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Description

Please answer the following three questions in your own words from your reading:

1. Analyze and expand on the example in Chapter 1, Example 3 (

Eddie’s Electric

v.

Lucille’s Laundry

) through the end of Chapter 1, Section II. What did the example case miss, if anything? Put another way, are there other types of damages to Eddie’s and/or to Lucille’s not considered by the authors?

2. Game Theory, discussed in Chapter 2, Section VII delves into optimal and sub-optimal actions. Re-read (or read!) that that Section and discuss how you may see game theory played out in your own area of interest or employment. Try and use examples, BUT DO NOT disclose any private or confidential information in your answer.

3. Chapter 3, Section I tackles the intersection of Civil Law and (English) Common Law. Does it matter that these bodies of law, one of which generally flows from the other? In your perfect world, should we favor one form of law over the other, and why? If your home legal system does NOT use English Common Law as its basis what is the basis for your Civil Law?

I expect that each of your answers will clearly express your own ideas, and if you cite to outside work you provide a proper APA 6th citation in the body of your answer and and the full citation below your answer.

I realize that some of you may be put off by the math and/or the charts in the text. In fact, you may skip Chapter 2, Section III (Mathematical Tools). My focus for you is not that you be able to perform or even fully understand the high level math and graphs, but that you learn the general concepts connected with the math.

Finally, please remember that in law, there is rarely a clear cut ‘winner’, especially when it comes to an economic analysis or a dispute between two or more litigants.

Berkeley Law
Berkeley Law Scholarship Repository
Berkeley Law Books
7-2016
Law and Economics, 6th edition
Robert Cooter
Berkeley Law
Thomas Ulen
Follow this and additional works at: http://scholarship.law.berkeley.edu/books
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Authors’ Note
LAW AND ECONOMICS (pdf 6th edition)
by Robert
Cooter and Thomas Ulen
This is a pdf version of the latest version (6th edition) of Law and Economics
by Cooter and Ulen. The ownership of this book has reverted from the publisher to
its authors, so we are posting it online for everyone freely to read or use as a
textbook. After more than thirty years as the field’s leading textbook, it continues to
cover the latest developments in the economic analysis of property, torts, contracts,
legal process, and crimes. Each new edition refines the analytical core, incorporates
new applications, and expands previous discussions of empirical legal studies and
behavioral law and economics. We hope that you enjoy reading this book as much as
we enjoyed writing it.
Looking forward to next year, this duet will become an internet symphony
that takes full advantage of the internet revolution in publishing. Improvements
will be posted to the internet continuously in small amounts (7.1, 7.2, 7.3, etc.), until
a new edition appears with large changes (8.0). Not just a textbook, the 7th edition
will have supporting materials, including translations. For updates, join the email
list found by googling “Cooter and Ulen Berkeley Law Repository”. Perhaps you will
have something to contribute to the website. For the best feast, the host supplies the
main course each guest contributes a dish.

Law&
Economics
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IN
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The Economics of the
Environment
Fusfeld
The Age of the Economist
Lipsey/Ragan/Storer
Economics*
Gerber
International Economics*
Lynn
Economic Development: Theory
Roberts
and Practice for a Divided
The Choice: A Fable of Free
World
Trade and Protection
Miller
Rohlf
Economics Today*
Introduction to Economic
Understanding Modern
Reasoning
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Edition*
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and Practice*
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Gregory
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Weimer
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Performance and Structure
Boyer
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and Policy
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Understanding Society
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Log onto www.myeconlab.com to learn more
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SIXTH EDITION
Law&
Economics
ROBERT COOTER
University of California, Berkeley
THOMAS ULEN
University of Illinois, Urbana-Champaign
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Library of Congress Cataloging-in-Publication Data
Cooter, Robert.
Law and economics / Robert Cooter, Thomas Ulen.—6th ed.
p. cm.
Rev. ed. of: Law & economics / Robert Cooter, Thomas Ulen.
Includes index.
ISBN 978-0-13-254065-0
1. Law and economics. I. Ulen, Thomas. II. Cooter, Robert. Law & economics. III. Title.
K487.E3C665 2011
340’.11—dc22
2010049060
10 9 8 7 6 5 4 3 2 1
ISBN-10:
0-13-254065-7
ISBN-13: 978-0-13-254065-0
Contents
Preface
1.
An Introduction to Law and Economics
I.
II.
III.
IV.
V.
2.
What Is the Economic Analysis of Law?
Some Examples
4
1
3
The Primacy of Efficiency Over Distribution in Analyzing
Private Law
7
Why Should Lawyers Study Economics? Why Should Economists
Study Law?
9
The Plan of This Book
10
A Brief Review of Microeconomic Theory
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
IX.
X.
XI.
XII.
3.
x
Overview: The Structure of Microeconomic Theory
11
11
Some Fundamental Concepts: Maximization, Equilibrium,
and Efficiency
12
Mathematical Tools
14
The Theory of Consumer Choice and Demand
18
The Theory of Supply
26
Market Equilibrium
28
Game Theory
33
The Theory of Asset Pricing
37
General Equilibrium and Welfare Economics
37
Decision Making Under Uncertainty: Risk and Insurance
Profits and Growth
49
Behavioral Economics
50
43
A Brief Introduction to Law and Legal Institutions
I.
II.
III.
IV.
55
The Civil Law and the Common Law Traditions
56
The Institutions of the Federal and the State Court Systems in the
United States
59
The Nature of a Legal Dispute
62
How Legal Rules Evolve
64
vii
viii
Contents
4.
An Economic Theory of Property
I.
II.
III.
5.
IV.
V.
VI.
How are Property Rights Protected?
94
What Can be Privately Owned?—Public and Private Goods
VII.
VIII.
What May Owners Do with Their Property?
105
On Distribution
106
Appendix: The Philosophical Concept of Property
109
112
What can be Privately Owned?
112
How are Property Rights Established and Verified?
143
What May Owners Do with Their Property?
156
What are the Remedies for the Violation of Property Rights?
An Economic Theory of Tort Law
Defining Tort Law
189
An Economic Theory of Tort Liability
199
Appendix: Liability and Symmetry
228
230
Extending the Economic Model
230
Computing Damages
253
An Empirical Assessment of the U.S. Tort Liability System
261
An Economic Theory of Contract Law
I.
II.
III.
IV.
V.
166
187
Topics in the Economics of Tort Liability
I.
II.
III.
8.
102
Topics in the Economics of Property Law
I.
II.
7.
73
The Origins of the Institution of Property: A Thought
Experiment
76
An Economic Theory of Property
81
I.
II.
III.
IV.
6.
The Legal Concept of Property
Bargaining Theory
74
70
Bargain Theory: An Introduction to Contracts
277
An Economic Theory of Contract Enforcement
283
An Economic Theory of Contract Remedies
287
Economic Interpretation of Contracts
291
Relational Contracts: The Economics of the Long-Run
276
299
ix
Contents
9.
Topics in the Economics of Contract Law
I.
II.
Remedies as Incentives
307
Formation Defenses and Performance Excuses
Appendix: Mathematical Appendix
307
341
373
10. An Economic Theory of the Legal Process
I.
II.
III.
IV.
V.
VI.
382
The Goal of the Legal Process: Minimizing Social Costs
Why Sue?
386
Exchange of Information
391
Settlement Bargaining
399
Trial
403
Appeals
410
11. Topics in the Economics of the Legal Process
I.
II.
419
Complaints, Lawyers, Nuisances, and Other Issues
in the Legal Process
419
An Empirical Assessment of the Legal Process
442
12. An Economic Theory of Crime and Punishment
I.
II.
The Traditional Theory of Criminal Law
455
An Economic Theory of Crime and Punishment
454
460
13. Topics in the Economics of Crime and Punishment
I.
II.
III.
IV.
V.
VI.
VII.
Case Index
Name Index
Subject Index
384
Crime and Punishment in the United States
485
Does Punishment Deter Crime?
491
Efficient Punishment
501
The Death Penalty
510
The Economics of Addictive Drugs and Crime
518
The Economics of Handgun Control
522
Explaining the Decline in Crime in the United States
526
533
535
539
485
Preface
T
his sixth edition of Law and Economics arrives as the field celebrates its
(roughly) 30th birthday. What began as a scholarly niche has grown into one of
the most widely used tools of legal analysis. The subject has spread from the
United States to many other countries. As scholarship deepens, the concepts in the core
of law and economics become clearer and more stable, and new applications develop
from the core like biological species evolving through specialization. With each new
edition, we continue to refine the explanation of the analytical core and to incorporate
new applications selectively as space permits. This edition expands previous discussions of empirical legal studies and behavioral law and economics. As we incorporate
new material and respond to the suggestions that so many people have sent us, the book
feels more like a symphony and less like a duet. We hope that you enjoy reading this
book as much as we enjoyed writing it.
The book continues to cover the economic analysis of the law of property, torts,
contracts, the legal process and crimes. Instructors and students who have used previous editions will notice that we have reversed the order in which we treat torts and contracts, and we have divided the material on legal process into two chapters—one on
theory and one on topics—in parallel with our treatment of all the other substantive areas of the law. Below we describe what is new in this edition, followed by an account
of the book’s website.
New to This Edition
The Sixth Edition has been revised and updated to reflect the latest developments in
law and economics. Major changes to the text are as follows:
•
•
•
•
•
x
Tables and graphs have been updated.
New boxes and suggested readings have been added throughout the text.
Web Notes have been updated and added.
Chapter 6 contains additional information on liability and customs in trade.
Chapter 8 improves the explanation of contractual commitments through a better
representation of the principal-agent problem.
Preface
•
•
•
•
•
xi
Chapter 9 now includes new material on lapses, vicarious liability, incomprehensible harms, punitive damages, mass torts, medical malpractice, and some behavioral aspects of contract remedies.
