Intermediate

Microeconomics

and Its Application

Walter Nicholson Amtierst College

Christopher Snyder Darlmouth College

mä

\

/ ,CENGAGE 4#" Learning*

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

Preface xxiii

PART 1 INTRODUCTION 1

CHARTER 1 Economic Models 3

1-1 What Is Microeconomics? 3 1-2 A Few Basic Principles 4 1 -3 Uses of Microeconomics 6 Application 1.1: Economics in the Natural World? 7 1-4 The Basic Supply-Demand Model 8 Application 1.2: Is It Worth Your Time to Be Here? 9 Application 1.3: The Rise and Fall of Blockbuster 10

Adam Smith and the Invisible Hand 11 David Ricardo and Diminishing Returns 11 Marginalism and Marshall's Model of Supply and Demand 12 Market Equilibrium 13 Nonequilibrium Outcomes 14 Change in Market Equilibrium 14

1-5 How Economists Verify Theoretical Models 15 Application 1.4: Supply and Demand According to Bono 16

Testing Assumptions 17 Testing Predictions 17 The Positive-Normative Distinction 17

Application 1.5: Do Economists Ever Agree on Anything? 18 Summary 19 Review Questions 19 Problems 20 Appendix to Chapter 1 Mathematics Used in Microeconomics 23 Al-1 Functions of One Variable 23 AI-2 Graphing Functions of One Variable 24

Linear Functions: Intercepts and Slopes 25 Interpreting Slopes: An Example 26 Slopes and Units of Measurement 26 Changes in Slope 27 Nonlinear Functions 29

Application 1A.1: How Does Zillow.com Do It? 30 The Slope of a Nonlinear Function 31 Marginal and Average Effects 31 Calculus and Marginalism 32

Application 1A.2: Can a "Fiat" Tax Be Progressive? 33 Al-3 Functions of Two or More Variables 34

Trade-Offs and Contour Lines: An Example 34 Contour Lines 35

AI-4 Simultaneous Equations 36 Changing Solutions for Simultaneous Equations 37 Graphing Simultaneous Equations 37

AI-5 Empirical Microeconomics and Econometrics 38 Random Influences 38 The Ceteris Paribus Assumption 39

Application 1A.3: Can Supply and Demand Explain Changing World Oil Prices? 40

Exogenous and Endogenous Variables 42 The Reduced Form 43

Summary 44

PART 2 DEMAND 45

CHARTER 2 Utility and Choice 47

2-1 Utility 47 Ceteris Paribus Assumption 47 Utility from Consuming Two Goods 48 Measuring Utility 48

Application 2.1: Can Money Buy Health and Happiness? 49 2-2 Assumptions about Preferences 50

Completeness 50 Transitivity 50 More Is Better: Defining an Economic "Good" 50

2-3 Voluntary Trades and Indifference Curves 51 Application 2.2: Should Economists Care about How the Mind Works? 52

Indifference Curves 53 Indifference Curves and the Marginal Rate of Substitution 54 Diminishing Marginal Rate of Substitution 54 Balance in Consumption 55

2-4 Indifference Curve Maps 55 2-5 Illustrating Particular Preferences 56

A Useless Good 57 An Economic Bad 57 Perfect Substitutes 57

Application 2.3: Product Positioning in Marketing 58 Perfect Complements 59

2-6 Utility Maximization: An Initial Survey 60 Choices Are Constrained 60 An Intuitive Illustration 60

2-7 Showing Utility Maximization on a Graph 61 The Budget Constraint 61 Budget-Constraint Algebra 62 A Numerical Example 63 Utility Maximization 63

2-8 Using the Model of Choice 65 Application 2.4: Ticket Scalping 66

A Few Numerical Examples 68 Application 2.5: What's a Rieh Uncle's Promise Worth? 69 2-9 Generalizations 72

