie'$y =

out"ut TP = = AP of the varible input i'"ut L ( (i)e' *ixe% i'"ut )

10#1#@ *',T

Producers who desire to earn profits must be concerned about both the
revenue (the demand side of the economic problem) and the costs of production& to cost& $rofits () are defined as the difference between the total revenue ()%) and the total cost ()C)& )he concept of ;efficiency< is also related

10#1#@#1 (1) 'PP'&T)%$T5 *',T

The relevant concept of cost is ;opportunity cost&< )his is the value of the
next best alternative use of a resource or good& Dt is the value sacrificed when a choice is made& # person who opens their own business and decides not to pay himself or herself any wages must reali,e that there is a ;cost< associated with their labor, they sacrifice a wage that they could have earned in some other use& # worker earns a wage based on their opportunity cost& #n employer must pay a worker a wage that is e+ual to or greater than an alternative employer would pay (opportunity cost) or the worker would have an incentive to change Eobs& Capital has a greater mobility than labor& Df a capital owner can earn a higher return in some other use, they will move their resources& )he opportunity cost for any use of land is its next highest valued use as well& Dt is also crucial to note that the entrepreneur also has an opportunity cost& Df the

12B

1P.1.A #ost

entrepreneur is not earning a ;normal profit< is some activity they will seek other opportunities& )he normal profit is determined by the market and is considered a cost&

10#1#@#2 (2) $+P2$*$T

A%(

E=P2$*$T *',T

The opportunity costs associated with any activity may be explicit, out of
pocket, expenditures made in monetary units or i/plicit costs that involve sacrifice that is not measured in monetary terms& Dt is often the Eob of economists and accountants to estimate implicit costs and express them in monetary terms& Cepreciation is an example& Capital is used in the production process and it is ;used< up, i&e& its value depreciates& #ccountants assume the expected life of the asset and a path (straight line, sum of year(s digits, double declining, etc) to calculate a monetary value& Dn economics both implicit and explicit opportunity costs are considered in decision making& # ;normal profit< is an example of an implicit cost of engaging in a business activity& #n implied wage to an owner-operator is an implicit opportunity cost that should be included in any economic analysis&

10#1#> *',T,

A%(

P&'()*T$'%

$% T4E

,4'&T-&)%

If

the short-run production function (O Nf(') given fixed input and

technology) and the prices of the inputs are known, all the short-run costs can be calculated& 4ften the producer will know the costs at a few levels of output and must estimate or calculate the production function in order to make decisions about how many units of the variable input to use or altering the si,e of the plant (fixed input)&
Fixed $ost 3F$5 is the 4uantity of the fi(ed input times the price of the fi(ed input* C& is total fi(ed cost and may be referred to as 'C&*

112

1P.1.4 #osts and Production in the Short?Run

+%era"e Fixed $ost 3+F$5 is the C& divided by the output or 'P, =, 3remember =H'P5* AC& is fi(ed cost per =* Jariable $ost 3J$5 is the 4uantity of the variable input times the price of the variable input* Sometimes P& is called total variable cost 3'P&5* +%era"e Jariable $ost 3+J$5 is the P& divided by the output, AP& H P&M=* /t is the variable cost per =* Total $ost 3T$5 is the sum of the C& and P&* +%era"e Total $ost 3+$ or +T$5 is the total cost per unit of output* A& H '&M=* Mar"inal cost 3M$5 is the change in '& or P& )caused+ by a change in = 3or 'P5* Aemember that fi(ed cost do not change and therefore do not influence &* /n Principles of Dconomics te(ts and courses & is usually described as the change in '& associated with a one unit change in output,

MC =

TC Q

3for infinitely small =, MC8

%TC 5 % Q

& will intersect AP& and A& at the minimum points on each of those cost functions*

10#1#7 8&AP4$*A2 &EP&E,E%TAT$'%, &E2AT$'%,4$P,

'-

P&'()*T$'%

A%(

*',T

The short-run, total product function and the price of the variable input(s)
determine the variable cost (3C or )3C) function& Dn :igure 3&5, the short-run )$ function and 3C function are shown&

111

1P.1.8 Draphica! Representations of Production and #ost Re!ationships

Cigure P*7
/n Cigure P*7 the production relationship is linked to the variable cost* /n the upper panel, the 'P function is shown* = @ f(L) 3Eiven fi(ed input and technology5 'P initially increases at an increasing rate to point A where -A amount of variable input is used* 'here is an inflection point at point A* 'P then increases at a decreasing rate to a ma(imum at point B produced by -B amount of input* Beyond -B amount of input the 'P declines* Using -A amount of labour, =A amount of output is produced* At input level -B, =B output results*

=
$r

TP =B

B 'P

=A

Dn the lower panel, 3C is expressed as a function of O,

J$ @ f(=)
3Eiven fi(ed input and technology5

'he vertical a(is, 3'P or =5 in the upper panel becomes the hori2ontal a(is 3=5 in the lower panel* 'he hori2ontal a(is 3-5 in the upper panel is multiplied by the P- and becomes the vertical a(is in the lower panel* 'he P& function is the 'P function )rotated and looked at from the back side*+ Ohen the 'P increases at an increasing rate, the P& increases at a decreasing rate* Ohen the 'P increases at a decreasing rate, P& will increase at an increasing rate* Ohen the 'P decreases at the 4uantity of input increases, the P& would increase while output would decrease*

$ J$
(PL*L)

-A

-B ,np!t 3-5

P-(-B

P&

BZ

P-(-A

AZ

"

=A
Cigure P*7

=B Q/ut

Dn the range from 2 to ' # amount of labor, the output increases from 2 to O#& )$ increases at an increasing rate in this range& )he -$ ' is increasing as additional units of labor are added& Since the 3C (total variable cost) is the price of labor times the +uantity of labor used ('$ '), 3C will increase at a decreasing rate& )he -C will be decreasing in this range&

111

1P.1.8 Draphica! Representations of Production and #ost Re!ationships

Dn the range from '# to ' amount of labor the output rises from O # to O , )$ increases at a decreasing rate (-$ will be decreasing in this range&)& 3ariable cost (3C) will increase at an increasing rate (-C will be rising)& #t the inflection point (#) in the production relationship, -$ will be a maximum& )his is consistent with the inflection point (#() in the 3C function& #t the maximum of )$ (' amount of labor, output O ) at point , the 3C

function will ;turn back< and as output decreases the 3C will continue to rise& # ;rational< producer would cease to add variable inputs when those additions reduce output&

10#1#7#1 (1) 3A&$A:2E *',T (3* (A3*)

'&

T3*)

A%(

A3E&A8E 3A&$A:2E *',T

The total variable cost is determined by the price of the variable input
and the )$ function& )he average variable cost is simply the variable cost per unit of output ()$ or O), AP& =

P& & Q

Dn :igure 3&6 the 3C is shown with 5 points identified& #( is on the )3C at the level of output where there is an inflection point& )his will be the same output level were the -C is a minimum& $oint C is found by constructing a ray, 4- from the origin to a point of tangency on the 3C& )he level of output will be the minimum of the #3C (also the maximum of the #$)& #t this point the -C will e+ual the #3C& Ghen -C is less than #3C, #3C will decline& Ghen -C is greater than #3C,C will rise& -C will always e+ual #3C at the minimum of the #3C&

115

1P.1.8 Draphica! Representations of Production and #ost Re!ationships

-i"ure 3#4 Dn :igure 3&6 )he relationships among the variable cost (3C), average variable cost (#3C) and the marginal cost (-C) are shown& Dn the top panel there are three points that are uni+ue and can be used to identify what is happening to the -C and #3C& #t point #( there is an inflection point in the 3C& #t point ( the slope of the 3C is infinity& $oint C is identified by a ray from the origin that is tangent to the 3C at point C& $oint #( is associated with O# amount of output& #t O# output the -C will be a minimum at #Z in the lower panel& #s the )$ increases at an increasing rate, the -$ rises, the 3C increases at a decreasing rate and -C decreases& eyond O# output, the )$ increases at a decreasing rate, -$ falls, 3C increases at an increasing rate and -C will increase& #t OC output, identified by the

J$
(PL*L)

P-(-B &

P&

BZ

P- ( -& P-(-A

AZ

" Q, +J$

=A

=c =B =H!t M$ +J $

$* +*

=c =A Cigure P*:

=H!tt

10#1#7#2 (2) AT*6 A3*6 +*

A%(

A-*

The fixed cost is determined by the amount of the fixed input and its
price& Dn the short-run the fixed cost does not change& #s the output (O) increases the average fixed cost (#:C) will decline& Since

AC& =

;ixe% Co!t Q

116

1P.1.8 Draphica! Representations of Production and #ost Re!ationships

as long as O increases, #:C will decrease, it approaches the O axis ;asymptotically&< )he average total cost (#)C) is the total cost per unit of output&

A'& =

'& = AC& + AP& Q

Dn :igure 3&7, the #:C is shown declining over the range of output& )he vertical distance between the #)C and #3C is the same as #:C& )he location or shape of the #3C is not related to the #:C&
+$ +J$

Q =

M$

)he -C is not relate to the #:C but will intersect both the #3C and #)C at their minimum points&
Fi"!re J.4
+F$

=Mut

10#1#? &E2AT$'%,4$P '- +* A%( A3* T' +P2 A%( AP2

In :igure 3&8 there are three panels& )he first shows the )$ or short-run
production function& )he second is the marginal (-$) and average (#$) product functions associated with the short-run production function& Dn the third panel the related marginal cost (-C) and average variable cost (#3C) function are shown& )here are three points easily identifiable on the )$ function. the inflection point (#), the point of tangency with a ray from the point of origin (F) and the maximum of the )$ ( )& *ach of these points identifies a level (an amount) of

117

1P.1.9 Re!ationship of M# and 0O# to MP1 and 0P1

the variable input (') and a +uantity of output& )hese points are associated with characteristics of the -$ and #$ functions&
Fi"!re J.3
'he average variable cost 3AP&5 and the average product 3AP5 are closely related* arginal cost 3 &5 reflects the marginal product 3 P5* /n the three panels of Cigure P*F, the total product 3'P in the upper panel5 is related to the AP and P in the middle panel* 'he lower panel shows the relationship of average variable cost 3AP&5 and marginal cost 3 &5 to AP, P and 'P* As the variable input 3- in this e(ample5 increases to -A the 'P in the upper panel increases at an increasing rate to point A* /n this range the marginal product 3in the middle panel5 will rise* Ohen more than -A amount of the labour input is used, the P will decrease for each additional unit* 'he inflection point at A in the upper panel is consistent with the ma(imum of the P at point A% in the middle panel* Point I on the 'P function 3in the upper panel5 is constructed by passing a ray from the origin to a point of tangency on the 'P function* 'his identifies -I amount of labour* /n the middle panel the AP of labour will rise up to -I amount of input* 6otice that in this range the P is above or greater than the AP* Ohen PNAP, the AP will be increasing* At point I% in the middle panel, AP will be a ma(imum* At this point P H AP* As the input is increased above -I, the AP will fall* Ohen P Q AP, AP will be decreasing* At the ma(imum of the 'P 3at point B in the upper panel5 -B amount of the variable input is used* At this level of labour 3-B5, the P will be 2ero* /t is important to note that when P H ", 'P is a ma(imum* /n the lower panel, & will be at a minimum at the output level 3=A5 where P is a ma(imum 3=A output at -A input5* AP& will be a minimum at =I output* 'his is where &HAP&* 'his is at output level =I produced by -I labour* Ohen AP& is a minimum, AP will be a ma(imum* Ohen &QAP&, AP& will be decreasing* Ohen &NAP&, AP& will increase* Ohen AP&H &, AP& is a minimum* +J$ M$

=
=B =I :

A &

TP

=A

MPL +PL PA API

-A

-I

-B

,np!t 3-5

+*

:*

+PL MPL -A -I

&* -B ,np!t 3-5

M$

+J$

A&I &A =A
Fi"!re J.3

3#MAPI5P- H AP&I 3#M PA5P- H &A

=I

118

1P.1.9 Re!ationship of M# and 0O# to MP1 and 0P1

#t point #, with '# amount of labor and O # output the inflection point in )$ is associated with the maximum of the -$& )his maximum of the -$ function is associated with the minimum of the -C&

& =

# ( price of labour ) & PL

Since -$T#$, the #$ is increasing& -C\#3C, so #3C is decreasing& #t point F, the #$ is a maximum at this level of input (' F)& #t this level of input use the output (OF) has a minimum of the average variable cost (#3C)& #t this #3C, the -C will e+ual the -C& $oint represents the level of input (' ) where the output (O ) is a maximum& #t this level the -$' will be ,ero&

10#1#H P&'()*T$'%

A%(

*',T TA:2E,

The data from production functions and the prices of inputs determines all
the cost functions& Dn the following example a short-run production function is given& Dn the table below the columns K, ' and )$ reflect short-run production& )he plant si,e is determined by capital (K) that is 7 in the example& Since the $K N R5, the fixed cost (:C) is R17 at all levels of output& )he price of the variable input (') is R11& )he variable cost (3C) can be calculated for each level of input use and associated with a level of output (O)& )otal cost ()C) is the sum of :C and 3C& )he average cost functions can be calculated. #:C N :C/O, 3&1& #3C - 3C/O and #)C N#:C P #3C N)C/O& =iven the production function and the prices of the inputs, the cost functions are shown in )able

119

1P.1.G Production and #ost Ta !es

-arginal cost in the table is an estimate& %emember that

&=

'& & Q

Since +uantity is not changing at a constant rate of one, the -$ will be used to represent _O& )his is not precisely -C but is only an estimate&
Table J.Prod!ction and $ost

