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Armen A. Alchian, Universal Economics [2018]

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Armen A. Alchian, Universal Economics. Edited by Jerry L. Jordan. Foreword by William R. Allen (Indianapolis: Liberty Fund, 2018).

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About this Title:

Universal Economics shows the critical importance of property rights to the existence and success of market economies. The authors explain the interconnection between goods prices and productive-asset prices and how market-determined interest rates bring about the allocation of resources toward the satisfaction of consumption demands versus saving/investment priorities. They show how the crucial role of prices in a market economy cannot be well understood without a firm grasp of the role of money in the modern world. The Alchian and Allen application of information and search-cost analysis to the subject of money, price determination, and inflation is unique in the teaching of economic principles.

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Published by permission.

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This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.

Table of Contents:

Edition: current; Page: [i]
Edition: current; Page: [ii] Edition: current; Page: [iii]
Universal Economics
edited by jerry l. jordan
Foreword by William R. Allen
liberty fund
Edition: current; Page: [iv]

This book is published by Liberty Fund, Inc., a foundation established to encourage study of the ideal of a society of free and responsible individuals.


The cuneiform inscription that serves as our logo and as the design motif for our endpapers is the earliest-known written appearance of the word “freedom” (amagi), or “liberty.” It is taken from a clay document written about 2300 bc in the Sumerian city-state of Lagash.

© 2018 by Pacific Academy for Advanced Studies (PAAS).

Published by permission.

All rights reserved

Printed in the United States of America

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Library of Congress Cataloging-in-Publication Data

Names: Alchian, Armen Albert, 1914– author. | Allen, William Richard, 1924– author. | Jordan, Jerry L., 1941– editor.

Title: Universal economics / Armen A. Alchian and William R. Allen ; edited by Jerry L. Jordan ; foreword by William R. Allen.

Description: Carmel, Indiana : Liberty Fund, Inc., [2018] | Includes bibliographical references and index. | Description based on print version record and CIP data provided by publisher; resource not viewed.

Identifiers: llcn 2017052105 (print) | lccn 2017054644 (ebook) | isbn 9781614876571 (Kindle) | isbn 9781614872818 (epub) | isbn 9781614879275 (pdf) | isbn 9780865979055 (hardcover : alk. paper) | isbn 9780865979062 (pbk. : alk. paper)

Subjects: lcsh: Economics.

Classification: lcc hb171.5 (ebook) | lcc hb171.5 .a339 2018 (print) | ddc 330—dc23

lc record available at

liberty fund, inc.

11301 North Meridian Street, Carmel, Indiana 46032-4564

Edition: current; Page: [v]


  • Detailed Contents vii
  • Foreword xxiii
  • part one: Demand, Exchange, and Property Rights
    • 1 Welcome to Economics 3
    • 2 Your Economic Society 15
    • 3 Choice and Cost 33
    • 4 Gains from Exchange 50
    • 5 Demands and the Laws of Demand 62
    • 6 The Extent of Exchange 81
    • 7 Keep Your Eye on the Marginals 97
    • 8 More Features of Demand 109
    • 9 Some Implications of the Laws of Demand 125
    • 10 Markets and Prices as Social Coordinators 133
    • 11 Illustrative Applications of Demand Principles 146
    • 12 Shortages, Surpluses, and Prices 157
    • 13 Markets and Property Rights 171
  • part two: Specialization, Production, Teams, and Firms
    • 14 Productivity and Costs of Production 197
    • 15 Specialization and Exchange 214
    • 16 Market Supply and Price with Price-Takers 231
    • 17 Timing of Adjustments 255
    • 18 Facts of Life 274
    • 19 Price-Searchers 285
    • 20 Price-Searcher Pricing 310
    • 21 Pricing and Marketing Tactics 324
    • 22 Teamwork and Firms 344
    • 23 The Firm’s Control and Reward Structure 363
    • 24 Protecting Your Dependencies 376
    • 25 Dependency Assurance by Reputation and Predictable Price 389
    • 26 Prohibited Marketing Tactics 402
    • 27 The Corporate Firm 420
    • 28 Competition for Control of the Corporation 436
    • 29 The Demand for Productive Resources 449
    Edition: current; Page: [vi]
  • part three: Wealth, Rates of Return, and Risk
    • 30 Arithmetic of Capital Values 475
    • 31 Series of Future Values and Annuities 490
    • 32 Wealth, Income, and Interest 516
    • 33 A Package Called the Rate of Interest 532
    • 34 Risk and Insurance 543
    • 35 The Full Equilibrium: Equalized Rates of Return 558
    • 36 Determinants of the Interest Rate 571
    • 37 Futures Markets 586
  • part four: Employment and Inflation
    • 38 Unemployment: What and Why 603
    • 39 Your Earnings: How and When 614
    • 40 Labor-Market Coalitions 628
    • 41 Labor-Market Constraints 644
    • 42 Money, Prices, and Inflation 657
  • Glossary 681
  • Index 693
Edition: current; Page: [vii]


  • Concise Contents v
  • Foreword, by William R. Allen xxiii
  • part one: Demand, Exchange, and Property Rights
    • 1 Welcome to Economics 3
      • Scarcity 4
      • Goods: Economic or Free 4
      • Self-Interest? 5
      • Competition 5
      • Our Intent 8
      • Sequence of Exposition and Unsolicited Advice for Study 9
      • Questions and Meditations 10
    • 2 Your Economic Society 15
      • Rights and Property Rights 16
      • Private Property Rights 17
      • The Rule against Perpetuities 20
      • Capitalist or Socialist 20
      • Alert! Free Speech Is Not “Free Resources” 21
      • Efficiency and the “Constrained Maximum” Concept 22
      • Meaning of a “Theory” 24
      • Economic Analysis Is Positive, Not Normative 24
      • Increased or Reduced Probability and Refutable Implications 25
      • Reported versus Verified Event 25
      • Transient Lucky Event versus Basic Difference: The Ubiquitous Regression Effect 25
      • Economics versus Economists 26
      • Which Economic Theory? 26
      • Economics and Biology 27
      • The Basic Unit of Analysis Is the Individual, Not a Group 27
      • Questions and Meditations 27
    • 3 Choice and Cost 33
      • Definition of Cost of a Chosen Action 33
      • Personal Worth 33
      • Some Confusions That Must Be Avoided 34
      • Externalities: Uncompensated Effects Borne by Other People 36
      • Costs and Effects of Actions 36 Edition: current; Page: [viii]
      • Choices Reflect Principles of Personal Preferences 39
      • The Personal Preference Principles 40
      • Questions and Meditations 42
      • Appendix to Chapter 3: Indifference Curves 44
    • 4 Gains from Exchange 50
      • Trade in a Refugee Camp 50
      • Less Is More: Fewer Goods, More Satisfaction 51
      • Thinking about the Trade 52
      • More about Personal Worth 53
      • To Have? 54
      • Back at the Refugee Camp, Competition Develops 54
      • Promises and Dependencies 56
      • Reliable General Dependency: Essential in Every Economy and Society 56
      • Trade Benefits Both Parties, Not Just One at the Expense of the Other 57
      • Questions and Meditations 57
    • 5 Demands and the Laws of Demand 62
      • First Law of Demand 62
      • “Quantity Demanded” versus “Demand” 63
      • Negatively Sloped Demand 65
      • Slide versus Shift 65
      • Assumptions about Actions, Not about Thought Processes 66
      • Direction of Relations, Not Exact Data, Is Pertinent 69
      • Why So Much Concentration on “Marginals” Rather Than Totals or Averages? 71
      • Dollar Price and Relative Price 72
      • Meaning of “Change in Price” 73
      • Suggestive Labels 74
      • Questions and Meditations 75
    • 6 The Extent of Exchange 81
      • Exchange 81
      • Basis of National Policy on Market Competition 82
      • Intermediaries and Transaction Costs 84
      • Intermediaries’ Reduction of Full Price by Reducing Transaction Preparation Costs 85
      • Markets: Open or Constrained Access? 88
      • Markets—Everywhere 90
      • Implications of Market Exchanges, Not Judgments 90
      • Contracts and Reliable Promises: The Binding Forces of Society 91
      • Questions and Meditations 92
    • 7 Keep Your Eye on the Marginals 97
      • Totals, Marginals, and Averages 97
      • Cost 97
      • Revenue 97
      • Use the Marginal or the Average? 99
      • Relations among Totals, Marginals, and Averages 99 Edition: current; Page: [ix]
      • A Basic Principle: “The Equalization of Marginals at the Maximum Aggregated Return” 102
      • Cost Minimizing 105
      • Questions and Meditations 105
    • 8 More Features of Demand 109
      • Why So Much Attention to Price? 109
      • Changes in Money Prices and Changes in Relative Prices 109
      • Which Demand? 109
      • Elasticities of Demand: Responsiveness of Quantity Demanded to the Price 110
      • Remember: Elasticity of Demand Is a Measure of Movements along a Demand Schedule, Not a Result of a Shift in the Demand Schedule 115
      • The Second Law of Demand 116
      • A Fan of Demand Curves 118
      • Income, Wealth, and Demand 118
      • Wealth and Income Effects of a Change of Price 119
      • Precisely What Is Meant by the Demanded Amount? 120
      • Rate of Demand versus Aggregate Volume Demanded 120
      • Questions and Meditations 121
    • 9 Some Implications of the Laws of Demand 125
      • “Needed” or “Demanded” Amounts? 125
      • Indirect Implications of the Laws of Demand 127
      • Alleged Exceptions to the Laws of Demand 129
      • Questions and Meditations 130
    • 10 Markets and Prices as Social Coordinators 133
      • A “Market-Clearing” Price? 133
      • Market-Clearing Price for Allocation of a Fixed Supply of a Good 133
      • “The Market” Sets the Price 134
      • The Market Demand: The Sums of the Individual Demands at Each Possible Price 134
      • Irrelevance of Initial Allocation of Goods for Their Final Allocation to Highest-Valuing Users 135
      • Shortages Are Not Results of Reductions in Supply 136
      • Markets and “Rights” 136
      • Creation of Markets 137
      • Reservation Demand to Own 137
      • Rents 138
      • Land Rent—A Pure Surplus? 138
      • Quasi-Rent 139
      • “Political Rent-Seeking” 139
      • Questions and Meditations 141
    • 11 Illustrative Applications of Demand Principles 146
      • Marketing Arrangements: Buffer Stocks, Reserve Capacity, Stable Prices, Waiting Times, and Price Response to Demand Uncertainty 146 Edition: current; Page: [x]
      • Speed of Detecting Changes in Demand or Supply: The Illusion That Cost Determines Price 148
      • Who Is Responsible for Higher Prices? Look in the Mirror 149
      • What Made the Price Change? Always, the Initial Question 150
      • Who Bears the Tax on Land Developments—Developers or Landowners? 150
      • Tax on Economic Rent? 151
      • Pollution and Land Values 151
      • Questions and Meditations 153
    • 12 Shortages, Surpluses, and Prices 157
      • Shortages and Price Ceilings 157
      • Shifts to Nonprice Competition 158
      • Wealth Transfers versus Costly Competitive Activity 159
      • Rationing by Coupons 159
      • Price Controls on Inputs (Petroleum) Do Not Reduce the Price of Outputs (Gasoline) 162
      • Statement of a Basic Principle 162
      • The Oil Industry Divided—Some Attacking and Others Defending Petroleum Price Controls 163
      • Surpluses and Price Floors 164
      • Competitive Behavior during a “Surplus” 166
      • Implications 167
      • Questions and Meditations 167
    • 13 Markets and Property Rights 171
      • How Relative Preferences Are Impressed on the Owner 172
      • Government Agencies and Private Property Rights 172
      • Two False Issues 175
      • The Rule of Private Property Rights 176
      • Protection and Preservation of Alienability 177
      • Shared Ownership 177
      • How to Become a Member-Owner? 178
      • Why Deliberately Suppress Private Property Rights of a College? 179
      • Externalities 180
      • “Public Goods” 181
      • Government Control 182
      • Public, or Group, Goods: Clubs 182
      • Privately Supplied Public Goods Financed by Tie-Ins 183
      • Charity 183
      • Questions and Meditations 185
  • part two: Specialization, Production, Teams, and Firms
    • 14 Productivity and Costs of Production 197
      • Productive Ability versus Costs of Production, or Absolute Advantage versus Comparative Advantage 197
      • Measure of Cost 197 Edition: current; Page: [xi]
      • Costs versus Productive Ability 198
      • No One Can Be the Lowest, or the Highest, Cost Producer of Every Good 198
      • Absolute Productive Ability versus Lower Costs 198
      • Marginal and Average Costs 199
      • Marginal Costs 199
      • Temporary Simplifying Assumptions 199
      • Ricardian Superiority and Ricardian Rent 199
      • Rates versus Volume of Production: An Important Distinction 200
      • Marginal and Average Costs and Their Realistic Relation to Rates of Production 200
      • Arithmetic of Marginal Cost 202
      • The Sum of the Marginal Costs Is the Total Cost 202
      • The Marginal-Average Relationship 203
      • Rate and Volumes of Production 203
      • Choice of Production and Consumption by Self-Sufficient Adam 203
      • Marginal Costs Are Higher at Faster Rates of Production 204
      • The Law of Diminishing Marginal Returns 205
      • Price of Labor versus Labor Cost of Output 206
      • Questions and Meditations 207
    • 15 Specialization and Exchange 214
      • Adam’s and Baker’s Production and Costs Compared 214
      • Differences in Costs and Marginal Worths Create Opportunities for Trade 217
      • Two’s Company, Three’s Even Better: Effects and Objections to New Entrants 218
      • An Economically Complete Analysis 219
      • Reduced Cost, Profit, and Dispersion of the Profit 221
      • Improved Quality and the Dispersion of the Benefit 221
      • Two Meanings of Specialization in Production and Several Sources of Benefits 223
      • No Free Benefits: Increased Dependence 225
      • Questions and Meditations 225
    • 16 Market Supply and Price with Price-Takers 231
      • Sunk Investment or Set-Up Cost 231
      • What Rate of Production? 231
      • Price-Taker/Sellers 232
      • Price-Taker/Seller Sees a Horizontal Demand Curve at the Market Price 233
      • No Rivalry among Price-Takers 233
      • Aggregated Demand and Aggregated Supply in the Market 234
      • Marginal Costs, Profits, and a Price-Taker’s Supply Response to the Market Price: A Price-Taker’s Marginal Revenue Is Equal to the Market Price 235
      • Determining the Rate of Production and Supply 236
      • Two Types of Constant Costs: 1) Constant Total Daily Costs Regardless of Daily Rate of Production (Even If Zero); 2) Constant Costs per Unit of Production 236
      • The Planned Output Rate for Profit Maximizing 237
      • A Graph Showing Price-Takers’ Response to the Market Price 238 Edition: current; Page: [xii]
      • Profit-Maximizing Rates of Output at Other Market Prices 238
      • Why Analyze Profit-Maximizing Rate of Production through Marginal Revenues and Marginal Costs? 239
      • A Role for Average Cost 239
      • The Long-Run Average Cost 240
      • The Short-Run Average Cost 240
      • Market Supply Curve of Price-Taker/Suppliers Is the Horizontal Sum of the Marginal Cost Curves 240
      • An Upward-Sloping Market Supply Curve 241
      • Industry-Wide Cost Minimization of the Profit-Maximizing Output 241
      • Is the Profit Test of Survival “Socially Desirable”? 242
      • Competition for Profitable Resources Converts Profit into Cost 243
      • A Person, Rather Than Equipment, as the Responsible Resource 244
      • Profits Are Increases in Wealth—Not Transfers of Wealth from One Person to Another 245
      • Productive Resources That Enter after a New Tax 249
      • Depreciation versus Capital Value Changes 249
      • Obsolescence versus Depreciation 249
      • Why Do Accounting Records Show Depreciation as Erosion of Initial Cost of Resource, Rather Than of Current Value? 250
      • Questions and Meditations 250
    • 17 Timing of Adjustments 255
      • Tax It: Demand and Supply 255
      • Deadweight Welfare Loss 257
      • Mobile versus Less-Mobile Resources 258
      • Comparison of Short-Run and Long-Run Effects 258
      • After the Long-Run Adjustments, Consumers Pay All the Tax; New Investors Pay None 260
      • Only Present and Future Costs Are Really Costs 261
      • Quasi-Rent: A Temporary Surplus 261
      • Infinite Elasticity of Supply 262
      • The Longer-Run Responses and Effects 262
      • For What Is the Tax Used? 263
      • Reducing Negative-Worth Externalities 264
      • Adjustments before Predicted Event Occurs 264
      • Gasoline and Oil Prices 265
      • Competitive Pricing Response to New Entrants: Is It Predatory? 267
      • Questions and Meditations 270
    • 18 Facts of Life 274
      • The Missing Entrepreneur 275
      • Example of Effect of Creative Destruction 276
      • Many Producers of a Consumer Product 276
      • Managers Don’t Know Their Costs as Accurately as Those Shown in the Examples 277
      • Allocating Common Costs to Joint Products 278
      • Supply in Terms of Mass Production and the Volume Produced 280 Edition: current; Page: [xiii]
      • Summary of Cost and Volume Output Relations 281
      • Warning 282
      • Demand in Terms of Volume Demanded 282
      • The Historical Pattern of Prices of a Product 282
      • Questions and Meditations 283
    • 19 Price-Searchers 285
      • Price-Takers and Price-Searchers 285
      • Differences for Customers because of Differences among Competing Sellers 286
      • Price-Searchers Search for the Best Price to Maximize Profits 286
      • Price-Searchers Must Set the Prices for Their Products 287
      • Signals to Price-Searchers 288
      • Pricing at a Uniform Price to the Entire Public 288
      • Price versus Marginal Revenue 288
      • The Profit-Maximizing Price and Quantity: Marginal Revenue Equality to Marginal Cost 289
      • Price-Searcher with Increasing Marginal Costs 289
      • Increasing Marginal Costs and the Profit-Maximizing Output 291
      • Knowing Patterns of Marginal Costs and Marginal Revenues 291
      • Sellers Aren’t Naive 292
      • Closed, Restricted, and Open Markets 293
      • Who Is Restricted by a Restriction on the Seller? 294
      • Categories of Sellers 294
      • Who Is a Monopolist? 295
      • Cartels 296
      • Personal Services? 296
      • Objectives of the Language of Economics and the Language of Litigation 296
      • Objections to (1) Closed Markets and (2) Price-Searchers in Open Markets 297
      • Normative Standard for the Laws: Open Markets and Forgone Consumer Worth? 298
      • “Monopoly” Distortion: Inefficient Output Ratio 298
      • Is It Really Wasteful or Inefficient? 300
      • Long-Run Response: Capacity and Cost Response to Demand Changes 300
      • The Meaning of Consumer Worth and to Whom It Belongs 302
      • Questions and Meditations 303
    • 20 Price-Searcher Pricing 310
      • Charging Different Prices among Customers to Equalize Marginal Revenues 310
      • What Rate of Production? 311
      • Marginal Revenue Equalization: Price Discrimination? 312
      • Dumping Is Not Selling Below Cost. It’s Simply Marginal Revenue 313
      • College Tuition Scholarships? 313
      • Discount Coupons 314
      • Free and Special Services: A Free Tie-In 314
      • Is Marginal Revenue Equalization Really Price Discrimination? 314 Edition: current; Page: [xiv]
      • Price-Searcher Buyer—Monopsonist 315
      • Why Higher Wage Rates to All Employees? 316
      • Differentiating Benefits 317
      • Questions and Meditations 318
    • 21 Pricing and Marketing Tactics 324
      • Tie-Ins 324
      • Basing-Point Pricing 329
      • Efficient, Competitive Pricing Response to New Entrants, Misconstrued as Predatory Pricing 331
      • Dominant Firm, with Market Power 333
      • Price Leaders? 336
      • Oligopoly 336
      • Networks, Monopoly Lock-Ins? 337
      • Patents and Copyrights: Conflicting Objectives and Ambiguous Policies of Reward to Inventors 338
      • Questions and Meditations 340
    • 22 Teamwork and Firms 344
      • No Definable, Separable, Individual Products for Each Team Member 344
      • Intrateam Dependencies 345
      • Are You Paid What You Add to the Total Value? A Futile Question 346
      • Hazards to Effective, Viable Teams: Dependencies, Moral Hazard, Uncertainty of Team Value, and a Risk-Accepting Owner 347
      • The Saga of Codlandia 348
      • National Development 358
      • Questions and Meditations 359
    • 23 The Firm’s Control and Reward Structure 363
      • The Boss 364
      • What Is the Meaning of “Owning a Firm”? 364
      • Management Rewards 365
      • Shirking as Moral Hazard or Opportunistic Hold-Ups 366
      • Monitoring and Deterring Shirking 366
      • Loyalty and Shirking 366
      • Customers, Rather Than the Employer, May Monitor and Restrain Employee Shirking: “Tips” 367
      • Firms Not Owned by Full Private Property Rights 370
      • Questions and Meditations 372
    • 24 Protecting Your Dependencies 376
      • Dependent Investments 376
      • Integrated Ownership 377
      • Reciprocal Dependency 378
      • Exclusive Service Contracts to Protect Reliability and Investments in a Person 378
      • Example: The Controversial Baseball Reserve Clause 379
      • Voluntary Maximum Retail Price 379 Edition: current; Page: [xv]
      • Publisher versus Distributor Conflict about Retail Price 380
      • Integration? 380
      • More Examples of Price Ceilings Imposed on Retail Distributors 381
      • Minimum Permissible Retailer Prices, Known as Retail Price Maintenance (RPM), to Avoid Free Riding of Discounters 381
      • Self-Enforcing Hostage Value That Depends on Performance 382
      • The Case of Coors Beer: How a Manufacturer Enhances the Reliability of Distributors 383
      • Exclusive Territories Protected by Resale Price Maintenance 384
      • End of Coors Dominance—New Technology 384
      • Government Regulation to Protect Dependent Customers of Closed Monopoly Supplier 384
      • Public Utilities and Natural Monopolies 384
      • Owning a Firm or Lending to It? 385
      • Questions and Meditations 385
    • 25 Dependency Assurance by Reputation and Predictable Price 389
      • Brand Names: Reducing Costs of Prepurchase Information and Shopping 389
      • Cost of Maintaining Brand-Name Value 389
      • Reputation as Self-Enforcer of Reliability 390
      • Franchises Rely on Reputation of Brand Names 390
      • Hostages to the Franchiser to Assure Reliable Performance by the Franchisee 390
      • Advertising—Reducing Search Costs 391
      • Good Samaritan: Am I My Brother’s Keeper? 391
      • Personal Shame 392
      • The Value of Predictability of Price 392
      • Predictability and Assurance of Future Prices 392
      • Announcing Reliable Prices 394
      • Voluntarily Tolerated Queues: Inventories and Rationing 394
      • Preferred Customers among Those Who Differ in Volume and Rate of Demand 395
      • No Surprise and No Haggling: Same Announced Price to All Customers 395
      • Blind Blocks to Economize on Duplicative Inspection and Sorting 396
      • Professional Codes of Ethics 398
      • Questions and Meditations 398
    • 26 Prohibited Marketing Tactics 402
      • What Is Antitrust? 402
      • The Clayton Antitrust Act of 1914 403
      • The Federal Trade Commission Act of 1914 404
      • Remedies and Enforcement Agencies 404
      • Specialization and Dependency 404
      • Meaning of a Benign and a Malign Effect? 405
      • The Basic Criterion: Maximizing Consumer Worth 405
      • Effects on Competitors 406
      • Surrogate Criteria for Permissible Actions: Rule of Reason 407
      • Per Se Illegality 407 Edition: current; Page: [xvi]
      • Vertical or Horizontal Agreements 408
      • Concentration Ratios 408
      • Coalition versus Collusion 410
      • Purpose of Collusion 411
      • Obstacles to Effective Collusion 411
      • Vulnerability of Government Agencies as Less-Careful Buyers 413
      • Government-Enforced Cartels: For Whose Benefit? 413
      • Farm Support Programs 414
      • Labor Unions 415
      • Politicians: Agents of the Public in the Competition for Government Aid 415
      • Questions and Meditations 417
    • 27 The Corporate Firm 420
      • Forms of Ownership of Firms 420
      • The Corporate Form of Business 420
      • Shares of Ownership 421
      • Management Structure 421
      • Characteristics of Ownership of Corporations—Sharing in Large Investments 421
      • Nondiscriminatory Sale of Shares of Ownership 421
      • Evolution of the Corporate Ownership Structure 422
      • Historical Evidence of the Effects of the Corporate Entity 423
      • Legislation to Constrain Corporate Form of Organizations 424
      • Differences between Large and Small Firms 424
      • Why Very Large Firms? 425
      • New Tax on Existing Corporations 427
      • New Investments in Corporations after the Tax 427
      • Questions and Meditations 428
      • Appendix to Chapter 27: Interpreting Financial Statements 429
    • 28 Competition for Control of the Corporation 436
      • Who Owns the Corporation? 436
      • Separation of Ownership from Control Can Be a Way to Specialize 437
      • Control of Behavior of Manager by Owners: The Universal Moral Hazard Phenomenon 437
      • Competition for Achievable Gains by Superior Control 438
      • Obstacles to Stockholder Control of Management: Legislation 438
      • Entrenched Management’s Resistance 439
      • Displacement of Owners and Managers by New Sets of Owners and Managers by Purchase of Complete Ownership 439
      • Takeovers Benefiting Stockholders by Transferring Wealth from Other Members of the Firm 441
      • Indirect Takeovers 442
      • Charity Is Better than Coercion 443
      • Shareholders or Stakeholders? Promises and Agreements? 443
      • Survival of the Corporate Organization 444
      • Managers and Consumers 444
      • Questions and Meditations 444
      Edition: current; Page: [xvii]
    • 29 The Demand for Productive Resources 449
      • Homogeneous, Uniform Units of a Productive Resource versus Nonuniform Units 449
      • The Demand for Productive Services of Uniform Inputs 449
      • The Long-Run Elasticity of Demand for Productive Inputs Exceeds the Short-Run Elasticity 453
      • Cross-Price Elasticity of Demand for Productive Resources 454
      • Input Substitutions in Production Caused by Consumer Substitutions among Consumer Goods 454
      • Substitutes and Complements 454
      • Generalization and Similarity to Demand for Consumption Goods 455
      • Summary of Principles of Demand for Amounts of a Kind of Productive Resources 455
      • Lagged Substitutions Tend to Be Veiled by Interim Events 455
      • The Fallacy of Energy Efficiency—Other Inputs Are Not Free 456
      • More Capital Increases Productivity, but Who Benefits? 456
      • Labor and Capital: Is There a Real Difference? Is It Current versus Earlier Labor? 457
      • Human Capital 457
      • Social and Cultural Resources as Productive Inputs 458
      • If Resources Are Not Owned, Less Attention Is Focused on Market Values 458
      • A Market for Labor or a Market for Persons 458
      • Individual Supply of Labor 460
      • What Is a Unit of Labor Service? The Value of the Service Is Critical 461
      • Questions and Meditations 461
      • Appendix to Chapter 29: Output and Input Equilibria of the Firm 468
  • part three: Wealth, Rates of Return, and Risk
    • 30 Arithmetic of Capital Values 475
      • Essential Concepts for Your Future 475
      • Current and Future Services of Durable Resources 475
      • Principles of Capital Valuations 478
      • Tables of Future Values of Present Amounts 479
      • The “Present Value” of a Future Amount, the “Principal” or “Maturity Value” 481
      • The Rule of Seventy-Two Is a Convenient Quick Aid 484
      • Questions and Meditations 484
    • 31 Series of Future Values and Annuities 490
      • Annuity: Present Capital Value of a Series of Future Values 490
      • Table of Present Values of Annuities 491
      • The Low-Interest-Rate Bias 492
      • Perpetuities—A Special Constant Annuity, Lasting Forever 493
      • A Distant Future Service’s Contribution to Present Capital Value 493
      • How Large Is a Gift? 494
      • Present Values of Annuities of Varied Annual Future Amounts 494 Edition: current; Page: [xviii]
      • Honor Thy Father and Thy Mother 494
      • Current Actions, Long-Run Effects, and Immediate Changes in Prices 495
      • The Words in Financial Markets: Lending Is “Buying” and Borrowing Is “Selling” 495
      • The Significance of Interest as a Cost—Even Without Debts 496
      • If the Interest Rate Is 7 Percent 498
      • Some Hidden Presumptions Deserving Suspicion 498
      • Questions and Meditations 499
      • Appendix to Chapter 31: Applications of Capital Value Principles 502
      • Questions and Meditations 509
    • 32 Wealth, Income, and Interest 516
      • Earnings: Personal Service Yields 516
      • Consumption 516
      • Profits, Losses, and Uncertainty 517
      • Saving 517
      • Income 518
      • More Meanings of “Income” 518
      • A Race to Acquire Private Property Rights of Lumber 525
      • Questions and Meditations 525
      • Appendix to Chapter 32: Balance Sheets and Budgets 528
    • 33 A Package Called the Rate of Interest 532
      • The Nominal and the Pure Rate of Interest 532
      • Premiums in the Package Called the Nominal Interest Rate 532
      • Add-Ons Specific to Individuals 533
      • The Market Risk: Economy-Wide Factors for All People and Financial Securities 534
      • Liquidity: A Subtraction in the Nominal Money Interest Rate Package 536
      • Very Short-Term Bonds Have More Liquidity and Smaller Market Risk Than Longer-Term Bonds 536
      • The “Real” versus the Realized Real Rate of Interest 536
      • Can Not Reliably Measure the Rate of Interest by Relative Prices of Resources 538
      • Investment Effects of Changes in Resource Prices, Rather Than in Cost of Borrowing 539
      • Competitive Equalizing of Pure Interest Rates on All Bonds and Resources 539
      • Questions and Meditations 539
    • 34 Risk and Insurance 543
      • Loss Spreading for Reduction of Private Loss 543
      • What Kind of Catastrophes Are Insurable? 544
      • Some Necessary Conditions for Voluntary Insurance 545
      • Moral Hazard of Employee Behavior 548
      • What Else Do You Get When You Buy Insurance? 548
      • Insurance That Was Not Insurance 549
      • Transformation of Insurance to Damage Compensation 550
      • Relief from Losses Is Not the Sole Purpose of Insurance 550
      • Lotteries—Increased Risk 551 Edition: current; Page: [xix]
      • Insurance, Assurance, and Gambling: A Play on Words? 551
      • Questions and Meditations 552
      • Appendix to Chapter 34: Viable Insurance 556
    • 35 The Full Equilibrium: Equalized Rates of Return with Intermediaries 558
      • Elimination of Sure-Profit Arbitrage 558
      • Unbiased Estimator 559
      • News, Not Events, Is Random and Always Surprises 559
      • Risk 560
      • Trade-Off between Mean and Variance 560
      • Random Walk: The Path of Successive Prices—Martingales 562
      • An Efficient Market Portfolio 564
      • Specialization and Intermediation in the Capital Markets 565
      • Questions and Meditations 567
    • 36 Determinants of the Interest Rate 571
      • Demand for More Current Income Relative to Future Income 571
      • The Price of Current Income: The Rate of Interest 571
      • Whether for Consumption or Investment Is Not Pertinent 573
      • The Supply of Current Relative to Future Income 573
      • Borrowing Is Selling Future Income; Lending Is Buying Future Income 574
      • The Markets for Current Income Relative to Future Income 574
      • Adjustments in Prices of Resources 576
      • The Money Supply and the Interest Rate 577
      • The Language of Buying and Selling Money—Instead of Lending and Borrowing Income 577
      • Lending, Borrowing, or Renting? 577
      • When Is the Rent Paid? 578
      • Changing the Supply of Money to Affect the Rate of Interest 579
      • Increasing the Money Supply Randomly 579
      • Increasing the Money Supply by Purchasing Bonds 579
      • Questions and Meditations 580
    • 37 Futures Markets 586
      • Control and Smoothing of Consumption between Harvests 586
      • Hedges 587
      • What Is a Futures Contract? 588
      • Example of Hedging against Changes in the Price of Wheat 588
      • The Seller of the Futures Contract 589
      • Structure of Futures Contracts and Intermediaries 589
      • Gamblers in Futures Contract Markets? 590
      • Example of a Foreign Exchange Futures Contract 590
      • What Determines the Price of the Futures Contract? 591
      • Predictor of the Price in the Future 591
      • Variety of Futures Markets 592
      • Price-Forecasting Errors and Risks in Futures Markets 594
      • Questions and Meditations 595
    Edition: current; Page: [xx]
  • part four: Employment and Inflation
    • 38 Unemployment: What and Why 603
      • Search for Best Job in a World of Changing Tastes, Demands, and Capabilities 604
      • Unemployment Insurance of Nonhuman Resources 606
      • Job Creation: The Nonsense of Creating Jobs to Reduce Unemployment 606
      • Creative Destruction 607
      • New Entrants to Labor Force 607
      • A Meaning of the Measured Rate of Unemployment 607
      • Transition to and from the Market Labor Force and to and from Employment and Unemployment 608
      • Personal and Gender Differences in Unemployment Rates 609
      • Spells of Unemployment or Reduced Employment 609
      • A Rise of Nonrecession Normal Rate of Unemployment: Changed Composition and Unemployment Benefits 609
      • Unemployment—A Beneficial Phenomenon? 610
      • Questions and Meditations 611
    • 39 Your Earnings: How and When 614
      • Full Earnings versus Money Earnings 614
      • Tying Earnings to Performance: Pay Later When Worth of the Work Is Known 615
      • Pitfalls in Perceptions of How Much Everyone Else Earns 618
      • Age-Related Annual Earnings versus Total Lifetime Earnings 619
      • Shifting Demand and Supply 619
      • Ricardian Superiority 620
      • Sensitivity of Earnings to Differences in Talent 620
      • Why Large-Firm CEOs Earn More Than Small-Firm CEOs 620
      • Replicability of Services Concentrates Rewards to the Best of the Competitors 621
      • Prize for Being the Best 621
      • Gender-Related Earnings 622
      • Human and Nonhuman Wealth 622
      • Poverty 623
      • Nonmoney Forms of Income and Aid 623
      • Poverty, How Long? Transitions to and from Poverty Status 623
      • Feminization of Poverty? 624
      • Questions and Meditations 624
    • 40 Labor-Market Coalitions 628
      • History and Organization 628
      • Rise of Unions 629
      • The National Labor Relations Board (NLRB) 630
      • Union Objectives via Monopoly Status 631
      • Labor Union Effects on Wages 631
      • Protection from Employer Opportunistic Expropriation 632
      • How Does Unionization Achieve Its Objectives? 632 Edition: current; Page: [xxi]
      • Selective Monopolization: Labor and Wage Effects 634
      • Why Do Private Employers Resist Unionization? 635
      • Difficulty of Maintaining Contrived Monopoly Rent: The Value of Monopoly Rent Is Competed Away Even If Price and Supply Are Effectively Controlled 636
      • Closed-Market Monopsonies of Buyers of Labor 637
      • Questions and Meditations 638
    • 41 Labor-Market Constraints 644
      • Minimum Legal Wages or Living Wage 644
      • Nonmoney Productivity and Nonmoney Components of Full Wages 645
      • Substitution by Demanders of Labor Services 646
      • Other Motives for Advocating Higher Minimum Legal Wage Rates 646
      • Equal Pay for Equal Work 647
      • Fair Employment Laws 647
      • Legislatively Mandated Benefits 648
      • Examples of Evidence of the Deduced Implications 649
      • Why Would Employees or Employers Object to Mandated Benefits? 650
      • Comparable Worth as a Basis of Wage Rates? 650
      • Questions and Meditations 651
    • 42 Money, Prices, and Inflation 657
      • Money and Prices 657
      • Inflation 658
      • How Is Inflation Measured? 660
      • The Cause of Inflation 660
      • The Cause of the Increased Money Supply 662
      • How Inflation Is Disruptive and Confusing 663
      • Mistaken Beliefs about Causes of Inflation 664
      • Wealth Transfers by Inflation 665
      • Why Lend If Inflation Is Expected? 667
      • Interpersonal Wealth Transfers as a Result of Incorrectly Anticipated Inflation 667
      • Summary 668
      • Questions and Meditations 668
      • Appendix A to Chapter 42: Adapting to Inflation 674
      • Appendix B to Chapter 42: Generalization of Interpersonal Wealth 676
  • Glossary 681
  • Index 693
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Living is an important activity. And in a world of limitations—faced with scarcities of talent and character and iron ore—living is also difficult. Alternatives must be compared, analyses have to be conducted, decisions inevitably are required. And we often complicate our situation further with personal peculiarities and social arrangements which unduly increase the costs and dilute the rewards of our existence.