Many Goods 72

Contents ix

Complicated Budget Constraints 72 Composite Goods 73

Application 2.6: Loyalty Programs 74 Summary 75 Review Questions 75 Problems 76

CHARTER 3 Demand Curves 79

3-1 Individual Demand Functions 79 Homogeneity 79

3-2 Changes in Income 80 Normal Goods 81 Inferior Goods 81

3-3 Changes in a Good s Price 81 Application 3.1: Engel's Law 82

Substitution and Income Effects from a Fall in Price 83 Substitution Effect 83 Income Effect 85 The Effects Combined: A Numerical Example 85 The Importance of Substitution Effects 85 Substitution and Income Effects for Inferior Goods 87

Application 3.2: The Consumer Price Index and Its Biases 88 Giffen's Paradox 90

3-4 An Application: The Lump-Sum Principle 90 A Graphical Approach 90 Generalizations 91

Application 3.3: The Inefftciency ofln-kind Programs 92 3-5 Changes in the Price of Another Good 93

Substitutes and Complements 94 3-6 Individual Demand Curves 94

Shape of the Demand Curve 96 3-7 Shifts in an Individual's Demand Curve 97

Be Careful in Using Terminology 98 3-8 Two Numerical Examples 98

Perfect Complements 98 Some Substitutability 99

3-9 Consumer Surplus 99 Demand Curves and Consumer Surplus 99 Consumer Surplus and Utility 101

3-10 Market Demand Curves 102 Construction of the Market Demand Curve 102

Application 3.4: Valuing New Goods 103 Shifis in the Market Demand Curve 104 Numerical Examples 104 A Simplified Notation 105

3-11 Elasticity 105 Use Percentage Changes 106 Linking Percentages 106

3-12 Price Elasticity of Demand 106 Values of the Price Elasticity of Demand 107

Price Elasticity and the Substitution Effect 107 Price Elasticity and Time 108 Price Elasticity and Total Expenditures 108

Application 3.5: Brand Loyalty 109 Application 3.6: Price Volatility 111 3-13 Demand Curves and Price Elasticity 112

Linear Demand Curves and Price Elasticity: A Numerical Example 112 A Unit Elastic Curve 114

3-14 Income Elasticity of Demand 115 Application 3.7: An Experiment in Health Insurance 116 3-15 Cross-Price Elasticity of Demand 117 3-16 Some Elasticity Estimates 117 Summary 119 Review Questions 119 Problems 120

PART 3 UNCERTAINTY AND STRATEGY 123

CHARTER 4 Uncertainty 125

4-1 Probability and Expected Value 125 4-2 Risk Aversion 126

Diminishing Marginal Utility 126 Application 4.1: Blackjack Systems 127

A Graphical Analysis of Risk Aversion 128 Willingness to Pay to Avoid Risk 129

4-3 Methods for Reducing Risk and Uncertainty 129 Insurance 130

Application 4.2: Deductibles in Insurance 132 Diversification 133

Application 4.3: Mutual Funds 135 Flexibility 136

Application 4.4: Puts, Calls, and Black-Scholes 139 Information 140 Information Differences among Economic Actors 142

Application 4.5: The Energy Paradox 144 4-4 Pricing of Risk in Financial Assets 145

Investors' Market Options 145 Choices by Individual Investors 146

Application 4.6: The Equity Premium Puzzle 147 Summary 148 Review Questions 148 Problems 149 Appendix to Chapter 4 Two-State Model of Uncertainty 152 A4-1 Model 152 A4-2 Risk Aversion 153 A4-3 Insurance 154 A4-4 Diversification 156 A4-5 Option Value 157 Summary 158

CHARTERS Game Theory 159

5-1 Background 159 5-2 Basic Concepts 160

Players 160 Strategies 160 Payoffs 160 Information 160

5-3 Equilibrium 161 Application 5.1: A Beautiful Mind 162 5-4 Illustrating Basic Concepts 163

The Prisoners' Dilemma 163 The Game in Normal Form 163 The Game in Extensive Form 163 Solving for the Nash Equilibrium 164 Dominant Strategies 165 The Dilemma 167 Mixed Strategies 167 Matching Pennies 167 Solving for a Mixed-Strategy Nash Equilibrium 168 Interpretation of Random Strategies 169