)he cost functions constructed from the data in )able 3&1 are shown in :igure 3&9& "ote that the -C intersects the #3C and #)C at the minimum points on those functions& )he vertical distance between #)C and #3C is the same as the #:C& )he #:C is unrelated to the -C and #3C& Dn this example the average fixed cost is less than the average variable cost and -C at every level of output& )his is coincidence& Dn some other production process it might be greater at each level of output&

11A

1P.1.G Production and #ost Ta !es

Dt is relevant that the #3C and -C are e+ual at the first unit of also output& )his will that always be true& )his means

Fi"!re J.0

&=

'& VC = & Q Q

11B

1P.1.1P Production and #ost in the 1ong?run

10#1#10 P&'()*T$'%

A%(

*',T

$% T4E

2'%8-&)%

!ong-run $roduction describes a period in which all inputs (and O) are

variable while technology is constant& # Cobb-Couglas production function can be used to describe the relationships& )here are a variety of other forms production functions can take, however the Cobb-Couglas is the simplest to describe& # short-run production function (O N f(') is a cross section from a long-run production function&

10#1#10#1 (1) 2'%8 &)% P&'()*T$'%

The long run production function is multidimensional, two or more inputs

and output changes& Df there are 1 inputs and one output, the long run production relationship is 5 dimensional& 0sing a topological map of ;iso+uants,< three dimensions can be shown in two dimensions& :igure 3&A is a representation of a long run production model using iso+uants and isocosts& )his model is an attempt to represent a threedimensional model in two dimensions& Dt can be thought of as a ;topological map< of production& Dn :igure 3&A, two different levels of output of the good are shown& )he term ;iso+uant< means e+ual +uantity& Dn the graph two iso+uants are shown& O1 and O1 represent two different levels of output& )here are an infinite number of iso+uants, one for each possible level of output but only two are shown& )he iso+uant (O1) represents all combinations of labor (') and capital (K) that will produce O1 amount of output& )hree input combinations that will produce O1 output are identified in the graph (points H, and F)& while there are an infinite number of input combinations that lie along the iso+uant (O1), only these three are marked& Dso+uant O1 is a larger output than O1& 4nly input combination ' #, K# at point # is identified&

112

1P.1.1P Production and #ost in the 1ong?run

)wo isocost functions are also shown in :igure 3&A& )hese are )C 1 and )C1& ;Dsocost< means e+ual cost& #ll output combinations that lie on )C 1 re+uire the same expenditure& #ll output combinations that cost less than )C 1 lie inside the isocost& 4utput combinations that cost more than )C 1 lie outside the isocost& )C1 represents a greater cost than )C 1& )he isocost function can be located by finding the intercepts on the K-axis (capital axis) and '-axis (labor axis)& )he '-intercept is found by dividing the total cost ()C 1 by the price of labor& Df )C1 were R122 and the price of labor were R7 the '-intercept ('Z) would be 62 units of labor, i&e& 62 units of labor at R7 each will cost R122& Df the price of capital were R6, the K-intercept for )C 1 is KZ (122/6 N 72)& # straight line between these two intercepts identifies all combinations of labor and capital that cost R122&
/n Cigure P*K, the iso4uants are represented as =# and =!* 'here are an infinite number of iso4uants, one for each possible 4uantity of output* /n our e(ample only two are shown* Along a given iso4uant 3=#5 there is a constant level of output* =! represents a greater output level* Along =# the output remains constant for different combinations of inputs 3- and B5 /nput combination depicted by point W 3BA capital and -W labour5 results in the same output as the input combination BB and -B at point B* 'he slope of the iso4uant between point W and B represent the marginal rate of substitution, the rate at which one input can be substituted for another holding output constant* 'he line '&# represents a given e(penditure or isocost* Dach point along the isocost represents different combinations of inputs that costs the same amount 3'&#5* Point B 3using BB and -B5 is the lowest cost combination of inputs to produce =# amount of output*

B R**

R* R+ R& R:

E &

+ =B : T$=T$B L** -

LE L&

L+ L* Fi"!re J.1

111

1P.1.1P Production and #ost in the 1ong?run

O1 output could be produced by using K # capital and 'H labor (point H on O1)& $oint F ('# labor and KF capital will also result in O1 output& "otice that both points H and F lie outside the isocost )C 1& Since point lies on )C 1, that input combination cost less than those at point H and F& Df O 1 output is desired, )C 1 is the lowest cost of production that can be attained& )his is accomplished by using ' labor and K capital& )he lowest cost of producing O1 given the price of labor and capital is at point #& )he slope of the iso+uant represents the rate at which one input can be substituted for another and still produce the same output& )he slope of the isocost represents relative price so of the inputs& )he lowest cost combination of inputs is at the point of tangency between the isocost and the iso+uant& Ghen the isocost function is tangent to an iso+uant, it identifies the combination of inputs that minimi,es the cost per unit for that level of output& )he short-run production relationships are cross-sections taken out of the iso+uant map& Dn intermediate microeconomics you will study the cost and production relationships in the iso+uant map&

10#1#10#2 (2) 2'%8-&)% *',T,

The

long-run costs are derived from the production function and the

prices of the inputs& "o inputs are fixed in the long run, so there are no fixed costs& #ll costs are variable in the long run& )he long run can be thought of as a series of short-run periods that reflect the cross-sections taken out of :igure 3&A& Conse+uently, the long run costs can be derived from a series of short-run cost functions& Dn principles of economics the ;envelope curve< is used as an approximation of the long run average cost function& Dn :igure 3&B, there are series of short run average cost (#C) functions shown& *ach represents a

111

1P.1.1P Production and #ost in the 1ong?run

different si,e plant& $lant si,e # is represented by #C #& #s the plant gets larger, up to plant si,e #CC,, the short-run #C function associated with each larger plant si,e is lower and further from the vertical axis& )his range is sometimes referred to as ;economies of scale&< =enerally it happens from speciali,ation and/or division of labor& $lant C, represented by #C C, represents the plant with the lowest cost per unit& #s the plant si,e increases above C, the short-run average cost begins to rise& )his region is often referred to as ;diseconomies of scale&< 'ack of information to make wise production choices is usually given as the reason for the increasing cost per unit as plant si,e increases above plant C&
A* 2&A*

)he
A*A A*: A** A*E A*2&A*

A*(

clc

O'C :igure 3&B

E!ut

envelope curve or '%#C is constructed by passing a line so it is smooth and Eust touches each of the short-run #C functions& Githin each short-run period there is a short run #C, -C, #3C and #:C& )he firm or plant will move from one set of short-run curves by changing the fixed input& Dn :igure 3&A this would be the same as moving from one cross section to another&
&ET)&%, T' ,*A2E

)he terms ;economies of scale,< ;increasing returns to scale,< ;constant returns to scale,< ;decreasing returns to scale< and ;diseconomies of scale< are fre+uently used& )hese terms involve subtle and complicated concepts that

115

1P.1.1P Production and #ost in the 1ong?run

apply to the long run production process& Dn principles of economics they are simplified& Conceptually, returns to scale implies that all inputs are variable& =iven a Cobb-Couglas production function of the form E A A 2 <R & O is output or +uantity, ' is +uantity of labor and K is the +uantity of capital& #, and are parameters that are determined by the technology of producing a specific product& Ghen S A 1, the production process demonstrates ;constant returns to scale&< Df ' and K both increased by 12M, output (O) would also increase by 12M& )his is consistent with a long run average cost (envelope) function that has a slope of 2& Ghen S T 1, production has increasing returns& # 12M increase in both ' and K results in a larger percentage (say 12M) increase in output (O)& )his is consistent with the declining portion of the long run average cost function ('%#C)& )his tends to be the result of speciali,ation and division of labor& Dt is sometimes referred to as economies of scale or economies of mass production& )here may be a variety of forces that cause the '%#C to decline& "ot all these forces are actually economies of scale& # larger firm (or monopsonist) may be able to negotiate lower prices for inputs& )his is not economies of scale, it is a transfer of income or wealth from one group to another& Ghen S U 1, decreasing returns are said to exist& #s both inputs increase 12M, output (O) will increase by a smaller percentage (say 8M)& )his condition is consistent with the rising portion of the long run average cost function ('%#C)& #s a firm gets larger it may lack the information about various aspects of the production process and be unable to coordinate all the processes& )his is the reason that a planned economy does not always produce optimal results&

116

1P.1.1P Production and #ost in the 1ong?run

Dn :igure 3&B economies of scale are said to exist up to output O 'C& Ciseconomies of scale occur as output expands about O'C&

117

11 =ptimi.ation and Mar/ets

11 'PT$+$9AT$'%

A%(

+A&<ET,

Economics can be viewed as a social science or as a tool for decision

science& #s a tool economics provides some insights that help identify optimal choices with respect to specific alternatives& 4ne of the basic precepts of "eoclassical microeconomics is that voluntary markets for goods with nonattenuated property rights will provide the information and incentives that coordinate individual behavior to achieve the maximum utility for society& -ost of "eoclassical economics presumes that the agent is trying to maximi,e or minimi,e (optimi,e) some obEective with respect to a set of constraints& %ational choices re+uire three basic steps. /dentify the ob0ective /dentify all feasible alternatives Develop a criteria to evaluate each alternative with respect to the ob0ective
CONSTRAINTS AND A!TERNATIVES

11.1 O$;ECTIVE*

The obEective is a function of the values and preferences of the individual

agent& *xperience, social background as well as many other social and psychological characteristics that relate to the individual determine the nature of the agent(s obEectives& *conomic agents have a variety of obEectives& (1) )here are a variety of obEectives that an agent might have& )hese include profits, utility, sales, market share, income, growth,&&&Gith in a firm different individuals may have different obEectives& )he C*4 may want to maximi,e profits while the 3ice president of engineering may want to minimi,e the cost per unit and the person in charge of marketing may want to maximi,e the growth in sales or market share& )he obEectives may not be consistent so some sort or hierarchical or bureaucratic process must resolve the

118

11.1 = 5ective% constraints and a!ternatives

inconsistency& Dn a market setting, competing obEectives of individuals is believed to be reconciled by voluntary transactions or exchanges& (1) )he achievement of any obEective is subEect to a set of constraints& Constraints may be technology, +uantity of factors of production, +uality of factors, profits, utility, sales, market share, income, growth, social institutions, values, law or a myriad of other possibilities& )he constraints and obEectives can be structured in a variety of ways& :or instance, a firm may try to maximi,e market share (obEective) subEect to the constraint that they earn a 11M return on capital investment& #lternatively, a firm might try to maximi,e the rate of return on capital subEect to the constraint that they maintain a 12M market share& #n individual might try to maximi,e income subEect to the constraint that they have 52 days of leisure time per year or they might try to maximi,e their leisure time subEect to the constraint that they have at least R72,222 income per year&

11.2 CRITERIA

TO EVA!UATE A!TERNATIVES

Choice implies that the agent has alternatives to choose among& 4nce the
agent has identified the obEective and constraints they must evaluate each alternative with respect to the obEective& )he criteria they use for this evaluation is crucial to their choice& =enerally, the criteria will involve two aspects. efficiency and ethics& (1) *fficiency is the measure of how well one achieves obEectives given a set of constraints& *fficiency is not in and of itself the obEective& )he word ;efficiency< is a popular term and is often used to Eustify choices and behavior& %econsider the concepts of efficiency discussed in the Dntroduction&

119

11.$ #riteria to eva!uate a!ternatives

'echnical Dfficiency =

Qy + Qx $b0ective output = = constraints input ( -, B, , technology )

Technical e00icienc. is conceptually measured as a ratio of output to input& :or any given set of inputs, technology and output of one good, the maximum output of the other good is technically efficient& )echnical efficiency can be considered in the production of a single good& Dn the short run where one input is fixed (say K), the maximum efficiency of the variable input (say ') occurs at the maximum of the #$ ' (where -$' N #$')& )he level of technical efficiency of labor is a function of the amount of K as well as technology& )echnical efficiency does not consider the value or relative prices of either inputs or outputs& Dn physics efficiency the concept of efficiency can be calculated by the different measures of energy (or the capacity to do work)& :oot-pounds, foot-pounds per sec, *rgs, Houles, horsepower, horsepowerhours, )0, kilowatts are all measures of energy& )he input and output of energy of a particular process (internal combustion engine, electric motor, etc) can often be measured& :rom the perspective of economics technical efficiency can be more problematic& Ghat is the efficiency of an automobileI )his depends on the measures of inputs and outputs chosen& )ypically, miles per gallon may be used as a measure& -iles traveled is the presumed output and ;gallons of fuel< is the input& )his measure presumes that the number of miles traveled is the sole obEective output& $assenger miles, passenger safety, status of owner, or many other measures may better reflect the desired output or obEective of the automobile& )he same problem exists for the inputs& )he presumption is that fuel is the only input& )he other inputs such as energy to produce the tons of steel to create the car may be ignored&

11A

11.$ #riteria to eva!uate a!ternatives

)he optimi,ation (maximi,ation) of technical efficiency can occur by maximi,ing the outputs for a given input or by minimi,ing the inputs for a given output& Dt is not possible to maximi,e output and minimi,e inputs at the same time& Df a public health agency instituted a policy to immuni,e preschoolers for C$) (diphtheria, pertussis and tetanus) and wanted to maximi,e efficiency, the problem could be framed in two ways& :irst, they might be allocated a set of recourses (vaccine, personnel, offices, etc) and then try to vaccinate as many children as possible& #lternatively, they might try to vaccinate all children by using as few resources as possible& "either the process nor the results are the same& Dn the transformation or production possibilities model, technical efficiency lies on the transformation or production possibilities frontier& %eview the earlier discussion of technical efficiency in the $ntroduction&
)he location and shape of the $$: is determined by )he location and shape of the $$: is determined by technology, +uantity and +uality of inputs& Dt technology, +uantity and +uality of inputs& Dt represents all output combinations possible& )he represents all output combinations possible& )he +uantity and +uality of inputs are fixed& )he task is to +uantity and +uality of inputs are fixed& )he task is to maximi,e the outputs& )he output combination maximi,e the outputs& )he output combination identified at point F is ;technically inefficient&< -ore identified at point F is ;technically inefficient&< -ore of good ! or good > (or more of both) can be of good ! or good > (or more of both) can be produced with the same set of inputs and technology& produced with the same set of inputs and technology& #ll technically efficient solutions lie on the $$:& #ll technically efficient solutions lie on the $$:& )echnical efficiency does not answer the +uestion )echnical efficiency does not answer the +uestion about which output combination is preferred or most about which output combination is preferred or most valuable& #llocative or economic efficiency is re+uired valuable& #llocative or economic efficiency is re+uired to answer that +uestion& to answer that +uestion&

O!