Chapter 10 contains a new treatment of decision making by potential litigants and
their lawyers, and new figures and decision trees.
Chapter 11, a new chapter, combines new material on the legal process and an
updated empirical assessment of various aspects of legal disputes.
Chapter 12 now contains the theoretical material on crime and punishment, updated
and clarified.
Chapter 13 applies the theoretical insights of the previous chapter to wide-ranging
policy issues in criminal justice and updates data and information from previous
editions.
Online Resources
The Companion Website presents a wealth of supplementary materials to help in
teaching and learning law and economics. “Web Notes” throughout the book indicate the points at which there is additional material on the Companion Website at
www.pearsonhighered.com/cooter_ulen. These notes extend the text presentations,
provide guides and links to new articles and books, and contain excerpts from cases.
We also include some examples of examinations and problem sets.
An updated Instructor’s Manual, reflective of changes to the new edition, will be
available for instructors’ reference. The Instructor’s Manual is available for download
on the Instructor’s Resource center at www.pearsonhighered.com/irc.
Acknowledgments
We continue to be extremely grateful to our colleagues at Boalt Hall of the
University of California, Berkeley, and at the University of Illinois College of Law
for the superb scholarly environments in which we work. Our colleagues have been
extremely generous with their time in helping us to understand the law better. And
in one of the great, ongoing miracles of the academic enterprise, we continue to
learn much from the students whom we have the pleasure to teach at Berkeley,
Illinois, and elsewhere.
We should also thank the many colleagues and students at other universities who
have used our book in their classes and sent us many helpful suggestions about how to
improve the book. We particularly thank Joe Kennedy of Georgetown, who has given
us remarkably thorough and singularly helpful comments on improvements in the text.
We’d like to thank the following reviewers for their thoughtful commentary on the fifth
edition: Howard Bodenhorn, J. Lon Carlson, Joseph M. Jadlow, and Mark E. McBride.
We would also like to thank those who have provided research assistance for this
sixth edition: Theodore Ulen, Timothy Ulen, and Brian Doxey. And, also, for their
long-time support and help: Jan Crouter, Dhammika Dharmapala, Lee Ann Fennell,
xii
Preface
Nuno Garoupa, John Lopatka, Richard McAdams, Andy Morriss, Tom Nonnenmacher,
Noel Netusil, Dan Vander Ploeg, and David Wishart.
Finally, we owe particular thanks to our assistants, Ida Ng at Boalt Hall and Sally
Cook at the University of Illinois College of Law. They do many big things to help us
get our work done, as well as many little things without which much of our work would
be impossible to do. Thanks so much.
ROBERT D. COOTER
Berkeley, CA
THOMAS S. ULEN
Champaign, IL
November, 2010
1
An Introduction to Law
and Economics
For the rational study of the law the black-letter man may be the man of the present,
but the man of the future is the man of statistics and the master of economics. . . . We
learn that for everything we have to give up something else, and we are taught to set
the advantage we gain against the other advantage we lose, and to know what we are
doing when we elect.
Oliver Wendell Holmes.
THE PATH OF THE LAW, 10 HARV. L. REV. 457, 469, 474 (1897)1
To me the most interesting aspect of the law and economics movement has been its aspiration to place the study of law on a scientific basis, with coherent theory, precise
hypotheses deduced from the theory, and empirical tests of the hypotheses. Law is a
social institution of enormous antiquity and importance, and I can see no reason why
it should not be amenable to scientific study. Economics is the most advanced of the
social sciences, and the legal system contains many parallels to and overlaps with the
systems that economists have studied successfully.
Judge Richard A. Posner, in MICHAEL FAURE &
ROGER VAN DEN BERGH, EDS., ESSAYS IN LAW AND ECONOMICS (1989)
U
NTIL RECENTLY, LAW
confined the use of economics to antitrust law, regulated industries, tax, and some special topics like determining monetary damages. In
these areas, law needed economics to answer such questions as “What is the defendant’s share of the market?”; “Will price controls on automobile insurance reduce
its availability?”; “Who really bears the burden of the capital gains tax?”; and “How
much future income did the children lose because of their mother’s death?”
Beginning in the early 1960s, this limited interaction changed dramatically when
the economic analysis of law expanded into the more traditional areas of the law, such
as property, contracts, torts, criminal law and procedure, and constitutional law.2 This
1
2
Our citation style is a variant of the legal citation style most commonly used in the United States. Here is
what the citation means: the author of the article from which the quotation was taken is Oliver Wendell
Holmes; the title of the article is “The Path of the Law”; and the article may be found in volume 10 of the
Harvard Law Review, which was published in 1897, beginning on page 457. The quoted material comes
from pages 469 and 474 of that article.
The modern field is said to have begun with the publication of two landmark articles—Ronald H. Coase,
The Problem of Social Cost, 3 J. L. & ECON. 1 (1960) and Guido Calabresi, Some Thoughts on Risk
Distribution and the Law of Torts, 70 YALE L.J. 499 (1961).
1
2
CHAPTER 1
An Introduction to Law and Economics
new use of economics in the law asked such questions as, “Will private ownership of
the electromagnetic spectrum encourage its efficient use?”; “What remedy for breach
of contract will cause efficient reliance on promises?”; “Do businesses take too much
or too little precaution when the law holds them strictly liable for injuries to consumers?”; and “Will harsher punishments deter violent crime?”
Economics has changed the nature of legal scholarship, the common understanding
of legal rules and institutions, and even the practice of law. As proof, consider these indicators of the impact of economics on law. By 1990 at least one economist was on the
faculty of each of the top law schools in North America and some in Western Europe.
Joint degree programs (a Ph.D. in economics and a J.D. in law) exist at many prominent
universities. Law reviews publish many articles using the economic approach, and there
are several journals devoted exclusively to the field.3 An exhaustive study found that articles using the economic approach are cited in the major American law journals more
than articles using any other approach.4 Many law school courses in America now include at least a brief summary of the economic analysis of law in question. Many substantive law areas, such as corporation law, are often taught from a law-and-economics
perspective.5 By the late 1990s, there were professional organizations in law and economics in Asia, Europe, Canada, the United States, Latin America, Australia, and elsewhere. The field received the highest level of recognition in 1991 and 1992 when
consecutive Nobel Prizes in Economics6 were awarded to economists who helped to
found the economic analysis of law—Ronald Coase and Gary Becker. Summing this up,
Professor Bruce Ackerman of the Yale Law School described the economic approach to
law as “the most important development in legal scholarship of the twentieth century.”
The new field’s impact extends beyond the universities to the practice of law and
the implementation of public policy. Economics provided the intellectual foundations
for the deregulation movement in the 1970s, which resulted in such dramatic changes
in America as the dissolution of regulatory bodies that set prices and routes for airlines,
trucks, and railroads. Economics also served as the intellectual force behind the revolution in antitrust law in the United States in the 1970s and 1980s. In another policy area,
a commission created by Congress in 1984 to reform criminal sentencing in the federal
courts explicitly used the findings of law and economics to reach some of its results.
Furthermore, several prominent law-and-economics scholars have become federal
judges and use economic analysis in their opinions—Associate Justice Stephen Breyer
of the U.S. Supreme Court; Judge Richard A. Posner and Judge Frank Easterbrook of
the U.S. Court of Appeals for the Seventh Circuit; Judge Guido Calabresi of the U.S.
3
4
5
6
For example, the Journal of Law and Economics began in 1958; the Journal of Legal Studies in 1972;
Research in Law and Economics, the International Review of Law and Economics, and the Journal of Law,
Economics, and Organization in the 1980s; and the Journal of Empirical Legal Studies in 2004.
William M. Landes & Richard A. Posner, The Influence of Economics on Law: A Quantitative Study, 36 J.
L. & ECON. 385 (1993).
See, e.g., STEPHEN M. BAINBRIDGE, CORPORATION LAW AND ECONOMICS (2002).
The full name of the Nobel Prize in Economics is the Bank of Sweden Prize in the Economic Sciences in
Memory of Alfred Nobel. See our book’s website for a full list of those who have won the Nobel Prize and
brief descriptions of their work.
I. What Is the Economic Analysis of Law?
3
Court of Appeals for the Second Circuit; Judge Douglas Ginsburg, and former Judge
Robert Bork of the U.S. Court of Appeals for the D.C. Circuit; and Judge Alex
Kozinski of the U.S. Court of Appeals for the Ninth Circuit.
I. What Is the Economic Analysis of Law?
Why has the economic analysis of law succeeded so spectacularly, especially in
the United States but increasingly also in other countries?7 Like the rabbit in Australia,
economics found a vacant niche in the “intellectual ecology” of the law and rapidly
filled it. To explain the niche, consider this classical definition of some kinds of laws:
“A law is an obligation backed by a state sanction.”
Lawmakers often ask, “How will a sanction affect behavior?” For example, if
punitive damages are imposed upon the maker of a defective product, what will happen
to the safety and price of the product in the future? Or will the amount of crime decrease if third-time offenders are automatically imprisoned? Lawyers answered such
questions in 1960 in much the same way as they had 2000 years earlier—by consulting
intuition and any available facts.
Economics provided a scientific theory to predict the effects of legal sanctions on
behavior. To economists, sanctions look like prices, and presumably, people respond to
these sanctions much as they respond to prices. People respond to higher prices by
consuming less of the more expensive good; presumably, people also respond to more
severe legal sanctions by doing less of the sanctioned activity. Economics has mathematically precise theories (price theory and game theory) and empirically sound
methods (statistics and econometrics) for analyzing the effects of the implicit prices
that laws attach to behavior.