5-5 Multiple Equilibria 169 Application 5.2: Mixed Strategies in Sports 170

Battie of the Sexes 171 Computing Mixed Strategies in the Battie of the Sexes 172 The Problem of Multiple Equilibria 174

5-6 Sequential Games 174 Application 5.3: High-Definition Standards War 175

The Sequential Battie of the Sexes 176 Subgame-Perfect Equilibrium 178 Backward Induction 180 Repeated Games 182 Defmite Time Horizon 182 Indefinite Time Horizon 182

Application 5.4: Laboratory Experiments 183 5-7 Continuous Actions 185

Tragedy of the Commons 185 Shifting Equilibria 186

5-8 N-Player Games 187 5-9 Incomplete Information 187 Application 5.5: Terrorism 188 Summary 189 Review Questions 189 Problems 190

PART 4 PRODUCTION, COSTS, AND SUPPLY 193

CHARTER 6 Production 195

6-1 Production Functions 195 Two-Input Production Function 196

6-2 Marginal Product 196

xii Contents

Diminishing Marginal Product 196 Application 6.1: Every Household Is a Firm 197

Marginal Product Curve 198 Average Product 198 Appraising the Marginal Product Concept 199

6-3 Isoquant Maps 199 Application 6.2: What Did U.S. Automakers Learn from the Japanese? 200

Rate of Technical Substitution 201 RTS and Marginal Products 202 Diminishing RTS 202

Application 6.3: Engineering and Economics 203 6-4 Returns to Scale 204

Adam Smith on Returns to Scale 204 A Precise Definition 204 Graphic Illustrations 204

Application 6.4: Returns to Scale in Beer and Wine 206 6-5 Input Substitution 207

Fixed-Proportions Production Function 207 Relevance of Input Substitutability 208

6-6 Changes in Technology 209 Technical Progress versus Input Substitution 210 Multifactor Productivity 210

Application 6.5: Finding the Computer Revolution 211 6-7 A Numerical Example of Production 212

The Production Function 212 Average and Marginal Productivities 212 The Isoquant Map 212 Rate of Technical Substitution 213 Technical Progress 214

Summary 215 Review Questions 215 Problems 216

CHARTER 7 Costs 219

7-1 Basic Cost Concepts 219 Economic versus Accounting Costs 219 Economic versus Opportunity Costs 221 Labor Costs 221 Capital Costs 222 Entrepreneurial Costs 222

Application 7.1: Stranded Costs and Deregulation 223 The Two-Input Case 224 Economic Profits and Cost Minimization 224

7-2 Cost-Minimizing Input Choice 224 Graphic Presentation 225 An Alternative Interpretation 226

Application 7.2: Is Social Responsibility Costly? 227 The Firm's Expansion Path 228

7-3 Cost Curves 228

Contents xiii

Average and Marginal Costs 230 Marginal Cost Curves 230 Average Cost Curves 232

Application 7.3: Findings on Firms' Average Costs 233 Economies of Scale 234

7-4 Distinction between the Short Run and the Long Run 234 Holding Capital Input Constant 235 Types of Short-Run Costs 235 Input Inflexibility and Cost Minimization 236

7-5 Per-Unit Short-Run Cost Curves 237 Application 7.4: Congestion Costs 238 7-6 Shifts in Cost Curves 239

Changes in Input Prices 239 Technological Innovation 239 Economies of Scope 240

7-7 A Numerical Example 240 Application 7.5: Are Economies of Scope in Banking a Bad Thing? 241

Long-Run Cost Curves 242 Short-Run Costs 243

Summary 244 Review Questions 245 Problems 246

CHARTER 8 Profit Maximization and Supply 249

8-1 The Nature of Firms 249 Why Firms Exist 249 Contracts within Firms 250 Contract Incentives 250 Firms' Goals and Profit Maximization 251

8-2 Profit Maximization 251 Marginalism 251

Application 8.1: Corporate Profits Taxes and Firms' Financing Decisions 252

The Output Decision 253 The Marginal Revenue/Marginal Cost Rule 254 Marginalism in Input Choices 254