Various sorts of observers and self-appointed counselors—theologians, poets, philosophers—have long worked to resolve some of the bittersweet mystery of life. And now we are blessed with economists.

Aristotle, over twenty-four centuries ago, was the most conspicuous of the meditators of antiquity to devote considerable attention to selected aspects of economic conditions and activity. Adam Smith, in the eighteenth century, is the acknowledged father figure in the early development of modern economics. Something resembling current theory began to take shape with the Marginalist Revolution of nearly 150 years ago. A veritable golden age waxed—and perhaps then waned in some respects—in the second half of the twentieth century. In this post–World War II era, there was a considerable band of innovative theorists and applicators of fruitful analytics. Few of these elite were as useful as Armen A. Alchian.

Useful economics relies conspicuously on a toolkit of formal analytic techniques. But tools must be manipulated by competent carpenters. And the carpenters follow building plans prepared by imaginative, inspired, broadly sophisticated architects. Alchian was a master craftsman and contributed additional tools to the kit. And he has been a striking architect. Most rarely, he was anointed with feel for and sense of the nature of individuals and their societies and the mechanisms of the economy on which a community is founded. Further, like many other stalwarts of the economics fraternity, he was motivated to teach.

Milton Friedman observed that “some have a natural instinct for economics and the economic way of reasoning,” but “for most, economic reasoning is an acquired skill—and taste.” Alchian helped a long stream of talented students to acquire productive skills—and sophisticated intellectual tastes.

A spectacular technical, bravura scholarly exhibition often will be of little Edition: current; Page: [xxiv] value to the general community. A conspicuous Alchian characteristic has been to explain important matters in the most simple manner, and he was ingenious in solving questions with use of only the most basic conceptions and constructs. Mark Twain noted that his wife, living along the Mississippi River, learned all the swear words—but not how to carry the tune. In economic analysis, Alchian knew the words well and also splendidly hummed the tune.

Useful economists have learned that elemental, even elementary, economic tools in the hands of an accomplished scholar, teacher, and practitioner can be highly productive. Alain A. Enthoven, while working at the highest levels of policymaking in the Department of Defense, reported: “the tools of analysis that we [in Defense] use are the simplest, most fundamental concepts of economic theory, combined with the simplest quantitative methods. The requirements for success in this line of work are a thorough understanding of and, if you like, belief in the relevance of such concepts as marginal products and marginal costs, and an ability to discover the marginal products and costs in complex situations, combined with a good quantitative sense. The economic theory we are using is the theory most of us learned as sophomores.” (Economic Analysis in the Department of Defense, American Economic Review, LIII [May 1963], 422.)

Armen and I became UCLA colleagues in 1952. We have collaborated in several ventures, primarily in writing University Economics (Wadsworth Publishing Co., 1964, 1967, 1972) and Exchange and Production (Wadsworth Publishing Co., 1969, 1977, 1983). This is a new volume, although it bears family resemblance to its predecessors. Like Exchange and Production, it is essentially price-and-allocation analysis, along with consideration of inflation and various references to the applicability of microeconomics to the aggregate economy and international implications. Above all, it continues the effort of the earlier volumes to present an exposition of economic analysis with persistent emphasis on empirical validity and meaningfulness. The original manuscript was prepared by Armen over the course of a decade, before deteriorating health ended further work, preventing a polished exposition. Now, belatedly, the draft has been completed, edited, and updated.

Bringing Armen’s last project to fruition has required considerable and varied effort. It would not have been completed—if attempted, at all—without Jerry Jordan. Jerry was among a substantial flow of graduate students who were definitively influenced by Armen from the 1950s through the 1980s, and, like many of them, he has had a highly distinguished and conspicuous economics career. Along with prodigious work directly on the manuscript, he has been Edition: current; Page: [xxv] the chief coordinator of the variety of activities by several people involved in producing such a large publication.

Many scholars across the world, affiliated formally or informally with the UCLA Department of Economics in the Alchian era, have taken an interest in the publication and contributed to the project. Linda Kleiger, another of Alchian’s students, has done much both as an administrator and a critic of content. Arline Alchian and Daniel Benjamin preserved the original manuscript and made it available to Jerry and me. Ben Zycher, Courtney Clifford Stone, Rachael Balbach, W. Lee Hoskins, Ken Clarkson, Zhaofeng Xue, and Kam-Ming Wan are among those who have provided guidance and encouragement. Michael Pistone aided greatly in preparing the diagrams and tables; Tsvetelin Tsonevski reformatted the entire manuscript. All who contributed to preparation of the manuscript are gratified that Liberty Fund has committed resources—most of all the time and talents of Laura Goetz, Senior Editor—and prestige to making available this final component of Armen’s legacy.

Armen Alchian—a colleague, mentor, coauthor, and virtual older brother of mine—left us, at age ninety-eight, in February 2013.

William R. Allen
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Universal Economics


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Since the discouraging fiasco in the Garden of Eden, all the world has been a place conspicuous in its scarcity of resources, contributing heavily to an abundance of various sorrows and sins. People have had to adjust and adapt to limitations of what is available to satisfy unlimited desires. Some individuals and societies have been much more successful than others in thus making do.

The study of economics deals with this yoke of scarcity and the modes of behavior intended to minimize the pains and maximize the gains of getting along—behavior which is restricted and channeled, sometimes helpfully and efficiently but often hurtfully and wastefully, by the social ground rules and institutions we adopt and have had imposed upon us.

To survive (much less to prosper a bit) in this vale of tears has required enormous, unrelenting effort. The vast variety of economic activity—bidding and offering in the market, producing and consuming currently, and saving and investing for the future—typically entails coordinated decision making and labor. But even seemingly simple operations of production and distribution can require contributions by many people, most of whom never meet or directly communicate with each other and are located in scattered corners of the world.

Consider this book. Thousands of people—in addition to the authors—contributed to placing this book in your hands. Some made paper; some made ink and glue; some edited the manuscript; some printed, warehoused, promoted, and distributed the product. No single person completely planned and supervised all that, and no one was a specialist in performing each of the myriad tasks. Yet, you have the book.

The essence of the story is not different for those who have escaped the surly bounds of conventional books to enter the era of e-books, iPads, Kindles, and Nooks. The more technically advanced modes of providing reading material still require elaborate collaboration of many producers. How are such complex, interrelated, varied activities by so many people in so many places organized? We will show how and why the modes of coordination in a basically private property, individualistic society have dominated all others in productivity, growth, and freedom.