Consider a legal example. Suppose that a manufacturer knows that his product
will sometimes injure consumers. How safe will he make the product? For a profitmaximizing firm, the answer depends upon three costs: First, the cost of making the
product safer, which depends on its design and manufacture; second, the manufacturer’s legal liability for injuries to consumers; and third, the extent to which injuries
discourage consumers from buying the product. The profit-maximizing firm will adjust
safety until the cost of additional safety equals the benefit from reduced liability and
higher consumer demand for the good.
Economics generally provides a behavioral theory to predict how people respond to
laws. This theory surpasses intuition just as science surpasses common sense. The response of people is always relevant to making, revising, repealing, and interpreting laws.
A famous essay in law and economics describes the law as a cathedral—a large, ancient,
complex, beautiful, mysterious, and sacred building.8 Behavioral science resembles the
mortar between the cathedral’s stones, which support the structure everywhere.
7
8
See Nuno Garoupa & Thomas S. Ulen, The Market for Legal Innovation: Law and Economics in Europe
and the United States, 59 ALA. L. REV. 1555 (2008).
Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One View of
the Cathedral, 85 HARV. L. REV. 1089 (1972).
4
CHAPTER 1
An Introduction to Law and Economics
A prediction can be neutral or loaded with respect to social values. A study finds
that higher fines for speeding on the highway will presumably cause less of it. Is this
good or bad on balance? The finding does not suggest an answer. In contrast, suppose
that a study proves that the additional cost of collecting higher fines exceeds the resulting benefit from fewer accidents, so a higher fine is “inefficient.” This finding suggests
that a higher fine would be bad. Efficiency is always relevant to policymaking, because
public officials never advocate wasting money. As this example shows, besides neutral
predictions, economics makes loaded predictions. Judges and other officials need a
method for evaluating laws’ effects on important social values. Economics provides
such a method for efficiency.
Besides efficiency, economics predicts the effects of laws on another important value:
the distribution of income. Among the earliest applications of economics to public policy
was its use to predict who really bears the burden of alternative taxes. More than other social scientists, economists understand how laws affect the distribution of income across
classes and groups. While almost all economists favor changes that increase efficiency,
some economists take sides in disputes about distribution and others do not take sides.
Instead of efficiency or distribution, people in business mostly talk about profits.
Much of the work of lawyers aims to increase the profits of businesses, especially by
helping businesses to make deals, avoid litigation, and obey regulations. These three activities correspond to three areas of legal practice in large law firms: transactions, litigation, and regulation. Efficiency and profitability are so closely related that lawyers can
use the efficiency principles in this book to help businesses make more money. Economic
efficiency is a comprehensive measure of public benefits that include the profits of firms,
the well-being of consumers, and the wages of workers. The logic of maximizing the
comprehensive measure (efficiency) is very similar to the logic of maximizing one of its
components (profits). A good legal system keeps the profitability of business and the welfare of people aligned, so that the pursuit of profits also benefits the public.
II. Some Examples
To give you a better idea of what law and economics is about, we turn to some examples based upon classics in the subject. First, we try to identify the implicit price that
the legal rule attaches to behavior in each example. Second, we predict the consequences of variations in that implicit price. Finally, we evaluate the effects in terms of
efficiency and, where possible, distribution.
Example 1: A commission on reforming criminal law has identified certain white-collar crimes (such as embezzling money from one’s employer) that are
typically committed after rational consideration of the potential gain and the risk
of getting caught and punished. After taking extensive testimony, much of it from
economists, the commission decides that a monetary fine is the appropriate punishment for these offenses, not imprisonment. The commission wants to know,
“How high should the fine be?”
The economists who testified before the commission have a framework for answering this question. The commission focused on rational crimes that seldom occur
unless the expected gain to the criminal exceeds the expected cost. The expected cost
II. Some Examples
5
depends upon two factors: the probability of being caught and convicted and the severity of the punishment. For our purposes, define the expected cost of crime to the criminal as the product of the probability of a fine times its magnitude.
Suppose that the probability of punishment decreases by 5 percent and the magnitude of the fine increases by 5 percent. In that case, the expected cost of crime to the
criminal roughly remains the same. Because of this, the criminal will presumably respond by committing the same amount of crime. (In Chapter 12 we shall explain the
exact conditions for this conclusion to be true.) This is a prediction about how illegal
behavior responds to its implicit price.
Now we evaluate this effect with respect to economic efficiency. When a decrease in
the probability of a fine offsets an increase in its magnitude, the expected cost of crime
remains roughly the same for criminals, but the costs of crime to the criminal justice system may change. The costs to the criminal justice system of increasing a fine’s probability include expenditures on apprehending and prosecuting criminals—for example, on
the number and quality of auditors, tax and bank examiners, police, prosecuting attorneys, and the like. While the cost of increasing the probability of catching and convicting
white-collar criminals is relatively high, administering fines is relatively cheap. These
facts imply a prescription for holding white-collar crime down to any specified level at
least cost to the state: Invest little in apprehending and prosecuting offenders, and fine severely those who are apprehended. Thus, the commission might recommend very high
monetary fines in its schedule of punishments for white-collar offenses.
Professor Gary Becker derived this result in a famous paper cited by the Nobel Prize
Committee in its award to him. Chapters 12 and 13 discuss these findings in detail.
Example 2: An oil company contracts to deliver oil from the Middle East
to a European manufacturer. Before the oil is delivered, war breaks out and the oil
company cannot perform as promised. The lack of oil causes the European manufacturer to lose money. The manufacturer brings an action (that is, files a lawsuit)
against the oil company for breach of contract. The manufacturer asks the court to
award damages equal to the money that it lost. The contract is silent about the risk
of war, so that the court cannot simply read the contract and resolve the dispute on
the contract’s own terms. The oil company contends that it should be excused from
performance because it could do nothing about the war and neither of the contracting parties foresaw it. In resolving the suit, the court must decide whether to
excuse the oil company from performance on the ground that the war made the
performance “impossible,” or to find the oil company in breach of contract and to
require the oil company to compensate the manufacturer for lost profits.9
War is a risk of doing business in the Middle East that one of the parties to the contract must bear, and the court must decide which one it is. What are the consequences
of different court rulings? The court’s decision simultaneously accomplishes two
things. First, it resolves the dispute between the litigants—“dispute resolution.”
Second, it guides future parties who are in similar circumstances about how courts
might resolve their dispute—“rule creation.” Law and economics is helpful in resolving
9
For a full discussion of the cases on which this example is based, see Richard A. Posner & Andrew
Rosenfield, Impossibility and Related Doctrines in Contract Law, 6 J. LEGAL STUD. 88 (1977).
6
CHAPTER 1
An Introduction to Law and Economics
disputes, but it particularly shines in creating rules. Indeed, a central question in this
book is, “How will the rule articulated by the lawmaker to resolve a particular dispute
affect the behavior of similarly situated parties in the future?” And, “Is the predicted
behavior desirable?”
The oil company and the manufacturer can take precautions against war in the
Middle East, although neither of them can prevent it. The oil company can sign backup
contracts for delivery of Venezuelan oil, and the manufacturer can store oil for emergency use. Efficiency requires the party to take precaution who can do so at least cost.
Is the oil company or the manufacturer better situated to take precautions against war?
Since the oil company works in the Middle East, it is probably better situated than a
European manufacturer to assess the risk of war in that region and to take precautions
against it. For the sake of efficiency, the court might hold the oil company liable and
cite the principle that courts will allocate risks uncovered in a contract to the party who
can bear them at least cost. This is the principle of the least-cost risk-bearer,10 which is
consistent with some decisions in cases that arose from the Middle Eastern war of
1967. Chapters 8 and 9 consider this principle’s foundation.
Example 3: Eddie’s Electric Company emits smoke that dirties the wash
hanging at Lucille’s Laundry. Eddie’s can completely abate the pollution by installing scrubbers on its stacks, and Lucille’s can completely exclude the smoke by
installing filters on its ventilation system. Installing filters is cheaper than installing
scrubbers. No one else is affected by this pollution because Eddie’s and Lucille’s
are near to each other and far from anyone else. Lucille’s initiates court proceedings to have Eddie’s declared to be a “nuisance.” If the action succeeds, the court
will order Eddie’s to abate its pollution. Otherwise, the court will not intervene in
the dispute. What is the appropriate resolution of this dispute?
Efficiency requires Lucille’s to install filters, which is cheaper than Eddie’s installing scrubbers. How can the court produce this result? The answer depends on
whether or not Eddie’s and Lucille’s can cooperate. First, assume that Eddie’s and
Lucille’s cannot bargain together or cooperate. If Lucille’s wins the action and the court
orders Eddie’s to abate the pollution, Eddie’s will have to install scrubbers, which is efficient. However, if Lucille’s loses the action, then Lucille’s will have to install filters,
which is inefficient. Consequently, it is efficient for Lucille’s to lose the action.
Now, consider how the analysis changes if Eddie’s and Lucille’s can bargain together
and cooperate. Their joint profits (the sum of the profits of Eddie’s and Lucille’s) will be
higher if they choose the cheaper means of eliminating the harm from pollution. When
their joint profits are higher, they can divide the gain between them in order to make both
of them better off. The cheaper means is also the efficient means. Efficiency is achieved
in this example when Lucille’s and Eddie’s bargain together and cooperate, regardless of
the rule of law. Ronald Coase derived this result in a famous paper cited by the Nobel
Prize Committee when he received the award. Chapter 4 elaborates on this famous result.
10
The principle assumes that the entire loss from nonperformance must be allocated by the court to one of
the parties. Alternatively, the court might divide the loss between the parties.
III. The Primacy of Efficiency Over Distribution in Analyzing Private Law
7
III. The Primacy of Efficiency Over Distribution
in Analyzing Private Law
We explained that economists are experts on two policy values—efficiency and
distribution. The stakes in most legal disputes have monetary value. Deciding a legal
dispute almost always involves allocating the stakes between the parties. The decision
about how much of the stakes each party gets creates incentives for future behavior, not
just for the parties to this dispute but also for everyone who is similarly situated. In this
book we use these incentive effects to make predictions about the consequences of legal decisions, policies, rules, and institutions. In evaluating these consequences, we
will focus on efficiency rather than distribution. Why?
