MICROECONOMICS DEMYSTIFIED DR. CRAIG A. DEPKEN, II McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2006 by The McGraw-Hill Companies. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-148674-7 The material in this eBook also appears in the print version of this title: 0-07-145911-1. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trade- marked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringe- ment of the trademark. 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Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMIT- ED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071459111 This book is dedicated to Linda and Campbell; both have helped demystify my life. ABOUT THE AUTHOR Dr. Craig A. Depken, II, is an associate professor of economics at the University of Texas at Arlington. Dr. Depken graduated with an undergraduate degree in economics from the University of Georgia in 1991, and with a PhD in economics from the University of Georgia in June 1996. He received a tenure-track appointment at the University of Texas at Arlington in the fall of 1996. Dr. Depken was promoted to Associate Professor with Tenure in the spring of 2002. Dr. Depken has published extensively in peer-reviewed journals, such as The Review of Industrial Organization, The Journal of Business, The Journal of Economic Behavior and Organization, The Journal of Sports Economics, Economics of Education Review, and Economics Letters, focusing primarily on the economics of sports and various topics in applied microeconomics. He has also received awards for his teaching, including the inaugural Innovation in Teaching award in the College of Business at the University of Texas in Arlington for his integration of the then young Internet and traditional classroom teaching. He was nominated in 2004 for the National Faculty of the Year award of the National Society of College Scholars. Copyright © 2006 by The McGraw-Hill Companies. Click here for terms of use. For more information about this title, click here CONTENTS Acknowledgments ix Introduction xi CHAPTER 1 The Language of Economics 1 Summary 7 Quiz 7 CHAPTER 2 Math Review 11 Summary 16 Quiz 16 CHAPTER 3 Production and Growth 19 Production 19 Production in a Robinson Crusoe Economy 20 Economic Growth 23 Gains from Trade 24 Summary 33 Quiz 33 CHAPTER 4 Demand and Supply 37 Demand 38 Supply 43 Price as a Regulator in the Market 47 Changes in Demand 50 Changes in Supply 51 v Microeconomics Demystifi ed vi Changes in Supply and Demand 52 Government Interventions in the Market 55 Price Floors and Ceilings 56 Quantity Controls 58 Taxation in the Supply and Demand Model 59 Summary 66 Quiz 67 CHAPTER 5 Elasticity 73 Price Elasticity of Demand 74 Income Elasticity of Demand 78 Cross Elasticity of Demand 79 Elasticity of Supply 79 Applications of Elasticity 80 Price Elasticity of Supply and Demand and the Burden of a Sales Tax 87 Summary 89 Quiz 90 CHAPTER 6 Consumer and Producer Surplus 93 Consumer Surplus 93 Producer Surplus 97 Changes in Consumer and Producer Surplus and Changes in Supply and Demand 100 The Impact of a Sales Tax on Consumer and Producer Surplus 102 Summary 105 Quiz 105 CHAPTER 7 Utility 111 The Utility Function and Indifference Curves 112 The Household’s Income Constraint 114 The Household’s Consumption Equilibrium 118 The Law of Demand and Utility Theory 120 Income and Substitution Effects 122 CONTENTS vii Substitution Effect 123 The Income Effect 125 Combining Substitution and Income Effects 126 Summary 129 Quiz 129 CHAPTER 8 Theory of the Firm 133 Why the Firm? 134 The Firm’s Production Function and Isoquants 135 Effi ciency and the Firm 138 The Firm’s Cost Constraint 140 A Firm’s Cost Functions: Total Cost, Average Cost, and Marginal Cost 143 Summary 147 Quiz 148 CHAPTER 9 Perfect Competition 153 Summary 164 Quiz 164 CHAPTER 10 Theory of Monopoly 169 Static Monopoly 169 Effi ciency Aspects of Static Monopoly 178 Price Discrimination 181 First Degree Price Discrimination 181 Third Degree Price Discrimination 182 Second Degree Price Discrimination 185 Cartel Theory 188 Contestable Market Theory 190 Summary 191 Quiz 192 CHAPTER 11 Monopolistic Competition and Oligopoly 197 Monopolistic Competition 198 Oligopoly 200 Microeconomics Demystifi ed viii The Kinked Demand Model 201 Oligopoly with a Dominant Firm 202 Strategic Interaction 204 Cournot Duopoly Game 205 Bertrand’s Duopoly Game 207 Summary 208 Quiz 209 CHAPTER 12 Factor Markets 213 Labor 215 Labor Demand 215 Labor Supply 217 Labor Market