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This book will help you grasp and gain a working familiarity with, and appreciation for, the most basic, universal concepts, principles, and techniques of Economics. With experience, you will build a sense of and feel for fruitful economic analysis and its worldly applications.


Motivating nearly all behavior is the inevitable existence of “scarcity”—simply put, our wants and desires exceed what is available to satisfy them. Most of what you enjoy is acquired by your efforts, accompanied by strain, sweat, and anxiety. However, no matter how successful are your efforts, you want even more.

Two apparent devils restrict what you can have—the limited amounts of goods and services available, and the rest of us who also want them. It is important to understand that scarcity does not exist because society produces the “wrong” things (e.g., beer, pop-jazz, TV games) instead of the “right” things (e.g., museums, symphony orchestras, art). Scarcity exists because of our boundless desires for limited goods of all kinds and types.


A “good,” as that word is used in Economics, is anything of which more is preferred to less. “Goods” includes services as well as physical things—services of doctors, painters, carpenters, and athletes. Fresh chicken eggs are more plentiful than stale eggs. But fresh eggs are scarce; stale eggs are not. Fresh eggs are economic goods—goods for which more is desired than is available.

If a good, however desirable, is so abundant that no one wants more of it, it is a “free” good. Hereafter, the word “good” will always mean an “economic” (scarce) good. If we mean “free good,” we’ll write “free good.” But examples are not easy to find. The classic case of a free good, to most of us most of the time, is air: we simply inhale, and there it is, without our sacrificing anything to obtain it. However, air is an economic good to the astronaut and the deep-sea diver, and so is fresh air to the city resident on a smoggy day.

Caution: “free good” does not mean something for which a zero price is charged, like “free education,” “freeways,” “free public parks,” “free libraries,” and “free beaches.” Those “zero price” goods are scarce (economic) goods. Charging a zero price does not convert an economic good into a free good. As we will see, distributing goods for “free”—at a zero price—paradoxically makes their scarcity seem even greater.

Admittedly, the term “good” creates a psychological bias suggesting that Edition: current; Page: [5] the “good” is good (“beneficial”). In Economics, however, the word “goods” refers to whatever a person wants, no matter why. Maybe you think cigarettes are not “goods” and people would be better off without them. Nevertheless, as long as someone thinks they are desirable and wants more—that makes them “goods.”


Self-interest, as the concept is used in Economics, means you want more power to control resources, whether for your own or for someone else’s benefit. Because we engage in market exchanges, without the intent of aiding other persons, some “philosophical critics” are misled into believing that economic principles presume people are purely and thoroughly selfish. That is incorrect. You often intentionally act in ways to benefit others. You act as a Good Samaritan in emergencies, even though that’s costly to you.

More important, economic analysis shows how our market actions benefit other people, even if we are not deliberately trying to help them. Both parties to an exchange must anticipate a gain; otherwise there would be no markets and voluntarily negotiated exchanges of private property. Though we act primarily with our own benefits in mind, others are benefited by market exchanges.

Let Adam Smith, the eighteenth-century Scot, author of the first systematic and classic treatise on economics, An Inquiry into the Nature and Causes of the Wealth of Nations, explain the incentive and effect:

Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them. . . . Give me that which I want, you shall have this which you want. . . . It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard of their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.


Scarcity’s inevitable companion is competition with other people for “more.” According to a master competitor, the golfer Arnold Palmer, “If you aren’t competing, you’re dead.” To which we add, “If you aren’t dead, you must be competing.” How? Consider a few ways to compete.

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Violence is a commonly respected mode of competition. Alexander, Caesar, Napoleon, Eisenhower, Lenin, and Mao used it. They were highly respected. To be sure, had Caesar merely roughed up a few Romans, he would have been crucified. Had Lenin been defeated, he would have been liquidated on the spot.

If violence is attempted on a large enough (e.g., national) scale, the perpetrators are condemned only if they fail. The power of violence is the jealously guarded near-monopoly of a “government”—by definition of what a government is. “Near-monopoly” because, within a nation, it is often used by individuals in street demonstrations for access to political power. A government will suppress violence by individuals—except in the realm of contact sports.

A wealthy nation is more likely to be attacked—unless potential aggressors know it is willing and able to impose severe losses on the aggressor. The Iraqi government in 1991 attempted to confiscate wealth from Kuwait via invasion, but was rebuffed by the cooperation of other nations. Some years earlier, the poorer North Koreans attacked the South Koreans, but they also were rebuffed by the aid of richer countries that had taken the precaution to have sufficient defensive armor. In much earlier times, the Vikings, Mongols, and Tartars lived by raiding productive, but less defended, communities. Europeans invaded the South American and Southeastern Asiatic regions to expropriate wealth from the less-ably defended areas. Similar events have occurred throughout history.

Political Power

Governments help maintain security of person and property from violence and theft. In a democracy, that power is directed by political leaders elected by voters who are competing for access to government power for their greater protection as well as to redistribute wealth. When we complain about high government taxes or expenditures, we are commonly complaining about our neighbors whose interests conflict with ours.

Discrimination: Allocations by Authorities

Consider a college that has five thousand students and only two thousand parking spaces. On the assumption that most students desire a parking space, the college has a rationing problem: Who gets a parking space? A method of discriminating—to decide who gets spaces—is inevitable. Somehow, some people will get a space, and some will not. There are alternative ways to discriminate. All competition and choice is discriminatory. Choice is merely another name for discrimination—to rank alternatives according to some attribute. It Edition: current; Page: [7] is not discrimination that is condemned, but “invidious” discrimination—by whatever criteria enough people consider undesirable—such as religion, nationality, and gender.

First Come, First Served

The parking spaces could be allocated on a first come, first served basis. Though the money price would be zero, a competitive cost would be incurred in getting to the campus before dawn in an effort to get a space. Costs need not be in money payments. A zero price does not make something free.

Most Deserving?

The costly scramble to get a space could be avoided by prior assignment to the most “deserving” or “needy.” The committee dispensing privileges would ask, “Who, other than professors, are the most deserving, most needy ones?” There is almost no limit to the ingenuity of dispensing committees in rationalizing their favors. Among the criteria may be: distance from campus, age, health, senior status, family size, major of student, grades, and so forth. But one question leads to another. For example, should those who are awarded rights to a parking space be allowed to sell the rights to others?

Jungle or Civilized Competition

You may have heard competition promotes antisocial, jungle-like, irresponsible behavior. That depends on the kind of competition that is tolerated. As we’ll see, a society with reliable private property rights and readily available markets for exchange of those rights has proven to be conducive to greater production and civilized behavior than a society that condones violence or brute force in resolving differences of opinions about use of economic resources.

Competitive Cooperation by Exchanges

The primary focus of economic analysis is on (a) competition in exchange of rights to services and goods and (b) coordinated cooperation in creating wealth. Competition by offers of exchange is a form of cooperation. “I’ll do this for you if you’ll do that for me—at better terms than someone else.” Though competing, we also cooperate—in the market, in the family, in firms, and in governments. We cooperate to make the “pie” larger; we compete over how much of the pie each of us gets. Any effective combination of cooperation and competition requires a control of the permissible types of competition so as to not obstruct social cohesion and cooperation.

Differences in amounts of wealth held by the richer and the poorer are not Edition: current; Page: [8] all results of the rich being winners and the poor being losers in some contest for the distribution of a given total. A source of the differences in wealth is difference in productivity and willingness to save for more wealth. But the resulting pattern of relative wealth can be so concentrated in a few that the distribution is deliberately altered to attempt to maintain greater social stability.


We want your study of economics to be interesting and even enjoyable. But we promise one unanticipated result: you’ll be brainwashed—in the “desirable” sense of removing erroneous beliefs. You will begin to suspect that a vast majority of what people popularly believe about economic events is at least misleading and often wrong. A few examples of such common errors are:

  • price controls prevent higher costs to consumers;
  • reducing unemployment necessarily requires creation of more jobs;
  • larger incomes for some people require smaller incomes for others;
  • free, or low, tuition reduces costs to students;
  • all unemployment must be wasteful;
  • stockbrokers and investment advisors predict better than the alternatives of throwing a dart at a list of stocks or the use of horoscopes;
  • taxes are borne entirely by consumers of taxed items;
  • employers pay for “employer-provided insurance”;
  • minimum wage legislation helps the unskilled and minorities;
  • housing developers drive up the price of land;
  • foreign imports reduce the total of domestic jobs;
  • “equal pay for equal work” laws aid women, minorities, and the young;
  • economic efficiency is a matter only of technology and engineering;
  • agricultural and other surpluses stem from productivity outrunning demand;
  • capitalism requires a social “harmony of interests”—but also capitalism is the source of competitiveness and conflict;
  • property rights commonly conflict with human rights;
  • business people are self-centered and rapacious, while government people are self-sacrificing and altruistic;
  • labor unions protect the natural brotherhood and collective well-being of workers against their natural enemies, employers;
  • charging a higher price always increases the seller’s profits;
  • the American economy is increasingly dominated by monopolists who arbitrarily set prices as high and wages as low as they please;Edition: current; Page: [9]
  • rent control improves and expands housing;
  • there is unemployment because workers outnumber jobs;
  • fluctuating prices create wasteful uncertainty and rising prices constitute inflation, so government should make it illegal to raise prices;
  • we cannot compete in a world in which most foreign wages are lower than wages paid to domestic workers;

and on and on and on.

Fortunately, societies have progressed despite almost universal ignorance of economic principles. Without an abundance of sophisticated economic analysts, the US economy, over more than two centuries, has generally performed very well, yielding a growth and prosperity that is embarrassingly conspicuous in world history.

The collapse of the socialist Soviet Union and the rise of China and India in world markets was not the result of their sudden awareness of their ignorance of economic principles. Instead, their disappointing economic experiences—in sharp contrast to the economic performance of other nations—showed that the lack of understanding of basic economic principles ultimately creates weaknesses, and motivated their social and market changes accordingly.


This text starts with the simplest principles and applies them to explain the meaning of the gains from trade and how these gains occur. It may seem silly to develop a method of analysis to explain what’s so obvious—that people gain from trade. However, looking at a simple action permits an easy exposition of the very important principles of “demand” and their meaning—without distractions by side details of more complex activities. Also, the initial familiarization with graphs for applications of these principles will ease the later study of more complex events that are far less commonly understood. These results will often be surprising and counterintuitive.

To anticipate briefly, the first thirteen chapters explain and apply the concepts of “property rights,” “efficiency,” “cost,” “marginals,” “equalization of marginals to avoid waste,” and the principles of personal choice and behavior, which determine the prices and allocation of existing goods. Chapters 14 through 29 introduce the principles of production, specialization, teams, and firms; decision making within organizations is viewed from the perspective of economic analysis. Market pricing tactics of different types of firms in alternative competitive situations are explored. Chapters 30 through 38 extend the Edition: current; Page: [10] exposition and application of financial capital value principles and adaptations to economic risk and wealth creation. Chapters 39 through 41 address issues that arise in labor markets, including search costs in seeking highest-valued employment opportunities. Chapter 42 addresses issues of money, inflation, and their effects on prices.

Economics really is easy—in a subtle sort of way. Rely on application of its analytic principles. Sometimes they supersede dictates of physics. The law of gravity says, “If you drop a $20 bill on the ground, it will stay there.” Economics says, “If you drop a $20 bill on the ground, it will quickly disappear.”


  • 1)

    A once popular book states (in essence): “We are trapped by the ‘dismal science’—economics, which is dominated by the belief that the achievement of abundance is impossible and that the economic problem is still the distribution of scarce resources. This is nonsense. Abundance has arrived! The United States can produce so much that the basic problems are to see that the potential production is realized and distributed fairly and equitably.” Are you inclined to agree or disagree?


    You are not expected to be able to answer this now. But upon finishing this course, you should be able to show why the concluding sentences are wrong. As for the first sentence, economic science has not trapped us—scarcity has.

  • 2)

    “If people were reasonable and acted with justice and good faith, there would be no strikes, no economic problems, and no wars.” Do you agree?


    False. It is because people are reasonable and, therefore, act in accord with their own interest that there are economic problems and wars.

  • 3)

    “A more equal distribution of wealth is socially preferred to a less equal distribution.”

    Explain why you agree or disagree.

    What is meant by “socially preferred,” as contrasted to “individually preferred”?


    Until you know what socially preferred means, you cannot answer this question. We do not know what socially preferred means. For example, does it mean that a majority prefer it, or that the most important people Edition: current; Page: [11] prefer it, or that the current rulers of a nation happen to prefer it, or that “everyone” prefers it, or that the speaker thinks everyone should prefer it, or that merely the speaker prefers it? Beware of any expression referring to the preference of a group.

  • 4)

    What do you think is meant by a fair share? Do you think other people will agree with your interpretation? How does your interpretation compare with the idea of students getting “fair” grades?


    Fair does not mean equal, and even if some asserted that it “should,” there is the problem of equal absolute versus equal proportional. It is often hard to know what people mean by equal. Would fair grades mean that there should be a minimum grade such as C−? Studies have shown that students who get better grades tend to lead more prosperous lives; but it would be absurd to assert that mandating minimum grades would cause students to be more successful.

  • 5)

    “Scarcity, competition, and discrimination are inextricably tied together. Any one implies the other two. Furthermore, to think of a society without these is to be a romantic dreamer.” Do you agree?


    Choice of one thing versus another occurs because there is scarcity; competition and discrimination occur even in an imaginary world of no money, no prices, and no markets. As we will see, suppression of market-determined prices of goods and services gives rise to nonmoney forms of competition and discrimination.

  • 6)

    Name three honored statesmen who obtained their status by successfully competing in the ability to use violence and who, had they failed, would have been punished for treason or crimes against mankind.


    William the Conqueror, Julius Caesar, Napoleon Bonaparte. You can add scores of others. (Hint: George Washington and every other leader of a successful revolution.)

  • 7)

    Permissible competition:

    What kind of competition is permissible in seeking political office but is not permissible in private business?

    What kinds of competition are permissible in seeking admission to college but not permissible for grades in this course?

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    What kinds of competition are approved for business but not for admission to fraternities?


    Promises to raise or lower taxes (affect other people’s wealth) in order to benefit those who vote for you. But the politician can’t (legally) offer to sell services as a businessman can.

    Will letters of recommendation help you get a better grade in this course? Does your past record influence the teacher of this course in making grades? Does wealth of parents?

    Employees can offer to work for a lower salary to get a job with a favored employer in a preferred town. Will this work in fraternities? How about a candidate’s ability to increase the wealth of the fraternity?

  • 8)

    “Government monopolizes coercive violence.” “Government is a social agency for resolving interpersonal conflict.”

    Are those two propositions correct and compatible statements of fact?

    What evidence can you cite for your answer?


    Yes. Until very recently, we know of no institution with the dominant power of coercive violence that is not the government in any country. Government is an institution for enforcing certain rules and procedures for resolving interpersonal conflicts of interest. The making and enforcement of laws and the judicial settlement of disputes are behaviors that support the propositions. (Note that the second statement says government is an agency, not the only agency. For example, many social disputes are resolved by social ostracism and by agreement to use an arbitrator.)

  • 9)

    Illegal competition:

    If you had the power to decide, what forms of competition would you declare illegal?

    What forms of competition are made illegal by laws establishing price ceilings, minimum wages, fair-employment practices, pure food and drug standards, private property rights, and by socialism?


    You should first want to know the behavioral consequence of each kind.

    More than that we can’t yet say.

    The only kind of competition made illegal by a price ceiling is that of offering more money than the legal limit as means of offsetting weaknesses in other attributes in competing for goods. Fair-employment laws (prohibiting Edition: current; Page: [13] choice of employees by race, color, creed, or age) prohibit competition in terms of personal attributes. Pure food and drug laws prohibit offers of inferior food at lower prices or of new and possibly better but untested (by government) foods and drugs. Private property rights prohibit competition by violence and involuntary dispossession of goods deemed to be private property. Socialism prohibits competition in terms of offers of types of services and goods that individuals privately prefer, without having to obtain authorization of government officials for propriety of producing the services. These are merely examples of types of competition that are ruled out—not a complete chronicle and certainly not an evaluation of the desirability of the various types.

  • 10)

    Competition for admission to colleges uses mental ability, athletic ability, good looks, residence, willingness to pay, alumni status of parents, race, sex, and religious belief. Why?


    Greater use of factors other than willingness to pay is enabled by the fact that most colleges are not privately owned.

  • 11)

    On the average, who do you think are most honest—politicians, businessmen, or teachers? Why? What is your evidence? Can you think of any reasons why dishonesty would be more surely detected and punished in one of these professions? If successful, would dishonesty be more rewarding in one rather than the others?


    A predisposition to tell the truth is essential to the long-run viability of a free and democratic society that relies on private property and market-determined prices to allocate scarce resources. A shocking reality of the Soviet Union of the twentieth century was that generations of people learned that it was important to be good at lying—not only to the government, but also to close friends and even one’s family.

  • 12)

    “Under socialism, cooperation will replace competition.”

    Is the quoted proposition correct?

    What evidence can you cite to support your answer?

    What is the difference between cooperation and competition?


    Since scarcity is present in socialism, as in capitalism, competition for control of resources is inescapable. In socialism more is in the form of political Edition: current; Page: [14] avenues of competition (persuasion, favors, personal connections). Competition is the interpersonal striving for more of what is scarce and desired—for production, by purchase, by striving for political power, and so on. Cooperation is a joint activity with mutual striving for a common end.

  • 13)

    Food is grown, harvested, sorted, processed, packed, transported, assembled in appropriately small bundles, and offered to consumers every day by individuals pursuing personal interests. No authority is responsible for seeing that these functions are performed and that the right amount of food is produced. Yet food is available every day. On the other hand, especially appointed authorities are responsible for seeing that such things as water, education, and electricity are made available. Is it not paradoxical that in the very areas where we consciously plan and control social output, we often find shortages and failure of service? References to classroom shortages and water shortages are rife; but who has heard of a shortage of restaurants, churches, furniture, beer, shoes, or paper? Even further, is it not surprising that privately owned businesses, operating for the private gain of the owners, provide as good, if not better, service to patrons and customers as do the post office, schools, and other publicly owned enterprises? Furthermore, wouldn’t you expect public agencies to be less discriminating according to race and creed rather than privately owned business? Yet the fact is that they are not. How do you explain these paradoxes?


    They will be explained in the course of study. The query is intended to whet your interest in what is coming.

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The United States is not the largest country in the world in either number of inhabitants or land area, but its enormous and complex economy produces more annual output than does the economy of any other country. However, reciting a collection of various economic measurements is not analytically very useful, especially when the measurements persistently change over time. Neither would it be highly helpful to tell a first-time viewer of a football game only how many players are on a team, the size of the field, and the typical scores. Without knowing the rules and something about the competitive tactics and strategies, the viewer would be bored or totally confused. The same risk faces you in learning about the competitive game, the “economy.” A first step in comprehension is awareness of the rule: private property.


You live in a largely private property society. Whether or not it is in any sense the best type of society is not our question here. We do know that it has evolved and dominated in competition against others. Though most economic resources in the United States are privately owned and managed, some, such as large acreages of land and sophisticated and massive military equipment, are held as government property. Also, while about 80 percent of national income is earned in the private sector, government purchases of goods and services (for example, fire, police, defense, judiciary, education, roads, sanitation) account for the critical other 20 percent.

In every society, each person has various kinds of “rights.” A “right” is a person’s socially recognized and supported authority to do certain things. The community at large will protect you from anyone who tries to interfere. If people saw someone trying to steal your car—violate your right to it—they would usually call the police or alert other bystanders to forestall that attempt. Your property right to the car rests on the willingness and ability of other people, not your ability alone, to protect your control over that resource—your property. But though you may have physical legal possession of an automobile, you don’t thereby have an inherent “right” to it. In a pride of lions, the male by dint of Edition: current; Page: [16] sheer physical prowess takes first choice of feeding on prey. That’s not what a right means here. A right is lacking because lions don’t enforce rights of other lions. Instead, there is cowed tolerance of dominant lions.


How much does the government spend? In the National Income Accounts—which measure the total output or product of an economy—the US government accounts for about 20 percent of everything produced. That is, the Gross Domestic Product (GDP) includes purchases of goods and services by the government along with the consumption spending of households and investment spending of business. Such government spending includes ships for the navy and the salaries of all the employees of the government.

Another measure, government expenditures—everything in the government’s budget—includes all such government purchases and much more. Interest payments on the trillions of dollars of government debt are an expense of government, but show up in the national income accounts as interest income earned by the bondholders. Government also makes transfer payments for Social Security, Medicare, Medicaid, food stamps, unemployment insurance, and housing vouchers. Such transfer payments do not directly contribute to the output of the economy, so are not included in the government component of GDP. Instead, the people and businesses that receive transfer payments from government will either spend or save—just as they would earned income from wages and dividends—so GDP components such as consumer spending and private investment are larger as a result of such transfers.

That does not mean the economy is larger or the people are richer because of such transfer payments. Those payments have to be financed either by taxes collected from households and businesses—thereby reducing private consumption and investment spending—or by the issuance of additional government debt—which also reduces household and business spending.

The government expenditure concept that includes transfer payments rose to 30 percent of GDP over thirty years ago and then in the great recession of 2007–2009 shot up to over 35 percent of GDP. The result has been that a large and growing share of the spending by households for consumption and some of the spending by businesses for investment are paid for by transfers from taxpayers or by debt issuance by government.