# C C F *

:igure D&#&8

O>

Allocative or econo/ic e00icienc. includes the values or relative prices of outputs and inputs& )he benefit or value of a choice is represented by the product of the price and +uantity of each good or output (value of output N $ xOx P$yOy P & & & P$nOn)& )he value of the inputs or cost is represented by the product of the prices and +uantities of the inputs (cost N $'' P $KK P LP $iOi)& #llocative efficiency is

11B

11.$ #riteria to eva!uate a!ternatives

attained when we maximi,e the value of the outputs relative to the value of the inputs& )he cost is minimi,ed for a given output or output is maximi,ed for a given cost& )he economically efficient solution must lie on the production possibilities function& Pareto e00icienc. is the condition where there are no alternatives that will increase the welfare (utility) of one person without reducing the welfare (utility) of any other person(s)& 4nce an output combination on the production possibility function is attained, that output combination is $areto 4ptimal&

)he output combination at point F is not $areto 4ptimal& )he output combination at point F is not $areto 4ptimal& Drrespective of individual preferences a move from point Drrespective of individual preferences a move from point F to output combinations at point or C (or any where F to output combinations at point or C (or any where in the area FC represent ;$areto Dmprovements&< in the area FC represent ;$areto Dmprovements&< *ach alternative in the area FC is ;$areto Superior< to *ach alternative in the area FC is ;$areto Superior< to the alternative represent by point F& the alternative represent by point F& Df the current output combination were at point *, it Df the current output combination were at point *, it would be $areto 4ptimal even if it were not he highest would be $areto 4ptimal even if it were not he highest valued output& #ny increase in good ! (or >) would valued output& #ny increase in good ! (or >) would re+uire a decrease in good > (or !)& )he individuals who re+uire a decrease in good > (or !)& )he individuals who prefer > (or !) to ! (or >) would be ;worse off< (their prefer > (or !) to ! (or >) would be ;worse off< (their utility or welfare is lower)& utility or welfare is lower)& Df the output is currently at point F, the area FC is Df the output is currently at point F, the area FC is called ;$areto Safe&< called ;$areto Safe&<

O!

# C

C F *

:igure D&#&8

O> is a

$areto

efficiency

restrictive criteria and tends to promote the status *uo& -ost choices involve marginal benefits and marginal costs that change the welfare or utility of more than one individual& )he $areto efficiency criterion fails to Eustify choices that result in the highest valued use of resources (economic efficiency)& )o remedy this problem the criterion of Pareto Potential is used& $areto $otential Eustifies the choice of an alternative so long as the ;winners< (individuals whose utility increased) can hypothetically compensate the ;losers< (individuals whose utility decreased) and still be better off& )his is the foundation of criteria such as enefit/cost analysis, rate of return on

152

11.$ #riteria to eva!uate a!ternatives

investment and internal rates of return& )he problem with $areto $otential is that it introduces the +uestion of e+uity& Consider the problem of breaching dam is the $acific "orthwest& )here are winners and losers& *nvironmentalists, individuals who benefit from anadromous fish and agents who earn income from tourists are some of the winners& *lectricity generators and farmers are examples of losers& *ven if the marginal benefits of breaching the dam exceeded the marginal costs, there is no mechanism to insure the winners would compensate the losers& )here is necessarily a Eudgment about the morality of the dams and the imposition of costs and benefits of various groups of individuals& )his example also illustrates the issue that the status *uo tends to be supported by the $areto 4ptimality criterion& uilding the dams imposed costs and conferred benefits on different groups of people Eust as breaching the dams will& #s societies and individuals change their preferences, technology and environments change and alter the obEectives and optimal use of scarce resources& Dn an ideal world, informed individuals engaged in voluntary exchanges will result in transfers of property rights that are $areto improvements and lead to economic efficiency& (1)*+uity is a Eudgment about the rightness or wrongness of the obEective& *arlier, deontological and conse+uentialist ethics were discussed& #ny obEective can be ethical or unethical based on the type of ethical system used& %emember that microeconomics relies primarily on a conse+uential ethic called ;0tilitarianism< and is directly related to the concept of $areto $otential& Df the benefits exceed the costs of an action, the conse+uence is an increase in utility& )his does not mean that deontological ethics (based on duty) are not necessary for a reasonably functioning society& Dt is important to consider the morality of our obEectives and the sacrifices that must be made to achieve them&

151

11.$.1 Margina! 0na!ysis

11#2#1 +A&8$%A2 A%A25,$,

1 F

The
FG

-arginalist %evolution in economics

during the last half of the 1B th century provided economists with a useful tool to find maximums and minimums given functional relationships 1G between variables& asically, this -arginalist %evolution was the application of calculus to economic analysis& 4ne of the purposes of economics is to maximi,e of minimi,e a given variable by making choices& Choices are always made at the margin& # saying attributed to some anonymous Chinese philosopher is ;)he longest Eourney begins with the first step&< )his is used here to point out that every decision is a change from an initial state& Dn production, the manager must understand that a change in an input such as labor ;causes a change in output& # consumer must understand that a change in +uantity consumed alters the level of utility& # seller must understand that a change in price alters the +uantity sold and the total revenue& -arginal analysis is the analysis of rates of changes in variables& *very time the word ;marginal< is used in economics it is related to a change in a dependent variable ;caused by a change in an independent variable& )he rate of change can be interpreted as the slope of a line& )he slope of a line is often defined as ;rise over run.< )he rise is usually the change in the dependent variable while the run is the change in the independent variable& :or example, the cost of producing more of one good, given full employment, re+uires a sacrifice of some other good& )his was demonstrated in a $roduction $ossibilities model& )he slope of the $$: is called the ;-arginal %ate of )ransformation< (-%))& )his is shown in :igure 3D&1& )he $$: function shows all combinations of !awls (!) and >ebecs (>) that can be produced given inputs and technology&

151

11.$.1 Margina! 0na!ysis

'awls (')

<" :<

+ +

& + $ + A +

7"

#G

D
!"" 7<

+ 7K :" 6ebecs (6)

At point B, an increase in > 3 >H#<, the run5 re4uires a sacrifice of #< units of @ 3 @H;#<5 'his tradeoff is called the arginal Aate of 'ransformation 3 A'5 and is illustrated by the line AA1* Ohen the A' 3or slope5 is calculated by subtracting values 3 5, the marginal value is the slope of an arc between the points* Ohen the slope is calculated by a derivative, the value of > approaches ", so the marginal value is represented by the slope of a tangent* /n this e(ample, it the slope of CC1 at point B*

Cigure P/*#

Df the output were at > N 12, ! N 67 (shown as point

in :igure 3D&1), an

increase in >ebecs would re+uire a decrease in the output of !& )he increase in > from 12 to 57 is 17 units of >& )his is labeled as > N 17 (57-12N17) and is the ;run&< )he change in ! (!) is -17 (52-67N -17) and is called the ; rise. )he line %%( represents the change in ! (!) caused by the change in > (>)&

Slope of AAZ =

rise Y = , or the change in @ caused by a change in X run X

)he slope of %%( is

;#< ( rise ) = # #< ( run )

Calculus lets the change in > approach 2& Ghen the change in > approaches 2, the change in ! is shown by the line ::( which is tangent to the $$: at point & Dn principles of economics calculus is not normally re+uired so the term marginal is calculated by differences and is represented by the slope of a straight line& Ghen a function is nonlinear, the slope between two points is the slope of an arc&

155

11.$.1 Margina! 0na!ysis

Dt is crucial to remember that the marginal value (cost, benefit, etc) is the value associated with a specific choice& (1) marginal benefit (- ) is the change in total benefits associated with a choice& :or an individual (1) marginal cost production& (5) marginal decision rule !ou should engage in any activity so long as the T -C, the optimal level of activity is where N -C, when -CTyou should not undertake the activity& )here is a variation of this rule called the e+uimarginal rule& )he marginal decision rule can be illustrated by the decision to gather wild blackberries (good >)& )he cost of travel to the blackberry patch is treated here as a sunk (fixed) cost, we are already at the patch& Fow many berries shall we pickI )he answer depends on our analysis of the benefits and costs of each unit of berries we pick& =enerally, the marginal benefits of berries will tend to decrease primarily because of diminishing marginal utility& )he marginal benefit (- ) of each unit of berries is shown in :igure 3D&1& )ypically we will gather the berries that are easiest to pick first& )hese are the berries
+: and +* +*

might be -0 for a firm it may be -%

(-C) is the change in total cost (or variable cost since

fixed costs don(t change) caused by a change in and activity, usually

PA - N -C

+: C 2 % 95 erries/ut -i"ure 3$#2

156

11.$.1 Margina! 0na!ysis

that are approximately waist level and on the outside of the bushes& #s we pick more berries we have to reach further up or down and into the bushes where there are thorns& )he marginal cost (-C) of berries rises& )he -C of each unit of berries is also shown in :igure 3D&1& )he more berries are obtained& )he area under the picked, ) function decreases as function up to the +uantity

obtained represents the total benefits () )& Dn :igure 3D&1 when 95 units are is the area 2%* & )he -C rises as berries become more difficult to pick& -C represents the marginal cost of each unit& )he total costs ()C) is the area under the -C function& Ghen 95 units of berries are picked, the )C will be represented by the area 2%*C (the area in blue)& )he first units of berries are picked because the marginal benefit of each unit (- ) is greater than the marginal cost (-C)& )here is a net benefit obtained from each unit& Seventythree units of berries are picked because the than the -C of those units& )he ) the area C* of the first 95 units is greater N -C& is 2%* . the )C is 2%*C& )he net benefit is

(in yellow)& "et benefits are maximi,ed when -

)his rule has several applications& Ohere Ohere AH &, profits are ma(imi2ed

B H P 3cost5, utility is ma(imi2ed

)his rule was first clearly stated by the :rench engineer/economist, Hules Cupuit in the 1A52(s&

157

11.$.$ Mar/et E+change and Efficiency

11#2#2 +A&<ET E=*4A%8E

A%(

E--$*$E%*5

The ideal market has two important characteristics.

/ndividuals voluntarily contract among themselves* 'here is no coercion and each is informed of their preferences 3ob0ectives5 and alternatives* 'hey make informed 0udgments about the outcomes of their choices* 'he individuals e(change goods that are characteri2ed by nonattenuated property rights* 6onattenuated property rights are e(clusive, enforceable and transferable* 'he benefits and cost associated with the production or consumption of any good falls only on the agents engaged in the contract or transaction*

0nder these conditions, from a utilitarian perspective, no one would rationally engage in a voluntary exchange if it made them worse off& )herefore, any voluntary exchange must lead to Pareto superior results& Dndividual agents know their preferences (obEectives) and react to any changes by altering their choices& )he ideali,ed market results in individuals who constantly reappraise their obEectives and alternatives and alter choices to maximi,e their welfare& Since exchanges are perceived to be voluntary, no individual would choose to make themselves worse off& 3oluntary markets of goods with nonattenuated property rights are consistent with the 0tilitarian *thic and $areto *fficiency&

158

11.$." Prices as Information

+: and +*

+*

PA - N -C

+: C 2 % 95 -i"ure 3$#2 erries/ut

11#2#1 P&$*E,

A,

$%-'&+AT$'%

)he function of the market is to coordinate the preferences and behavior of the buyers and sellers& )here are two important elements that are necessary if markets are to perform this task of coordination& :irst, buyers and sellers must have information& $rices, or more precisely relative prices perform this task& Secondly, buyers and sellers must have an incentive to respond to the information contained in prices& 0sing :igure 3D&1 again, the role of prices can be shown& )he of berries increases, the marginal value goes down, )he function

represents the buyers( evaluations of their marginal benefits& #s the +uantity function is negatively sloped and resembles a demand function& Dt is not a demand function because it does not include the ability to buy the goods& Dt only measures the buyers( evaluation of marginal benefits& "otice the 95rd unit to the buyers is $& of the Similarly, the -C function represents the unit, the is

opportunity cost or producing each unit& )he -C of producing the 95 rd unit is also $& :or all unit of berries, up to and including, the 95 rd greater than the -C& Ge could restate this. the marginal benefit from each of

159

11.$." Prices as Information

the first 95 units is greater than its opportunity cost& )he value (- ) that buyers have for each of the first 95 units is greater than the market price of $& )he sellers sacrifice an opportunity cost of less than $ on each of the first 95 units& )he price of $ represents the marginal value (- ) of the last unit exchanged to the buyers& $ also represents the marginal value (-C) of the last unit exchanged to the sellers& # price of $ provides information about both the buyers and sellers evaluations& Since benefit, the ideal is where the price reflects So long as the price is less than the be purchased& 4nce the $ T N -C produces maximum net and -C, +: A P A +*#

of the buyers, additional units will

buyers cease to purchase the good&

Ghen the $ T -C, sellers will produce and offer units for sale& 4nce the $ \ -C, the sellers will cease production&