By making a rule, the division of the stakes in a legal dispute affects all similarly
situated people. If a plaintiff in a case is a consumer of a particular good, an investor in
a particular stock, or the driver of a car, then a decision for the plaintiff may benefit
everyone who consumes this good, invests in this stock, or drives a car. Most proponents of income redistribution, however, have something else in mind. Instead of contemplating distribution to consumers, investors, or drivers, advocates of income
redistribution usually target social groups, such as the poor, women, or minorities.
Some people passionately advocate government redistribution of income by class, gender, or race for the sake of social justice. A possible way to pursue redistribution is
through private law—the law of property, contracts, and torts. According to this philosophy, courts should interpret or make private laws to redistribute income to deserving
groups of people. For example, if consumers are poorer on average than investors, then
courts should interpret liability rules to favor consumers and disfavor corporations.
This book rejects the redistributive approach to private law. Pursuing redistributive
goals is an exceptional use of private law that special circumstances may justify but that
ought not be the usual use of private law. Here is why. Like the rest of the population,
economists disagree among themselves about redistributive ends. However, economists
generally agree about redistributive means. By avoiding waste, efficient redistribution
benefits everyone relative to inefficient redistribution. By avoiding waste, efficient redistribution also builds support for redistribution. For example, people are more likely
to donate to a charitable organization that efficiently redistributes income than to one
that spends most of its revenue on administration.
A piquant example will help you to appreciate the advantages of efficient redistribution. Assume that a desert contains two oases, one of which has ice cream and the
other has none. The advocates of social justice who favor redistribution obtain control
over the state and declare that the first oasis should share its ice cream with the second
oasis. In response, the first oasis fills a large bowl with ice cream and sends a youth
running across the desert carrying the bowl to the second oasis. The hot sun melts some
of the ice cream, so the first oasis gives up more ice cream than the second oasis receives. The melted ice cream represents the cost of redistribution. People who disagree
vehemently about how much ice cream the first oasis should give to the second oasis
may agree that a fast runner should transport it. Also they might agree to choose an
honest runner who will not eat the ice cream along the route.
8
CHAPTER 1
An Introduction to Law and Economics
Many economists believe that progressive taxation and social welfare programs—
the “tax-and-transfer system,” as it is usually called—can accomplish redistributive
goals in modern states more efficiently than can be done through modifying or reshuffling private legal rights. There are several reasons why reshuffling private legal rights
resembles giving the ice cream to a slow runner.
First, the income tax precisely targets inequality, whereas redistribution by private
legal rights relies on crude averages. To illustrate, assume that courts interpret a law to
favor consumers over corporations in order to redistribute income from rich to poor.11
“Consumers” and “investors” imperfectly correspond to “poor” and “rich.” Consumers
of Ferrari automobiles, skiing vacations, and the opera tend to be relatively rich. Many
small businesses are organized as corporations. Furthermore, the members of unions
with good pension plans own the stocks of large companies. By taxing income progressively, law distinguishes more precisely between rich and poor than by taking the indirect approach of targeting “consumers” and “investors.”
Second, the distributive effects of reshuffling private rights are hard to predict. To
illustrate, the courts cannot be confident that holding a corporation liable to its consumers will reduce the wealth of its stockholders. Perhaps the corporation will pass on
its higher costs to consumers in the form of higher prices, in which case the court’s
holding will redistribute costs from some consumers to other consumers.
Third, the transaction costs of redistribution through private legal rights are typically high. To illustrate, a plaintiff’s attorney working on a contingency fee in the
United States routinely charges one-third of the judgment. If the defendant’s attorney
collects a similar amount in hourly fees, then attorneys for the two sides will absorb
two-thirds of the stakes in dispute. The tax-and-transfer system is more efficient.
Besides these three reasons, there is a fourth: Redistribution by private law distorts
the economy more than progressive taxation does. In general, relying on broad-based
taxes, rather than narrowly focused laws, reduces the distorting effects of redistributive
policies. For example, assume that a law to benefit consumers of tomatoes causes a decline in the return enjoyed by investors in tomato farms. Investors will respond by withdrawing funds from tomato farms and investing in other businesses. Consequently, the
supply of tomatoes will be too small and consumers will pay too high a price for them.
This law distorts the market for tomatoes.
For these reasons and more, economists who favor redistribution and economists
who oppose it can agree that private legal rights are usually the wrong way to pursue
distributive justice. Unfortunately, lawyers without training in economics seldom appreciate these facts.
We have presented several reasons against basing private law on redistributive goals.
Specifically, we discussed imprecise targeting, unpredictable consequences, high transaction costs, and distortions in incentives. For these reasons, the general principles of private
law cannot rest on income redistribution. (In special circumstances, however, a private law
can redistribute relatively efficiently, such as a well-designed law giving crippled people
the right to sue employers for not providing wheelchair access to the workplace.)
11
Courts might always find in favor of the individual consumer when he or she sues a corporation regarding
liability for harms arising in the use of the corporation’s products.
IV. Why Should Lawyers Study Economics? Why Should Economists Study Law?
9
Web Note 1.1
Besides efficiency, what other policy values should matter to making law and
applying it? In Fairness Versus Welfare (2002), Louis Kaplow and Steven
Shavell of the Harvard Law School say “None.” Others disagree. See Chris
Sanchirico, Deconstructing the New Efficiency Rationale, 86 CORNELL L. REV.
1005 (2001), and Daniel Farber, What (If Anything) Can Economics Say About
Equity?, 101 MICH. L. REV. 1791 (2003).
There is a more complete discussion of this literature under Chapter 1 at
the website for this book and links to additional sites of interest.
IV. Why Should Lawyers Study Economics? Why Should
Economists Study Law?
The economic analysis of law unites two great fields and facilitates understanding
each of them. You probably think of laws as promoting justice; indeed, many people can
think in no other way. Economics conceives of laws as incentives for changing behavior
(implicit prices) and as instruments for policy objectives (efficiency and distribution).
However, economic analysis often takes for granted such legal institutions as property
and contract, which dramatically affect the economy. Thus, differences in laws cause
capital markets to be organized differently in Japan, Germany, and the United States.
Failures in financial laws and contracting contributed to the banking collapse of 2008 in
the United States and the subsequent recession, which was less severe in Japan and
Germany. Also, the absence of secure property and reliable contracts paralyzes the
economies of some poor nations. Improving the effectiveness of law in poor countries is
important to their economic development. Law needs economics to understand its behavioral consequences, and economics needs law to understand the underpinnings of
markets.
Economists and lawyers can also learn techniques from each other. From economists, lawyers can learn quantitative reasoning for making theories and doing empirical research. From lawyers, economists can learn to persuade ordinary people—an art
Stern Warning for Students
If you are like most students who read this book—scholars of the highest moral caliber—you
need not upset yourself by reading the rest of this paragraph. If you are one of those wicked
students—we get a few every year—here is a stern warning for you. According to traditional
Chinese beliefs, sinners are tried and punished in ten courts of hell after they die. The sixth court
tries the sin of “abusing books,” punishable by being sawn in half from head to toe. The eighth
court tries the sin of “cheating on exams,” punishable by being cut open and having your intestines ripped out. So don’t you dare abuse this book or cheat on the exams!
10
CHAPTER 1
An Introduction to Law and Economics
that lawyers continually practice and refine. Lawyers can describe facts and give them
names with moral resonance, whereas economists are obtuse to language too often. If
economists will listen to what the law has to teach them, they will find their models being drawn closer to what people really care about.
V. The Plan of This Book
To benefit from each other, lawyers must learn some economics and economists
must learn some law. Readers can do so in the next two chapters. Chapter 2 briefly reviews microeconomic theory. If you are familiar with that theory, then you can read the
material quickly as a review or skim the headings for unfamiliar topics. As a check, you
might try the problems at the end of Chapter 2.
Chapter 3 is an introduction to the law and the legal process, which is essential
reading for those without legal training. We explain how the legal system works, how
the U.S. legal system differs from the rest of the world, and what counts as “law.”
Chapter 4 begins the substantive treatment of the law from an economic viewpoint.
The chapters on substantive legal issues are arranged in pairs. Chapters 4 and 5 focus on
property law; Chapters 6 and 7, on tort law; Chapters 8 and 9, on contract law; Chapters 10
and 11, on resolving legal disputes; and 12 and 13, on criminal law. The first chapter of
each pair explains the basic economic analysis of that area of law, and the second chapter applies the core economic theory to a series of topics. So, Chapter 6 develops an economic theory of tort liability, and Chapter 7 applies it to automobile accidents, medical
practice, and defective products. Chapters 4 through 11 deal with laws where the typical
plaintiff in a suit is a private person (“private law”), and Chapters 12 and 13 deal with
criminal law where the plaintiff is the public prosecutor (“public law”).
Suggested Readings
At the end of every chapter we shall list some of the most important writings on the subject.
Please check the website for this book (www.cooter-ulen.com) for additional resources.
BOUCKAERT, BOUDEWIJN, & GERRIT DE GEEST, EDS., ENCYCLOPEDIA OF LAW AND ECONOMICS
(rev. ed., 2011).
DAU-SCHMIDT, KEN, & THOMAS S. ULEN, EDS., A LAW AND ECONOMICS ANTHOLOGY (1997).
MICELI, THOMAS J, THE ECONOMIC APPROACH TO LAW (2d ed. 2008).
NEWMAN, PETER, ED., THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND LAW (3 vols., 1998).
POLINSKY, A. MITCHELL, AN INTRODUCTION TO LAW AND ECONOMICS (3rd, 2003).