Equilibrium 218 Additional Topics in Labor Markets 220 Capital Markets 230 Demand for Capital 230 Supply of Capital 231 Capital Market Equilibrium 231 Land 238 Summary 240 Quiz 242 CHAPTER 13 Market Failure and Government Intervention in Markets 245 Public Goods 246 Externalities 251 Summary 262 Quiz 263 APPENDIX A Quiz Answers 267 APPENDIX B Final Exam 279 Final Exam Answers 309 Index 313 ACKNOWLEDGMENTS I primarily want to thank my parents, Geraldine and Craig Depken for their countless sacrifi ces in helping me throughout the years. Their examples of personal dedication to learning and investigation are testimony to the effect that parents have on their children. I also owe a debt to the faculty of the economics department at the University of Georgia, especially Arthur Snow, Fred Bateman, and David Kamerschen. Without these individuals I would not have been able to complete my graduate degree program or obtained the extensive experience of teaching at the undergraduate level that ultimately provided the basis for the approach taken in this book. For their anonymous efforts, I acknowledge the undergraduate students that took my principles of economics courses at the University of Georgia and the University of Texas at Arlington. At the University of Georgia, especially, several students made signifi cant contributions to my approach in teaching the principles of microeconomics, many of which appear in this book. I thank the faculty of the Department of Economics at the University of Texas at Arlington for providing one of the best environments in the country for research and collegiality. Our countless discussions about economics––always interesting and provocative––have provided some of the examples included in this text. I specifi cally want to thank Daniel Himarios for his personal support during my appointment as assistant professor and my promotion to associate professor. Richard Buttimer, Bill Crowder, Courtney LaFountain, Robert Sonora, Mike Ward, and Dennis Wilson are also acknowledged for their indirect contributions to this text. Finally, I thank Trisha Bezmen for her helpful comments on an earlier version of this manuscript; her eye to fi ne details is greatly appreciated. ix Copyright © 2006 by The McGraw-Hill Companies. Click here for terms of use. INTRODUCTION This book provides a self-study approach to understanding the theory of microeco- nomics, avoiding unnecessary mathematics. The approach in this book assumes that you have not studied economics before. What exactly is economics? You are probably familiar with economic terms from watching the nightly news or reading the daily newspaper. Economics is often discussed in terms of unemployment, the stock market, gross national product, the trade defi cit, or consumer confi dence. However, none of these topics really defi nes economics. Instead, these are elements of the broader set of questions that economics addresses. Economics is a relatively young fi eld of formal investigation. While individuals have made choices from the fi rst days of consciousness, the focused investigation into the elements of human choice that would today be considered “mainstream” economics can be dated to Adam Smith’s 1776 treatise An Inquiry into the Causes of the Wealth of Nations. As the title suggest, Smith was concerned with what infl uenced the general well being of nation states and the citizenry therein. After Smith’s work was disseminated (in the non-Internet age!) several notable economists extended his analysis to include topics that are today considered standard elements of a principles course in economics, including Ricardo, Mill, Jevons, Edgeworth, Marshall, and Keynes. Many of these names are unfamiliar to those who have not studies economics, but that does not indicate that their contributions are inconsequential. Like any fi eld of study, economics has its “mighty pillars” upon which later generations base their study, philosophy, and approach to problem solving. The names of those who contributed the “principles of economics” are perhaps less important than the concepts themselves. Over the past hundred years, the fi eld of economics has expanded from the study of what makes a country “wealthy” to an area that investigates all sorts of human behavior. Indeed, some might point out that economics is less the study of numbers, such as unemployment, interest rates, and prices, as it is a study of human behavior—borrowing xi Copyright © 2006 by The McGraw-Hill Companies. Click here for terms of use.