15A

1$ Pure #ompetition

12 P)&E *'+PET$T$'%

Purely

competitive markets are used as the benchmark to evaluate

market performance& Dt is generally believed that market structure influences the behavior and performance of agents within the market& Structure influences conduct which, in turn affects performance&

12.1 MAR+ET STRUCTURE

Neoclassical

microeconomics is an explanation of the behavior of

individuals, firms, and organi,ations within a market context& )heir behavior is thought to be a function of their obEectives and the constraints that exist because of technology, +uantity/+uality of inputs and market structure& -arket structures can be characteri,ed by sellers or buyers or both& -ost economics texts classify markets by seller& =enerally, they identify 6 basic types of markets. (1) pure (or perfect) competition, (1) monopolistic (or imperfect) competition, (5) oligopolistic competition, and (6) monopoly& $ure competition is believed to produce ideal results in the allocation of resources& -onopoly is usually depicted as having less than optimal outcomes& )he basic market structures based on sellers is shown in :igure 3DD&1

15B

1$.1 Mar/et Structure

Fi"!re J,,./deal outcomes

Pure *o/petition
1& -any sellers 1& homogeneous products 5& relative ease of entry

Market *tr!ct!re ,mperfect or Monopolistic $ompetition

#* any sellers !* differentiated products 7* relative ease of entry

Deviate from /deal Monopoly

#* one seller !* no close substitutes 7 complete B'D

Mli"opoly
#* Cew sellers 3interdependence5 !* identical or differentiated product 7* B'D

$ure competition and -onopoly are at each end of the spectrum of markets& Dn fact, probably neither occur in market economies& $ure competition and monopoly are the boundaries and the ;real world< (wherever that is) lies somewhere between the two extremes& $ure competition provides the benchmark that can be use to evaluate markets& )he physician who attends you knows that BA&8o is a benchmark& !our temperature may not be precisely BA&8o, but if it deviates significantly, that deviation suggests problems& Dt might be in your best interests to know what the ;normal< temperature is and the cause of the deviation from ;normal&<

162

1$.1.1 #haracteristics of Pure #ompetition

12#1#1 *4A&A*TE&$,T$*,

'-

P)&E *'+PET$T$'%

The ideali,ed purely competitive market insures that no buyer or seller

has any market power or ability to influence the price& )he sellers in a purely competitive market are .0i=e t2ke0/& )he market sets the price and each seller reacts to that price by altering the variable input and output in the short run& Dn the long rung they can alter the scale of plant (si,e of the fixed input in each short run period)& )he conditions that ensure no seller has any market pose are. 'arge number of sellers (and buyers), no one of which can influence the market& Iomogeneous output, buyers see goods as perfect substitutes* Aelatively )free+ entry and e(it to and from the market* Sellers cannot charge a price above the market price because sellers see all other goods in the market as perfect substitutes& )hey can buy those goods at the market price&

12.2 T

FIRM

IN

PURE COMPETITION

purely competitive market is characteri,ed by a large number of

relatively small firms& "o single firm can influence the market price and are considered price ta/ers& Dn :igure 3DD&1 graphs representing a purely competitive market and one firm are shown& $anel #&3DD&1 represents the market& C - and S- represent the market demand and supply functions& Df the market is in e+uilibrium the e+uilibrium price and +uantities are $*- and O*- respectively& "otice that the +uantity measured along the O-axis in $anel # represent large +uantities&

161

1$.$ The ;irm in Pure #ompetition

Price, Q

*M

D PD PD

Price, Q

Df AAfH Af

AM =D Panel +.J,,.B 3 arket5 =x(-5B0) Fi"!re J,,.B Panel &.J,,.B 3Cirm5 =xH!t

Price, Q

*M

*M*

D PD P* PD P* AAfH D%, AA%,

Price, Q

Df Af A%

AM =D Panel +.J,,.. 3 arket5 =x(-5B0) Fi"!re J,,.. Panel &.J,,.. 3Cirm5 =xH!t

$anel

&3DD&1 represents a single firm in the market& "ote that the +uantity is small relative to that in $anel #& )he

measured along the O-axis in $anel

firm accounts for a very small portion of the goods offered for sale in the market& Since there are a a large number of firms in the market with identical or homogeneous products, buyers have no preference for any one firm(s product& )he demand faced by a single firm is perfectly elastic at the market

161

1$.$ The ;irm in Pure #ompetition

price& )his is represented as a hori,ontal line at the price of $ *- in $anel

&

%emember that demand and #% coincide& -arginal revenue decreases at twice the rate (has twice the slope of the #%) as a linear #% function& Since the slope the #% for the purely competitive firm is 2, the -% does not decrease and lies along the demand and #% functions& Consider an increase in the market supply shown in :igure 3DD&5& )he market supply function increases from S- to S-Z in $anel #&3DD&5& #s a result, the e+uilibrium price (in $anel #) in the market falls from $ *- to $Z& )he e+uilibrium +uantity will rise& Since the market price has fallen, the demand, #% and -% functions faced by the firm will fall to CZ, #%Z and -%Z& (#s shown in $anel &3DD&5&) "ote that a decrease in market supply will shift the firm(s demand function up& #n increase (decrease) in market demand would shift the firm(s demand up (down)& Changes in the conditions in the market alter the price& )hese changes in price provide information to the firms who then react to those changes&

12#2#1 P&'-$T +A=$+$9AT$'%

$% T4E

,4'&T &)%

If the firm(s obEective is to maximi,e profits (a), they must maximi,e the
difference between total revenue ()%) and total cost ()C)& a N )% ^)C& Dt is possible to identify the output level that will maximi,e profits for the firm if the -% and -C functions are known& Ghere -% N -C, profits will be maximi,ed (or losses minimi,ed)& efore we consider these problems there are several points to reconsider&
A normal profit is included as a cost of production 0ust as wages, interest, rent and materials costs are e(penses* 'he ob0ective of the firm is to ma(imi2e profits 3not revenue5 & is the change in '& 3or P&5 caused by a change in output*

165

1$.$.1 Profit Ma+imi.ation in the Short Run

&=

X'& XP& = X= X=

A& is the total cost per unit* /t is calculated by dividing '& by =* A& tends to fall and then rise as output increases* Ohen & is less than A&, A& is decreasing* Ohen & is greater than A&, A& will be increasing* Ohen & e4uals A&, A& will be a

A& =
minimum*

'& Q

AP& is the variable cost per unit* AP& is the variable cost per unit* /t is calculated by dividing P& by =* AP& tends to fall and then rise as output increases* Ohen & is less than AP&, AP& is decreasing* Ohen & is greater than AP&, AP& will be increasing* Ohen & e4uals AP&, AP& will be a minimum*

AP& =

P& Q

'he vertical distance between A& and AP& is the AC&* 3AC& H A&;AP&5 AC& will tend to decrease as long as output 3=5 increases* Demand faced by a purely competitive firm is perfectly elastic 3hori2ontal, straight line5 at the market price* 'he AA is the same as the demand function* A falls at twice the rate of AA* Since AA has a slope of " in a purely competitive market, A and AA are the same in a purely competitive market* A H price in a purely competitive market* A firm will offer additional units for sale so long as the price they obtain is greater than the opportunity cost 3 &5 of producing the units*

)he behavior of the firm in the short run can be shown using total values ()% and )C) or unit values (-%, -C and #C)
)C T& C )% )C # (

12#2#1#1 ,4'&T &)% P&'-$T, ),$%8 T& A%( T*

)%, )C

Maximum
occur at the

profits output

will level

where there is the greatest vertical distance between )% and )C, when )%T)C& Dn

G 2 O# O Oc -i"ure 3$$#4

166
O/ut

1$.$.1 Profit Ma+imi.ation in the Short Run

:igure 3DD&6 the )% and )C functions for a firm are shown& )he )% is a straight line (with a constant slope)& )% is price times +uantity& Since )% is a linear function this implies that the price for all +uantities are the same, the firm is in a purely competitive market (the demand is perfectly elastic at the market price&)& -% is defined as the change in )% associated with a change in O& -% is the slope of )%, so -% is the price& )he )C intercept is at G, which is the fixed cost and shows that this is a graph depicting a short run condition& )he )C function increases at a decreasing rate that implies that -C is falling and -$ of the variable input is rising& eyond the inflection point in the )C, )C increases at an increasing rate& )he model shows ;break-even< points (# and C) at output level O # and OC& #t these break-even point the firm is earning a normal profit& (%emember normal profits are included in the cost functions&) etween output levels O # and OC, the )%T)C& )his means that economic profits (a) exist& -aximum a occur at output level O &, the greatest vertical distance between )% and )C& "ote that at point # (producing O #) the firm obtains a normal profit& Df they produce and additional unit the -C (slope of )C at point #) is less than the slope of the )% (-%), i&e& they can produce additional units for less than someone is willing to pay for them& #t output level O , the slope of the )C (-C) is e+ual to the slope of the )% (-%)& Df they attempt to increase output above O , the cost of additional units (shown by the slope of the )C) increases faster the increase in )% (shown by the slope to )%)& Ghere the slope of the )C (-C) is the same as the slope of the )% (-%), profits (the vertical distance between )% and )C) are maximi,ed&

167

1$.$.1 Profit Ma+imi.ation in the Short Run

12#2#1#2 ,4'&T &)% P&'-$T,

),$%8

)%$T *',T

A%(

&E3E%)E

The process of determining the output level that maximi,es profits in the
short run can also be made by an analysis of the unit cost and revenue functions& -C and -% determine whether to produce a given output of not& Df the cost of and additional unit (-C) is less than the revenue obtained from that same additional unit (-%), producing the additional units will add to profits (or reduce losses)& Df the cost of additional units of output (-C) cost more than they add to revenue (-%), the firm should not produce the additional units& )he rules for profit maximi,ation are simple. A N &, produce itR AQ Ohen &, don1t produce itR AH &, you are earning ma(imum profitsR

)he process of determining the profit maximi,ing level of output using unit cost and revenue functions is shown in :igure 3DD&7&
Cigure P//*< represents a single firm in a purely competitive market* /t must be pure competition because of the perfectly elastic demand function at the price P* D, A and AA are all hori2ontal functions at the price P* As output increases from " to =& the AP& decreases* A& decreases up to output =B* Both AP& and A& are U;shaped functions* Aemember the AP of the variable input increases while the AP& falls* 'he & falls 3up to output =A5 and then rises intersecting AP& and A& at their minimum points* At outputs =A and =W the firm has break;even points, normal profits e(ist at output level =A and =W* 'he firm produces where A H & 3point I5 to ma(imi2e profits at output level =I* Since AA N A& at this level, the firm earns above normal profits*

M$ +$

P & &B

A B &

+J$ A, +R, MR

&&

"

=A

=&

=B

=I

=W

=H!t

Fi"!re J,,.4

168

1$.$.1 Profit Ma+imi.ation in the Short Run

)he firm will produce units so long as the market price ($, which is e+ual to -% when Cemand is perfectly elastic&) is greater than the cost of producing the additional unit (-C)& Df -C is greater than the price (or -%) the firm will not produce& #ll possible profits are captured where -% N -C& )his is shown as point F at output level OF in :igure 3DD&7& #t output level OF, where -% N -C, profits are a maximum and can be shown as the area C--F$ (the area in yellow)& )otal revenue ()%) is area 2OFF$& )% is calculated by price multiplied by +uantity, in this model, $ZO F is the area 2OFF$& )otal cost ()C) is area 2OF-C- (the product of the #C and +uantity, which is C-ZOF& $rofits are the difference between )% and )C, area C--F$ or ($-C-)O-&

12#2#1#1 2',, +$%$+$9AT$'%

A%(

,4)T('7%

$% T4E

,4'&T

&)%

In the short run the maximum the firm must loose is its fixed cost& Df the
firm can recover all its variable cost it may as well operate unless it sees no hope of improvement in the future& Dn :igure 3DD&7 the firm is earning above normal profits by producing at O F output& Df the price were to fall to C (which is consistent with the minimum of the #C function) the firm would earn normal profits& (%emember that normal profits are included in the cost functions as an opportunity cost for the entrepreneur&) Df the price falls below C , the firm will lose money, i&e& will earn less than normal profits& So long as the price is above CC, the firm is recovering all the variable cost and a little more to offset the fixed cost that it would have lost if the firm would have shutdown& #t a price of CC, the firm is recovering all its variable cost and losing its fixed cost (which it would have done anyway if it had closed down&)& )herefore, so long as the firm can recover all its variable costs at a price of C C, it may as well operate in the short run& $oint C, at a price of CC and output of OC is called

169

1$.$.1 Profit Ma+imi.ation in the Short Run

the shutdown point& Dt will always be at the point where the -C intersects the #3C (the minimum of the #3C)& Dn the long run all costs are variable, therefore the shut down point in the long run is the minimum of the '%#C where -CN '%#C& )here may be other reasons for operating a production facility& Dn some cases individuals may operate at less than normal profits because the get nonmonetary benefits from being in a particular line of work or being ;their own boss&< # government may encourage firms that produce particular products to operate for reasons of national defense or national pride& Dn these cases public policy may be used to subsidi,e the firms that would find it necessary to shut down in a free market economy&

12#2#2 P&'-$T,

$%

2'%8 &)% P)&E *'+PET$T$'%

In the long run, producers are able to alter their scale of plant& )he '%#C
or envelope curve was constructed from a series of short run periods with different plant si,es& Dn the long run the firm is essentially able to select the scale of plant (or a specific set short run production and cost functions associated with a specific fixed (in the short run) input)& )he is essentially the meaning of ;relative ease of exit and entry from the market& #nother crucial aspect of long run pure competition is that the demand faced by the firm is perfectly elastic at the market price& )he #% and -% functions coincide with the firm(s demand function& ecause the firm(s demand function is perfectly elastic, they cannot raise their price above the market price& Df they do, their sales will fall to 2& )here is no reason to lower their price below the market price because they can sell all they want to a the market price& )he firms in pure competition have no ; 420ket .o3e0.< -arket power, in microeconomics, refers to the ability of an agent to raise the price

16A

1$.$.$ Profits in 1ong Run Pure #ompetition

and not have their sales fall to 2& # +uick review of price elasticity suggests that market power is influenced by a firm(s demand function& $urely competitive firms are price takers& )hese firms have no incentive to advertise& )he largest producer in a purely competitive market can sell all they can produce or none at all and the market price will be unaltered&

16B

1$.$.$ Profits in 1ong Run Pure #ompetition

LRM$ *M Price, Q Price, Q *M*

*R+$* *R+$.