POLINSKY, A. MITCHELL, & STEVEN SHAVELL, EDS., HANDBOOK OF LAW AND ECONOMICS, vs. 1
AND 2 (2007).
Posner, Richard A., The Decline of Law as an Autonomous Discipline, 1962–1987,
100 HARV. L. REV. 761 (1987).
POSNER, RICHARD A., ECONOMIC ANALYSIS OF LAW (7th ed., 2007).
SHAVELL, STEVEN, FOUNDATIONS OF THE ECONOMIC ANALYSIS OF LAW (2003).
2
A Brief Review of
Microeconomic Theory
Practical men, who believe themselves to be quite exempt from any intellectual
influences, are usually the slaves of some defunct economist. . . . It is ideas, not vested
interests, which are dangerous for good or evil.
JOHN MAYNARD KEYNES,
THE GENERAL THEORY OF EMPLOYMENT, INTEREST, AND MONEY (1936)
In this state of imbecility, I had, for amusement, turned my attention to political
economy.
THOMAS DEQUINCEY,
CONFESSIONS OF AN ENGLISH OPIUM EATER (1821)
Economics is the science which studies human behavior as a relationship between
ends and scarce means which have alternative uses.
LIONEL CHARLES ROBBINS, LORD ROBBINS,
AN ESSAY ON THE NATURE AND SIGNIFICANCE OF ECONOMIC SCIENCE (1932)
T
of law draws upon the principles of microeconomic theory, which we review in this chapter. For those who have not studied this branch
of economics, reading this chapter will prove challenging but useful for understanding the remainder of the book. For those who have already mastered microeconomic theory, reading this chapter is unnecessary. For those readers who are
somewhere in between these extremes, we suggest that you begin reading this chapter,
skimming what is familiar and studying carefully what is unfamiliar. If you’re not sure
where you lie on this spectrum of knowledge, turn to the questions at the end of the
chapter. If you have difficulty answering them, you will benefit from studying this
chapter carefully.
HE ECONOMIC ANALYSIS
I. Overview: The Structure of Microeconomic Theory
Microeconomics concerns decision making by individuals and small groups, such
as families, clubs, firms, and governmental agencies. As the famous quote from Lord
Robbins at the beginning of the chapter says, microeconomics is the study of how
11
12
CHAPTER 2
A Brief Review of Microeconomic Theory
scarce resources are allocated among competing ends. Should you buy that digital audiotape player you’d like, or should you buy a dapper suit for your job interview?
Should you take a trip with some friends this weekend or study at home? Because you
have limited income and time and cannot, therefore, buy or do everything that you
might want to buy or do, you have to make choices. Microeconomic theory offers a
general theory about how people make such decisions.
We divide our study of microeconomics into five sections. The first is the theory of
consumer choice and demand. This theory describes how the typical consumer, constrained by a limited income, chooses among the many goods and services offered for
sale.
The second section deals with the choices made by business organizations or firms.
We shall develop a model of the firm that helps us to see how the firm decides what
goods and services to produce, how much to produce, and at what price to sell its output. In the third section, we shall consider how consumers and firms interact. By combining the theory of the consumer and the firm, we shall explain how the decisions of
consumers and firms are coordinated through movements in market price. Eventually,
the decisions of consumers and firms must be made consistent in the sense that somehow the two sides agree about the quantity and price of the good or service that will be
produced and consumed. When these consumption and production decisions are consistent in this sense, we say that the market is in equilibrium. We shall see that powerful forces propel markets toward equilibrium, so that attempts to divert the market from
its path are frequently ineffectual or harmful.
The fourth section of microeconomic theory describes the supply and demand for
inputs into the productive process. These inputs include labor, capital, land, and managerial talent; more generally, inputs are all the things that firms must acquire in order to
produce the goods and services that consumers or other firms wish to purchase.
The final section of microeconomics deals with the area known as welfare
economics. There we shall discuss the organization of markets and how they achieve
efficiency.
These topics constitute the core of our review of microeconomic theory. There are
four additional topics that do not fit neatly into the sections noted above but that we
think you should know about them in order to understand the economic analysis of
legal rules and institutions. These are game theory, the economic theory of decision
making under uncertainty, growth theory, and behavioral economics. We shall cover
these four topics in the final sections of this chapter.
II. Some Fundamental Concepts: Maximization,
Equilibrium, and Efficiency
Economists usually assume that each economic actor maximizes something:
Consumers maximize utility (that is, happiness or satisfaction), firms maximize profits,
politicians maximize votes, bureaucracies maximize revenues, charities maximize
social welfare, and so forth. Economists often say that models assuming maximizing
behavior work because most people are rational, and rationality requires maximization.
II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency
13
One conception of rationality holds that a rational actor can rank alternatives according
to the extent that they give her what she wants. In practice, the alternatives available to
the actor are constrained. For example, a rational consumer can rank alternative bundles of consumer goods, and the consumer’s budget constrains her choice among them.
A rational consumer should choose the best alternative that the constraints allow.
Another common way of understanding this conception of rational behavior is to recognize that consumers choose alternatives that are well suited to achieving their ends.
Choosing the best alternative that the constraints allow can be described mathematically as maximizing. To see why, consider that the real numbers can be ranked
from small to large, just as the rational consumer ranks alternatives according to the
extent that they give her what she wants. Consequently, better alternatives can be associated with larger numbers. Economists call this association a “utility function,” about
which we shall say more in the following sections. Furthermore, the constraint on
choice can usually be expressed mathematically as a “feasibility constraint.” Choosing
the best alternative that the constraints allow corresponds to maximizing the utility
function subject to the feasibility constraint. So, the consumer who goes shopping is
said to maximize utility subject to her budget constraint.
Turning to the second fundamental concept, there is no habit of thought so deeply
ingrained among economists as the urge to characterize each social phenomenon as an
equilibrium in the interaction of maximizing actors. An equilibrium is a pattern of interaction that persists unless disturbed by outside forces. Economists usually assume
that interactions tend toward an equilibrium, regardless of whether they occur in markets, elections, clubs, games, teams, corporations, or marriages.
There is a vital connection between maximization and equilibrium in microeconomic theory. We characterize the behavior of every individual or group as maximizing
something. Maximizing behavior tends to push these individuals and groups toward a
point of rest, an equilibrium. They certainly do not intend for an equilibrium to result;
instead, they simply try to maximize whatever it is that interests them. Nonetheless, the
interaction of maximizing agents usually results in an equilibrium.
A stable equilibrium is one that will not change unless outside forces intervene. To
illustrate, the snowpack in a mountain valley is in stable equilibrium, whereas the
snowpack on the mountain’s peak may be in unstable equilibrium. An interaction
headed toward a stable equilibrium actually reaches this destination unless outside
forces divert it. In social life, outside forces often intervene before an interaction
reaches equilibrium. Nevertheless, equilibrium analysis makes sense. Advanced microeconomic theories of growth, cycles, and disequilibria exist, but we shall not need them
in this book. The comparison of equilibria, called comparative statics, will be our basic
approach.
Turning to the third fundamental concept, economists have several distinct definitions of efficiency. A production process is said to be productively efficient if either of
two conditions holds:
1. It is not possible to produce the same amount of output using a lower-cost
combination of inputs, or
2. It is not possible to produce more output using the same combination of
inputs.
14
CHAPTER 2
A Brief Review of Microeconomic Theory
Consider a firm that uses labor and machinery to produce a consumer good called
a “widget.” Suppose that the firm currently produces 100 widgets per week using
10 workers and 15 machines. The firm is productively efficient if
1. it is not possible to produce 100 widgets per week by using 10 workers and
fewer than 15 machines, or by using 15 machines and fewer than 10 workers, or
2. it is not possible to produce more than 100 widgets per week from the combination of 10 workers and 15 machines.
The other kind of efficiency, called Pareto efficiency after its inventor1 or sometimes
referred to as allocative efficiency, concerns the satisfaction of individual preferences. A
particular situation is said to be Pareto or allocatively efficient if it is impossible to
change it so as to make at least one person better off (in his own estimation) without
making another person worse off (again, in his own estimation). For simplicity’s sake,
assume that there are only two consumers, Smith and Jones, and two goods, umbrellas
and bread. Initially, the goods are distributed between them. Is the allocation Pareto efficient? Yes, if it is impossible to reallocate the bread and umbrellas so as to make either
Smith or Jones better off without making the other person worse off.2
These three basic concepts—maximization, equilibrium, and efficiency—are fundamental to explaining economic behavior, especially in decentralized institutions like
markets that involve the coordinated interaction of many different people.
III. Mathematical Tools
You may have been anxious about the amount of mathematics that you will find in
this book. There is not much. We use simple algebra and graphs.
A. Functions
Economics is rife with functions: production functions, utility functions, cost functions, social welfare functions, and others. A function is a relationship between two sets
of numbers such that for each number in one set, there corresponds exactly one number
in the other set. To illustrate, the columns below correspond to a functional relationship
between the numbers in the left-hand column and those in the right-hand column. Thus,
the number 4 in the x-column below corresponds to the number 10 in the y-column.
In fact, notice that each number in the x-column corresponds to exactly one number in
the y-column. Thus, we can say that the variable y is a function of the variable x, or in the
most common form of notation.
y = f(x).
1
2
Vilfredo Pareto was an Italian-Swiss political scientist, lawyer, and economist who wrote around 1900.
There is another efficiency concept—a potential Pareto improvement or Kaldor-Hicks efficiency—that we
describe in section IX.C that follows.