Donald Marron, Musings on Economics, Finance, and Life, July 2012, “Has Government Gotten Bigger or Smaller? Yes,”

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Your rights determine your status and potential welfare and your “freedoms”—what the rest of society will let you do. To understand your economy and society, you must know the “rules of the game.” The “rights” are part of the rules. In playing a game, the rules are the rights defining actions a player can choose. If you don’t know who has what rights, you won’t understand behavior in a society.

Comparing socialist and capitalistic nations without knowing the different rights people have to economic goods would suggest that the nature of people differs in the two societies. In their underlying natures, people are everywhere much the same, but in different societies they may act within very different contexts and restraints and incentives—the ground rules differ. That’s why we start with a statement of some of the property rights that dominate in a private property nation—often called “capitalistic.”


Private property rights contain three key features: (1) the right to make decisions about the physical1 conditions and uses of specified goods, (2) the right to sell the rights of ownership to other people, and (3) the right to enjoy the resulting income and to bear the loss of the use decision. These are exclusive rights; they all belong to the same person. These three elements together constitute the essence of private property rights. If any of the three is missing, private property rights are not present.

Private property rights restrain you from interfering with other peoples’ rights. The physical attributes or yields of all resources owned by other persons must not be affected. If you own private property rights to something, you, and only you, may choose its future use and physical condition, or transfer that right to a willing recipient. No other person has a right to alter its physical features or uses of the good to which you have the private property right. We refer to “private property rights.” If you sell something, according to the law, that is interpreted as being a sale of private property rights, not the thing itself. Even if the good itself can’t be moved, as a tract of land, the rights are transferable to others. Don’t be misled by statements that private property rights put rights of property over rights of people. Private property rights are rights of people over uses of goods they own.

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Avoid another confusion. In economics, we are concerned about constitutionally protected rights. This is different from some people’s claims to rights to education, health care, housing, a good job, and so forth. Such claims would amount to other people being forced to provide something that I want. No such constitutional rights exist. Constitutional scholars make a distinction between “negative rights,” which limit what governments can do, versus the notion of “positive rights,” which would require government actions to benefit some people at the expense of other people.

Physical Attributes, Not Market Values

Private property rights protect your property from physical2 effects caused by other people. I can’t legally use my hammer to break your windows. But you are not protected from market-value effects caused by a reduced demand for your property. If I build an apartment building and increase the supply of apartments enough to reduce the rental value of your apartment, that’s legal. Or if this textbook reduces the sales of a competitor’s book, that’s legal. It doesn’t reduce the offers the competitors can make to potential customers. Nor does it reduce competitors’ physical productive potential.

Beware of Presumed Clarity and Definiteness of Private Property Rights

The distinction between physical effects and market-value effects seems clear—at first thought. But consider the following situation. From your land, you have a beautiful view over land owned by someone else who proposes to erect a building obstructing your sight. Would the physical attributes of your land be affected? Yes and no—depending on what is meant by the physical attributes of your land. Physical features might not be interpreted to include the “light rays” reflected onto your land. Usually, but not always, they are excluded from your private property rights. Your neighbor can block your view without violating your private property rights. The moral is: When buying private property rights to something, first identify what the rights include and what is excluded. The less that is included, the lower the market value will be.

Alienability of Private Property Rights

Another essential feature of private property rights is “transferability,” often called “alienability.” That’s the right to sell your rights. And that makes you pay attention to potential market value of what you own. The way you use your Edition: current; Page: [19] car or house will affect their market values. If you have the right to resell this textbook, you’ll take better care of it than if you have no right to sell it. This salability of rights to the resource is a fundamental difference between private property rights and all other forms of property rights over resources.

In England, until about one hundred years ago, major land holdings were not “alienable.” They passed from parent to child. All the “owner-occupant” could do was live on it or enjoy its income if rented to someone else. In China, publicly traded companies issue shares of “ownership” that are not resalable without government approval. In Switzerland, until a couple of decades ago, shares in many publicly traded corporations could not be sold to other people unless the buyer was approved by the corporate directors.

Private property rights are transferable to any person willing to accept it or share in it. You bear that right until someone else is willing to accept it. You can’t just revoke your right and abandon all future responsibility for its subsequent condition. Once you acquire a private property right to some good, you either must transfer it to some other willing recipient or bear it until death. At that inevitable time, without a willing designated recipient (inheritor), the government takes the right.

At your college, if not a privately owned institution, no one has a private property right to the marketable value of the college’s resources. Because the administrators are thereby more insulated from changes in market values of the resources, they use those resources less in accord with their highest market-valued uses. This does not mean that private property rights are necessarily always better. There are reasons for not having private property rights in some institutions, such as “not-for-profit” hospitals, colleges, museums, fraternities, and sororities—and we’ll see later some of these reasons.


We note another kind of “property right.” A taking or using of another person’s property in an emergency is called a “tort.” Because this occurs commonly, there is a whole body of law about “torts.” In a sudden storm on a lake, if you berth your boat at my dock to save your life (without prior negotiation for my permission), have my “rights” been violated? Or, if you could have attracted my attention and asked for the right to use my dock, could I extract from you a promise to all your wealth to save your life? A more common example of a tort occurs when you berth your boat on my dock (with or without my permission), but because of some proven negligence on my part your boat is damaged or you are injured. In such cases, courts may force me to compensate you.

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An important restriction on the scope of private property rights is contained in the Rule against Perpetuities. That rule restricts your control of the future uses of what you own now. You might in your will try to restrict the future uses of your enormous wealth, perhaps leaving a parcel of land to a foundation as a permanent refuge for deer.

However, a reason for the ban on your unlimited future control is that it reduces the influence of future market values on the way that resource will then be used. The “dead hand of the past” is not allowed to overrule the “invisible hand” of future generations’ market values. The rule against perpetuities permits restrictions on use and salability of resources for only about twenty-one years after the death of persons who were alive at the time of the death of the donor. If that rule were not enforced, resources today would still be used in ways they were generations ago—a potentially unattractive result.


A major difference between societies is not whether property rights do or do not exist, but is instead the extent to which they apply. Even in formerly communist Russia, private property rights were not totally absent. People owned and could buy and sell furniture and automobiles, as well as vegetables grown in their gardens. However, almost all productive resources—those used to produce goods and services for other people—were “owned” by the government.

An economy with extensive private property rights over most resources is usually called a “capitalist” economy. With salable resources, the anticipated future consequences of present uses of resources are “capitalized” into current market values of the resources, as we’ll be examining. Explaining what those capitalized market values reflect, and how they influence our behavior and uses of resources, is one of the basic achievements of economic analysis.

To incorporate anticipation into present values requires establishing and maintaining consistency of actions among the populace. That has to be done in an economy in which decisions and adjustments are independent in the sense that each person makes choices without requiring permission from someone else. Yet, the decisions are dependent in that they depend on what other people are expected to do. In a market economy—with restrictive private property rules of the game—individuals make risky decisions and bear the consequences of their decisions.

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We have separated the particular “system” from universal “economic principles,” because these principles apply to any economic system. They reflect characteristics of individuals’ preferences and productive abilities that are found everywhere. We refer to “demand” to identify universal features of people’s preferences among types and quantities of goods. We use “supply” to identify the abilities to produce goods and services that are common to all economies. We will start in the next chapter by looking at demand for various amounts and types of goods, assuming initially they already have been produced.


“Economically Free” and “Politically Free” have different meanings. Your private property rights to your land prevent me from encroaching to pitch a tent or dump garbage or hold a meeting without your permission. I would be violating your private property rights to your land. Similarly, if, without prior permission, I took your loudspeaker to talk to people, I would be violating your private property rights to the loudspeaker. I do have a right to free speech, but that does not mean I have a right to take your loudspeaker or land to communicate with others even if they would be willing listeners.

A right of free speech is not an “economically free” right. It uses scarce resources. “Free speech” means the right to communicate with your own resources to other willing listeners—without political intervention about what you say. I can’t force you to hear or read my “speech” any more than I can force you to give me your wealth. I can’t take property of others to communicate, nor can I regard the attention of other people as “free” to me. I must use my own, or rented, resources to communicate, and then only to willing persons. Both these critical features, (1) use of one’s owned or rented resources by the speaker and (2) a willing listener, are often ignored.

This kind of confusion of “free speech” with a “free right” to use resources, as if they become “free” when the resources are to be used for speech, has confounded many judges and lawmakers and college administrators. Someone sends unwanted email to your computer. You are an unwilling recipient. Both required conditions of free speech are violated. Your computer is being used without your permission, and you are not a willing recipient of the messages. The right of free speech is neither a right to “free” access to resources of other people nor a right to “unwilling listeners.”

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Within the private property “rules of the game,” a person can use resources under his control to produce other assets. An efficiently produced amount of some good is a “constrained maximum” of that good. More of a specified good requires reduced production of some other goods.

The necessity of that trade-off is represented by the production possibility boundary (PPB), as shown in figure 2.1.

Figure 2.1

Meaning of “Efficiency” Contrasted to “Maximizing”

The production possibility boundary (PPB) curve, also called the production possibility curve (PPC), shows the meaning of “efficient” or “efficiency.” Think of automobiles and wheat as the only possible alternative goods. The curved boundary line indicates, vertically, the maximum amount of autos that can be produced, given that a specified amount of wheat, measured on the horizontal scale, is to be produced also. Every point on the PPB represents a combination of annual amounts of automobiles produced, measured on the vertical axis, and annual amounts of wheat, measured on the horizontal axis. All points below (inside) the curve represent wasteful, inefficient situations, because more of both autos and wheat could be produced. All points on the curve represent efficient combinations of autos and wheat—meaning you can’t then have more of one without less of the other.

The end points (at the vertical scale and at the horizontal scale) are measures of the maximum amounts of a good when only that one good is produced. The negative (downward) slope of the boundary curve represents the fact that more of one good means less of other goods. Moving on the boundary line upward to the left means more of the vertically measured good is produced, but with a necessary reduction in the production of the other good. The boundary line represents all the efficient points—no waste—with the maximum amounts of one good along with minimum necessary reductions in production of other goods. All points on the PPB can be called “cost efficient.”

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Sometimes some equipment, say a refrigerator, is called “electricity efficient,” meaning merely that the refrigerator was constructed so as to use less electricity than some other refrigerator. But the “electricity energy-efficient refrigerator” costs more to produce. Whether the saving in electricity is worth more than the increased cost of production of the refrigerator is the pertinent question, not the fact that less electricity is used.

Again, the concept of “efficient” is different from the concept of an unconstrained, or “unconditional,” maximum. More housing could be produced if we didn’t care about anything else. That would be maximum housing, with nothing else. We’d all starve in nice homes. Similarly, a maximum of clean air would mean no production of anything that “dirtied” the air. We’d all starve while breathing perfectly clean air. Clearly, we want more than just one good. We want combinations of goods. But more of one means less of others, if we are efficient.

With investment, such as new equipment, buildings, and production techniques, the PPB is expanded outward, in one or more dimensions, though only two are shown in figure 2.1. But the PPB reminds us that at any given moment the production potential is limited.

Is Efficiency Desirable?

“Efficient and inefficient” suggests that it’s “bad” or “undesirable” to be inefficient, because more of some goods or desirable things could otherwise be obtained without reduction of the presently available amount of other goods. However, if some of the alternatives are “good” in one person’s opinion while being “bad” in another’s preferences, disputes will arise. You’ll be told you’re considering the wrong alternatives, and therefore the efficiency for your set of possible goods is irrelevant. People differ in their preferences and evaluations. You want cleaner air even at the cost of less driving. I want more driving even at the cost of less clean air. Both of us want efficiency with respect to our preferred mixtures. Therefore, “efficiency” is not a basis for choosing among alternative “efficient” combinations.

Incomplete Span of “Components” for Efficiency!

A new refrigerator may be labeled “energy efficient” and uses less energy than required in the old model, but at the cost of having to use a more expensive motor and more expensive insulation. Does efficiency mean the least possible amount of energy is used—regardless of cost of other materials? Reducing the amount of one component, while having to increase the costs of other components even more, is not “cost efficient.”

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Every point on the production boundary curve is efficient; all points inside the boundary are “inefficient.” But which of all the points on the boundary—all the efficient points—is most desirable has not been answered. Furthermore, the location (higher or lower) of the boundary curve depends on the reliability of laws and contracts, government policies, taxes, security of property, work ethic, entrepreneurship, education, access to markets, mobility of resources—a lot more than just the number of people and quantity of physical resources. Those other factors are major features that economic principles help us understand.

We now prepare to learn economic principles and how to use them reliably to understand events in the economy. The set of principles we’ll explain is “economic theory.” But don’t let the label, “theory,” mislead you into supposing that it’s all “theoretical” and “abstract” rather than practical. There’s a difference between theoretical and theory. “Theoretical” suggests it’s debatable, conjectural, unproven, and thus not reliable. In fact, the economic principles that form economic theory are very powerful, proven, and reliable.


In scientific analysis and interpretation of an event, theory means a set of principles, or propositions, which, when logically used, will guide us to state correctly what will be the consequences of some initial action—a set of concepts and relationships that enables us to deduce what action will lead to what result.

Principles form a “science” if people can deduce from those principles consequences as a result of specified initial events. If those implied consequences happen reliably, that set of principles is a “science.” The theory of physics tells us features of the swing of a golf club that reliably will make the ball go straight. That’s true no matter who is the player. The theory is reliable, even if the players are not reliable in their performance.


Economic principles form a “positive,” not a “normative,” set. It’s an “If this, then that” form of analysis. It helps to understand or deduce consequences. It contains no basis for deciding what is ultimately “good” or “bad,” commendable or condemnable.

Principles of chemistry explain what happens if you add iron filings into sulfuric acid, or if you toss a match into a pile of paper, but it does not tell whether you should add the filings or toss the match. Physics does not imply carbon is better than lithium, or that heavier elements are better than lighter.

Economics does not tell us (imply) that governments should be smaller Edition: current; Page: [25] rather than larger, or that taxes should be lower or higher. Economics can foretell some of the consequences of a law or event, and you can then decide for yourself whether the prior action is desirable. Whether some event or consequence is good or bad is not implied, indicated, or deducible solely from economic theory.


To say something “may” or “might” or “could” happen is empty, useless, irrefutable—and worthless! “Could, may, or might” statements permit anything—not what will or will not happen. The world’s entire population may suddenly change their behavior and act like angels. You may, might, or could become the world’s greatest violinist.

A useful statement indicates (a) what will or will not happen, or b) a probability of the event, or c) what raises, or lowers, the probability. Economic analysis implies that price controls increase the probability of shortages and discrimination by gender, ethnicity, and religion. The collected evidence supports that implication. Since nothing in the world is certain, except probably death and taxes, you should think in terms of increased or lowered probabilities. For brevity, we’ll often say that the implied consequence “will” occur. But in life virtually everything is probabilistic.


A research “result” is announced in the news. Later, someone reexamines the data to see how, and how reliably, it was collected and what significant features, if any, were omitted. But by then, if the initial results were misinterpreted, the first wrong impression is hard to remove. Whether in medicine, physics, nutrition, or economics, be careful in placing heavy reliance on first reports.


Compounding the doubts about unusual events is the “regression effect,” which states that there is a higher probability of good luck to be followed by just “normal” luck, than by continued good luck. Of one hundred identical salespeople, some would, by good luck, have higher sales than others in any one week. But in the next week those who were unusually lucky in the first week would more likely get fewer sales, nearer their long-run averages. Similarly, those with very bad luck the first week would not have such bad luck the next week, so in the second week their sales would improve. The very lucky as well Edition: current; Page: [26] as the very unlucky in the first week tend to “regress” toward their longer-run average.

This universal tendency to regress toward the long-run average is the regression effect. One of the classic ways of taking advantage of this effect is to invite people to take some performance test—say a reading test—and to tell those who score below average to take lessons in “reading improvement.” After the lessons (which could be nothing more than taking ten deep breaths or blinking their eyes three times) their test performance will on average improve, because their unusually low performance on the first test was at least in part due to unusually bad (nonrepetitive) luck.


What economics says is not always what economists say. An economist (one capable of applying economic analysis logically) may express personal preferences, recommendations, and advice, such as, “Invest more, reduce the size of government, reduce tariffs, and buy this stock.” But those normative, prescriptive statements are hardly more reliable or authoritative than if uttered by anyone else. What the economist can do with economic analysis is to deduce some of the consequences of a proposed act, presumably more accurately than a noneconomist. But definitely to assess and appraise whether the consequences of the action are good or bad is, to the economist, forbidden fruit. Yet, like Adam, many economists eat of it.


The principles of economics, which form “economic theory,” are intended to be reliable, useful guides to understanding economic events. Don’t make the intellectual mistake of asking whether the theory (the set of principles) is “true.” No theory is perfect. Ask instead, “Is it useful and reliable enough for my purposes? That is, will it lead to generally correct implications and guidance at sufficiently low cost without intolerable error?” That’s the question to ask in every discipline, whether Chemistry, Physics, Biology, or Economics.

Every theory is wrong and incomplete with respect to some things—just as with maps. Maps of the same area differ in accord with the purpose of the user. No map, and likewise no theory, is a literally correct representation of every detail. Your useful road map doesn’t show all the bumps, traffic signs, overpasses, degrees of traffic congestion to be expected, and so forth. There is a variety of maps, each appropriate for a different purpose—some for travel by car, airplane, or boat, some for surveying land and rivers, and some for building roads. Nevertheless, though the variety differs, all of the maps must be consistent Edition: current; Page: [27] with each other in certain fundamental respects. No valid map of the United States would show the Mississippi River emptying into the San Francisco Bay, though useful maps will differ in the degree of details.

There is not one economic theory for capitalism and another for socialism and another for some other form of economy. The situation parallels biology. The same biological principles hold no matter where animals and people live. In every society, the basic principles of human behavior are the same.


Economics is part of “biology”—the study of life. “Economics” concentrates on the activities that are dominant in the “market” for the production and distribution of desired goods and services. Other actions, such as the social activities within the family and in social groups, or in governments, are studied in sociology and political science—although economics increasingly is being used to explain these actions as well.


Economics assumes that choices are made by individuals, not by a group, family, business, or government. We don’t inquire about why some “firm” or “union” or “government” does something. Always, it is some person who is doing something. That’s why we’ll always look at the choices individuals make, whether when isolated or in organizations. However, this does not mean people make choices with only their own narrow interests in mind. Effects on other people are not excluded from a person’s interests. But our focus is on an individual’s chosen action.


  • 1)

    What does “equality of opportunity” mean? How could you determine whether it exists? What is the difference between increasing opportunity and equalizing it?


    We don’t know. It depends upon your point of view and what you think is “equal” or “fair.” Does it mean starting with the same amount? Then what about the differences in people’s natural abilities or ability to learn? Does it mean ending with the same amount? What if people value the same amount differently? Economics doesn’t answer subjective issues. The purpose of this question is to make you aware of the ambiguities in such questions.

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  • 2)

    When you purchase a car, what is it that you are actually buying?


    You are purchasing the rights to exclusive use of that car provided you do not violate the rights of others to use their resources. By “owning” the car you also possess the rights to transfer (sell) the exclusive rights of usage to another person, something you cannot do if the car is rented, leased, or “owned” by the community.

  • 3)

    “The free-enterprise, capitalist system is free in that it involves no imposition of force or compulsion.” Do you agree? Explain your answer.


    All societies use force and compulsion. The pertinent issue is: What kinds of coercion and force do various economic, political, and social systems use? The capitalist system uses the force of self-interest; it is impersonal in its market effects. The effects of decisions are borne by the owner of a resource. Someone who produces at a loss bears the effect and is forced out of business into some other task, perhaps with less compassion than under a socialist dictator, who might spread the loss to other people instead of concentrating the effect on one person, the owner.

    More sensible than the question of which system uses less force is the question of what effects the various kinds of forces (incentives, rewards, signals, orders, and penalties) have on individuals’ economic, cultural, and political behavior. For example, how does the economic system affect freedom of speech, job mobility, social fluidity, individual dignity, worship, search for the truth, and so on? The effects on all the various goals of a person must be considered. Not even reference to the use of the rule of law versus the rule of arbitrary dictators is a basis for ultimate judgment. Here too, the question is: What law and what rules will be enforced? Will it be the rule of private property rights, the rule of socialism, or some other?

  • 4)

    “The free-enterprise, capitalist system is good because it gives individuals more opportunity or freedom to choose for themselves than other systems.” Do you agree? Why?


    Economics cannot make value judgments and answer the question of what is “good.” Differences are implied about the kinds of opportunities or “freedoms” provided to individuals living under each system. The implications are that a free-enterprise, market economy gives individuals a Edition: current; Page: [29] greater range of consumption patterns or goods from which to choose. Whether it is “good” that individuals should have such a range of options to explore is a question that economic theory cannot answer. A greater range of choice can be regarded as a greater range of temptation, risk, error, regret, and deviant behavior. Just as parents restrain children’s choices for their own good, we may prefer to restrain the choices of adults because everyone retains some childlike impulses. Whether you wish to regard one system or the other as giving more freedom depends upon your meaning of “freedom.” In one sense, freedom can include protection from the costs of temptation and unfortunate choices; in another sense, freedom might include the right to bear those costs and to make those choices and explore tempting alternatives. The implications derived from economic theory about the factual consequences of different systems will be helpful in forming a judgment.

  • 5)

    “The college football team has a goal.”

    • a. Is it the social goal of the “team,” or is it the common individual goal of each member of the team?
    • b. Are you sure that each member has only that goal?
    • c. Is it helpful to talk of one goal being preferred over another?


    • a. Each team member has a goal. In analyzing problems look at the individual. Individuals make decisions, not entities such as “teams, firms, governments.”
    • b. We’re not sure; some members may have more goals.
    • c. No. It’s a matter of fulfilling some of one goal and some of the next.
  • 6)

    In trying to understand some policy enforced at your college, why may it be misleading to ask why the college adopts that policy?