*R+$-

+ D PD P* PD P*
SAA&!

& $

Df AAfH Af D%, AA%, A%

AM =D Panel +.J,,.3 3 arket5 =x(-5B0) Fi"!re J,,.3 =+ =$ =& Panel &.J,,.3 3Cirm5 =xH!t

/n Cigure P//*F 'he market demand an supply functions 3in Panel A5 are initially D and S * Eiven thess demand and supply functions, the market e4uilibrium is at point D resulting in an e4uilibrium price 3P D 5 and 4uantity 3=D 5* Ohen the market price is P D , the firm reacts to that price 3'he firm is a price taker*5* /f the firm1s ob0ective is to ma(imi2e profits, it will operate at the point where A H &* 'his e4uality of A and & occurs at point at Point B in panel B* 6ote that the short run & will lie to the right of the -A & at this point, so short run output would be greater* 'he firm will select plant si2e SAA&! since it will minimi2e the cost per unit at that output level 3= B5* 'his SAA&! is not the most efficient si2e plant 3SAA&%5* 'he AA is greater than the A& at this point* 'he firm can earn ) economic profits+ under these conditions* Aemember ) normal profits+ are included in the cost functions* Since entry is relatively free, other entrepreneurs will desire to capture some of these economic profits and enter the industry* 'he supply function will increase 3shift to the right5 causing the e4uilibrium price to fall from P D to P%* 'he e4uilibrium 4uantity in the market rises but there are more firms* 'he firm represented in Panel B must ad0ust to the lower market price, P%*'he new demand and revenue functions faced by the firm is D%, AA% and A%* A% H & at point &* 'he firm reduces output to = & and ad0usts plant si2e to SAA&%* 'he firm now is operating where:
the plant that has allows the lowest cost per unit (most efficient si,e plant), they operate that plant at the level of output that has the lowest cost per unit, they earn a normal profit, )hey are maximi,ing their profits given circumstances ()hey have no incentive to change output or plant si,e, they are in e+uilibrium&), )he price is e+ual to the -C ()his is the condition to optimi,e the welfare of the individuals in society given the income distribution&)

172

1$.$.$ Profits in 1ong Run Pure #ompetition

)he process of long run e+uilibrium in pure competition can be shown in :igure 3DD&8& !ou may remember part of :igure 3DD&8 as :igure 3DD&5& shown& Dn :igure 3DD&8, it is apparent that a market price below $Z would result in the firm(s #C exceeding the #% at all levels& Df this were the case firms would earn less than normal profits and would have an incentive to leave the market& #s firms leave the market, the market supply decreases (shifts to the left) and the market price would rise& )here are two important features in pure competition& :irst each firm is a price taker and has no market power& )he demand function faced by the firm is perfectly elastic at the e+uilibrium price established in the market& )his is because the output of the purely competitive firms is homogeneous and there are a large number of sellers, none of whom can influence the market price& Secondly, entry and exit from the market is relatively free& #bove normal profits attract new producer/seller that increases the market supply driving the market price down& Df profits are below normal, firms exit the market& )his reduces the market supply and drives the price up& 'ong run e+uilibrium in a purely competitive market is established when the C (#% and -%) is Eust tangent to the long run average cost function ('%#C)& )his will be at the minimum of the '%#C where its slope is 2 (the demand function faced by the firm has a slope of 2)& :irm earn normal profits at this point and there is no incentive to enter or leave the market& )here is no incentive to alter plant si,e or change the output level& #t the point of long run e+uilibrium in :igure 3DD&8 at point C, the following conditions will exist. oth the market and an individual firm(s demand and cost (supply) functions are

171

1$.$.$ Profits in 1ong Run Pure #ompetition

+R @ +$: Cirms earn a normal profit* 'here is no incentive for firms to enter or leave the market* LRM$ @ LR+$: the firm is operating with the plant si2e that results in the lowest cost per unit, i*e* the fewest resources per unit of output are used* MR @LRM$: the firm has no incentive to alter output or plant si2e* P @ MR @M$: the price reflects the marginal value of the good to the buyers and the marginal cost to the producerMseller* 'ong run e+uilibrium in pure competition results in an optimal allocation of resources& )he price reflects the marginal benefits of the buyers and the marginal cost of production& )he user of the last unit of the good places a value (the price they are willing and able to pay) on the good e+ual to the cost of producing that unit of the good& 0nits of the good between 2 and the e+uilibrium +uantity have a greater value than the cost of production& )he purely competitive model provides a benchmark or criteria to evaluate the performance of a market. +: A P A +* & )he marginal benefit (- ) to the buyer is suggested by the price they are willing and able to pay& )he the opportunity cost to society& to the seller is the marginal revenue (-%) they earn& )he marginal cost (-C) reflects

171

1" ;irms )ith Mar/et Po'er

11 -$&+, 7$T4 C+A&<ET P'7E&D

Pure competition results in an optimal allocation or resources given the

obEective of an economic system to allocate resources to their highest valued uses or to allocate relative scarce resource to maximi,e the satisfaction of (unlimited) wants in a cultural context& $ure competition is the ideal that is be benchmark to evaluate the performance markets& )he economic theory of monopolistic competitive markets, oligopoly and monopoly is used to suggest the nature of problems that may exist when firms or agents have market power and are able to distort prices away from the purely competitive optimum& )he existence of market power is tied to the demand conditions the firm faces& Df their product is (or can be differentiated), consumers may have a preference for one firm(s output relative to others& # negatively sloped demand function (less than perfectly elastic) allows the firm to raise its price and not have its sales fall to ,ero& Dn pure competition, the firms may all try to influence market demand (eat Colorado product (*at %ancher Hones(s eef, *at lack #ngus eef, Crink :lorida orange Euice, etc) but individual producers do not advertise their own eef)& -any agricultural markets are close to pure competition& Dn many cases some producers try to differentiate their products& 4rganic produce is one example& Dn pure competition, the firms( outputs are homogeneous& Df the firm has is no opportunity to differentiate their product they have no incentive to advertise and to try to influence the demand for their product& Df a product can be differentiated by altering the characteristics of the good or simply by convincing the consumers that the product is different, the firm achieves market power& -arket power is the ability to have some control over the price

175

1" ;irms )ith Mar/et Po'er

of the good offered for sale& #dvertising can be used to differentiate a product or increase the demand for a product& )he crucial factor is the demand for the firm(s output must be negatively sloped. the firm becomes a ; .0i=e 42ke0&< )he extent to which a firm is a price maker (i&e& has market power) is partially determined by the price elasticity of demand in the relevant price range& "ote that when the seller selects a price (price maker) the demand function determines the +uantity that will be purchased& )he conditions of entry or barriers to entry ( )*) are also important determinants of market power& Df there are significant prevented from entry to capture the above normal profits& -onopoly is the market structure that is usually associated with the greatest market power& )he monopolist produces a good with no close substitutes (increased probability the demand is relatively inelastic) and there are barriers to entry& :irms in monopolistic competition or imperfectly competitive markets are more likely to have limited market power because there are many firms with differentiated products (there are substitutes) and there is relative ease of entry and exit into the market& )*, a firm or firms may be able to sustain above normal profits over time because other firms are

176

1".1 Monopo!y

1".1 MONOPO!Y

A monopoly is a market characteri,ed by a single seller of a good with no

close substitutes and barriers to entry& -onopolies rarely occur in a pure form& )here are almost always substitutes or methods of possible entry into a market& Ghen the term ;monopoly< is used it is usually referring to a degree of monopoly or market power& Dn many cases the existence of a monopoly results in regulation or the enforcement of antitrust laws that attempt to introduce competition to reduce market power& )he definition of monopoly re+uires a Eudgment about the phrase ;no close substitutes< and what ;barriers to entry< mean& D might be the only producer of mink lined, titanium trash cans& )his is not relevant as a monopoly since there are many good substitutes. plastic or steel containers or even brown paper bags will serve as trash containers& )here are substitutes for the electricity (KGF) produced by a public utility& Dt is possible to purchase a portable generator powered by an internal combustion engine or use candles for use in your home& Fowever, neither of these can be regarded as a close substitute& )he concept of cross elasticity of demand can be used to identify whether two goods are substitutes on not&

( &ross price elasticity of demand ) E >@

[X Q X [X P Y [ a change in the 4uantity of good >, caused by a change in the price of good Y ]
arriers to entry are another important characteristic of monopoly&

Complete barriers to entry ( )*) make it impossible for competing firms to inter a market& Fowever, in n most cases, )*(s can be due to. )* are not complete but are relative& :irms( entry into a market can be restricted by a variety of factors&

177

1".1 Monopo!y

'he ownership of a key resource or location maybe important* A-&$A1s monopoly in aluminum was at first due to a patent on a low cost process to reduce bau(ite into aluminum* After the patent e(pired, their ownership of bau(ite reserves allowed them to maintain their monopoly position* /n earlier times there may have been only one location on a river where a dam could be built to power a gristmill* A movie theatre gains monopoly power over its sale of popcorn by prohibiting customers from bringing their own food into the theatre* /nformation or knowledge not available to others* 3/ndustrial secrets5* Bnowledge about a process may kept secret 3rather than using a patent since patent information is publicly available5* -egal barriers such as license, franchise, patent, copyright, etc* A-&$A1s monopoly began when the government gave them a patent on a low cost method of reducing bau(ite to aluminum* $ther methods of making aluminum are possible but cannot compete with the method pioneered and patented by A-&$A* A State park might license a firm to provide prepared foods within the boundary of the park* 'his would confer market power on the firm unless their price was regulated* A city that licenses a ta(i company gives them market power* 'hey may license several ta(i companies so that there is some competition and or they may regulate the services and rates* Public utilities often have a license to operate in a specific area* /n return for this monopoly power, they are sub0ect to regulation* /n fact, the British colonies that became the United States and &anada were the result or grants from the British government* Iudson Bay &ompany and the Dast /ndia &ompanies were firms that were granted rights to operate in specific areas* 6atural monopoly caused by economies of scale usually associated with a cost structure with a high fi(ed cost relative to variable costs* A natural monopoly is the result of significant economies of scale due to a high fi(ed cost* As the output increases the -AA& falls* /f the market demand intersects the -AA& as it falls 3or at its minimum5, a natural monopoly e(ists*

178

1".1.1 Profit Ma+imi.ation In a Monopo!y

T1, TC (')

T1<

1< <T

TC

TC<

C<

T1 E<ET Fig#re V222)1 EI#t

11#1#1 P&'-$T +A=$+$9AT$'% $%

+'%'P'25

Since a monopoly is characteri,ed by a single seller, the market demand

and the demand faced by the firm are the same& )he demand will tend to be negatively :igure 3DDD&1 represents profit maximi,ation by a firm in a monopoly market& )he )% function increases up to an output level of O ) then it declines& %emember that any negatively sloped demand function is elastic at high prices (top half of demand where price increases reduce )%) and inelastic at low prices (bottom half of demand where price increases increase )%)& )he )C increases at a decreasing rate, passes an inflection point and then increases at

179

1".1.1 Profit Ma+imi.ation In a Monopo!y

an increasing rate& -aximum profits is occurs at the output level where )% T)% by the greatest vertical distance& )his occurs at output O -& $rofits are reflected by the vertical distance, C -%-, or )%--)C-& #t point C- the slope of the )C (-C) is the same as the slope of the )% at point % - (-%)& )he maximum )% occurs at point - ) at output level O)& Df the firm increases output from O- to O) profits will decrease because the costs of the additional units (O)-O-) is greater than the additional revenue produced by those units of output& 0nit cost and revenue functions can also be used to show the output and price decisions of a monopolist& Dn :igure 3DDD&1 the demand, #%, -%, -C and #C cost functions are shown&
/n Cigure P///*!, revenue and cost functions for a monopolist are shown* 'he demand and AA are negatively sloped, so the A falls at twice the rate and intersects the =; a(is half way between the origin and AA 3or demand5 intercept* 'he firm will ma(imi2e profits where & H A 3at point T5 producing = I output* Buyers are willing and able to pay a price of PI for the =Ith unit produced 3they would be willing to pay more for units from " to =I, but don1t if there is no price discrimination 'he cost per unit is &C, so profits are area &CCIPI or 3P I;&C5=I* Profits are above normal but B'D prevent others from entering the market to capture the above normal profits*

Price

M$

P: $E
$F $$

: E
F

+$

$ +R A =E =Mut

MR 5 =: =$

Fi"!re J,,,.B

:igure 3DDD&1 represents a monopolist& Dn the long run the monopolist might adEust the scale of plant, but )* prevents other firms from entering and driving profits to normal& -onopoly or market power is suggested by two

17A

1".1.1 Profit Ma+imi.ation In a Monopo!y

things& :irst, the price is greater than the marginal cost ($T-C)& Secondly, above normal profits will persist over time&