15
III. Mathematical Tools
This is read as “y is a function of x” or “y equals some f of x.”
y-column
x-column
2
3
10
10
12
7
3
0
4
6
9
12
Note that the number 4 is not the only number in the x-column that corresponds to
the number 10 in the y-column; the number 6 also corresponds to the number 10. In this
table, for a given value of x, there corresponds one value of y, but for some values of y,
there corresponds more than one value of x. A value of x determines an exact value of y,
whereas a value of y does not determine an exact value of x. Thus, in y = f(x), y is
called the dependent variable, because it depends on the value of x, and x is called the
independent variable. Because y depends upon x in this table, y is a function of x, but
because x does not (to our knowledge) depend for its values on y, x is not a function of y.
Now suppose that there is another dependent variable, named z, that also depends
upon x. The function relating z to x might be named g:
z = g(x).
When there are two functions, g(x) and f(x), with different dependent variables, z
and y, remembering which function goes with which variable can be hard. To avoid
this difficulty, the same name is often given to a function and the variable determined
by it. Following this strategy, the preceding functions would be renamed as follows:
y = f(x) Q y = y(x),
z = g(x) Q z = z(x).
Sometimes an abstract function will be discussed without ever specifying the exact
numbers that belong to it. For example, the reader might be told that y is a function of
x, and never be told exactly which values of y correspond to which values of x. The
point then is simply to make the general statement that y depends upon x but in an as
yet unspecified way. If exact numbers are given, they may be listed in a table, as we
have seen. Another way of showing the relationship between a dependent and an independent variable is to give an exact equation. For example, a function z = z(x) might
be given the exact form
z = z(x) = 5 + x>2,
which states that the function z matches values of x with values of z equal to five plus
one-half of whatever value x takes. The table below gives the values of z associated
with several different values of x:
16
CHAPTER 2
A Brief Review of Microeconomic Theory
z-column
6.5
12.5
8.0
6.0
9.5
x-column
3
15
6
2
9
A function can relate a dependent variable (there is always just one of them to a
function) to more than one independent variable. If we write y = h(x, z), we are
saying that the function h matches one value of the dependent variable y to every
pair of values of the independent variables x and z. This function might have the
specific form
y = h(x, z) = -3x + z,
according to which y decreases by 3 units when x increases by 1 unit, and y increases
by 1 unit when z increases by 1 unit.
B. Graphs
We can improve the intuitive understanding of a functional relationship by visualizing it in a graph. In a graph, values of the independent variable are usually read off
the horizontal axis, and values of the dependent variable are usually read off the vertical axis. Each point in the grid of lines corresponds to a pair of values for the variables.
For an example, see Figure 2.1. The upward-sloping line on the graph represents all of
the pairs of values that satisfy the function y = 5 + x>2. You can check this by finding a couple of points that ought to be on the line that corresponds to that function. For
example, what if y = 0? What value should x have? If y = 0, then a little arithmetic
will reveal that x should equal -10. Thus, the pair (0, -10) is a point on the line defined by the function. What if x = 0? What value will y have? In that case, the second
FIGURE 2.1
y
Graphs of the linear relationships
y = 5 + x>2 (with a positive slope) and
y = 5 – x>2 (with a negative slope).
15
y = 5 + x!2
10
5
–x
x
– 15 – 10 – 5 0
5
–5
10
15
y = 5 – x!2
– 10
–y
III. Mathematical Tools
17
term in the right-hand side of the equation disappears, so that y = 5. Thus, the pair of
values (5, 0) is a point on the line defined by the function.
The graph of y = 5 + x>2 reveals some things about the relationship between y
and x that we otherwise might not so easily discover. For example, notice that the line
representing the equation slopes upward, or from southwest to northeast. The positive
slope, as it is called, reveals that the relationship between x and y is a direct one. Thus,
as x increases, so does y. And as x decreases, y decreases. Put more generally, when the
independent and dependent variables move in the same direction, the slope of the graph
of their relationship will be positive.
The graph also reveals the strength of this direct relationship by showing whether
small changes in x lead to small or large changes in y. Notice that if x increases by 2
units, y increases by 1 unit. Another way of putting this is to say that in order to get a
10-unit increase in y, there must be a 20-unit increase in x.3
The opposite of a direct relationship is an inverse relationship. In that sort of relationship, the dependent and independent variables move in opposite directions. Thus, if
x and y are inversely related, an increase in x (the independent variable) will lead to a
decrease in y. Also, a decrease in x will lead to an increase in y. An example of an inverse relationship between an independent and a dependent variable is y = 5 – x>2.
The graph of this line is also shown in Figure 2.1. Note that the line is downwardsloping; that is, the line runs from northwest to southeast.
QUESTION 2.1: Suppose that the equation were y = 5 + x. Show in a
graph like the one in Figure 2.1 what the graph of that equation would look
like. Is the relationship between x and y direct or inverse? Is the slope of the
new equation greater or less than the slope shown in Figure 2.1?
Now suppose that the equation were y = 5 – x. Show in a graph like the
one in Figure 2.1 what the graph of that equation would look like. Is the relationship between x and y direct or inverse? Is the slope of the new equation
positive or negative? Would the slope of the equation y = 5 – x>2 be steeper
or shallower than that of the one in y = 5 – x?
The graph of y = 5 + x>2 in Figure 2.1 also reveals that the relationship between
the variables is linear. This means that when we graph the values of the independent
and dependent variables, the resulting relationship is a straight line. One of the implications of linearity is that changes in the independent variable cause a constant rate of
change in the dependent variable. In terms of Figure 2.1, if we would like to know the
effect on y of doubling the amount of x, it doesn’t matter whether we investigate that
effect when x equals 2 or 3147. The effect on y of doubling the value of x is proportionally the same, regardless of the value of x.
The alternative to a linear relationship is, of course, a nonlinear relationship. In
general, nonlinear relationships are trickier to deal with than are linear relationships.
3
The slope of the equation we have been dealing with in Figure 2.1 is 21 , which is the coefficient of x in the
equation. In fact, in any linear relationship the coefficient of the independent variable gives the slope of the
equation.
18
CHAPTER 2
A Brief Review of Microeconomic Theory
FIGURE 2.2
y
The graph of a nonlinear relationship,
given by the equation y = x 2.
y = x2
–x
x
0
FIGURE 2.3
y
The graph of a nonlinear relationship,
A = xy.
A = xy
0
x
They frequently, although not always, are characterized by the independent1 variable being raised to a power by an exponent. Examples are y = x2 and y = 5>x 2. Figure 2.2
shows a graph of y = x2. Another common nonlinear relationship in economics is
given by the example A = xy, where A is a constant. A graph of that function is given
in Figure 2.3.
IV. The Theory of Consumer Choice and Demand
The economist’s general theory of how people make choices is referred to as the
theory of rational choice. In this section we show how that theory explains the consumer’s choice of what goods and services to purchase and in what amounts.
A. Consumer Preference Orderings
The construction of the economic model of consumer choice begins with an account of the preferences of consumers. Consumers are assumed to know the things they
like and dislike and to be able to rank the available alternative combinations of goods
and services according to their ability to satisfy the consumer’s preferences. This involves no more than ranking the alternatives as better than, worse than, or equally as
good as one another. Indeed, some economists believe that the conditions they impose
on the ordering or ranking of consumer preferences constitute what an economist
means by the term rational. What are those conditions? They are that a consumer’s
preference ordering or ranking be complete, transitive, and reflexive. For an ordering to
be complete simply means that the consumer be able to tell us how she ranks all the
IV. The Theory of Consumer Choice and Demand
19
possible combinations of goods and services. Suppose that A represents a bundle of
certain goods and services and B represents another bundle of the same goods and services but in different amounts. Completeness requires that the consumer be able to tell
us that she prefers A to B, or that she prefers B to A, or that A and B are equally good
(that is, that the consumer is indifferent between having A and having B). The consumer
is not allowed to say, “I can’t compare them.”
Reflexivity is an arcane condition on consumer preferences. It means that any bundle of goods, A, is at least as good as itself. That condition is so trivially true that it is
difficult to give a justification for its inclusion.
Transitivity means that the preference ordering obeys the following condition:
If bundle A is preferred to bundle B and bundle B is preferred to bundle C, then it
must be the case that A is preferred to C. This also applies to indifference: If the
consumer is indifferent between A and B and between B and C, then she is also indifferent between A and C. Transitivity precludes the circularity of individual preferences. That is, transitivity means that it is impossible for A to be preferred to B,
B to be preferred to C, and C to be preferred to A. Most of us would probably feel
that someone who had circular preferences was extremely young or childish or
crazy.
QUESTION 2.2: Suppose that you have asked James whether he would like
a hamburger or a hot dog for lunch, and he said that he wanted a hot dog. Five
hours later you ask him what he would like for dinner, a hamburger or a hot
dog. James answers, “A hamburger.” Do James’s preferences for hot dogs versus hamburgers obey the conditions above? Why or why not?
It is important to remember that the preferences of the consumer are subjective.
Different people have different tastes, and these will be reflected in the fact that they
may have very different preference orderings over the same goods and services.
Economists leave to other disciplines, such as psychology and sociology, the study of
the source of these preferences. We take consumer tastes or preferences as given, or, as
economists say, as exogenous, which means that they are determined outside the economic system.4
An important consequence of the subjectivity of individual preferences is that
economists have no accepted method for comparing the strength of people’s preferences. Suppose that Stan tells us that he prefers bundle A to bundle B, and Jill tells us
that she feels the same way: She also prefers A to B. Is there any way to tell who would
prefer having A more? In the abstract, the answer is, “No, there is not.” All we have
from each consumer is the order of preference, not the strength of those preferences.
Indeed, there is no metric by which to measure the strength of preferences, although
economists sometimes jokingly refer to the “utils” of satisfaction that a consumer is
enjoying. The inability to make interpersonal comparisons of well-being has some
4
Many people new to the study of microeconomics will find this assumption of the exogeneity of preferences
to be highly unrealistic. And there is some controversy about this assumption even within economics, some
economists contending that preferences are endogenous—that is, determined within the economic system by
such things as advertising. We cannot elaborate on this controversy here but are well aware of it.