    Individuals, not abstract things called “colleges,” make decisions.

  • 7)

    If you don’t smoke, is tobacco a good? Are purchase and sale necessary for something to be considered a good?


    Although you do not smoke, there are others who want more tobacco products than are available at a zero price. They are willing to trade some amount of other goods to acquire a given amount of tobacco. Tobacco is an economic good, even if you do not think it is good to use tobacco.

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  • 8)

    “Economic theory is built on an idealization of people: that they have tremendous computational power, a detailed knowledge of their desires and needs, a thorough understanding of their environment and its causal relationships, a resistance to acting on impulse or by habit.” Explain why this statement incorrectly characterizes economic theory.


    It is theory and its structure that are logical. The predictable regularities of people’s responses to changes in their environment do not require their rationality any more than the response of water to a slope requires rationality by each molecule of water.

  • 9)

    Suppose it were claimed that a denial of college facilities to some speaker is a denial of the right of free speech. Show how that argument confuses free resources with free speech.


    Free speech means a right to speak or communicate with others who are willing to listen, free of intervention or prohibition. It is not a right to take resources of other people for one’s own purposes of communication. To use college property without permission of the college authorities is not a right of free speech; it is simply appropriation of property as if the property were free for the taking. Nor is it a denial of free speech if a college or anyone else denies the use of resources under its or his control which others would like to use for their own purposes. This does not mean that colleges ought to refuse to others all uses of their resources for communication of popular or unpopular ideas; it is a clarification of the difference between free speech and the proposition that resources are “free” to anyone for the taking to be used for communication.

  • 10)

    Evaluate the statement: “When property rights conflict with human rights, property rights must give way.”


    The statement is vacuous. Human rights are the rights of people to use scarce resources. The property itself has no rights.

  • 11)

    What is nonsensical about the proposition, “A good economic system maximizes the welfare of the maximum number of people”?


    Only one quantity can be maximized subject to all others being held at specified levels. You can maximize the welfare of one person provided that the welfare of each of the other people is unchanged.

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  • 12)

    What are theories, and why are they useful? What is logical validity of a theory? What is empirical validity of a theory? Does either imply the other?


    Theories provide a coherent and facilitating framework for explaining and predicting events in the world. Theories have two aspects—logical and empirical. A theory interprets events in terms of a general framework, using principles considered to be true. Using logic and the principles on which a theory is based, one can draw implications. If the principles and the derived implications are logical, the theory is logically valid. Second, useful implications are those which can be tested empirically against events in the world and shown to be wrong or “refuted.” If the implications are not refuted by empirical testing—that is, by events in the world—the theory is empirically valid or conditionally confirmed. Logical and empirical validity do not imply each other. In short, use of theory and empirical testing is a way to increase the probability of making more accurate predictions or reduce the probability of making erroneous predictions.

  • 13)

    Can a theory be proven true?


    No. Logically it’s impossible to prove a theory. A theory says that an assertion or proposition X logically implies some event Y. Empirically, if we observe event X and then the event Y, we can’t infer that X caused Y to occur, because there may be something else (Z, which we may not be aware of) that caused Y to occur. We can say that the evidence supports the theory. “Confirmed” or “validated” however do not here mean “proven.”

  • 14)

    “The assumptions or principles underlying the theory are too simplistic or unrealistic, so the theory is not useful or won’t work.” Do you agree?


    No. The usefulness of a theory depends upon its simplicity (how easy it is to use) and predictive power (how accurately it predicts events in the world). A theory with complicated “realistic” assumptions may generate implications which are not supported or confirmed by events (it predicts very poorly) while a theory with simplistic assumptions may generate implications that are largely realized by events (it predicts well). Use the theory that predicts best—even though its assumptions are simplistic. The predictive power or empirical validity of a theory does not depend upon the complexity (or realism) of the theory’s underlying assumptions, propositions, or assertions.

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  • 15)

    “It’s better in theory than in practice.” What do you think this means? Do you agree?


    “It’s a good theory but it predicts badly.” Disagree. If the theory predicts badly, it’s not a useful theory. A useful theory predicts well—the theory makes implications that are confirmed or supported by events.

  • 16)

    What is meant by (a) the logical validity of a theory? (b) the empirical validity? Does either imply the other?


    A theory is logically valid if all its elements are logically consistent with each other or with some broader theory with which it is associated. It is empirically valid if its implications about observable phenomena are consistent with the observed phenomena. Neither implies the other.

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A candy-store owner told Annie: “I want to give you some candy for free. Select whichever one you want.” She responded, “Thank you. But it’s not free!” Annie’s smart! She recognized that choosing her favorite, Snickers, is costly. She would have to give up her next best-liked candy, a bag of M&Ms—her alternate personal highest-worth good. Costs can occur in several forms, and some things that are not costs are often called costs.


The cost of an action is the best alternative you otherwise would have chosen. Cost is what you forgo. When Annie chose the Snickers, she gave up one of the several other kinds of candy she could have had. The best—the highest valued—alternative in her opinion was the M&Ms. So for Annie, the cost of the Snickers was the M&Ms. “Opportunity” is sometimes used with “cost”—“opportunity cost”—to emphasize that the cost of an act is the best of the forgone opportunities.

Annie did get the right to choose some candy. Getting that right didn’t cost her anything. The cost occurred when she had to choose to have this rather than that. We must recognize the difference between (a) the gift of the right to choose among the specified items and (b) the act of choosing among them. Though the right to choose some candy was obtained without payment, the choice itself was not free.


When Annie was then asked if she would rather have the Snickers over two bags of M&M’s, she replied, “No, I’d still choose the Snickers. But I would have a hard time deciding whether one Snickers was worth to me as much as three bags of M&Ms. I’d let you choose whether I obtained a Snickers or three bags of M&Ms.” She could have added, “My personal worth of a Snickers is the most bags of M&Ms I’d be willing to give up to get a Snickers. Cost is what you must pay to get something. Personal worth is the highest value you’d be willing to pay. For any action, if your personal worth exceeds your cost, you’ll do it. If your cost exceeds your personal worth for it, you’ll not do it.”

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Consequences of Act versus Cost

Distinguish between (a) the cost of a chosen act and (b) the “bad” consequences of that act. Undesirable features of choices are not the “cost.” People say that the cost of playing tennis is the resulting sore arm, or that the cost of studying is eyestrain. The eyestrain is a consequence, or part of the act, of studying; the sore arm is a consequence, or part of the act, of playing tennis. Don’t confuse the undesirable features of a chosen act with its cost—the best alternative given up. The cost of “studying and getting a headache” is the “best opportunity” thereby given up, which may be the two hours of playing video games you give up in order to study.

Purchases versus Use—Explicit and Implicit Costs

Another distinction is between the cost of getting some good and the cost of using that good. When you buy something, you trade rights, giving up rights to one good in exchange for rights to what you bought. What you paid is a cost of getting what you bought. But when you use something you already own, you incur a cost—giving up the next best use of the object. You might call that a cost of “use.” Whatever it’s called, cost can occur without giving up some good in exchange.

If I use my garage as a workshop, there’s a cost of using the garage in that way—the loss of storage space for my car. Because no rights are transferred or goods given up to someone else, the cost is called an “implicit” cost. The implicit cost here is the best forgone use of goods I already have. Thus, even already owned resources are not costless to use, because their use for “this” means giving up the opportunity to use them for “that.” The label “implicit” is a way of reminding us that a forgone opportunity is a cost. Every cost is appropriately called an “opportunity” cost, to emphasize the opportunity forgone, whether as a payment or as some alternative use.

Precisely What Is the Action?

Consider three related activities concerning an auto: (1) purchase of its title, the ownership; (2) continued ownership of the car; and (3) use of the car. Each of these acts has its cost. Suppose a car with a purchase price of $20,000 could immediately be resold for $19,000. What is the cost of purchasing title to the car? Is it $1,000 or is it $20,000? The cost is $1,000, because your wealth is reduced by only $1,000 when you purchase the car ($1,000 = $20,000 minus the immediate resale value of $19,000). Only $1,000 is initially forsaken. But immediately there is a cost of continuing to own the car. And there will be costs of driving the car.

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Price versus Full Cost

More than money payments are involved in the costs of most acts. Suppose you spend an hour shopping for a movie on DVD you then purchase for $10. That’s an hour of time otherwise available for some other activity, like working at $8 per hour. The full cost of the purchase is $18, the $10 money payment plus the $8 value of what you could have done with that time. Suppose, instead, you hired an agent to do the shopping, purchasing, and delivery for a total money price of $15 ($10 price of the DVD plus the $5 cost of the agent’s services). That would have been cheaper, though the money price was higher—the $18 full cost without the agent compared to $15 with the agent.

The value of your time is one reason you don’t drive across town to purchase at a lower money price—but at higher full price. The relatively high value of time for some customers is why convenience stores thrive. Richer people (who have higher-valued alternative uses for their time) typically pay higher money prices to get faster service. They don’t shop around to save a dollar waiting in lines as long as do people with lower hourly earnings. Wealthy people pay higher greens fees on golf courses or higher fees for tennis courts that have less waiting time or faster play; they insist that sellers of service (restaurants, hair stylists, tailors, lawyers, doctors, auto mechanics) provide reservations and faster service. The rich pay a higher dollar price for the faster service, because the greater value of time saved reduces the full cost for them. Conclusion: Do not regard the money price as the full cost. Consider all components of cost.

Expenditures versus Purchases

An expenditure (payment of money) is not a cost if you are already obligated to make the payment, as when you repay a debt. After you buy an automobile under an installment payment plan, the later expenditures, when made, are not costs. You incurred the cost at the moment you agreed to the installment plan. At that moment, you gave up your right to the stipulated amount of future income to be used for other things. When making the installment payments, you are fulfilling an obligation. Those contracted expenditures are not costs—and some costs are not expenditures, as we’ll see next.

Changes in Implicit Costs

Depreciation is a reduction of current value, not of initial purchase price. Suppose you have just purchased a used car for $15,000 to use in a limousine service business. You contemplate a 100,000 mile service life, with zero final resale value. The depreciation due to use of the auto would be $.15 a mile (= $15,000/100,000 miles).

The day after you bought the car, you discover it has been owned by a celebrity Edition: current; Page: [36] and therefore could be resold for $100,000! You’ve just gained $85,000 in wealth. But at the same time, the rate of depreciation of the car has increased from $.15 a mile to $1 a mile (= $100,000/100,000 miles). You have become wealthier. But you now lose more of that greater wealth with each unit of use. Depreciation always must be based on the pro-rata share of its current value—not its initial purchase price.

Misfortune can make us understand the world more clearly. You buy a used car for $15,000 for a limousine service, and the next day you discover some defects in it, which reduce the value of the car to $5,000. You’ve suffered a wealth loss of $10,000. However, the depreciation per mile of use of the car falls to $.05 per mile (= $5,000/100,000 miles), assuming the car will still render 100,000 miles of service. Again, the point is that the depreciation of an asset is the decrease in its current value, not in the initial value at the time of purchase.

“Sunk Cost” Is No Longer a Cost

The concept “sunk costs” is important in many decisions. You are writing a term paper and have already spent twenty hours on it. Someone says you could write a paper on a different topic and get a better grade. Would your decision depend upon how much time and effort you have already spent on the present topic? We hope not! That time spent is sunk, gone, and unaffected by any future actions.

A sunk cost is the cost of a past act. It is not a cost of any present or future action. It may provoke tears, sadness, and regret. But costs of past acts are bygones, sunk and irrelevant for present acts. However, at the earlier time of initial action, the contemplated act’s foreseen (but not yet incurred) sunk cost is of prime relevance in deciding whether to undertake the act.

Time Used versus Time of Use

Time passes no matter what you do. It can’t be saved and accumulated; there is no choice about delaying or speeding up time. Therefore, the time required to do something cannot itself be a cost. Instead, the cost is the alternative act that otherwise would have been accomplished within that amount of time—possibly later and not just at the present moment.


“Externalities” are effects on other people to whom adequate—mutually agreeable—compensation is not made. If compensation for effects on another person were made, that would be a “purchase.” Theft has an external effect, but if you had bought the item, that would not be said to result in an externality. Edition: current; Page: [37] So long as mutually agreeable compensation is made to those who would otherwise be harmed, that’s not an externality.

You will not always bear all the costs of your action. You may impose some losses on the property of other people. That would happen if you stole some of the resources you were going to use. Or your action might inadvertently harm someone. If I eat a hamburger with onions during a close conversation with you, that’s legal, even though I have polluted the air you breathe.

If I turn up my sound system and annoy neighbors, or throw litter on their land, or drive my noisy motorcycle near their land, I am abusing—reducing—the benefits they receive from their property rights in land. But often the actor abuses resources that aren’t clearly owned by anyone. If a steel mill discharges polluted water, or if a refinery emits pollutants and reduces the quality of air, these acts change the physical characteristics of resources over which no one seems to have unambiguous enforceable and transferable property rights.

Actions that are legal but incidentally impose costs or losses on other people are “externalities.” Whether such actions would be illegal usually depends on the cost of assigning and protecting property rights over the abused resources. If declared illegal, they are punishable by government power.

Trivial harms to other people’s property are permitted if the harm is a side effect of some productive action, or if its prohibition is too expensive relative to the benefits of initiating action. Many external effects typically are tolerated because the costs of prevention by laws would exceed the benefits of prevention. Smoke from a neighbor’s bonfire of leaves in the fall season may be legally “dumped” on neighboring property. The same is true for typical traffic noises. In many situations, social customs, rules of etiquette, and ostracism help control our behavior.

If you owned well-defined and enforceable property rights to air over your land, I would have to compensate you for the right to dump smoke on your property. Then I would have to take those costs into account when deciding whether to burn leaves or haul them to a dump. The costs would be “internalized” (borne by me). But since complete private property rights are not perfectly enforceable over all resources, people aren’t forced to take account of, or bear, all the costs. As another example, an employee strains and suffers in his work. That would be an external effect imposed on the employee by the employer—if the employer hadn’t agreed to pay enough to the employee for the right to have the employee do that work.

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Environmental Pollution

What is called “pollution” is the use of a nonowned resource without compensation. In some situations, there are no private owners, as with the air. If there were, they could demand compensation for permission to use the resources, as with ordinary purchases. The consequences would be “internalized” on the responsible person, and pollution might be avoided or reduced.

Complete, exhaustive private property rights are difficult to specify and enforce. Does a right to the view across the parcel of land neighboring your property belong to you or to the neighbor? If someone did own the view and that ownership was salable, as land is bought or an employer buys one’s labor, the effects and costs and benefits would be “internalized” on the actor, and the resources would be used accordingly.

Inducing Beneficial Externalities

Some of your actions improve the resources or environment of other people, increasing the benefits they derive from their property, though you weren’t paid to do that. Examples are better hygiene, prettier gardens, politeness, and so forth. How are we persuaded to do that when we are not paid to do so, or no reward can be forced from the beneficiaries? Social pressures, social approbation, ethics—such as “Keep up the neighborhood” or “Neighborhood Watch”—are sometimes influential. Also government rules and regulations are applied, as in compulsory vaccination.

Pecuniary Externalities

All these examples of externalities are “physical” externalities, pertaining to the physical attributes or uses of a resource. There are also “pecuniary”—market value—external effects, without any physical impact. An example of a pure pecuniary externality is provided by the book in your hands. When this textbook was published, it lowered the market value of competing texts. Other text publishers did not have to be compensated for the loss in the market value of their texts. No one has rights to particular market values of resources. The market value depends on offers of other people. No one has the right to make other people continue to buy something and to do so at a specified price. That kind of “right” is not part of private property rights. Only governments have that right—mainly in the power of taxation.


The distinctions among costs, losses, rights, and externalities are not hair-splitting trivial distinctions. Let’s review some of these key concepts.

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  • Definition of Cost: The cost of a chosen act is the best of the alternative actions forgone. The chosen act is the one most preferred of all options.
  • Full Cost: Money plus other resource costs.
  • Implicit Cost: Best alternative use value of already possessed resources.
  • Explicit Cost: Transfer, or reduction in value, of property rights in an exchange.
  • External Cost: Reduction of options of uses of resources owned by other people and for which no compensation is made to the other people.
  • Sunk Cost: Past cost of a past action; not a cost of current or future choice.


Individuals Are the Choosers

If you couldn’t choose, you’d have no costs! But when free to choose, you don’t choose at random. Your choices reflect patterns of preferences. We will always look at the behavior and choices of individuals. If you ask, “Why does the government or General Electric or some union behave as it does?” you should ask instead, “Why do the decision makers decide as they do?” This direction of attention to individuals does not mean that people are solely self-interested and self-seeking without regard to other people. But we regard individuals as the basic units of choice, no matter what are a person’s motives or ultimate objectives.

The likelihood of a particular choice depends on its cost and personal worth. And a bigger “basket” will, at the same cost, be chosen over a smaller one. “More is preferred to less.” But our choices aren’t typically the easy choices between bigger and smaller baskets. Instead, we must choose between combinations of goods. They differ in the relative amounts of various goods. One has more “oranges” but fewer “apples.” One area has nicer indoor living, while another has better outdoor activities. The fundamental premise is that for each person there are several other equally preferred and equally costly (affordable) combinations of goods or activities among which he can choose. If the cost of any of the components in that combination should change, you’d shift to a new equally costly, but possibly better or worse, combination. In other words, you’d alter your lifestyle, behavior, and the goods you buy.

If we know of some reliable regularities in personal preferences, we can deduce the adjustments to changes in costs and opportunities, whether in Edition: current; Page: [40] domestic or in business activities. Some reliably consistent features, called a “pattern of personal preferences,” have been identified. The preferences are about more of one good relative to more of other goods.

The principles are not about which goods we prefer over other goods. No such absolute ranking of goods according to importance or purpose is known. Instead, what is known are some preferences for amounts of one good relative to other goods—how much more or less of one good is substitutable for how much more or less of other goods. These principles apply to people living in socialist, as well as to those in capitalist, systems. And they apply to all living objects—people, animals, and even plants.


Principle 1:: For Every Good You Desire More

You want more of this and more of that. You want also to accomplish more than one goal. But we live in a world of scarcity and limitations. Choices must be made.

Principle 2:: You Are Willing to Forgo Some of One Good for More of Other Goods

You do not wait until you have obtained some “necessary minimum” of one good, say food, before you want to have some clothes. And you don’t then wait until you have some minimum necessary amount of clothes before you want some of other things. There is no hierarchical ranking of goods as “needs.” You prefer combinations of goods, rather than a successive fulfillment of essential goods. This is described by the principle of marginal substitutability among all goods. The principle asserts that you are willing to give up some (not necessarily all) of any good, if you are able to get enough of other goods in return.

Principle 3:: The More You Have of Some Good, the Less of Other Goods You Are Willing to Give Up to Get an Additional Unit

To obtain one more pint of ice cream a week, you would be willing to pay only a lower price if you are already consuming much, than if you are consuming little. An extra pint has less added worth to you, the more you have. Some would call that “diminishing marginal utility” at larger amounts of a good. The larger the amount of a good a person possesses or controls, the lower is its marginal personal worth to that person.

We use the word “worth” rather than “utility,” because we don’t know how to measure utility or if it means anything other than “personal worth.” Edition: current; Page: [41] This principle can be called “diminishing marginal rate of substitution.” The amount you’d be willing to pay (give up) for an additional unit diminishes the more you have of the good. We always refer to personal worth, because it reflects each person’s own personal opinion and judgment. Often we’ll write just “worth,” instead of “personal worth.” But “worth” always will refer to one’s personal worth, not the market value.

We take the following “observations” to be true:


Preferences differ among people, and they are different for any given individual at different times and different circumstances. Though the three “principles of patterns of preferences” apply to everyone, not everyone has exactly the same numerical magnitudes in their trade-offs among relative amounts of goods.


People innovate and experiment in attempting to improve their situation, at the risk of ending up worse off. This does not mean people like risk and uncertainty; instead, in the prospect of a (sufficiently large) gain, they are willing to incur some risk of loss.


People are not purely selfish, without interest in the welfare of other persons. An enormous amount of philanthropy and charitable activity occurs. This is consistent with the principle that a person prefers command over more rather than less goods and wealth: one can want such power in order to help others as well as one’s self. But people are not charitable in all their actions. The market (wherein people exchange property rights in arranging for consumption, earning incomes, and investing) is not the place to expect charity. Charity begins outside the market.


Ethical, honest, reliable, and moral behavior is generally a survival behavior and wealth-enhancing characteristic in the market. Not only are violations of ethics more likely to prevent successful market activities but they are arguably more powerful in the economic market than in the markets of political and social exchange. Ask whether a seller/supplier or a politician tends to make more reliable promises. Which will suffer most, and most quickly, if caught being dishonest or evasive?

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The three personal preference principles apply to all goods and all desired attributes of life. Living in Los Angeles or Miami provides some combinations of conditions and attributes more cheaply than does living in some other area. There are combinations in Omaha that are equally desired, possibly involving larger homes on more land with more wide roads and security, but with poorer climate and cosmopolitan variety. We “trade” some amount of one desirable attribute for more of another.

These trade-offs (substitutions on the margin) apply to ideals and even to honesty. Each of us on occasion sacrifices or risks some small degree of our integrity, of our fidelity to an ideal or principle, for some sufficient increase in income or safety or popularity or power. (Imagine a world in which no one ever told the slightest “white lie,” such as “I’ve had a wonderful time,” when you were bored stiff, or hid the slightest truth when commenting on someone’s new clothes or hairstyle.) Goals and ideals, like ordinary goods, are competitive and substitutable in degrees of attainment and fulfillment, where the tradeoff is between more or less, not between all or none.