11#1#2 $+PE&-E*T *'+PET$T$'%

A%(

+'%'P'2$,T$* *'+PET$T$'%

During

1B55 *dward F& Chamberlin ?1ABB-1B89@ and Hoan %obinson

?1B25-1BA5@ independently published similar theories on ;monopolistic< and ;imperfect< competition& )he terms ;monopolistic competition< and ;imperfect competition< originally were basically the same even though there were subtle differences& Currently, the use of ;imperfect competition< is more generic, it refers to all market structures that lie between pure competition and monopoly& Dn this usage monopolistically competitive and oligopolistic markets are considered imperfect& -onopolistically competitive markets are characteri,ed by.
a large number of sellers, no one of which can influence the market, differentiated products, relative free entry and e(it from the market*

%elaxing the characteristic of outputs from homogeneous to ;differentiated products< was the basic change from the purely competitive market model& )he differentiation of output results in the demand faced by each seller being less than perfectly elastic& Since there are ;many sellers,< many substitutes for each seller(s output is implied& )his suggests that the demand faced by a firm in a monopolistically competitive market is likely more elastic than in a monopoly& )he elasticity obviously depends on the preferences and behavior of the buyers& )he negative slope of a firm(s demand function in imperfect competition results in a different result than in pure competition&

17B

1".1.$ Imperfect #ompetition and Monopo!istic #ompetition

)he conditions of entry and exit to and from a monopolistically competitive market are similar to the purely competitive market. there are no maEor )*& *ntry and exit are relatively easy& )he relative ease of entry/exit makes the long run results of an imperfectly competitive market different from a monopoly&

11#1#1 (E+A%( -A*E( *'+PET$T$3E -$&+

:5

+'%'P'2$,T$*A225 ($+PE&-E*T25)

The

market demand is the result of a hori,ontal summation of the

individual buyer(s demand functions& )he market demand function can be divided among the sellers& # simplified example is shown in :igure 3DDD&5& Df A2 units are demanded in the market at a price of R7, a sum of A2 units is demanded from the sellers in the market& )o simplify, assume 5 firms in the market& )he demand for firm #(s product at R7 is 19 units& )he demand for firm (s output is 52 units& )herefore, 55 units of output from firm C must be demanded& Df a fourth firm entered the market, there is no reason to believe that the buyers would desire more at a price of R7& )he demand for one or all firms( products would necessarily shift to the left (decrease in demand) by the same number of units that the entrant (firm C) would sell at that price&
N (a (b -i"ure 3$$$#1

)he entry of firms will mean each existing firm will have a smaller share of the market and are faced by more implies each substitutes& that firm the faces *ntry demand for its

N@

(+

17 182

10 11

?0

E!ut

1".1." 3emand ;aced y Monopo!istica!!y 6Imperfect!y7 #ompetitive ;irm

product will decrease (shift to the left) and become relatively more elastic at each price& *ach firm would like to capture a larger share of the market and make the demand for its product more inelastic& #dvertising is an attempt to alter buyers( perceptions and increase the demand& *conomists identify two types of advertising. informative and persuasive& Dnformative advertising provides buyers with information about availability, features and relative prices& Dt helps the market to perform allocation processes& # grocery who advertises milk at R1&5B per gallon in its store (plant) at the corner of Figh Street and roadway, has helped the market to perform& $ersuasive advertising is an attempt to alter preference functions& Criving a new S03 makes one a member of the right social group& Smoking a (given brand) makes one sexier or more macho, independent or whatever& Dt is not clear that persuasive advertising improves the ability of the market to allocate resources& Dt must also be noted that advertising increases the costs of the firm and alters the output decisions and profits&

11#1#4 P&'-$T +A=$+$9AT$'% *'+PET$T$'%

$%

$+PE&-E*T

'&

+'%'P'2$,T$*

If the firm in an imperfectly competitive market has profit maximi,ation

as an obEective, they will produce the output where marginal cost is e+ual to the marginal revenue& Short run profit maximi,ation is shown in :igure 3DDD&6&

181

1".1.( Profit Ma+imi.ation in Imperfect or Monopo!istic #ompetition

Short run profit ma(imi2ation for a firm in imperfect competition occurs at the output =W* 'his output level is found at point W where AH &* At this level of output, the vertical intersects A& at A* 'he firm is producing =W units at a cost of &% per unit* 'otal cost 3'&5 would be &%=W or area "=WA&% 3the area in yellow5* 'he firm can sell =W units at a price of P%* 'otal Aevenue 3'A5 is P%=W or area "=WIP%* Profits 38 H'A;'&5 are shown by area &%AIP% or 3P%;&%5=W* Short run e4uilibrium in monopolistic competition resembles the e4uilibrium conditions in a monopoly* Iowever, entry in monopolistic competition will drive profits to normal in the long run*

Q M$ +$ P*
$* R E :

A, +R

MR "
=E =M

=H!t

Fi"!re J,,,.2

Dn the long run, above normal profits will attract the entry of firms into monopolistic competition& elow normal profits will encourage firms to exit& #s firms enter the market demand is split among a larger number of firms which will shift the demand for each firm to the left (decrease) and probably make it more inelastic& )here are more substitutes& *xit of firms will shift the demand for each firm(s output to the right (increase)& *ntry to and exit from the industry occur until the profits for each firm are normal, i&e& the #% N #C& )he results of long run e+uilibrium in a monopolistically competitive market are shown in :igure 3DDD&7& )he logical result of profit maximi,ing monopolistically competitive markets is to encourage firms to build plants that are smaller than optimal, i&e& a larger plant can produce with fewer inputs per unit of output (or costs per unit of output)& :urther inefficiency is expected since the inefficient plant is operated at an output level that is less than the minimum point on the S%#C& )his result is due to the fact that the -% must be lower than #% when #% is negatively sloped& )herefore -%N-C at less than the price which lies on the demand (or #%) function& Since the demand is negatively sloped and #C is usually 0-

181

1".1.( Profit Ma+imi.ation in Imperfect or Monopo!istic #ompetition

shaped, the point of tangency between #% and '%#C (normal profits) will lie to the left of the minimum cost per unit of output& )his is sometimes called the ;excess capacity theorem.< firms build plants that are too small and operate them at less than full capacity&
Above normal profits attract firms to enter the market* 'he demand for each firm1s output is reduced and becomes more elastic 3shifts to the left and is flatter at each price5* /f AA is less than -AA& firms leave and demand faced by each firm increases* D4uilibrium is attained when AA H A& and firms cannot make ad0ustments to increase profits above normal* Ohere A? &, at point W, the firm produces =W output that is sold at a price of P%* At =W output, the cost per unit of output is also P%* Cirms are earning a normal profit* 6ote that P% is necessarily above & and the firm has a plant si2e that is less than optimal and operates at less than the minimum cost per unit*

LRM$ LR+$

*R+$*

P*
M$*

A, +R MR

=E

=H!t Fi"!re J,,,.4

1".2 O!IGOPO!Y

An oligopoly is a market that is characteri,ed by the interdependence of

firms& )he outcomes that follow from the decisions of one firm are dependent on what the other firms do& #ugustin Cournot (1A21-1A99), a :rench mathematician/economist developed the theory of monopoly and then considered the effects of two interdependent competitors (sellers) in a 5uo.o1y& Cournot(s analysis of two sellers of spring water clearly established that the price and output of one seller was a reaction to the price and output of the other seller& Df the two collude they can act as a single monopolist and

185

1".$ =!igopo!y

divide monopoly profits& Df they compete, Cournot concluded that the output

would

be

N< times the competitive output& #s the number of ( N= # )

competitors (") increases, the result approaches the purely competitive result& Cournot(s recognition of the interdependence of sellers provided the foundation for a variety of approaches to explain the interdependent behavior of oligopolists& Dn the 1B52(s the ;kinked demand< model ?published by $aul Swee,y in #ugust 1B5B and by %&'& Fall and C&H& Fitch in -ay 1B5B@ and the ;administered price hypothesis< ?=ardner C& -eans in 1B57@ were developed as an attempt to explain price rigidities in some markets during the great depression& Dn 1B65 Hohn von "eumann and 4skar -orgenstern published a path breaking work on game theory& =ame theory has been used to try to explain the behavior of independent competitors& )here have been a variety of other models that attempted to explain the interdependent behavior in oligopolies& )he number of models is evidence that it is a difficult task and there are problems with most approaches& )he kinked demand model is used here to emphasi,e the interdependence of oligopolistic behavior rather than to explain the determination of price&

11#2#1 <$%<E( (E+A%( +'(E2

The kinked demand model begins with an oligopoly that has two sellers of
a homogeneous good& )he typical characteristics that constitute an oligopoly are.

186

1".$.1 :in/ed 3emand Mode!

A )few+ firms: the concept of )few+ means that there are few enough sellers that they recogni2e their interdependence* 'he output may be homogeneous or differentiated* Primary metals industries are e(amples of oligopolies with homogeneous goods* /nstant breakfast drink mi(es are an e(ample of an oligopoly with differentiated products* /n an oligopoly there are usually significant barriers to entry* :igure 3DDD&8 is a graphical representation of the demand and revenue functions of a firm in a oligopoly that is modeled as a kinked demand&
A
A single firm in a two firm duopoly is represented* 'he current price is P and output is =* Point I must lie on )the+ demand function* 'he nature of the perceived demand depends on what the firm believes its competitor will do* 'here are two possibilities with respect to price* Dither the competitor will follow every price change or they will ignore every price change* D%D% assumes the competition will follow every price changeL DD assumes that price changes are ignored* A% is associated with D%D% and A is associated with DD* /f there is )e(cess capacity+ the firm may realistically e(pect that their price cuts will be followed and price increases will be ignored* 'he demand for price increases is D%I and for price cuts is ID* 'he total demand is D%ID* 'he sections of the A associated with the demand D%ID is D%W, then a gap from WC and then the remainder of A* M$-

Q
M$B

A*

MR

MR* =H!t

= Fi"!re J,,,.3

)he kinked demand model is dependent on the firm believing that the competitor will follow price cuts but not price increases& Df there is additional capacity available (firms can increase output without increasing plant si,e), a price cut will followed& )he reasoning is that if the competitor does not follow the price cut, firm will entice customers away from the competitor& )herefore, the competition must follow price cuts or lose customers and sales& )he demand function relative to price cuts in inelastic. cut price and )% falls& )he perception is that the competition will not follow a firm(s price increases& Df they do not follow they will get the firm(s customers and sales& )he demand above the prevailing price is relatively elastic. raise price and )% falls& #t the

187

1".$.1 :in/ed 3emand Mode!

prevailing price, there is a kink in the demand function and an associated gap or discontinuity in the -% (shown as the gap from H to : in :igure 3DDD&8)& )he marginal cost function can rise to -C1 or fall to -C1 with no change in output or price& )he kinked demand model of the =reat Cepression was used as evidence that concentrated markets were rigid and failed to respond to changing conditions& $ro market advocates obviously attached the model and its conclusions& #ll models of market structure must be considered as examples& Ghen

analy,ing a market, it is not a mater of selecting and applying one of the market models presented in principles of microeconomics& !ou must consider all the relevant characteristics of the firms and the market and then construct a workable model to explain the +uestion you have asked&

11#2#2 PE&-'&+A%*E

The

function of a market system is to provide the information and

incentives that will result in the allocation of relatively scarce resources and goods to their highest valued use within a social system& :rom an e+uity perspective we tend to believe that anyone who uses or consumes a good should bear the opportunity costs that result from that use& )he price should e+ual the marginal cost& %ational consumers will buy goods so long as their marginal benefits are greater than or e+ual to the price they pay& Sellers will produce and offer goods for sale so long as the marginal cost of producing the goods is less than the price they can get& )he optimal allocation of resources is characteri,ed by the simple e+uation.

+: A P A +*
'ong run e+uilibrium in purely competitive markets is the ideal and provides the benchmark for market performance& #s market power is

188

1".$.$ Performance

increased the price tends to rise above the -C suggesting less than an optimal allocation& Ghen price is greater than -C, it should be considered as evidence that something may be amiss& Dt does not mean that it must be corrected& Hust as a body temperature of BB&A2 suggests a problem it does not mean you should be taking an antibiotic or undergoing surgery& Dn a market the price may exceed the -C but the cost of correcting the problem may exceed the benefits of the correction&

189

1( Mar/ets for Inputs and 3istri ution of Income

14 +A&<ET,

-'&

$%P)T, A%( ($,T&$:)T$'% $%*'+E

'-

The factor markets allocate the factors of production among the various
producers/sellers& Dn a market economy, the inputs ?land Q, labor ('), capital (K) and entrepreneurial ability@ are owned by individual agents who make decisions about the amount of each input they want to supply& )he decisions of the producers determine the demand for the inputs& %emember that the decisions of the producers reflects the preferences and ability Dn the "oods /arkets, each individual consumer will maximi,e their utility

UX PX

UY PY

= =

UN PN

, sub0ect to: P X Q X + P Y Q Y + + P N Q N BUDED'

when.