8-3 Marginal Revenue 255 Marginal Revenue for a Downward-Sloping Demand Curve 255 A Numerical Example 255 Marginal Revenue and Price Elasticity 257

8-4 Marginal Revenue Curve 259 Numerical Example Revisited 259

Application 8.2: Maximizing Profits from Bagels and Catalog Sales 260 Shifts in Demand and Marginal Revenue Curves 262

8-5 Supply Decisions of a Price-Taking Firm 262 Price-Taking Behavior 262

Application 8.3: Evolving Airline Pricing Strategies 263 A Numerical Example Showing Price-Taking Behavior 264 Short-Run Profit Maximization 264

Application 8.4: Price-Taking Behavior 265 Showing Profits 266 The Firm's Short-Run Supply Curve 267 Negative Profits and the Shutdown Decision 267 A Numerical Illustration 268

Application 8.5: Boom and Bust in the Oil Patch 269 Summary 270 Review Questions 271 Problems 272

PART 5 PERFECT COMPETITION 275

CHARTER 9 Perfect Competition in a Single Market 277

9-1 Timing of a Supply Response 277 9-2 Pricing in the Very Short Run 277

Shifts in Demand: Price as a Rationing Device 278 Applicability of the Very Short-Run Model 278

Application 9.1: Internet Auctions 279 9-3 Short-Run Supply 280

Construction of a Short-Run Supply Curve 280 9-4 Short-Run Price Determination 281

Functions of the Equilibrium Price 281 Effect of an Increase in Market Demand 282

9-5 Shifts in Supply and Demand Curves 283 Short-Run Supply Elasticity 283 Shifts in Supply Curves and the Importance of the Shape of the Demand Curve 284 Shifts in Demand Curves and the Importance of the Shape of the Supply Curve 285

Application 9.2: Ethanol Subsidies in the United States and Brazil 286 A Numerical Illustration 287 Algebra is Easier 288

9-6 The Long Run 289 Equilibrium Conditions 289 Profit Maximization 289 Entry and Exit 289 Long-Run Equilibrium 290

9-7 Long-Run Supply: The Constant Cost Gase 290 Market Equilibrium 290 A Shift in Demand 291 Long-Run Supply Curve 291

9-8 Shape of the Long-Run Supply Curve 292 The Increasing Cost Case 292 Long-Run Supply Elasticity 293 Estimating Long-Run Elasticities of Supply 293 Can Supply Curves Be Negatively Sloped? 294

Application 9.3: How Do Network Externalities Affect Supply Curves? 295 9-9 Consumer and Producer Surplus 296

Short-Run Producer Surplus 297 Long-Run Producer Surplus 297

Contents xv

Ricardian Rent 297 Economic Efficiency 299 A Numerical Illustration 299

Application 9.4: Does Buying Things on the Internet Improve Weifare? 300 9-10 Some Supply-Demand Applications 301

Tax lncidence 302 Long-Run lncidence with Increasing Costs 303

Application 9.5: The Tobacco "Settlement" Is Just a Tax 305 A Numerical Illustration 306 Trade Restrictions 307

Application 9.6: The Saga of Steel Tariffs 309 Sum mary 310 Review Questions 311 Problems 312

CHARTER 10 General Equilibrium and Weifare 315

10-1 A Perfectly Competitive Price System 315 10-2 Why Is General Equilibrium Necessary? 316

Disturbing the Equilibrium 317 Reestablishing Equilibrium 317

10-3 A Simple General Equilibrium Model 317 Application 10.1: Modeling Excess Bürden with a Computer 318 10-4 The Economic Efficiency of Perfect Competition 320

Some Numerical Examples 322 Prices, Efficiency, and Laissez-Faire Economics 324

10-5 Why Markets Fail to Achieve Economic Efficiency 325 Imperfect Competition 325 Externalities 325 Public Goods 325

Application 10.2: Gains from Free Trade and Free Trade Agreements 326 Imperfect Information 328

10-6 Efficiency and Equity 328 Defining and Achieving Equity 328 Equity and Competitive Markets 329