  • 1)

    If there is more than one opportunity to be forsaken, which forsaken opportunity is the cost?

    • a. How are opportunities made comparable so that one can determine which one is the cost?
    • b. Can there be production without cost?


    The highest-valued opportunity is the cost.

    Expressed in a common denominator or measure of value.

    In general, no. Not if more than one thing could have been produced—including leisure.

  • 2)

    “The time involved in purchasing something cannot be considered part of the cost since the time would have passed anyway. It is an error to count the value of time as part of the cost of any action.” Evaluate: What is meant by the value (or cost) of time?


    The first statement is true, but the second is false. The value of an hour is the highest-valued use one could have made of that hour. Hence the cost of an act taking an hour is the value of the best alternative action forsaken Edition: current; Page: [43] during that hour. (A common, though not always accurate, measure of the value of time is the earnings one could have obtained during the time.)

  • 3)

    “Joe builds a garage next to his house. Later, he decides to park his vehicle on the street and use the garage for storing miscellaneous items. Since the garage has already been built and paid for, it costs nothing to use it for general storage.” What is “cost”? Is using the garage for storage “costless”?


    Cost is the most valuable of options forgone. Joe cannot use the garage for both housing his chariot and storage: he must make a choice. Evidently, he values the garage for storage more than for coddling the car, but that treatment of the car is the cost of the storage capacity, even though Joe now makes no money payment.

  • 4)

    “In an open market, with buyers and sellers unrestricted in coming to agreements on transactions, the money price of the traded object is the full price: the specified market price is not greater than the personal valuation of the buyer.” Right? Or are there nonprice ways in which consumers compete in obtaining commodities? Are there costs to the buyer in addition to the money expenditure directly for the good?


    There are exertions, time expenditures, uncertainties and frustrations, and money outlays in buying almost anything—put on your shoes, drive to the store, park and deal with clerks who may be inept, gamble on the quality of products, and pay the babysitter. All this is part of the “full” price.

  • 5)

    Are costs the same thing as the undesirable consequences of some action? Explain why not.


    Costs are not the undesirable consequences of an act; they are the highest-valued forsaken opportunity. Anticipated unattractive consequences of a possible action may well play a role in deciding whether or not to pursue the activity or in determining how far to pursue it, but they are not formally a “cost” of the venture.

  • 6)

    What is meant by equality between private and social costs?


    All costs are private. Social costs are simply the total of all private costs. If a person does not bear all the costs of his action, then the social costs Edition: current; Page: [44] exceed the total of the costs he bears, because some of the costs are borne by others. With equality of private with social costs, all costs of a decision are then borne by the decision maker.

  • 7)

    “Cost is an opportunity concept and exists wherever a choice exists.” Explain.


    A choice is an opportunity among two or more options. The cost of the chosen alternative is the most valuable option given up.

  • 8)

    What is the relation between opportunity costs and compensation for work?


    If my rights to myself and my labor are protected, I cannot be forced to work. But I can be induced to work if paid at least the costs of my doing the work—the value of what I otherwise could have done. If I had been forced to work without regard to my rights, then I would be suffering the externalities of the actions by the person who forced me to work. But if I’m compensated by a negotiated wage, the “externality” has been “internalized.” The employer bears the cost. We could use the term “uncompen-sated externality” to mean “taking without compensation” or theft, while reserving the term “compensated externality” or “internalized externality” for an ordinary purchase and sale of goods and labor. But we already have such standard terms as “purchase,” “sale,” “wages,” and so forth. Later we’ll examine some important examples of existing externalities.


The principles of choice and behavior can be described by so-called preference maps. In figure 3.1, point A denotes a combination of two goods, X and Y. The amount of X is measured by the horizontal distance to the right from the vertical axis, and the amount of Y by the vertical distance upward from the horizontal axis. Point B contains more Y, but no more X, than does combination A. Combination C contains more X than point A, but no more Y.

If point B is preferred to A, Y must be an economic good. If point C is preferred to A, X must be an economic good. If B were not preferred to A, the good Y must either be a free good or a “bad” (rather than a “good”). But we have defined X and Y to be economic goods, meaning they are not so plentiful as to make no more wanted even at a zero price.

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Figure 3.1

How could you portray the personal worth of an additional (marginal) unit of X at point A? Since “personal worth” of a good is defined and measured only in terms of an added amount of some other substitutable good that would offset one unit of X, that personal worth depends on the amount of X that is held. The greater the initial amount of X, the less the amount of Y that will be offered for one unit more (preference principle #3).

Combination B has more Y, and no less X than at A, so more Y will be offered for an X if that person is initially at B than if at A. A person at B would offer more Y to get an X than if that person were at C, for the more Y held, the less each is worth relative to other goods.

In figure 3.2, points B and C are on the same indifference curve I2, meaning either is as preferred as the other. And point A is less preferred than C or B or any other point on I2. The two lines become flatter as they extend to the right to more X. The resulting shape of the line connecting all combinations (points) that are equally preferred (indifferent) is curved, and sags in toward the origin. (In chapter 2, the production possibility boundary [PPB] also was not a straight line, but it bulged out from the origin.) The slope of curve I2 is (negatively) “steeper” at B than at C; I2 is “steeper” at B than is I1 at A; and I1 is “steeper” at A than is I2 at C. For example, one more unit of Y (vertical movement) is worth more X forgone (leftward horizontal movement) when starting at C than when starting at A.

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Figure 3.2

Meaning and Measures of Marginal “Personal Worth”

A marginal personal worth of a unit more of a good, X, is the amount of other goods (here denoted by Y) that a person is willing to give up to get the added unit of X. The curvature of an indifference curve reflects the diminishing marginal personal worth at more units of a good (measured on one axis) and with less of another good (measured on the other axis). If an indifference line were straight from upper left to lower right, the relative marginal personal worth of the two goods would be constant regardless of the relative amounts of the two goods. That would not be consistent with reality. The marginal rate of substitution of X for Y can be expressed: MRSxy = −ΔY/ΔX (where Δ denotes the quantity change). The ratio is negative, for X and Y change in opposite directions as we substitute a little more of one for a little less of the other. And the numerical value decreases as we move to the right on an indifference curve, for we must gain ever larger amounts of X to compensate for a given reduction in Y.

We use a smooth curved line for simplicity, though a realistic curve could be kinked with straight-line segments, but the slope becomes successively flatter, meaning that the less of a good a person has, the more of other goods that must be obtained for further unit reduction in the good.

The meaning of the first principle, “More of a good is preferred to less,” is represented by a choice of a point on a higher indifference curve. Being at any point on the higher indifference curve is preferred to being on any of the points on a lower indifference curve. In figure 3.2, the higher curve, above and Edition: current; Page: [47] to the right, represents a set of baskets that are: (1) each of the same worth to a person, and (2) each preferred (superior) to each basket on the lower curve.

Figure 3.3

Higher and Lower Indifference Curves

All points on an indifference curve represent equally preferred alternative combinations. Combination A and B on curve I2 are equally preferred, as are points A′ and B′ on curve I1, and any point of the higher curve, I2, is preferred to any on the lower.

All three preference principles are summarized graphically in figure 3.3. (1) The upper indifference curve, representing combinations preferred to those on the lower indifference curve, portrays the first proposition—more is preferred to less. (2) The negative slope portrays proposition 2—the principle of substitution on the margin. (3) Sagging toward the origin, and becoming flatter as one moves from left to right, portrays proposition 3—diminishing rates of marginal substitutability of X for Y at larger amounts of X relative to Y along a given indifference curve.

We can think of “personal worth” of this versus that good or action without having to make psychological comparisons with any other person. The comparison is “before” and “after” for the same person. Personal worth means how much a person is willing to pay for something, not measures of psychological Edition: current; Page: [48] satisfaction or distress of some action. For each person, personal worth of one action is compared with that person’s personal worth of an alternative action, measured in market value of what is given up.

An indifference curve is sometimes called a “constant utility” curve. That doesn’t define what “utility” is. It means only that, no matter what you mean by the word “utility,” its amount is constant—the same at every combination on an indifference curve.


Table 3.1 lists alternative, equally preferred combinations—baskets—of amounts of meat and apples for Adam. Adam is indifferent in his preference among these alternative baskets. That is to say, “Each alternative is equally preferred.” Or, “Adam is indifferent among those baskets—he doesn’t care which one is obtained. Or, “Adam would let even his worst enemy choose which of those combinations Adam gets!”

If Adam initially had basket D, representing a weekly rate of consumption of eight apples and thirteen pounds of meat, Adam would be neither helped nor hurt (as judged by Adam) by having basket E instead—with two fewer pounds of meat (eleven versus thirteen) but one more apple (nine versus eight). Two fewer pounds of meat for one more apple is a “marginal rate of substitution” between apples and meat that would leave Adam no better or worse off than before, according to his own opinion.

Table 3.1 Adam‘s Equally Preferred Combinations of Apples and Meat
Basket Apples Meat Meat given up for additional apple
A 5 24.5
B 6 18.5 6.0
C 7 15.5 3.0
D 8 13.0 2.5
E 9 11.0 2.0
F 10 9.3 1.7
G 11 8.0 1.3
H 12 7.0 1.0
I 13 6.2 0.8
J 14 5.6 0.6
K 15 5.2 0.4
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The adjective “marginal” means two more pounds of meat is the personal worth of one more apple, not the personal worth of all nine apples.

Why is the marginal personal worth of another apple lower between E and F (1.7 pounds of meat) than between D and E (two pounds)? Adam has more apples at E than D, and less meat. An additional apple is not worth as much to him when more apples are possessed. The marginal personal worth of an apple (or of any good) falls the more one has of the good. He is willing to give up less meat (only 1.7 pounds) for another apple between combinations E and F, where more apples are possessed.

As we move to more apples and less meat for Adam, the amount of meat that would be given up for one more apple diminishes. The larger the ratio of the amount of one good possessed relative to other goods, the lower is the marginal personal worth of the first good. The greater is the amount of a good relative to other goods in one’s consumption pattern, the less is the amount of other goods one will be willing to give up for one more unit of the first good.

If the amount of apples and the amount of meat were both twice as large as in the initial situation, we don’t know how that doubling of wealth would affect the marginal personal worth of apples relative to meat. We don’t know how wealth (having more apples and more meat) affects your willingness to substitute among the goods. But we can be sure that at larger amounts of a good, its marginal rate of substitution with any other good will fall. Note also, in accord with our earlier observation 1, that one person’s marginal personal worth of apples may be different from another person’s even though both have the same combination of all goods.

You can move up the table and discover the marginal personal worth of meat, instead of the marginal personal worth of apples. Between baskets I and H, the marginal substitution ratio is one apple for .8 pounds of meat. So the marginal personal worth of one pound of meat is 1.25 apples (= 1 apple/.8 pounds of meat). Between E and D, the marginal personal worth of one pound of meat is .5 of an apple (= 1 apple/2 pounds of meat), or the marginal personal worth of one apple is two pounds of meat.

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It’s been going on for thousands of years. Long ago, flint arrowheads were traded for olive oil and fish. Today, it’s crude oil for fish. But there is much misunderstanding about why we trade. Sometimes, trading is (wrongly) called a zero-sum activity, in the sense that what one person gets another gives up—with no net change in the total.

Trading (or exchanging) is a positive-sum activity in that both participants end in preferred situations. In some exchanges, both traders may end up with fewer goods—even though they both gain. To see how, we’ll look at exchange in an imaginary refugee camp.


We visit a camp where hurricane refugees are housed. Monthly, each receives Red Cross parcels containing, among other things, twenty bottled waters and twenty granola bars (shown as basket A in tables 4.1 and 4.2). Into the camp comes a newcomer, who does not receive a gift parcel. The wily newcomer offers Sam ten bottled waters in exchange for seven granola bars: “If you’ll give me seven granola bars, I’ll be back in a moment with the ten bottled waters.” Sam is willing to give as many as eight granola bars for the extra ten bottled waters. So Sam agrees.

Sam started with basket A. The hypothetical basket B1 is equal to basket A in terms of Sam’s preferences: he is indifferent between baskets A and B1 in table 4.1. Now, we’ll see exchanges among all three—Sam, Joe, and newcomer—improve everyone’s situation despite the fact that Sam and Joe end up with less water and granola between them, because some are taken by the newcomer.

The newcomer dashes to Joe and offers five granola bars in exchange for ten bottled waters. Joe would have been indifferent to selling the ten bottled waters for as few as four granola bars (basket B1 in table 4.2). Being offered five granola bars, Joe agrees to the trade.

The newcomer pays Joe five granola bars and delivers the promised ten bottled waters to Sam (baskets B2 in tables 4.1 and 4.2). Both Sam and Joe are pleased by the improvements in their situations; for each, basket B2 is better

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Table 4.1 Sam’s Equivalent and Preferred Baskets (to Basket A)
Water Granola Baskets
Basket A 20 20 Original
Changes from A to B1 (+10) (−8) Changes from A
Basket B1 30 12 Indifferent to A
Changes from A to B2 (+10) (−7) Changes from A
Basket B2 30 13 Preferred to A
Table 4.2 Joe’s Equivalent and Preferred Baskets (to Basket A)
Baskets Water Granola Baskets
Basket A 20 20 Original Baskets
Changes from A to B1 (−10) (+4) Changes from A
Basket B1 10 24 Indifferent to A
Changes from A to B2 (−10) (+5) Changes from A
Basket B2 10 25 Preferred to A

than basket B1. The newcomer, too, is happy, having acquired a profit of two granola bars by selling water to Sam at a price of seven granola bars after buying from Joe for only five.


The total of goods left to Sam and the Joe has been reduced! The newcomer has taken two granola bars from them. Yet, each thought the trade to be a good deal. Has the wily newcomer confused them or exploited their irrationality? No, everyone is better off. The newcomer explains:

“You have not been cheated. In fact, you are both better off. You both obtained something worth more to you than what you paid. Sam, table 4.1 shows that you accepted my offer of ten bottled waters for seven granola bars as a good deal. You were willing to pay as many as eight granola bars for ten additional bottled waters, but I accepted a price of only seven. That trade was worth as much to you as a gift of one granola bar. And Joe, you paid ten waters and received five granola bars, which gave you one more granola bar than your value of the ten bottled waters you paid. You received a benefit equal to a gift of one granola bar.

“You both benefited. I kept two granola bars as payment for my services. True, I didn’t do this only because I liked you. I was interested also in helping myself. Edition: current; Page: [52] In helping you, I helped myself—or if you wish, in helping myself, I helped you. Furthermore, admit it—each of you thought you were outwitting and exploiting me, because you were each prepared to give up more (or receive less) than you did. Of course, you would have benefited more if I had traded on less favorable terms to myself, and kept fewer than two granola bars. Yet, there is no denying that you are now better off. None of us has been foolish.”


  • 1)

    What made the trade mutually beneficial?

    When two individuals have different personal worths of a good, each can gain from a trade. Sam’s personal worth of ten bottles of water was eight granola bars; Joe’s was four granola bars.

  • 2)

    Which is the direction of the trade? That is, who gives up water, and who receives it in the trade?

    Sam has a higher personal worth of bottled water in terms of granola bars, so Sam buys water, and Joe sells it.

  • 3)

    What is the maximum possible payment to the wily newcomer

    (intermediary) that would leave neither Sam nor Joe better or worse off?

    At the limit, the intermediary could receive four granola bars per ten bottles of water traded. This is the difference between Sam’s personal worth of ten bottles of water (eight granola bars) and Joe’s personal worth of the bottled water (four granola bars).

  • 4)

    Who has a higher personal worth of granola bars in terms of bottled water?

    Sam’s personal worth of a granola bar is 1.25 bottles (ten bottles/eight granola bars = 1.25 bottles per granola bar). Joe’s personal worth of a granola bar is 2.5 bottled waters (ten bottles/four granola bars = 2.5 bottles per granola bar). Joe’s personal value of granola bars is greater than Sam’s.

  • 5)

    Arranging trades can sometimes be very costly. Suppose the cost of arranging the trade of ten bottled waters amounted to six granola bars. Would the trade still occur?

    The cost of setting up the trade would exceed the difference between Sam’s and Joe’s personal worths of bottled water. The trade would not occur because the costs exceed any possible gains from trading.

  • 6)

    What would be the final achieved combinations of bottled water and granola bars for each person at which no further trades would be Edition: current; Page: [53] mutually acceptable? How far might the trading go between Sam and Joe?

    The answer depends on a more complete understanding of personal worth, which later chapters explain.


The intermediary, or “middleman,” did not ask if Sam likes bottled water more than Joe. One of them may regard both granola and water as barely desirable, while the other may drool at the thought of each. Instead, what was important for the exchange to occur was each person’s personal worth—the value of one good relative to another.

Nor did either Sam or Joe have a “surplus” or too much of the good traded away. The critical feature is that the two persons had different personal worths of bottled water and of granola. Trade can benefit both if their personal worths for a good differ.

Personal Worth: The Most of Other Goods a Person Is Willing to Pay to Get a Good

While people do barter some goods for others, “most of other goods” are typically measured in terms of their dollar value. The largest dollar amount a person would be willing to pay for a good is a measure of its personal worth to that person. If you are willing to give at most $100 for a fancy pair of shoes, your personal worth of those shoes is measured at $100. You’d prefer to get them for less. But if you wouldn’t pay the $100, then your personal worth must, by definition, be less than $100. Or, in reverse, a person’s personal worth is the smallest amount of other goods for which that person would sell a good. If you already owned a good and would not sell it for less than $120, then $120 is a measure of its personal worth to you.

Personal worth doesn’t refer to an emotional or psychological concept. Mere words, wishes, or assertions of desires say nothing about one’s personal worth for a good. Actions are what count—how much of other goods one is willing and able to pay to get more of a good.

Economic analysis doesn’t rest on any presumptions of why a good is desired. You may believe that someone is foolish, or ill informed, in placing high personal worth on some good, such as opera tickets, tofu, or a round of golf. Personal worth differs for each of us because we make different judgments and have different preferences or whims. Certainly, one’s opinion may be influenced by the arguments, pleadings, and behavior of other people. And a parent Edition: current; Page: [54] may regard a child’s personal worth for a good (e.g., candy) as “improperly and inappropriately” high. The parent might not allow the child to have the candy, but that wouldn’t alter the child’s personal worth for it. That would merely restrict the child’s right to make exchanges.

Presumably, a person becomes an adult when one has a right to choose according to one’s own personal worth. By law, that comes for most goods and services at the age of eighteen in the United States. Nevertheless, you can’t buy some kinds of medication without the approval of a physician, reflecting that physician’s judgment of what the personal worth of the medication should be for you. We will hereafter ignore those restrictions and deal with goods and services you may choose on the basis of your own personal worth.

Distinguish between a) an individual’s personal worth of a good (the most that person is willing to pay, or the least that would be accepted for its sale) and b) the good’s market value (its market price). In any exchange, the buyer’s anticipated personal worth of a good exceeds its market value (price), or the purchase would not be made. And the reverse is true for the seller, whose personal worth of the good is less than its market value (price).


“The most that a person is willing to pay to have more of a good.” What is meant by “have”? When buying some land, what does it mean to “have” the land—which may be located far away? We will mean by “have” the possession of the private property rights to the good. In any exchange, one obtains the private property rights to goods. If some other exchange is meant—like rental, or loan, or permission to use without ownership—we’ll say so.


Back in the hurricane refugee camp, a competing copycat dissipates the newcomer’s profits. She offers to sell Sam ten bottles of water at a price of 6.5 granola bars for ten bottles—a price 0.5 bottles below the former price of seven bottles. Sam accepts, saving 0.5 granola bars per ten bottles bought.

In turn, the new dealer offers to pay Joe a higher price, 5.5 granola bars, rather than the five paid by the first dealer, who argues that the new dealer is unreliable and will not deliver granola bars as promised, or will deliver dry, old granola and sell impure water. But Joe takes a chance and trades with the new dealer. Both Joe and Sam benefit. Buyers like lower prices, and sellers like higher prices. Joe and Sam now are even better off than they were with only one intermediary.

Competition between the two dealers decreases the dealer gains by reducing

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Table 4.3 Achieved Baskets after Competition among Dealers
Water Granola
 Before Trade 20 20
 After Trade with Only One Dealer 30 13
 After Trade with Second Dealer 30 13.5
 Gain is equivalent of 0.5 bar. +0.5 bar
 Before Trade 20 20
 After Trade with Only One Dealer 10 25
 After Trade with Second Dealer 10 25.5
 Gain is equivalent of 0.5 bar. +0.5 bar

the spread between the buying and selling prices of the goods. The consumer/buyer pays less to the intermediary dealer, and the supplier/seller gets a higher price. The spread between the buying and selling price for bottled water is narrowed from .2 bars (two bars/ten bottles) to .1 bars (one bar/ten bottles), and the gain to the new dealer is one bar instead of the two formerly obtained by the initial dealer.

Competition among actual and potential intermediary dealers reduces the price spread to where it just covers the costs of providing the service customers demand. A larger spread would attract new dealers, while a loss would force some people out of business into other, more useful tasks. Competition that reduces prices to buyers and raises prices to sellers is competition of intermediaries against each other. Intermediaries do not compete against consumers or against suppliers; they compete against other intermediaries.