)his is an

e+uilibrium condition& )he

consumer

cannot

alter

their

expenditure and improve their welfare or increase their utility& Dncome (budget), preferences (-0 ") and the relative prices determine the outcomes& )he market demand reflects these conditions to the market& )he demand function is a schedule of the maximum price (reservation price) that buyers are willing and able to pay for a schedule of +uantities of a good in a given period of time (ut), ceteris pari us& )he supply function in the market reflects the opportunity cost or producing each unit of output& Dt can be defined as the minimum price (reservation price) that the seller will accept for each unit of output& -arket e+uilibrium is determined by the interaction of the buyers and sellers&

18A

1( Mar/ets for Inputs and 3istri ution of Income

)he e+uilibrium of the buyers and market e+uilibrium depends on the income of the buyers& )he way in which income is distributed in a system determines the allocation decisions& )he Eudgment about the criteria used to distribute income has both an ethical and efficiency dimension& Dn most social groups, it is considered desirable that income be distributed in proportion to the contributions to the achievement of obEectives& Clearly, most societies make exceptions. most societies refuse to let individuals who are incapable of making contributions do without resources and goods to support life& Dn industrial societies there is a range of Eudgments regarding what things should be provided& #t one extreme few resources are provided& #t the other extreme a higher level of comfort is considered appropriate& :rom an efficiency perspective, each factor should receive a share of income in proportion to the factor(s contribution to the value of the output& Hohn ates Clark (1A69-1B5A) was one of the architects of the ;marginal productivity theory of income distribution&< Dn concept the idea is simple, in practice it is difficult to measure the contributions of each factor to the production process& )he production process was described by a production function& Dn its simplistic form it is. E A 0(labor6 kaptial6 land6 technolo".6 # # # ) )he marginal product of each factor describes the contribution of each factor to the production of the output& )he marginal product of a factor can be described as.

P;

X= , the change in output ( Q ) $au!e% by a change in ; ( the factor ) XC

Gith the use of calculus the marginal products of a set of inputs can be described as partial derivatives& =iven a production function.

18B

1( Mar/ets for Inputs and 3istri ution of Income

O N #'K , the marginal products of the factors is.

Q = 4>L >< K ? L Q PK = = A- > K ?# K PL =
Df the marginal products are known and the relative prices of goods in the markets reflect the values of the outputs, the value of each factors contribution can be calculated as the product of -$ : and the price of the output& )he marginal productivity theory of income distribution suggests that the income share each factor of production should receive is determined by the marginal product of the input and the price of the output& )he change in the value of the output associated with a change in an input is called the value o0 /ar"inal product (3+P) or the /ar"inal revenue product (+&P)& 4riginally the 3-$ was used to describe the demand for an input into production process for a purely competitive firm and the -%$ was used to describe the demand for an input used to produce a product where market power (a negatively sloped product demand) existed& -ost texts currently use -%$ as a generic term that covers both 3-$ and -%$&

1#.1 A. T

DEMAND

FOR

INPUTS

The demand for a factor of production is a derived de/and# !ou do not

have a direct demand for an auto mechanic. rather you have a demand for an automobile that functions properly& )he demand for the mechanic is a derived demand& !ou probably do not have a demand for 1>6(s (they really aren(t 1< by 6<), you have a demand for a house that is constructed with the lumber& )he demand for an input is determined by the relative value of the good produced and the productivity of the input&

192

1(.1 0. The 3emand for Inputs

)he demand for an input can be derived by using the production function (the -$ for an input) and the price of the good& )he marginal revenue product is shown in )able D>&1& )able D>&1 shows a short run production function& Capital is fixed at 6 units& #s labor is added, the output (O or )$) increases at an increasing rate& Dn this example the marginal product of labor (-$ ') declines from the first unit& )his makes the -%$' or demand for labor less messy& )he constant price at all levels of output ($ > N R11 at all output levels) is the result of the firm being in a purely competitive market. the demand faced by the firm is perfectly elastic& )he marginal revenue product is a measure of the value of the output that is attributable to each unit of the input& )he first unit of labor ;produces ; A units of output (-$' N A)& )hese A units of output can be sold for RAA ($>NR11, -$'1N A. so $>Z-$'N AZ11NAA)& )he maximum that an employer would be willing to pay the first unit of labor would be RAA& )he -%$ of the second worker is R99& )he second worker produces 9 units of output valued at R11 each&

191

1(.1 0. The 3emand for Inputs

Table XI.1 Short Run Demand for Labor in Pure Competition Kaptial (fixed) Labor (L) $ $ $ $ $ $ $ $ $ $ % 1 ( + $ ) , * ' ! TP % ' 1) (1 (, +% ++ +) +, +, ' * , ) $ + ( 1 % "PL Produ#t pri#e! PX &11 &11 &11 &11 &11 &11 &11 &11 &11 &11 &'' &** &,, &)) &$$ &++ &(( &11 &% ("PL)PX "RPL

)he -%$ of each unit of input is the maximum an employer would be willing to pay each unit of input and can be interpreted as a demand function& "otice that if 57 units could be sold, 9 units of labor would be hired& )he -%$ '9 is R11& )he maximum the employer would be willing to pay the 9th unit of labor is
Q
3Oage5

)he -%$ is the maximum the employer will pay each unit of labour in a given period of time given the productivity (-$) and the price of the output ($>)& #t a wage of G%, the firm will hire " workers& #ll " workers are paid the same wage rateb i&e& there is no price discrimination& )he wage bill or expense is shown as area 2"%G%, measure by "G%& the producer surplus is area G%%#& )he producer surplus is not the same as profit& )he payment to the fixed factor must be subtracted from the producer surplus to calculate profit&

8R

MRPL 5 ) Fi"!re ,6.LH!t

191

1(.1 0. The 3emand for Inputs

R11& Gage/price discrimination is technically illegal, all workers are paid R11& )he employer gains R88 on the first unit of labor (RAA-R11), R77 on the second, R66 on the third, R55 on the forth, R11 on the fifth, R11 on the sixth and nothing on the seventh& )his is shown graphically in :igure D>&1 )he -%$ of an input used by a firm with market power (a negatively sloped demand for it output) is shown in )able D>&1&

Table XI.( Short Run Demand for Labor .or .irm in Imperfe#t Competition or "onopol/ Kapital (fixed) $ $ $ $ $ $ $ $ $ $ Labor (L) % 1 ( + $ ) , * ' ! TP % ' 1) (1 (, +% ++ +) +, +, ' * , ) $ + ( 1 % "PL Produ#t pri#e! PX &1+ &11 &1% &&' &* &, &, &, &,.%% &-1 &*% &)+ &+-.%% &(' &1&1( &, &% ("PL)PX "RPL

"ote that the only difference in )able D>&1 and D>&1 is that he price of the output must be decreased if more units are to be sold& )his makes the demand for the input relatively more inelastic&

195

1(.1 0. The 3emand for Inputs

Q 8: &

8R :

E Cigure />*!

LMut

14#1#1 ,)PP25

'-

$%P)T,

The individual agent who owns the input will decide how much of a factor
they want to offer for sale at each price offered for the input& # worker must decide how many units of labor (hours, days, weeks, years, etc) they will offer for sale at each possible wage rate& )he supply of labor is a function of the wage rate, the value of leisure, alternatives available, taxes and other circumstances& =enerally it is believed that more labor will be offered for sale at higher wage rates, up to a point& 4wners of other factors of production (land, capital, entrepreneurial ability) make decisions that determine the supply functions of those factors& :igure D>&1 illustrates several possible supply functions& )he segment F= is one possibility, it represents a supply where & #t a wage rates higher than G F, the worker is willing to offer more labor at higher wage rates& )he maximum labor that will be offered for sale is at point the supplier substitutes leisure for income and offers less labor for sale as the

196

1(.1.1 Supp!y of Inputs

wage increases& #nother possibility is a supply of labor that is represented by segment G%= & # hori,ontal segment at the prevailing wage rate is caused by a worker or workers who refuse to work at any wage that is less than the prevailing wage, G%&

14#1#2 +A&<ET

-'&

$%P)T,
an
N 74 , 8 :

The

market

for

input includes all potential buyers and sellers of an input& )he demand reflects the decisions of the buyers of the inputs and is based on the -%$ for the factor& )he supply function represents the decisions of the factor owners to supply the input at various prices& :igure D>&5 represents a market for labor& -%$

7& 72

+&P +&P1

w4

2/ut

:igure D>&5

represents the demand and S is the supply of '& )he market e+uilibrium occurs at point = where the +uantity of labor offered for sale is e+ual to the +uantity of labor that is demanded at a the wage rate G %& H units of labor are hired& #n increase in the productivity of labor or the price of the good produced ($>) will increase the demand (-%$)& # decrease in productivity or $> will shift the -%$ to the left (-%$ 1)& Df worker are unwilling to work for less than the market wage, G%, the supply is represented by line G%= & )he level of

197

1(.1.$ Mar/et for Inputs

employment would fall to : units of labor& Df F=

were the relevant supply,

unemployment would fall to ) units and the wage would fall to G '& Df the -%$ increased so the wage rate exceeded G F, workers would supply a smaller +uantity of labor in a given period of time&

14#1#1 $%*'+E ($,T&$:)T$'%

Income

distribution can be described as a functional or personal

distribution& )he functional distribution of income describes the allocation of income among the factors of production& )he distribution of income among the members of society, individuals and families, is called the personal distribution of income& #dam Smith, Cavid %icardo, Karl -arx and other early economists were primarily concerned about the distribution of income among social classes that were partially based on economic criteria& Curing the feudal era labor (serfs) and land owners (aristocracy and church) were the important factors of production& =enerally, the social classes were the serfs, aristocracy and clergy& *conomic behavior was coordinated by a complex set of social institutions that were based on deontological ethics (duty)& %eciprocity and command were the primary organi,ing mechanisms& -arkets existed and were used in many cases& -arket towns and fairs were used to allocate some goods while labor, land and many goods were allocated through obligations specified by tradition and command& )he personal distribution of income describes the allocation of income among economic agents& Dn most modern, industrial societies, markets are the primary organi,ing institution of economic processes& -arkets determine the allocation of income as well as the allocation of scarce resources& 4ther social

198

1(.1." Income 3istri ution

institutions such as welfare and philanthropy play a minor role in the personal distribution of income& Drvin )ucker (microE#=&=MI#S for Today, South-Gestern 1222, p 1A5) shows the distribution of income based on the head of household& Fis data is based on the Census data and is shown in )able D>&5&

Table $=#1 $nco/e (istribution :ased on 4ead o0 4ousehold - 1HH7

Drvin )ucker, microE#=&=MI#S for Today, South-Gestern 1222, p 1A5

*haracteristic :. 4ead o0 4ousehold

+edian $nco/e

#ll :amilies -ale :emale #ge 17-56 #ge 87P Fead non Figh School =rad Fead Figh School =rad Fead with achelor(s degree

R66,78A R51,B82 R11,215 R5B,B9B R52,882 R17,687 R62,262 R89,152

)he information in )able D>&5 poses several issues& Ghen considering income distribution by age of household, there is a ;life cycle< of a person(s earnings and needs that should be considered& Dt should be noted that the distribution of wealth and income are two related but different problems& #nother issue is the role of education and training& Cisease and the industrial revolution significantly altered the social classes and the distribution of income& )echnological change is a fundamental feature of modern industrial societies and will change the nature and role of education and training in the distribution of income&

199

1(.1." Income 3istri ution

# ;'oren, Curve< can also describe the personal distribution of income& # 'oren, curve can be used to show either the distribution of income or wealth and can be applied to the world, a country or a sub category of individuals (the military, lawyers, or & & & )& # 'oren, curve plots the cumulative proportion of income units and cumulative proportion of income received when income units are arrayed from lowest to highest& )he data for a 'oren, curve is shown in )able D>&6& (Drvin )ucker, microE#=&=MI#S for Today, South-Gestern 1222, p 1A1) )he income distribution is arrayed from lowest to highest& )he data in )able D>&6 suggest that the income distribution became more e+ual from 1B1B to 1B92 and less e+ual from 1B92 to 1BB9& )he trends in income distribution are subEect to controversy& )here are many forces that influence income distribution& Dt is highly unlikely that the -%$ is the single determinate of the income share received by a factor or individual who owns the factor& $olitical forces, technological change, tradition, law and a variety of other forces influence the distribution of income& Ciscrimination by gender or race are hotly debated issues&

19A

1(.1." Income 3istri ution

Table $=#4 $nco/e (istribution A/on" -a/ilies 1H2H-1HH7 M :amilies 1B1B 1B92 'owest 12M 5&7 5&7 7&7 7&7 Second 'owest 12M -iddle 12M Second highest 12M Fighest 12M Fighest 7M 2M B&2 M 15& AM 1B& 5M 76& 6M 52 M 11& 7M 18& 5M 67& 8M 122 M
Cumu lative

1BB9 6&1 M B&B M 17& 9M 15& 2M 69& 1M 12&

6&1 M 16& 1M 1B& AM 71& AM 122 M

Cumul ative

M 11& 1M 19& 8M 15& AM 62& BM 17&

M 19& 9M 57& 5M 7B& 1M 122 M

Cumul ative

M 8M 9M # 'oren, curve is usually shown as plots of the cumulative proportion of income units and cumulative proportion of income received when income units are arrayed from lowest to highest& Dn :igure D>&6 data from 1B1B, 1B92 and 1BB9 are compared to an e+ual income distribution& #n e+ual income distribution is shown as a diagonal line # & )he further the 'oren, curve deviates from the diagonal, the more une+ual the distribution of income&

19B

1(.1." Income 3istri ution

-55S

&

$!m!lati%e S of ,ncome

45S

ELual (istribu tion o0 $nco/e

-/05

-/B/
)neLual distribution o0 $nco/e

-//0 +

5S

45S $!m!lati%e S of Families Fi"!re ,6.2

-55S

1A2

1A Property Rights and Mar/ets

1@ P&'PE&T5 &$84T,

A%(

+A&<ET,

The optimal solution to the allocation problem re+uires the participants to

have accurate information about the marginal costs and marginal benefits associated with specific alternatives& -ost of "eoclassical microeconomics is a story about the way market exchange reveals, communicates and uses individual evaluations about marginal benefits (- ) and marginal costs (-C)& )he information about -C and revealed by market exchanges (like all information) is never perfect& $roblems arise when exchange is not voluntary and property rights are attenuated& $ure competition is one way to ensure that no one buyer or seller has the ability to alter the outcome of market exchanges and the information revealed in prices& )he existence of market power allows a buyer or seller to influence the outcome of a market exchange and distort the information about and -C&