10-7 The Edgeworth Box Diagram for Exchange 329 Mutually Beneficial Trades 329 Efficiency in Exchange 331 Contract Curve 331 Efficiency and Equity 331 Equity and Efficiency with Production 332

Application 10.3: The Second Theorem of Weifare Economics 333 10-8 Money in General Equilibrium Models 334

Nature and Function of Money 334 Money as the Accounting Standard 334 Commodity Money 335 Fiat Money and the Monetary Veil 335

Application 10.4: Commodity Money 336 Summary 337 Review Questions 338 Problems 338

xvi Contents

PART 6 MARKET POWER 343

CHARTER 11 Monopoly 345

11-1 Causes of Monopoly 345 Technical Barriers to Entry 345 Legal Barriers to Entry 346

11-2 Profit Maximization 346 A Graphic Treatment 346

Application 11.1: Should You Need a License to Shampoo a Dog? 347 Monopoly Supply Curve? 348 Monopoly Profits 349

11-3 What's Wrong with Monopoly? 350 Deadweight Loss 351 Redistribution from Consumers to the Firm 351

Application 11.2: Who Makes Money at Casinos? 352 A Numerical Illustration of Deadweight Loss 353 Buying a Monopoly Position 354

11-4 Price Discrimination 355 Perfect Price Discrimination 355

Application 11.3: Financial Aid at Private Colleges 357 Market Separation 358 Nonlinear Pricing 359

Application 11.4: Mickey Mouse Monopoly 362 Durability 364

Application 11.5: Bundling of Cable and Satellite Television Ojferings 365 11-5 Natural Monopolies 366

Marginal Cost Pricing and the Natural Monopoly Dilemma 367 Two-Tier Pricing Systems 367

Application 11.6: Does Anyone JJnderstand Telephone Pricing? 368 Rate of Return Regulation 369

Summary 369 Review Questions 370 Problems 370

CHARTER 12 Imperfect Competition 374

12-1 Overview: Pricing of Homogeneous Goods 374 Competitive Outcome 374 Perfect Cartel Outcome 375 Other Possibilities 376

12-2 Cournot Model 376 Nash Equilibrium in the Cournot Model 377

Application 12.1: Measuring Oligopoly Power 378 Comparisons and Antitrust Considerations 380 Generalizations 381 Bertrand Model 381

Application 12.2: Cournot in California 382 Nash Equilibrium in the Bertrand Model 383 Bertrand Paradox 384 Capacity Choice and Cournot Equilibrium 384 Comparing the Bertrand and Cournot Results 385

Contents xvii

12-3 Product Differentiation 385 Market Definition 386 Bertrand Model with Differentiated Products 386

Application 12.3: Competition on the Beach 387 Product Selection 388 Search Costs 389 Advertising 390

Application 12.4: Searching the Internet 391 12-4 Tacit Collusion 392

Finite Time Horizon 392 Application 12.5: The Great Electrical Equipment Conspiracy 393

Indefinite Time Horizon 394 Generalizations and Limitations 395

12-5 Entry and Exit 396 Sunk Costs and Commitment 396 First-Mover Advantages 396 Entry Deterrence 398 A Numerical Example 398 Limit Pricing 399 Asymmetrie Information 400 Predatory Pricing 401

Application 12.6: The Standard Oil Legend 402 12-6 Other Models of Imperfect Competition 403

Price Leadership 403 Monopolistic Competition 404

12-7 Barriers to Entry 405 Summary 406 Review Questions 407 Problems 407

PART 7 INPUT MARKETS 411

CHARTER 13 Pricing in Input Markets 413

13-1 Marginal Productivity Theory of Input Demand 413 Profit-Maximizing Behavior and the Hiring oflnputs 413 Price-Taking Behavior 414 Marginal Revenue Product 414 A Special Case—Marginal Value Product 414

13-2 Responses to Changes in Input Prices 415 Single Variable Input Case 415

Application 13.1: Jet Fuel and Hybrid Seeds 416 A Numerical Example 417 Two-Variable Input Case 418 Substitution Effect 418 Output Effect 418 Summary ofFirm's Demand for Labor 419