It is often argued that intermediaries like wholesalers, retailers, sales agents, and advertisers exploit the ignorance of customers. That is true in the same way a teacher exploits the ignorance of students, doctors exploit the ignorance of patients, and authors the ignorance of readers. Intermediaries exist (survive) because they reduce the costs of exchange. Imagine what it would cost you to obtain the products you normally buy from their producers. You’d have to know who and where they are; you’d have to travel and communicate with producers; you’d have to inspect their offerings; you’d have to know enough about each product to be able to judge quality; and you’d have to arrange for components to be assembled properly and delivered. Instead, you rely on retailers—intermediaries who supply goods they think customers will prefer and will value at more than the cost of supplying them.

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The intermediary in our story has the opportunity to take the offered goods and not return with the promised goods. But intermediaries rarely disappoint customers. When an intermediary receives ten bottles and promises to return promptly with granola bars, it happens. The intermediary is swift to pay even the most timid and weak of customers. Why? Why not “hold-up” a customer by promising the 6.5 granola bars, but later pay less and keep the difference? Or perhaps the intermediary might mix sawdust with the granola, diluting quality and retaining an extra portion of granola. The customer wouldn’t discover the loss until later.

Intermediaries don’t tend to cheat customers because intermediaries have valuable reputations to protect. A customer treated unfairly would not only refuse to patronize the intermediary again but would broadcast the intermediary’s dishonest behavior. While the intermediary might have made a one-time gain by cheating a customer, the lost reputation implies a loss of future profitable business. But what about an aging intermediary who is growing too weak to run between customers? Why not hold up all customers and make a final profit before retiring—known as the “end problem”?

There are at least two restraints against that. One is that a retiring intermediary often can do better. He can sell the business to a young protégé for a share of future profits, vouching for the reliability of the protégé. Another powerful restraint on cheating “at the end” is the force of a personal sense of shame. This is considered more fully in chapter 34. Here, we say merely that you will render help to someone in an accident or emergency because you “want to.” If you did not, and even if no one else knows, you still would suffer qualms of conscience from your unethical behavior. Ethics commonly are effective, widespread, and desirable in a harmonious, productive, and civilized society.


You depend in general on other people to play an important part in your welfare, so long as you make an attractive offer. You depend also on specific other persons. This distinction between “general” and “specific” dependency is important. When you shop for goods, you depend on the rest of the world to supply you. But once you decide to buy from a specific seller, you become dependent on that seller.

In many situations, such as marriage or as an employee in a firm, you will continue to be dependent on the behavior of specific other persons. Much of economics Edition: current; Page: [57] is about methods of assuring reliabilities of dependencies on specific other persons.


We’ve considered a) the conditions for mutually preferred trade, b) the direction of trade, c) the nature of the gain from trade, and d) the extent of trade. Trade is not a matter of one person gaining at the expense of the other. Instead, it supplies a gain to both—each moves to a new combination of goods preferred to the prior combination.

Trade provides more personal worth to each party. What may lead many to think a trade results merely in a transfer from one person to another is the presence of “haggling, dickering, and bargaining” about the terms of trade. That haggling is a zero-sum activity, in which one person gets a greater share of the gains of trade at the other’s expense. But the trade itself is a positive-sum activity in which both sides gain.

In the next chapter, we will flesh out the nature and extent of the gains from trade. To do that, we will define and explain marginal personal worth and show why marginal is a critical concept in economics and in all sciences. You will learn, for example, how marginal underlies the basic principle of demand.


  • 1)

    The left half of the table shows three combinations of vegetables and meat among which Linus would have been indifferent if he had been offered a choice; that is, all three are equally desirable to him. The right half shows three combinations among which Charlie would have been indifferent.

    • a. If Linus has combination B, what is his highest and lowest personal worth of vegetables? What is his highest and lowest personal worth of meat?
      Table 4.4
      Linus Charlie
      Options Vegetables Meat Options Vegetables Meat
      A 10 and 14 A 40 and 16
      B 13 and 13 B 45 and 15
      C 17 and 12 C 52 and 14
      Edition: current; Page: [58]
    • b. If Charlie has combination B, what is his highest and lowest personal worth of vegetables? What is his highest and lowest personal worth of meat?
    • c. In what sense is it impossible to say who likes vegetables more, Linus or Charlie? In what sense is it possible?
    • d. If Linus and Charlie each have their combinations designated B, does any possible trade exist whereby each could reach a preferred combination? If so, give an example.
    • e. What must be true about personal worth of two individuals if they are to gain by trading with one another, even though they lose part of their goods in the process?


    • a. Between .25 and .33 meat for one unit of vegetables. Between three and four vegetables for one unit of meat.
    • b. Between .14 and .2 units of meat for one unit of vegetables. Between five and seven vegetables for one unit of meat.
    • c. We don’t know who gets more psychological satisfaction or utility from each good considered separately. We can measure only their value of one good in terms of the other—their personal worths. Linus values vegetables more than Charlie in the sense that his personal worth of vegetables is higher. And Charlie values meat more than Linus because his personal worth for meat is higher.
    • d. Linus would be willing to move to combination C, giving up no more than one meat for four vegetables; Charlie would be willing to give up as many as five vegetables to gain one meat in a move to combination A. They both have an incentive to arrange a trade in which one unit of meat is traded for between four and five units of vegetables. The trade would make each of them better off.
    • e. The personal worths of both individuals must differ if exchange is to be mutually acceptable.
  • 2)

    Suppose that Charlie and Linus have the following initial personal worths:

    Charlie: 7 meat = 1 fruit

    Linus: 3 meat = 1 fruit

    • a. Compared to Linus, is Charlie fonder of fruit or meat?
    • b. If the government makes it illegal to trade fruit for meat, always assuming that the law is obeyed, who gains and who loses? Why?
    • c. Now, the government relents and allows trade, but makes it illegal Edition: current; Page: [59] for anyone to trade at any exchange ratio other than one meat for one fruit. Explain the likely consequences of this new ruling.
    • d. Next, suppose the government relents even more, but in order to protect fruit consumers a price ceiling is put on fruit. The maximum price of one unit of fruit is set at four meats. Who is likely to gain, and who is likely to lose by this price control? Explain.
    • e. Finally, imagine that the government takes off all restrictions on the trade of meat and fruit. Introduce a middleman who conducts the trade between Charlie and Linus. What is the maximum cut the middleman can take in the form of meat? Or of fruit?


    • a. Fruit.
    • b. Both lose because both could be better off if permitted to trade.
    • c. No trade will occur; neither is willing to give up 1 fruit for only 1 meat.
    • d. Neither will be as well off as they would be under free trade; however, there is opportunity for trade because Charlie would be willing to give up 7 meats for 1 fruit, while Linus demands only 3 meats in exchange for 1 fruit.
    • e. With free trade, a middleman can offer Linus 3 meats for 1 fruit, then trade 1 fruit to Charlie for 7 meats, keeping 4 meats for his efforts.
  • 3)

    You obtain a permit for one of a limited number of parking spaces allotted by your college; a friend is allotted a desk in the library stacks. Suppose that you would each be better off if you were to trade your parking permit for your friend’s desk space.

    • a. This kind of trading is almost invariably prohibited by the college authorities. Why?
    • b. If you were the college president, why would you prohibit it?
    • c. Would you consider solving the whole problem by simply selling parking space to one and all, like a private downtown parking garage? Why?


    • a. College authorities cannot pocket the money from the sale of the parking space since it is not their private property. However, the power to control who gets the use of the parking space is a valuable good, so the authorities could capture that value in nonmonetary forms.
    • b. Since the president cannot pocket money from the sale of parking spaces, nonmonetary forms of competition for the parking space become Edition: current; Page: [60] more important. He can capture the value of the space in non-monetary forms, such as from commitments to help raise funds for the college, from speeches to promote the college, or from personal favors.
    • c. The value of the parking space can be captured in either monetary or nonmonetary forms. If decision makers cannot receive money for the space, nonmonetary forms of payment become more important. (As a student, would you prefer the parking space be sold, or would you prefer to have the college authorities decide how the space is distributed?)
  • 4)

    “Economic analysis implies that permitting trade is better than prohibiting it.” Does it?


    No. It does not imply what is good, bad, better, or worse. It implies what will be observed in the real world. Individual economists, however, often assert that trade in various circumstances is good or bad.

  • 5)

    “Trade between the Mediterranean and the Baltic developed when each area produced a surplus of some good.” What do you think this quotation from a history text means? Can you propose an alternative explanation of that trade?


    If it is supposed to mean that one area had more of some good than it wanted (could possibly use at all), the statement is wrong. And we can’t think of anything else it might mean. We propose that the relative supplies were different, so the relative values (personal worths) were different, leading to mutually preferred exchange and reallocation of goods among Mediterranean and Baltic people.

  • 6)

    “Middlemen and the do-it-yourself principle are incompatible.” Explain.


    Middlemen facilitate exchange and specialization, while “do-it-yourself” is a reduction of specialization and exchange—“eliminating the middleman” who economizes on transactions costs and doing it yourself is not necessarily cheaper. (This doesn’t mean that it’s not ever cheaper to “do it yourself”—to the contrary, look at the home improvement industry.)

  • 7)

    Based on tables 4.1 and 4.2, what is the value of the combined gains of trade to Sam and Joe measured in bottled water? What is the combined Edition: current; Page: [61] value, measured in granola bars, of the gains of trade to Sam, Joe, and the newcomer?


    Sam gained an additional 10 bottled waters worth 8 granola bars but paid only 7. To Sam, therefore, the gains were 1 granola bar, worth 1.25 bottles of water. Joe paid 10 bottles worth 4 granola bars but received 5 granola bars. To Joe, the gain was 1 granola bar, worth 2.5 bottles of water. So the combined gains to both Sam and Joe were worth 3.75 bottled waters (or 2 granola bars).

    The newcomer gained 2 granola bars from the trade, so the combined worth of the exchange to all three participants (its social gain) was: 1 granola bar + 1 granola bar + 2 granola bars = 4 granola bars. Everyone gained from the trade, even though Sam and Joe ended up with 2 fewer granola bars between them.

    Can we also measure the social gain in terms of bottled water? No, because we don’t know the newcomer’s personal value of granola bars in terms of bottled water.

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We don’t live in refugee camps. We live in economies with markets, where we can compare goods and offers and can buy and sell. So widely recognized are the advantages of markets that “primitive” tribes have truces on market days. Several medieval political leaders amassed fortunes by fostering marketplaces (fairs) in their favorite cities and inviting foreign merchants to attend—for a modest fee. And doubtless merchants recognized one general economic law: the “First Law of Demand.”


The First Law of Demand says, “Less is demanded at a higher price.” No matter what the amount demanded at the current price, there is a higher price at which less would be demanded. Or, in the opposite direction, “The amount demanded is larger at a lower price.” We will be explaining two demand functions. One is the demand by one person; the second is the demand aggregated over a population.

Demand Function Relates Amounts Demanded to Prices: The word “function” is a way of indicating that the amount demanded depends on—is a function of—something. Here, it’s the price. Sometimes we’ll refer to a demand curve or schedule (when imagining the demand function in a graph). “Demand” will mean the whole curve, schedule, or function—not just the amount demanded at some specific price.

Simplicity Is a Virtue: Realistic Data Are a Burden: Concepts and principles will be explained with simple, seemingly unrealistic numbers. Don’t assume that the simplicity weakens the analysis. And we use “quantity demanded” and “amount demanded” interchangeably.

Arithmetic Example of a Demand Function: Table 5.1 shows the typical feature of a demand function. Here, the commodity is quarts of milk per week. The demand function, or demand schedule, lists the number of quarts demanded per week for each price. In table 5.1, at the price $.70, the quantity demanded is four quarts per week.

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Table 5.1 Demand Function (Schedule) for Quarts of Milk Weekly
Price of a Quart Weekly Demanded
$1.00 1
.90 2
.80 3
.70 4
.60 5
.50 6
.40 7
.30 8
.20 9
.10 10


It is analytically sinful to confuse (a) the whole schedule of amounts demanded at various prices, such as shown in table 5.1, with (b) one of the amounts demanded at a specific price, like six units at $.50. In figure 5.1, the demand schedule is represented by a graph. The line on the graph is the “demand curve.” The “amount demanded at a particular price” is represented by one point on the demand curve.

Graph of the Principle of Demand—Demand Curve

The data of table 5.1 are plotted in figure 5.1, with the points identifying the combinations of price and quantity being linked with a smoothed line. It is conventional to measure price along the vertical scale and quantity along the horizontal scale.

The “quantity demanded” is the amount demanded at any one of the prices in the schedule. An increase in “demand” means the whole schedule of listed quantities has increased. A person’s wealth may have increased, so that at each possible price more is now demanded.

Quantity: Rate or Stock?

For some storable or durable goods like tennis rackets, shoes, or automobiles, the number demanded at a particular price may mean the number of items kept on hand as a stock. At some price of milk, you might wish to keep consistently about two quarts on hand, replenishing your supply at convenient shopping times, while consuming at a relatively steady daily rate. So there are Edition: current; Page: [64] two measures of the “amount demanded.” One is the stock of milk on hand, say, generally two quarts. The other is the flow or rate of consumption of milk per week. Even though at any moment there are only some two quarts in the refrigerator, the demand measured as a rate of consumption (or use) might be six quarts per week.

Figure 5.1

Demand for X

This is a bar graph of the demand schedule in table 5.1. A smoothed line, or demand curve, has been superimposed, because a simple line is easier for graphic techniques. The demand curve can be read: “At any specified price, the horizontal distance indicates the quantity demanded.” Or it could be read: “For a given quantity demanded, the height indicates the marginal personal worth at that quantity, expressed as a price.”

The demand function does not require that the amounts demanded have to adjust continuously and smoothly to every tiny change in price. A slightly higher price might have no discernible effect on the current quantity demanded; nevertheless, at some sufficiently higher price, or threshold, the quantity demanded will be reduced. The quantity of gasoline you demand at $3.50 per gallon might be the same as at $3.40 a gallon. But at some higher price, say, $4.00, you would buy less. You’d cut back on the gasoline to minimize reductions in everything else.

At some higher price of a good, less will be demanded, and at some lower price more will be demanded. That’s the First Law of Demand.

Examples of possible shapes of demand curves are shown in figure 5.2. Each of these demand curves “slopes downward.” At lower prices more is demanded, Edition: current; Page: [65] and at higher prices less is demanded. The amount demanded and a price are “negatively” related.

Fig. 5.2

Possible Demand Curves

Any line, whether smooth or stepped, straight or curved, is an acceptable representation of the relationships among marginal personal worth, price, and the quantity demanded. We’ll often use a straight line because it’s easy to read. The line is assumed not to have any upward sloping portion (a possible exception will be discussed much later).


While the demand curve can have many shapes and slopes, it will not have an upward (positive) sloping segment—unless an unusual “wealth effect” occurs. A demand curve can be vertical in a range of prices, indicating that within that range, the quantity demanded doesn’t change. But at a sufficiently higher price, the amount demanded will be decreased. The principle of demand is possibly the most reliable and most important principle in Economics.


Though many other things affect the quantity demanded—income, health, age, sex, family size, past personal experience, prices of other goods—they are assumed to be unchanged during the time the demand schedule is used. The effects of changes in any factor other than the price of the good are represented by a changed demand—a shift in the demand, which means that at a given price the quantity demanded has changed.

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“Change in demand” means the whole demand schedule has shifted. “Change in amount demanded” means a change in quantity demanded because of a change in price with no change in the demand schedule. Always distinguish between: (1) a change in the quantity demanded because of a price change (a slide along the demand schedule) and (2) a change in demand (a shift in the entire demand schedule due to a change in some factor other than the price).

Demand depends in large part on a demander’s income or wealth. In figure 5.3B, the lower demand is associated with a lower income. Shifting the demand curve shows the effect of a higher income.

By common terminology, the quantity demanded of a “normal” good increases or decreases with increases or decreases in income. “Income elasticity of demand”—the proportionate change in quantity demanded relative to the proportionate change in income—is positive, but not necessarily unitary. If less of the good is bought as a result of greater income, the good is designated as “inferior.” Our attention is generally directed to demand responses to income changes of “normal” goods, that is, goods with positive income elasticity of demand.

Relative Prices

We’ve looked at the price of just one good, without regard for the prices of other goods. However, if the dollar price of eggs was $13 a dozen and gasoline was $29 a gallon and a hair styling was $100 and a hamburger was $16, you’d probably consider a $1 price of bread to be “low”—relative to prices of other goods. The price of just one good is not sufficient to discern the true cost of buying a good. The relative price of a good is important in determining its “real” price in deciding whether to buy and how much to buy.

During inflation, when almost all prices rise, there’s an extra complication. A rise in the price of one good doesn’t mean its price has risen relative to prices of other goods. Others may have gone up even more. You’ve got to look at many other prices, more than if there were no inflation. More mistakes of computation and comparison are then made. This confusion is a major reason inflation tends to reduce “productivity” of the economy. The effects of inflation on money prices are discussed further in chapter 42.


We are not presuming people consciously think in terms of explicit demand curves. You may never have heard of the “demand function,” yet you behave in accord with what the demand curve concept implies. Atoms and rocks have Edition: current; Page: [67] Edition: current; Page: [68] never heard of the laws of physics, yet their behavior is consistent with—implied by—the laws of physics. We use those laws and principles to deduce behavior—not to deduce or characterize some process of thought.

Figure 5.3A & B

Change in Amount Demanded versus Changed Demand Curve

Figure 5.3A shows a change in the “amount demanded” in response to a change in X’s own price. That’s shown as a slide along a given unchanged demand curve to the new amount at the new price. Figure 5.3B shows a change in “demand,” meaning the whole demand curve has shifted consequent to a change in something other than its own price, say the price of a substitute or an individual’s income. Thus, a “demand change” means a shift in the demand curve, say from Demand Lower to Demand Higher in Figure 5.3B.

Interpretation of a Person’s Demand Function with “Personal Worth”

If you buy two quarts of milk per week, we’ll assume you do so because the milk is worth to you at least the price to be paid. Your total personal worth of the 2 quarts of milk per week is the total amount of other goods you’d be willing to give up, or pay, to get the 2 quarts. The measure of the “amount of other goods” we’ll use is a generalized measure—the dollar purchase cost of the other goods. If you were willing to pay $7 for 2 quarts per week, your total personal worth of 2 quarts per week would be $7. We don’t have to ask why the milk is wanted. It’s sufficient for our purposes that you are willing to give up something to get it. And people accept options and exchanges that have a personal worth to them at least equal to the price to be paid.

In table 5.2, we interpret the demand function (schedule) in terms of “personal worths.”

Total and Marginal Personal Worth

The first two columns of table 5.2 describe the demand function (schedule). Because one unit per day is demanded at $1.00, we interpret that to mean that having one unit daily has a personal worth at least equal to $1.00 to the buyer—or else the buyer wouldn’t have bought it.

Looking at two units, the data indicate that if the price were $.90, two units are demanded. A second unit must have an added (marginal) personal worth

Table 5.2 The Demand Schedule and Personal Worths
Price Quantity Marginal Personal Worths Total Personal Worths
(1) (2) (3) (4)
$1.00 1 $1.00 $1.00
.90 2 .90 1.90
.80 3 .80 2.70
.70 4 .70 3.40
.60 5 .60 4.00
.50 6 .50 4.50
.40 7 .40 4.90
.30 8 .30 5.20
.20 9 .20 5.40
.10 10 .10 5.50
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of at least $.90 (column 3), or else the buyer would not have purchased a second unit at a price of $.90. The total personal worth of two units daily is $1.90 (column 4). That’s the sum of the marginal personal worth of one unit plus the marginal personal worth of a second unit. It is not equal to the price ($.90) multiplied by the quantity purchased (2) at that price.

“Personal worth” identifies the greatest price a person would offer to get that unit of the good. We didn’t specify what item or items we’d give up to get the good. We’ll think and measure in terms of the most dollars a person would offer to get the good. Fortunately, we’re almost always able to buy the good for less—yielding a “gain from trade” whether measured in money or in goods purchasable with that amount of money.

At a price of $.80 per unit, a buyer would buy 3 units each week. We deduce that a fourth must add less than $.80 of personal worth, or the fourth would be demanded at that price. We are presuming that a buyer won’t buy a unit whose contribution to the buyer’s total personal worth is less than the price of that unit.

Distinguish between the total and the marginal personal worths. The total personal worths increase at larger amounts of the good. This is a generally valid relationship for every good and for every person. In contrast, marginal personal worth decreases at larger amounts of the good. Diminishing marginal personal worths at greater amounts of a good is a universal characteristic of all people for all goods—or so we presume in economic analysis.


Two Margins: Marginal Personal Worth and Marginal Units of the Good

“Marginal” applies to a) the added unit of a good, and b) the added amount of “personal worth” associated with that marginal unit of the good. The “marginal personal worth” of a marginal unit of a good is the increase in total personal worth consequent to that additional (marginal) unit of the good. In table 5.2, if the buyer purchases six, instead of five, units, the total personal worth to the buyer increases by $.50. That’s a marginal personal worth of $.50 at the sixth unit of the good. Table 5.3 is the same as table 5.2 with two added columns, “market value” and “consumer surplus.”