#ttenuated or weakened property rights also may distort information about and/or -C and result in an allocation that is less than optimal& ;"onattenuated< or strong private property rights have three important characteristics. exclusive, enforceable, and transferable&

1&.1 PRIVATE PROPERTY RIG

TS

Private

property

rights

have

three

important

characteristics

that

contribute to the efficient functioning of the market. exclusivity, enforceability and transferability& # lack of any one of these characteristics will distort market exchanges and result in less than optimal results& :uruboton and $eEovich define property rights as.
Property rights are understood as sanctioned ehaviora! re!ations among men KsicL that arise from the e+istence of goods and pertain to their use. These re!ations specify the norms of ehavior 'ith respect to goods

1A1

1A.1 Private Property Rights

that each and every person must o serve in his dai!y interactions 'ith other persons% or ear the cost of non?o servance. The term good is used here for anything that yie!ds uti!ity or satisfaction to a person. Thus% and this point is important% the concept of property rights in the conte+t of the ne' approach app!ies to a!! scarce goods. The concept encompasses oth the rights over materia! things 6to se!! my type'riter7 as 'e!! as Bhuman@ rights 6the right to vote% pu !ish etcetera7. The prevai!ing system of property rights in the community is% them% the sum of economic and socia! re!ations 'ith respect to scarce resources in 'hich individua!s stand to each other. ?*riik :uruboton and Sveto,ar
$eEovich, )he *conomics of $roperty %ights, Cambridge, -ass&. p 5@ allenger, 1B96,

)his definition implies that an individual has a bundle of rights or claims empowering him or her to control the outcome of specific events or alternatives& Secondly, it implies these claims are sanctioned by social institutions and are social in character& $rivate property rights implies that the individual has the power to determine the use of an economic ;good< and incurs all benefits and cost associated with that use&

1&.2 TRANSFERA$I!ITY

Clearly a good must have property rights that can be transferable before
it can be exchanged in a market& Dn some cases it may be physically impossible to transfer a property right (D cannot buy some one else(s good health or height or athletic skills)& Dn other cases it may be illegal to transfer or ac+uire the property rights to a good (D cannot legally sell my kidney in the 0S or 0K)& Dn cases where it is technically possible to transfer a property right but illegal, a ;black market< may emerge& $art of the cost of ac+uiring or selling a good is the risk an punishment of violating the law& )here is a large literature on the economics of crime not addressed here&

1&." ENFORCEA$I!ITY
$roperty rights can be enforced in formal or informal ways& oth #dam Smith and Karl -arx believed that one of the primary functions of government

1A1

1A." Enforcea i!ity

was to enforce property rights& *xplicit laws enforced by the state are often used to define and determine the nature of property rights& $roperty rights can also be enforced by implicit social institutions& %espect for others and social sanctions are important determinants of property rights& )he property rights to ;material things< are more obvious and clear cut than intellectual property rights& )he property rights to computer software, books, music and the like are more difficult to define and enforce due the nature of the goods and the technical ability to copy and communicate& $atents and copyright laws are attempts by the government to assign and protect property rights&

1&.# E9C!USIVITY

,hen private property rights are exclusive, all the costs and benefits of
an alternative are exclusive to the person(s) engaged in the exercise of the property right& Dn some cases the exchange or use of an economic good may have ;third-party< or ;spillover< effects& )here may be costs or benefits that impact individuals who are not engaged in the actual use of the good& Ghen this happens it is called an externalit.& *xternalities can be positive (a benefit is conferred on a third party) or negative (a cost is imposed on individuals)& )hese externalities may occur in consumption (smoking a cigar can impose costs on others) or production (producing paper generates air and/or water pollution)& Dn some cases it is technically impossible to exclude (prevent an individual) individuals from the consumption and benefits of a produced economic good& )hese are called collective or public "oods& "ational defense is an example of a public good& Dn other cases it may be technically possible to exclude

1A5

1A.( E+c!usivity

individuals from the benefits of a good but the cost of doing so makes it impractical& )hese are often referred to as Luasi-public "oods& )here are also ;fugitive or fugacious< goods& # fugitive good is one that is owned by no one until some one ;captures< it& )he process of capture and use of these goods imposes cost on others& )hese goods are called ; co//on propert. resources&<

1&.& 6MAR+ET FAI!URE7

AND

PROPERTY RIG
information

TS

,ith
common resources&

the presence of externalities, public or collective goods and property resources, the generated by market

transactions may be distorted and incorrect signals result in misallocation of

1@#@#1 E=TE&%A2$T$E,

Externalities may be positive or negative&

P',$T$3E E=TE&%A2$T5

# positive externality exists when there market transaction or the use of a good& Dn :igure is >& &1 a positive H &
> >% =uan, > Cigure >*B*#

M& and M$

are ;Social

enefits< that result from a

M$

P% P A M&P (to t7e

,ndi%id!al)

M&P T M&*

externality

shown&

Dndividual

perceives the marginal costs of > as -C and the marginal benefits as )o optimi,e the net want benefits > individual would
$

the

amount&

Fowever, there are other individuals

1A6

1A.A.1 E+terna!ities

who benefit from the H(s use of good >& )he )he marginal benefit to society is $

of others or society is -

&

P-

& the optimal amount of good > is

>Z, not >& Dn the case of a positive externality, market exchanges result in less than the optimal amount of the good& 4ne solution is to subsidi,e good > by the amount 3Z-#&
%E8AT$3E E=TE&%A2$T5

# negative externality exists when an

M& and M$

M$P T M$*

alternative

results

in

costs

being

imposed on individuals who are not involved with the transaction or use of the good& #n individual who smokes a cigarette in a restaurant has made a decision to smoke based on the

M$P P% P + M& >%% > Cigure >*B*! =uan, >

marginal benefits and marginal costs to themselves& )he second hand costs impose marginal costs on others& Dn :igure >& &1 the individual recogni,es the costs and benefits to themselves as -C$ and - $& %ecogni,ing these costs and benefits, the individual will maximi,e net benefits by consuming > amount of good >& Since the consumption of good > imposes costs on others, the -$$ P -$S reflects the marginal costs to the individual and society& )he optimal amount of the good from a social perspective is >ZZ rather than >& # negative externality results in decisions to produce and consume more than the socially optimal amount of a good& 4ne solution is levy a tax of 3Z-# on good >&

1A7

1A.A.$ Pu !ic or #o!!ective Doods

1@#@#2 P):2$*

'&

*'22E*T$3E 8''(,

public good has two important characteristics& :irst, it is technically

impossible to exclude any individual from consuming the good& Second, the marginal cost of the additional consumer is ,ero& )he optimal result in a market is that the output occur at the level where the N -C and the price should reflect both the +: A P A +* Ghen the -C of another user is ,ero the optimal price is also ,ero& Dt is not possible for a private provider to produce and offer a public good for consumption (unless they are an altruistic philanthropist)& "ational defense is the primary example of a public good& # private market will not produce a public good& Since individual cannot be excluded and there is no reason for them to contribute to the costs of production, they become ;free riders&< Dn some cases free riders can be encouraged to contribute through social mechanisms such as feelings of philanthropy or guilt& Dn cases where a society decides to undertake an alternative, and an individual prefers not to be a participant, the individual may become a forced rider& and -C.

1@#@#1 *'++'% P&'PE&T5

A common property resource is a fugitive resource that is owned by the

individual who ;captures< it& )he use of a common property resource imposes costs on others in the society& uffalo, whales, ;commons< and water +uality are examples of common property resources& =arret Fardin(s article on the Tragedy of the #ommons discusses the tradition of a common pasture in villages& *ach person can use the commons

1A8

1A.A." #ommon Property

to gra,e their animal& Since no one owns the commons the incentive is to get another animal to gra,e& Since everyone has the same incentive every one takes more animals to gra,e and eventually the commons is overgra,ed and every one loses&

1A9

14 References

1> &E-E&E%*E,
0ristot*e, The Politics, 'enguin +*assics, 19,2 #udi, -obert .enera* /ditor, The Cambridge Dictionary of Philosophy, +ambridge 0ni1ersit2 'ress3 +ambridge, 199& 4acon, 5rancis The Worlds Great Classics: The d!ancement of Learning and "o!um #rganum, re1ised edition, !he +o*onia* 'ress3 6e" Yor7, 1899, /dited b2 8 / +reighton 4entham, 8erem2, edited b2 9tar7, : $eremy %entham&s Economic Writings, ;o*ume $$$, .eorge #**en < 0n"in, =td 3 =ondon, 19&) 4entham, 8erem2 n 'ntroduction to the Principles of (orals and Legislation, 1>89, reprinted in The Utilitarians, #nchor 4oo7s, #nchor 'ress?doub*eda23 .arden +it2, 6e" Yor7, 19>@ 4*aug, Aar7 The (ethodology of Economics: or ho) economists e*plain, +ambridge 0ni1ersit2 'ress, +ambridge, 1980 4o*and, =a"rence BAethodo*og2C, The "e) Palgra!e: a Dictionary of Economics, /dited b2 /at"e**, 8ohn, Aurra2 Ai*gate and 'eter 6e"man, AacAi**an 'ress =imited, =ondon, 198> 4oorstin, Danie* 8 The Disco!erers: +istory of (ans ,earch to -no) +is World and +imself. -andom Eouse3 6e" Yor7, 198@ 4ou*ding, Fenneth E!olutionary Economics, 9age 'ub*ications3 4e1er*2 Ei**s, 1981 4rono"s7i, 8acob, The Common ,ense of ,cience, Ear1ard 0ni1ersit2 'ress, +ambridge, A#, 19>8 4rono"s7i, 8acob, The #rigins of -no)ledge and 'magination, Ya*e 0ni1ersit2 'ress, 6e" Ea1en, 19>8 4ur7e, 8ames and -obert Grnstein 199& *ema/ers Gift, .rosset?'utnam 4oo7s3 6e" Yor7,

4ur7e, 8ames, Connections, =itt*e, 4ro"n and +ompan2, 4oston, 6Y, !ronto, =ondon, 19>8

1AA

14 References

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5isher, -obert The Logic of Economic Disco!ery, 6e" Yor7 0ni1ersit2 'ress3 6Y, 198, 5riedman, Ai*ton J!he Aethodo*og2 of 'ositi1e /conomics,J The (ethodology of Positi!e Economics, 0ni1ersit2 of +hicago 'ress3 +hicago, 19&@ 5urubotn, /iri7 and 91etoHar 'eKo1ich, The Economics of Property 1ights. Cambridge, Aass 4a**enger, 19>) .ordon, 9cott The +istory and Philosophy of ,ocial ,cience, -out*edge3 =ondon, 1991 Eausman, Danie* Essays on Philosophy and Economic (ethodology, +ambridge 0ni1ersit2 'ress, +ambridge, 1992 Eausman, Danie* !he 'ne*act and ,eparate ,cience of Economics, +ambridge 0ni1ersit2 'ress, 1992 Eei*broner, -obert, The (a/ing of an Economic ,ociety, 9th edition, 'rentice Ea**, 199@ Eei*broner, -obert, %ehind the 2eil of Economics, : : 6orton,6Y, =ondon, 1988

1AB

14 References

Ei**, $1an,Ieditor) The Ethical %asis of Economic 0reedom. merican 2ie)point , +hape* Ei**, 6+,19>, 8ardine, =isa Worldly Goods: 199, "e) +istory of the 1enaissance, Doub*eda23 6e" Yor7,

Fahneman, Danie*, BAaps of 4ounded -ationa*it2C 's2cho*og2 for 4eha1iora* /conomics,C merican Economic 1e!ie), 1o* 9@, no &, December, 200@, pp 1))9-1)>& Feen 9am and #nne ;a**e2-5ox 3our (ythic $ourney, 8erem2 ' !archer, $nc 3 =# 1989 Fuhn, !homas The ,tructure of ,cientific 1e!olutions, 2cd /dition, 0ni1ersit2 of +hicago 'ress3 +hicago, 19>0 =a7atos, $mre and #*an Ausgra1e Criticism and The Gro)th of -no)ledge, +ambridge 0ni1ersit2 'ress3 +ambridge, 19>0 =a7atos, $mre Proofs and 1efutations, +ambridge 0ni1ersit2 'ress3 +ambridge, 19>, =essig, =a"rence The 0uture of 'deas: The 0ate of The Commons in a Connected World, ;intage 4oo7s?-andom Eouse $nc , 2002 =essig, =a"rence 0ree Culture: +o) %ig (edia Uses Technology and The La) to Loc/ Do)n Culture and Control Creati!ity, !he 'enguin 'ress, 200) !his 'D5 1ersion of 5ree +u*ture is *icensed under a +reati1e +ommons *icense !his *icense permits noncommercia* use of this "or7, so *ong as attribution is gi1en Lhttp3??creati1ecommons org?*icenses?b2-nc?1 0?M =oc7e, 8ohn n Essay Concerning +uman Understanding, N1,89O, +*arendon 'ress3 Gxford, 19>& AP7i, 0s7a*i, 4o .ustafsson and +hristian Fnudsen 1ationality. 'nstitutions and Economic (ethodology, -out*edge, =ondon, 199@ Aarsha**, #*fred, Principles of Economics, 8th edition, 1920, 'orcupine 'ress, reprint Aa2er, !homas Truth !ersus Precision in Economics, /d"ard /*gar, #*dershot, 1992 Ac+*os7e2, Deirdre The 1hetoric of Economics, 0ni1ersit2 of :isconsin 'ress3 Aadison, :isconsin, 198&

1B2

14 References

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1B1

14 References

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