20
CHAPTER 2
A Brief Review of Microeconomic Theory
important implications for the design and implementation of public policy, as we shall
see in the section on welfare economics.
B. Utility Functions and Indifference Curves
Once a consumer describes what his or her preference ordering is, we may derive
a utility function for that consumer. The utility function identifies higher preferences
with larger numbers. Suppose that there are only two commodities or services, x and y,
available to a given consumer. If we let u stand for the consumer’s utility, then the function u = u(x, y) describes the utility that the consumer gets from different combinations of x and y.
A very helpful way of visualizing the consumer’s utility function is by means of
a graph called an indifference map. An example is shown in Figure 2.4. There we
have drawn several indifference curves. Each curve represents all the combinations
of x and y that give the consumer the same amount of utility or well-being. Alternatively,
we might say that the consumer’s tastes are such that he is indifferent among all the
combinations of x and y that lie along a given curve—hence, the name indifference
curve. Thus, all those combinations of x and y lying along the indifference curve
marked U0 give the consumer the same utility. Those combinations lying on the
higher indifference curve marked U1 give this consumer similar utility, but this level
of utility is higher than that of all those combinations of x and y lying along indifference curve U0.
QUESTION 2.3: Begin at point (x0, y 0). Now decrease x from x0 to x1. How
much must y increase to offset the decrease in x and keep the consumer
indifferent?
The problem of consumer choice arises from the collision of the consumer’s preferences with obstacles to his or her satisfaction. The obstacles are the constraints that
force decision makers to choose among alternatives. There are many constraints,
including time, energy, knowledge, and one’s culture, but foremost among these is
y
FIGURE 2.4
The consumer’s indifference map.
(x0, y0)
y0
U
U2 3
U1
U0
0
x1 x0
x
21
IV. The Theory of Consumer Choice and Demand
FIGURE 2.5
y
The consumer’s income constraint or
budget line.
I = px x + pyy
0
x
limited income. We can represent the consumer’s income constraint or budget line by
the line in Figure 2.5. The area below the line and the line itself represent all the combinations of x and y that are affordable, given the consumer’s income, I.5 Presumably,
the consumer intends to spend all of her income on purchases of these two goods and
services, so that the combinations upon which we shall focus are those that are on the
budget line itself.
QUESTION 2.4: In a figure like the one in Figure 2.5 and beginning with a
budget line like the one in Figure 2.5, show how you would draw the new income constraint to reflect the following changes?
1.
2.
3.
4.
An increase in the consumer’s income, prices held constant.
A decrease in the consumer’s income, prices held constant.
A decrease in the price of x, income and the price of y held constant.
An increase in the price of y, income and the price of x held constant.
C. The Consumer’s Optimum
We may now combine the information about the consumer’s tastes given by the
indifference map and the information about the income constraint given by the
budget line in order to show what combination of x and y maximizes the consumer’s
utility, subject to the constraint imposed by her income. See Figure 2.6. There the
consumer’s optimum bundle is shown as point M, which contains x* and y*. Of all
the feasible combinations of x and y, that combination gives this consumer the greatest utility.6
5
6
The equation for the budget line is I = pxx + pyy, where px is the price per unit of x and py is the price
per unit of y. As an exercise, you might try to rearrange this equation, with y as the dependent variable, in
order to show that the slope of the line is negative. When you do so, you will find that the coefficient of the
x-term is equal to – px>py. Economists refer to this ratio as relative price.
Because we have assumed that the normal indifference curves are convex to the origin, there is a unique
bundle of x and y that maximizes the consumer’s utility. For other shapes of the indifference curves it is
possible that there is more than one bundle that maximizes utility.
22
CHAPTER 2
A Brief Review of Microeconomic Theory
FIGURE 2.6
y
The consumer’s optimum.
M
y*
U = xy
0
x
x*
D. A Generalization: The Economic Optimum
as Marginal Cost ! Marginal Benefit
Because of the central importance of constrained maximization in microeconomic
theory, let us take a moment to examine a more general way of characterizing such a
maximum:
A constrained maximum, or any other economic optimum, can be described as a point
where marginal cost equals marginal benefit.
Let’s see how this rule characterizes maximizing decisions.7 Begin by assuming
that the decision maker chooses some initial level of whatever it is he is interested in
maximizing. He then attempts to determine whether that initial level is his maximum;
is that level as good as he can do, given his constraints? He can answer the question by
making very small, what an economist calls marginal, changes away from that initial
level. Suppose that the decision maker proposes to increase slightly above his initial
level whatever it is he is doing. There will be a cost associated with this small increase
called marginal cost. But there will also be a benefit of having or doing more of whatever it is that he is attempting to maximize. The benefit of this small increase is called
marginal benefit. The decision maker will perceive himself as doing better at this new
level, by comparison to his initial level, so long as the marginal benefit of the small increase is greater than the marginal cost of the change. He will continue to make these
small, or marginal, adjustments so long as the marginal benefit exceeds the marginal
cost, and he will stop making changes when the marginal cost of the last change made
equals (or is greater than) the marginal benefit. That level is the decision maker’s
maximum.
QUESTION 2.5: Suppose that, instead of increasing his level above the initial choice, the decision maker first tries decreasing the amount of whatever it
is he is attempting to maximize. Explain how the comparison of marginal cost
7
This rule could describe equally well an economic optimum where the goal of the decision maker is to minimize
something. In that case, the optimum would still be the point at which MC = MB, but the demonstration of
the stylized decision making that got one to that point would be different from that given in the text.
23
IV. The Theory of Consumer Choice and Demand
and marginal benefit for these decreases is made and leads the decision maker
to the optimum. (Assume that the initial level is greater than what will ultimately prove to be the optimum.)
We can characterize the consumer’s income-constrained maximum, M in Figure
2.6, in terms of the equality of marginal cost and benefit. Small changes in either direction along the budget line, I, represent a situation in which the consumer spends
a dollar less on one good and a dollar more on the other. To illustrate, assume the
consumer decides to spend a dollar less on y and a dollar more on x. Purchasing a
dollar less of y causes a loss in utility that we may call the marginal cost of the
budget reallocation. But the dollar previously spent on y can now be spent on x.
More units of x mean greater utility, so that we may call this increase the marginal
benefit of the budget reallocation.
Should the consumer spend a dollar less on good y and a dollar more on x? Only if
the marginal cost (the decrease in utility from one dollar less of y) is less than the marginal benefit (the increase in utility from having one dollar more of x). The rational
consumer will continue to reallocate dollars away from the purchase of y and toward
the purchase of x until the marginal benefit of the last change made equals the marginal
cost. This occurs at the point M in Figure 2.6.
Figure 2.7 applies constrained maximization to reduce the amount of pollution.
Along the vertical axis are dollar amounts. Along the horizontal axis are units of pollution reduction. At the origin there is no effort to reduce pollution. At the vertical line
labeled “100%,” pollution has been completely eliminated.
The curve labeled MB shows the marginal benefit to society of reducing pollution.
We assume that this has been correctly measured to take into account health, scenic,
and all other benefits that accrue to members of society from reducing pollution at various levels. This line starts off high and then declines. This downward slope captures
the fact that the very first efforts at pollution reduction confer large benefits on society.
The next effort at reducing pollution also confers a social benefit, but not quite as great
as the initial efforts. Finally, as we approach the vertical line labeled “100%” and all
vestiges of pollution are being eliminated, the benefit to society of achieving those last
steps is positive, but not nearly as great as the benefit of the early stages of pollution
reduction.
FIGURE 2.7
$
The socially optimal amount of
pollution-reduction effort.
Marginal cost of
pollution reduction
MC
MC = MB
Marginal benefit
of pollution reduction
0
MB Reduction
in pollution
P* 100%
24
CHAPTER 2
A Brief Review of Microeconomic Theory
The curve labeled MC represents the “social” as opposed to “private” marginal
cost of achieving given levels of pollution reduction. The individuals and firms that pollute must incur costs to reduce pollution: They may have to adopt cleaner and safer production processes that are also more expensive; they may have to install monitoring
devices that check the levels of pollution they generate; and they may have to defend
themselves in court when they are accused of violating the pollution-reduction guidelines. We have drawn the MC curve to be upward-sloping to indicate that the marginal
costs of achieving any given level of pollution-reduction increase. This means that the
cost of reducing the very worst pollution may not be very high, but that successive
levels of reduction will be ever more expensive.
Given declining marginal benefit and rising marginal cost, the question then arises,
“What is the optimal amount of pollution-reduction effort for society?” An examination of Figure 2.7 shows that P* is the socially optimal amount of pollution-reduction
effort. Any more effort will cost more than it is worth. Any less would cause a reduction in benefits that would be greater than the savings in costs.
Note that, according to this particular graph, it would not be optimal for society to
try to eliminate pollution entirely. Here it is socially optimal to tolerate some pollution.
Specifically, when pollution reduction equals P*, the remaining pollution equals
100% – P*, which is the “optimal amount of pollution.” Few goods are free. Much of
the wisdom of economics comes from the recognition of this fact and of the derivation
of techniques for computing the costs and benefits.
QUESTION 2.6: Suppose that we were to characterize society’s decision
making with regard to pollution-reduction efforts as an attempt to maximize
the net benefit of pollution-reduction efforts. Let us define net benefit as the
difference between marginal benefit and marginal cost. What level of pollutionreduction effort corresponds to this goal?
QUESTION 2.7: Using a graph like Figure 2.7, show the effect on the determination of the socially optimal amount of pollution-reduction effort of the
following:
1. Some technological change that lowers the marginal cost of achieving every
level of pollution reduction.
2. A discovery that there are greater health risks associated with every given level
of pollution than were previously thought to be the case.
If you understand that for economists, the optimum for nearly all decisions occurs
at the point at which marginal benefit equals marginal cost, then you have gone a long
way toward mastering the microeconomic tools necessary to answer most questions
that we will raise in this book.