13-3 Responsiveness of Input Demand to Input Price Changes 420

Ease of Substitution 420 Costs and the Output Effect 420

13-4 Input Supply 421

xviii Contents

Application 13.2: Controversy over the Minimum Wage 422 Labor Supply and Wages 423

13-5 Equilibrium Input Price Determination 423 Shifts in Demand and Supply 423

13-6 Monopsony 425 Marginal Expense 425 A Numerical Illustration 425

Application 13.3: Why Is Wage lnequality Increasing? 426 Monopsonist's Input Choice 428 A Graphical Demonstration 428 Numerical Example Revisited 428 Monopsonists and Resource Allocation 430 Causes of Monopsony 430

Application 13.4: Monopsony in the Market for Sports Stars 431 Bilateral Monopoly 432

Application 13.5: Superstars 433 Summary 434 Review Questions 434 Problems 435 Appendix to Chapter 13 Labor Supply 438 A13-1 Allocation of Time 438

A Simple Model of Time Use 438 The Opportunity Cost of Leisure 439

Application 13A.1: The Opportunity Cost of Time 440 Utility Maximization 441

A13-2 Income and Substitution Effects of a Change in the Real Wage Rate 441

A Graphical Analysis 442 AI3-3 Market Supply Curve for Labor 442 Application 13A.2: The Earned Income Tax Credit 444 Summary 445

CHAPTER 14 Capital and Time 446

14-1 Time Periods and the Flow of Economic Transactions 446 14-2 Individual Savings—The Supply of Loans 447

Two-Period Model of Saving 447 A Graphical Analysis 447 A Numerical Example 448 Substitution and Income Effects of a Change in r 449

14-3 Firms' Demand for Capital and Loans 449 Application 14.1: Do We Need Tax Breaks for Savers? 450

Rental Rates and Interest Rates 451 Ownership of Capital Equipment 452

14-4 Determination of the Real Interest Rate 452 Application 14.2: Do Taxes Affect Investment? 453 Application 14.3: Usury 454

Changes in the Real Interest Rate 455 14-5 Present Discounted Value 455 Application 14.4: The Real Interest Rate Paradox 456

Single-Period Discounting 457

Multiperiod Discounting 457 Present Value and Economic Decisions 458

14-6 Pricing of Exhaustible Resources 458 Scarcity Costs 458

Application 14.5: Discounting Cash Flows and Derivative Securities 459 The Size of Scarcity Costs 460

Application 14.6: Are Any Resources Scarce? 461 Time Pattern of Resource Prices 462

Summary 462 Review Questions 463 Problems 464 Appendix to Chapter 14 Compound Interest 466 A14-1 Interest 466 A14-2 Compound Interest 466

Interest for One Year 466 Interest for Two Years 467 Interest for Three Years 467 A General Formula 467 Compounding with Any Dollar Amount 468

Application 14A.1: Compound Interest Gone Berserk 469 A14-3 Present Discounted Value 469

An Algebraic Definition 470 General PDV Formulas 470

A14-4 Discounting Payment Streams 471 Application 14A.2: Zero-Coupon Bonds 472

An Algebraic Presentation 473 Perpetual Payments 474 Varying Payment Streams 475 Calculating Yields 475 Reading Bond Tables 475

A14-5 Frequency of Compounding 476 Semiannual Compounding 476 A General Treatment 477 Real versus Nominal Interest Rates 477

Application 14A.3: Continuous Compounding 478 A14-6 The Present Discounted Value Approach to Investment Decisions 479

Present Discounted Value and the Rental Rate 480 Summary 480

PART 8 MARKET FAILURES 483

CHAPTER 15 Asymmetrie Information 485

15-1 Principal-Agent Model 485 15-2 Worker Moral Hazard 486 Application 15.1: Principals and Agents in Franchising and Medicine 487

Füll Information about Effort 488 Unobservable Effort 489 Problems with High-Powered Incentives 491 Substitutes for High-Powered Incentives 492

xx Contents

A Numerical Example 493 Executives in the Firm 494 Summing Up 495

Application 15.2: The Good and Bad Effects of Stock Options 496 Application 15.3: Moral Hazard in the Financial Crisis 497 15-3 Private Information about Consumer Type 498

One Consumer Type 498 Two Consumer Types, Füll Information 499 Two Consumer Types: Asymmetrie Information 499 Examples 501 Inefficiency with Hidden Types 503 Adverse Selection in Warranties and Insurance 504

15-4 Asymmetrie Information in Competitive Markets 504 Moral Hazard with Several Agents 504

Application 15.4: Adverse Selection in Insurance 505 Auctions 506 The Market for Lemons 508

15-5 Signaling 509 Spence Education Model 509

Application 15.5: Looking for Lemons 510 Separating Equilibrium 512 Pooling Equilibria 513 Predatory Pricing and Other Signaling Games 514 Inefficiency in Signaling Games 514

Summary 515 Review Questions 515 Problems 516

CHARTER 16 Externalities and Public Goods 519

16-1 Defining Externalities 519 Externalities between Firms 519 Externalities between Firms and People 520 Externalities between People 520 Reciprocal Nature of Externalities 520

16-2 Externalities and Allocational Efficiency 521 A Graphical Demonstration 521

Application 16.1: Secondhand Smoke 522 16-3 Property Rights, Bargaining, and the Coase Theorem 523

Costless Bargaining and Competitive Markets 524 Ownership by the Polluting Firm 524 Ownership by the Injured Firm 524 The Coase Theorem 525 Distributional Effects 525 The Role of Transactions Costs 525

Application 16.2: Property Rights and Nature 526 16-4 Externalities with High Transactions Costs 527

Legal Redress 527 Taxation 527

Application 16.3: Product Liability 528

Contents xxi

Regulation of Externalities 529 Optimal Regulation 530 Fees, Permits, and Direct Controls 530

16-5 Public Goods 531 Attributes of Public Goods 531

Application 16.4: Power Plant Emissions and the Global Warming Debate 532

Nonexclusivity 534 Nonrivalry 534 Categories of Public Goods 534

16-6 Public Goods and Market Failure 535 A Graphical Demonstration 535

Application 16.5: Ideas as Public Goods 536 16-7 Solutions to the Public Goods Problem 538

Nash Equilibrium and Underproduction 538 Compulsory Taxation 538 The Lindahl Equilibrium 539

16-8 Revealing the Demand for Public Goods 540 Local Public Goods 540

16-9 Voting for Public Goods 540 Application 16.6: Fund Raising on Public Broadcasting 541

Majority Rule 542 The Paradox of Voting 542 Single-Peaked Preferences and the Median Voter Theorem 543 Voting and Efficient Resource Allocation 544 Representative Government and Bureaucracies 544

Application 16.7: Referenda on Limiting Public Spending 545 Summary 546 Review Questions 546 Problems 547

CHARTER 17 Behavioral Economics 550

17-1 Should We Abandon Neoclassical Economics? 550 17-2 Limits to Human Decision Making: An Overview 551 17-3 Limited Cognitive Power 552

Uncertainty 553 Application 17.1: Household Finance 554

Prospect Theory 556 Framing 558 Paradox of Choice 558 Multiple Steps in Reasoning 559 Evolution and Learning 561

Application 17.2: Cold Movie Openings 562 Self-Awareness 563

17-4 Limited Willpower 563 Application 17.3: Going for It on Fourth Down 564 Application 17.4: Let's Make a Deal 565

Flyperbolic Discounting 566 Numerical Example 566

xxii Contents

Further Applications 568 Commitment Strategies 569

Application 17.5: "Put a Contract Out on Yourself" 570 17-5 Limited Self-Interest 571

Altruism 571 Fairness 572 Market versus Personal Dealings 574

17-6 Policy Implications 575 Borrowing and Savings Decisions 575

Application 17.6: Late for Daycare Pickup 576 Other Goods and Services 577 Market Solutions 577 "Nudging" the Market 578

Summary 578 Review Questions 579 Problems 579

Glossary 583

Solutions 588

Brief Answers 608

Index 616