E. Individual Demand
We may use the model of consumer choice of the previous sections to derive a relationship between the price of a good and the amount of that good in a consumer’s optimum bundle. The demand curve represents this relationship.
25
IV. The Theory of Consumer Choice and Demand
FIGURE 2.8
Px
An individual’s demand curve, showing
the inverse relationship between price
and quantity demanded.
P0
P1
D
0
x
x0
x1
Starting from point M in Figure 2.6, note that when the price of x is that given by
the budget line, the optimal amount of x to consume is x*. But what amount of x will
this consumer want to purchase so as to maximize utility when the price of x is lower
than that given by the budget line in Figure 2.6? We can answer that question by holding Py and I constant, letting Px fall, and writing down the amount of x in the succeeding optimal bundles. Not surprisingly, the result of this exercise will be that the price of
x and the amount of x in the optimum bundles are inversely related. That is, when the
price of x goes up, Py and I held constant (or ceteris paribus, “all other things equal,”
as economists say), the amount of x that the consumer will purchase goes down, and
vice versa. This result is the famous law of demand.
We may graph this relationship between Px and the quantity of x demanded to
get the individual demand curve, D, shown in Figure 2.8. The demand curve we
have drawn in Figure 2.8 could have had a different slope than that shown; it might
have been either flatter or steeper. The steepness of the demand curve is related to
an important concept called the price elasticity of demand, or simply elasticity of
demand.8
This is an extremely useful concept: It measures how responsive consumer demand is to changes in price. And there are some standard attributes of goods that influence how responsive demand is likely to be. For instance, if two goods are similar
in their use, then an increase in the price of the first good with no change in the price
of the second good causes consumers to buy significantly less of the first good.
Generalizing, the most important determinant of the price elasticity of demand for a
8
The measure is frequently denoted by the letter e, and the ranges of elasticity are called inelastic (e 6 1),
elastic (e 7 1), and unitary elastic (e = 1). By convention, e, the price elasticity of demand, is a positive
(or absolute) number, even though the calculation we suggested will lead to a negative number. For an inelastically demanded good, the percentage change in price exceeds the percentage change in quantity
demanded. Thus, a good that has e = 0.5 is one for which a 50 percent decline in price will cause a 25 percent
increase in the quantity demanded, or for which a 15 percent increase in price will cause a 7.5 percent decline in quantity demanded. For an elastically demanded good, the percentage change in price is less than
the percentage change in quantity demanded. As a result, a good that has e = 1.5 is one for which a 50 percent decline in price will cause a 75 percent increase in quantity demanded, or for which a 20 percent increase in price will cause a 30 percent decline in quantity demanded.
26
CHAPTER 2
A Brief Review of Microeconomic Theory
good is the availability of substitutes. The more substitutes for the good, the greater
the elasticity of demand; the fewer the substitutes, the lower the elasticity.
Substitution is easier for narrowly defined goods and harder for broad categories. If
the price of cucumbers goes up, switching to peas or carrots is easy; if the price of
vegetables goes up, switching to meat is possible; but if the price of food goes up,
eating less is hard to do. So, we expect that demand is more elastic for cucumbers
than vegetables and more elastic for vegetables than food. Also, demand is more
elastic in the long run than the short run. To illustrate, if electricity prices rise relative to natural gas, consumers will increasingly switch to burning gas as they gradually replace furnaces and appliances. Economists often measure and remeasure the
price elasticities of demand for numerous goods and services to predict responses to
price changes.
V. The Theory of Supply
We now turn to a review of the other side of the market: the supply side. The key
institution in supplying goods and services for sale to consumers is the business firm. In
this section we shall see what goal the firm seeks and how it decides what to supply. In
the following section, we merge our models of supply and demand to see how the independent maximizing activities of consumers and firms achieve a market equilibrium.
A. The Profit-Maximizing Firm
The firm is the institution in which output (products and services) is fabricated
from inputs (capital, labor, land, and so on). Just as we assume that consumers rationally maximize utility subject to their income constraint, we assume that firms maximize
profits subject to the constraints imposed on them by consumer demand and the technology of production.
In microeconomics, profits are defined as the difference between total revenue and
the total costs of production. Total revenue for the firm equals the number of units of
output sold multiplied by the price of each unit. Total costs equal the costs of each of
the inputs times the number of units of input used, summed over all inputs. The profitmaximizing firm produces that amount of output that leads to the greatest positive difference between the firm’s revenue and its costs. Microeconomic theory demonstrates
that the firm will maximize its profits if it produces that amount of output whose marginal cost equals its marginal revenue. (In fact, this is simply an application of the general rule we discussed in section IV.D earlier: To achieve an optimum, equate marginal
cost and marginal benefit.)
These considerations suggest that when marginal revenue exceeds marginal cost,
the firm should expand production, and that when marginal cost exceeds marginal revenue, it should reduce production. It follows that profits will be maximized for that output for which marginal cost and marginal revenue are equal. Note the economy of this
rule: To maximize profits, the firm need not concern itself with its total costs or total
revenues; instead, it can simply experiment on production unit by unit in order to discover the output level that maximizes its profits.
27
V. The Theory of Supply
FIGURE 2.9
Price
The profit-maximizing output for
a firm.
MC
AC
p
p = MR
AC ‘
0
q
q*
In Figure 2.9 the profit-maximizing output of the firm is shown at the point at
which the marginal cost curve, labeled MC, and marginal revenue curve of the firm are
equal. The profit-maximizing output level is denoted q*. Total profits at this level of
production, denoted by the shaded area in the figure, equal the difference between the
total revenues of the firm ( p times q*) and the total costs of the firm (the average cost
of producing q* times q*).
There are several things you should note about the curves in the graph. We have
drawn the marginal revenue curve as horizontal and equal to the prevailing price. This
implies that the firm can sell as much as it likes at that prevailing price. Doubling its
sales will have no effect on the market price of the good or service. This sort of behavior is referred to as price-taking behavior. It characterizes industries in which there are
so many firms, most of them small, that the actions of no single firm can affect the market price of the good or service. An example might be farming. There are so many suppliers of wheat that the decision of one farmer to double or triple output or cut it in half
will have no impact on its market price. (Of course, if all farms decide to double output, there will be a substantial impact on market price.) Such an industry is said to be
“perfectly competitive.”
B. The Short Run and the Long Run
In microeconomics the firm is said to operate in two different time frames: the
short run and the long run. These time periods do not correspond to calendar time.
Instead they are defined in terms of the firm’s inputs. In the short run at least one input
is fixed (all others being variable), and the usual factor of production that is fixed is
capital (the firm’s buildings, machines, and other durable inputs). Because capital is
fixed in the short run, all the costs associated with capital are called fixed costs. In the
short run the firm can, in essence, ignore those costs: They will be incurred regardless
of whether the firm produces nothing at all or 10 million units of output. (The only
costs that change in the short run are “variable costs,” which rise or fall depending on
how much output the firm produces.) The long run is distinguished by the fact that all
factors of production become variable. There are no longer any fixed costs. Established
firms may expand their productive capacity or leave the industry entirely, and new
firms may enter the business.
28
CHAPTER 2
A Brief Review of Microeconomic Theory
Another important distinction between the long and the short run has to do with
the equilibrium level of profits for each firm. At any point in time there is an average
rate of return earned by capital in the economy as a whole. When profits being earned
in a particular industry exceed the average profit rate for comparable investments, firms
will enter the industry, assuming there are no barriers to entry. As entry occurs, the total industry output increases, and the price of the industry output goes down, causing
each firm’s revenue to decrease. Also, the increased competition for the factors of production causes input prices to rise, pushing up each firm’s costs. The combination of
these two forces causes each firm’s profits to decline. Entry ceases when profits fall to
the average rate.
Economists have a special way of describing these facts. The average return on
capital is treated as part of the costs that are subtracted from revenues to get “economic
profits.” Thus, when the rate of return on invested capital in this industry equals the
average for the economy as a whole, it is said that “economic profits are zero.”9
This leads to the conclusion that economic profits are zero in an industry that is in
long-run equilibrium. Because this condition can occur only at the minimum point of
the firm’s average cost curve, where the average costs of production are as low as they
can possibly be, inputs will be most efficiently used in long-run equilibrium. Thus, the
condition of zero economic profits, far from being a nightmare, is really a desirable
state.
VI. Market Equilibrium
Having described the behavior of utility-maximizing consumers and profitmaximizing producers, our next task is to bring them together to explain how they
interact. We shall first demonstrate how a unique price and quantity are determined
by the interaction of supply and demand in a perfectly competitive market and then
show what happens to price and quantity when the market structure changes to one
of monopoly. We conclude this section with an example of equilibrium analysis of
an important public policy issue.
A. Equilibrium in a Perfectly Competitive Industry
An industry in which there are so many firms that no one of them can influence the
market price by its individual decisions and in which there are so many consumers that
the individual utility-maximizing decisions of no one consumer can affect the market
price is called a perfectly competitive industry. For such an industry the aggregate demand for and the aggregate supply of output can be represented by the downward-sloping
demand curve, d = d(p), and the upward-sloping supply curve, s = s(p), shown
9
When profits in a given industry are less than the average in the economy as a whole, economic profits are
said to be negative. When that is the case, firms exit this industry for other industries where the profits are
at least equal to the average for the economy. As an exercise, see if you can demonstrate the process by
which profits go to zero when negative economic profits in an industry cause exit to take place.
29
VI. Market Equilibrium
FIGURE 2.10
Price
Market equilibrium in a perfectly
competitive market.
s = s(p)
excess supply
P1
Pc
d = d(p)
0
qd1
qc
qs1
Quantity
in Figure 2.10. The market-clearing or equilibrium price and quantity occur…
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