Marginal Units with Marginal, Total, and Surplus Consumer Worths

The sum of marginal worths on the marginal units one through five plus the marginal personal worth at the sixth, the marginal unit, is $4.50 (= $1 + .90 + .80 + .70 + .60 + .50); this is the total personal worth of six units. The consumer surplus is $1.50 (= $4.50 − $3.00, the excess of personal worth over

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Table 5.3 Concepts in the Demand Function
Price Quantity Personal Total Worth Marginal Personal Worth Total Market Value Total Consumer Surplus
If the price were $.50, the buyer purchases six units at an expenditure of $3.00 ($.50 × 6), while personally assessing the total personal worth of the six units at the equivalent of $4.50, as illustrated in figure 5.4. The buyer would have achieved a consumer surplus that is the equivalent of obtaining $1.50 (= $4.50 − $3) more of total personal worth.
$1.00 1 $1.00 $1.00 $1.00 $0.00
.90 2 1.90 .90 1.80 0.10
.80 3 2.70 .80 2.40 0.30
.70 4 3.40 .70 2.80 0.60
.60 5 4.00 .60 3.00 1.00
.50 6 4.50 .50 3.00 1.50
.40 7 4.90 .40 2.80 2.10
.30 8 5.20 .30 2.40 2.80
.20 9 5.40 .20 1.80 3.60
.10 10 5.50 .10 1.00 4.50

market value). The quantity demanded brings the marginal personal worth down to equality with the price. That maximizes the “consumer surplus worth” at that price.

Personal Worth or Market Value: Which One Indicates Welfare?

Don’t be like a governor of California who—in defending a law that reduced the aggregate quantity of tomatoes harvested in California—bragged that the total market value had increased. (He neglected to mention that the smaller crop had a smaller total personal worth.) The increase in the market value of the entire crop may have made the tomato growers wealthier, but it cost society a reduction in total personal worth.

It is an error to try to leap from total market value of some quantity of a good to an inference about its total personal worth. Both the market value and the total personal worth are shown in figure 5.5. The market value rectangle, formed by the new price and the smaller quantity produced, may be larger at the higher price. But total personal worth, shown by the entire area under the demand curve, is smaller at the smaller quantity. And, more pertinently, the consumer surplus is smaller at that smaller quantity.

The consumer’s surplus, not the market value, is usually considered the desirable thing to maximize. How much of the personal worth is obtained by the buyer/consumer or is captured by the seller depends on the pricing tactic Edition: current; Page: [71] of the seller. How much should go to the seller is a source of argument, with no general consensus.

Figure 5.4

Marginal Worths

The sum of the marginal personal worths at the 1st, 2nd, 3rd, 4th, and 5th units plus the marginal worth of the marginal unit (the 6th) is the total personal worth of six units. The “market value” of the six units is represented by the area of the rectangle formed by the horizontal distance measuring the quantity demanded (6 units) multiplied by the vertical distance measuring the price ($.50). The consumer (or buyer) surplus is the excess of total personal worths over the prices paid on each unit—the total consumer worth in excess of the market value. The total consumer worth at 6 units is the equivalent of $4.50 (= $1 + .90 + .80 + .70 + .60 + .50). The market value (total cost of purchase) is $3.00 (= 6 × $.50).

In general, a higher price for a good will reduce the quantity demanded, and therefore will reduce both total personal worth and consumer surplus. But that higher price may cause consumer spending on the good (market value) to rise or fall, so changes in market value of the quantity purchased as the output and price change tell us nothing about changes in consumers’ total personal worth.


When you buy something, you act as if you had made two decisions: 1) whether or not to buy, and then 2) how much of it to buy. Those two become just one if you are considering the purchase of just one unit, say a car, house, or piano—at least for most people!

The amount you’ll buy will be interpreted as being the amount that maximizes Edition: current; Page: [72] your net personal worth (your personal total worth of the good minus the cost). That net total personal worth is “consumer surplus.” We assume the most reliable presumption is that people will buy an amount for which the achieved consumer surplus is maximized. You won’t buy one more if the added personal worth to you is less than the cost of buying one more. And you will buy more so long as added personal worth to you exceeds the cost of buying one more. The prospective addition to total personal worth is compared to the additional cost of one more. The cost of one more is the “marginal cost.” The added personal worth obtained with an additional unit is the “marginal personal worth.”

Figure 5.5

Buyer’s Surplus plus Market Value Equals Total Worth

The left diagram shows consumer’s (buyer’s) surplus at a small amount of the good. It shows also the smaller total personal worth than in the right diagram, where the price is lower. A smaller quantity of the good always means a smaller total worth and smaller consumer surplus; the market value may be higher or lower depending on the slope of the demand curve. The consumer/buyer’s surplus worth—the gains from the purchase—is the excess of total personal worth over the total market value.

The average personal worths and average costs don’t tell how much will be bought. In table 5.2, at the fifth unit, the marginal personal worth is $.60, and the average per unit personal worth of 5 units is $4.00/5, or $.80. However, you wouldn’t buy a fifth if it costs more than $.60, its marginal personal worth. Indeed, at any price over $.60 you’d be worse off (less total personal worth net of cost) if you bought more than 5 units, despite their higher average personal worth.


When making purchase decisions, you want to know something about the general, or average, level of prices so you can tell whether the price of something is high or low. What counts is the “relative price,” not just the “dollar” price. A Edition: current; Page: [73] relative price change occurs, for example, when just one price in dollar terms changes while other prices are constant.

But in the real world, we can’t reliably assume other dollar prices are constant. If the dollar price for the product of some business firm falls, the question facing the business manager is: “Is there also a fall in the (dollar) price of all other goods (called deflation) or is it a fall in just this one good’s (dollar) price? If it’s a fall for this one product, I may not be able to continue to produce profitably. If I were sure it’s associated with a fall in the dollar price of all goods, so that the costs of my inputs also will fall, I am more likely to be able to continue profitable production. If I’m not sure which it is, however, I’m going to hesitate in maintaining production and in investing.”

The confusion caused by inflation and deflation, which mask relative price changes, reduces productivity of the economy and even causes recessions. People tend to speak in terms of “dollar prices,” but act in response to relative prices.


When referring to a change in the price of a good, we’ll mean that only that good’s price changes. Thus, the price of that good has changed relative to the prices of other goods. If, instead, every other price also were to be changed by the same proportion, there’d be no change in prices of one good relative to another. The demand curve shows that more is demanded at a lower dollar price on the assumption other prices aren’t changed.

Cross-Price Effects on Demand: Substitutes and Complements

Goods can be substitutes or complements in the sense that the demand for the good depends strongly also on the price of another good. The demand (curve) for margarine depends on the price of butter, as illustrated in figure 5.6. A higher price of butter raises the whole demand for margarine. As a result, at a given price of margarine more will be demanded the higher is the price of butter.

This shift in the demand curve for one good caused by a price change in another is a “cross-price” effect. The goods can be substitutes, in the sense that a higher price of one raises the demand curve for the other, as people shift to purchases of the good whose price has fallen relative to the good whose price was raised. Pairs of goods are “complements” if a higher price of one good reduces the demand curve for the other good. And two goods are “independent” if a change in the price of one has no discernible effect on the demand for the other.

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Figure 5.6

The Cross-Price Effects on a Good’s Demands of Changing Prices of Substitutes and Complements

Changes in the prices of other goods can produce “cross-price” effects on the demand for a good. As the left-hand graph indicates, an increase (decrease) in the price of one good, butter, can cause not only a decrease (increase) in the quantity demanded of that good, butter, but can also cause the quantity demanded of another good, margarine, to increase (decrease) at all prices. Goods related to one another in this way, where a change in the price of one good causes a shift in the same direction in the demand of another good, are “substitutes.”

As illustrated in figure 5.6, a rise of the price of butter causes the demand for margarine to shift in the same direction, for margarine and butter are “substitutes in demand.” But if a rise in the price of one good causes a reduction in the demand for another good, those are “complements in demand.”

On the other hand, as the right-hand diagram indicates, an increase (decrease) in the price of one good, butter, can cause the quantity demanded of another good, dinner rolls, to decrease (increase) at all prices. Goods related to one another such that the change in the price of one good causes a shift in the demand of another good in the opposite direction are “complements.” When the change in price of one good causes no discernible change in the demand schedule of another, the goods are said to be “independent.”


Is “personal worth” just a fancy label? Note the distinction between labels or names as a) “identifiers” versus b) “descriptor-definers.” A movie labeled “Gone with the Wind” has nothing to do with a past hurricane. A “hot-dog” is not a dog in heat.

The word “worth” in “personal worth” is dangerous, because it suggests Edition: current; Page: [75] some inherent “worth” in the good being demanded. Economists have used the word “utility,” which suggested a reason the good was demanded. But what is “utility” to one person is often “disutility” to another. Smoking, alcohol, pornographic literature, golfing, and playing games on computers have disputable “utility.” By using the more neutral expression “personal worth,” we can avoid disputable opinions about “good” and “bad.” If someone is willing to pay for something, it has “worth” to that person, whether other people approve or disapprove.


  • 1)

    Figures 5.3A and 5.3B illustrated the difference between a change in demand and a change in quantity demanded. This distinction is crucial. In figure 5.3Alt, identify which movement indicates a change in demand and concomitant change in quantity demanded and which indicates a change in quantity demanded with no change in demand.

  • 2)

    The following is characteristic of Mr. A’s market demand for pencils. Each price is associated with the number of pencils he would buy each year.

    Figure 5.3Alt

    At price OP and demand D1, we are at point 1. If price falls to OP′, quantity demanded increases from OQ to OQ′, but demand (D1) has not changed. Alternatively, starting at point 1, demand increases from D1 to D2. If price doesn’t change, quantity demanded increases from OQ to OQ′—so both demand and quantity demanded increase.

    Edition: current; Page: [76]
    Price Quantity Total Revenue
    $1.00 1 $1.00
    .90 2 $1.80
    .80 3 $2.40
    .70 4 $2.80
    .60 5 $3.00
    .50 6 $3.00
    .40 7 $2.80
    .30 8 $2.40
    .20 9 $1.80
    .10 10 $1.00

    At a price of $.60 Mr. A would own five. At a price of $.50 he would own six. At each of these two prices, he would have a total of $3.00 in pencils. Does this mean that he attaches no value to a sixth? What value does he attach to the sixth?


    He values the sixth at $.50.

  • 3)

    The demand schedule of the preceding question shows that at a price of $1, the annual consumption is 1 unit. At a price of $.90, the annual consumption is 2 units.

    Can it be said that this person wants each one of those 2 units more than he wants 90 cents’ worth of annual expenditures on any other goods? Note that at the price of $1, he spent annually $1.00 on this good, whereas at a price of 90 cents he spent $1.80 or $.80 more than previously. Do you still say he values the extra unit at approximately cents, even though he spends only $.80 more? In explaining your previous answer, what is meant by “value”?


    No. Only a second unit.

    Yes—90 cents.

    He can choose to buy one or two or more at the price of $.90. He chooses to buy two, so the second must be worth the extra $.90 he pays for it. Value is the amount of some other good one is willing to give up to get this good whose value is being defined.

  • 4)

    Can the table in question (2) be read as follows: “A person sees a price of $1, and he therefore buys one egg. The next hour he sees the price has fallen to 80 cents; so he dashes out and buys three. A couple of hours Edition: current; Page: [77] later, the price rises to 90 cents; so he buys two”? If it can’t be interpreted that way—and it can’t—how is it to be interpreted?


    A person’s demand schedule relates his quantities demanded at alternative possible prices at a given time; if a purchase is then made, circumstances affecting his preferences are thereby altered, and he will have a new schedule.

  • 5)

    Consumption is a rate concept, even though the good being consumed may be held as a stock of goods. True or false?



  • 6)

    Mr. A currently uses water at a rate of 3,650 gallons per year at the present price. Suppose that his demand doubles, so that his rate increases to 7,300 gallons per year. How many more gallons of water will he consume during the first week of higher demand?


    If Mr. A spreads his purchases out evenly over each week of the year, he will consume an additional 70 gallons for a total of 140 gallons during the first week. However, consumption is a rate concept, hence we do not know the pattern of purchases—we do not know how many he will consume during the first week. He may consume nothing during the first 51 weeks and then in the 52nd week consume the initial 3,650 gallons as well as the additional 3,650 gallons (maybe to refill his now new and larger swimming pool).

  • 7)

    “According to the law of demand, the lower the price of vacations, the more vacations I should take. Yet I take only one per year. Obviously the law of demand must be wrong.” Is it?


    No. I may take longer vacations. Or, the length of my vacations does not change, but they will be more elaborate or exotic.

  • 8)

    There are three conceptions of the amount demanded: (1) the rate of consumption; (2) the quantity a person wants to buy in order to increase his current stock; (3) the quantity a person wants to own. As an example of each: (1) a person may consume eggs at the rate of 6/7 per day (which does not necessarily mean he buys and eats a fraction of an egg each day); (2) on Saturday he buys a half dozen eggs; (3) he may own an average of Edition: current; Page: [78] three eggs in his refrigerator. Which of these three measures is a rate of activity and which is a “stock”?


    First is rate; second and third are stocks.

  • 9)

    Using the demand-schedule data in question 2, suppose that these refer to the number of diamond rings a person would want to own at each price. He now owns four rings.

    • a. How many more would he buy or sell at each possible price?
    • b. If the equilibrium price in the market turned out to be $.30, how many would he want to buy or sell and how many would he then own—remembering that he has four initially?


    • a. Sell 3 at $1, for he presently holds 4 but wishes to hold only 1 at a price of $1; 2 at $.90; 1 at $.80; and so on. Buy 1 at $.60; 2 at $.50; and so on.
    • b. He would buy 4 more to have a total of 8.
  • 10)

    Why is it nonsense to talk about urgent, critical, crying, vital, basic, minimum, social, or private needs?


    No such thing as basic, vital need—except that we “need” more of everything that is not free. It’s a matter of what price we are willing to pay and a matter of more or less, not all or none.

  • 11)

    A book was entitled Social Needs and Private Wants. Would the title have suggested something different if it had been Social Wants and Private Needs?


    Whatever might be suggested to innocent readers, each title displays sloppy use of analytic language.

  • 12)

    An increase in demand (the demand schedule) is shown graphically by a demand curve above (to the right of) or below (to the left of) the old demand curve. Which is it?


    To the right or above.

  • 13)

    Which of the following would increase the demand for wigs?

    • a. A raise in one’s salary
    • b. Higher price of hats Edition: current; Page: [79]
    • c. Having a swimming pool
    • d. Rise in cost of hair care
    • e. Getting divorced
    • f. Number of other people who wear wigs
    • g. Lower price of wigs


    All, except the last one. Why? (Lower price induces a movement along the demand schedule, not a shift in the schedule.)

  • 14)

    Explain how what is often called “impulse” buying is consistent with the laws of demand. Explain why habitual buying is also consistent. Suggest some behavior that would not be consistent.


    Whatever provides the impulse, the lower the price of the item, the greater is the probability the impulse to buy will result in a purchase, and the higher the price, the less likely the impulse will be effective. Habitual buying is consistent with knowing the price from prior purchases and having settled on a consumption plan which is generally repeated over time. However, let the price of the consumption goods change, and the habit will be revised. Only with inconsistent behavior would less be purchased at lower prices and more at higher prices.

  • 15)

    Does the demand to have children obey the fundamental theorem of demand? The demand by immigrants for entry to the United States? The demand for divorces? The demand for pianos? The demand for a winning college football team? The demand for “As” in this course? The demand for appendectomies?


    Yes, to all.

  • 16)

    A governor of California once asserted that the reduction of Mexican labor in California (as a result of the end of the guest worker program) did no harm, because the total value of the crop harvested was larger than before. Evaluate the relevance of that criterion.


    Welfare change is not measured by total market value of the entire crop. If demand elasticity is less than one, bigger supply will lower total market value (total market revenue) while total personal worth increases because of larger supply (larger total worth measured by total area under the relevant Edition: current; Page: [80] portion of the demand curve). Do not confuse total personal worth with total market-exchange value (market sales revenue). Total personal worth is closer to a welfare criterion.

  • 17)

    If one pair of shoes can be exchanged for four shirts, and one shirt trades for two pairs of socks, and if one pair of shoes trades for six pairs of socks, what series of trades could you make to get steadily richer? (This is known as “arbitraging” among markets for different goods.)


    Borrow one pair of shoes; sell the pair for four shirts; sell the four shirts for eight pairs of socks; then sell the six pairs of socks for one pair of shoes—leaving you with two pairs of socks. Repeat the operation, each time picking up a net gain of two pairs of socks.

  • 18)

    What are prices? Can there be prices without money?


    Exchange rates among goods are prices, whether or not money is one of the goods exchanged.

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With the concept of the demand function, we can answer the question asked at the end of the refugee camp story, “What determines the extent of mutually preferred exchanges?”


We start with two-person exchange and later explain the advantages of intermediaries in facilitating trade. Figure 6.1 shows two demand curves, one for Rae and one for Ted. Each person initially has 20 eggs. Rae places a higher marginal worth, $.12, on one more egg, when she has 20, than does Ted, whose marginal worth of eggs at 20 eggs is only $.04.

Mutually advantageous trade opportunities exist when the marginal worths of a good differ among people. Both Ted and Rae would gain by trading, wherein Ted offers to sell some eggs at a price over $.04, and Rae will buy at a price below $.12. When their marginal worths are equalized, with Ted then having 8 fewer for a total of 12 eggs and Rae having 8 more at 28, there can be no further mutually beneficial trade.

The Gain to Rae: Consumer Surplus

Because their marginal personal worths differed initially ($.12 and $.04), both will gain by trade at some price between $.12 and $.04 per egg. When Rae has 28 eggs per month, her marginal personal worth of eggs is down to $.08, the price. Her total gain in personal worth is represented by the area under her marginal worth line, her demand curve, and above the $.08 price paid to Ted. That gain is “buyer’s surplus,” or “consumer surplus,” obtained by trade.

The Gain to Ted: Seller Surplus

Ted was willing to sell 8 eggs to Rae at a price of $.08 each, because his marginal worth of the 8 eggs sold was less than $.08. His gain, “seller’s surplus,” is represented by the shaded area above his demand curve and below the price received for what is sold.

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Figure 6.1

Demands and Exchange

Rae will buy some eggs at prices below $0.12, and Ted will sell at prices above $.04. Buying eggs at $.08 gives Rae the gain indicated by the shaded area under her marginal worth line and above the price line at $.08. Rae’s purchase of 8 eggs brings her total amount to 28 and reduces her marginal worth of eggs to the price. As the seller, Ted’s gain is shown by the area under his price line ($.08) and above his marginal worth line for 8 units sold.

The Extent of Gains to Both: Exchange Brings the Marginal Worths of Both Parties to Equality

The total personal worth of Ted plus that of Rae was maximized. Of course, neither Ted nor Rae cared about that combined total personal worth; they each traded only because what they got was “worth” more than what they gave up. Whenever marginal personal worths are not equal, there is an exchange that both will be willing to make.

The exchange benefits the trading parties as if there had been a costless increase in goods to both of them. Each achieves a situation of greater personal worth even though the total amount of goods has not increased. The reallocation of various goods in the trade benefited both. It is as if we each had bread and butter, but I had a lot of butter and only a little bread, and you had a lot of bread and only a little bit of butter. A trade of some butter for bread would improve each of our situations.


Demand versus Demand, Instead of Demand versus Supply

The two traders are viewed as “cooperative rivals,” “cooperative” in being willing to trade, and “rivals” in trying to buy at a lower, or sell at a higher, price. Cooperative rivalry is a fundamental trait of a civilized and productive society.

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Figure 6.2

Demand and Supply as Two Competing Demanders for a Fixed Total Supply (Stock) of a Good

Reversing and then superimposing one of the marginal worth lines of figure 6.1 interprets exchange in terms of a demander and a supplier—with the lower marginal worth demander becoming a supplier to the higher marginal worth demander. One person’s demand confronts demands of other people. The supply to a person is represented by the amounts not demanded by other people at various prices. The supply facing you is what is released, at the price offered, from the demand by the rest of the world. Fundamentally, it’s not demand and supply—it’s your demand curve against the rest of the world’s demand curve, which is perceived as the supply curve to you.

In figure 6.2, the total supply of 40 eggs is measured by the entire width of the base of the diagram. Both Ted and Rae initially have 20 eggs. Ted’s demand is measured to the left from the right edge. We start with the case in which there are no costs of trading—that is, no search, information, or transactions costs are incurred by either Rae or Ted.

We wish to see not only why trade is mutually beneficial, but also why intermediaries, despite their costs, can reduce the total costs of trade and enable everyone to obtain more total personal worth.

In the initial allocation, each party has 20 eggs. Rae’s marginal personal worth exceeds Ted’s. That difference in heights (marginal personal worths) of the two demand curves implies that both would gain by trade, by sales of eggs from the lower marginal worth person (Ted) to the higher marginal worth person (Rae). The feasible gains to each are marked as shaded areas.

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Supply to “Me” Depends upon “Your” Demand

The supply of more eggs to Rae depends on the demand by Ted. And the supply of eggs to Ted depends on Rae’s demand for eggs. The supply conditions facing you depend on the demands of other people. The higher their demands, the smaller is the supply to you from the existing supply of eggs.

Convergence to “Equilibrium”

We can expect a series of transactions in moving to the final revised distribution. The agreeable prices will be between the two different initial marginal valuations of the traders.

With 20 eggs held by each, Rae would offer up to $.12 for an egg, and Ted would be willing to sell at any price above $.04. As they trade, Ted’s marginal worth of eggs rises, and Rae’s decreases. The price to which they converge is 8 cents, indicated by the height at which the two demand curves intersect.

Trade slides people along their demand curves toward equalization of their marginal personal worths. Each puts a higher worth on what is obtained than on what is given up. The resulting price is the “equilibrium” price, and the final marginal worth equalizing allocation is the same no matter what the initial allocation. A good from other people is obtained by pushing up the price so as to induce others to demand less (offer more) to you, when you are willing to pay a price higher than their marginal worth of those units.

We have dealt with the prerequisite conditions, the direction, the gains, and the extent of trade. But there are, for both parties, costs of searching for someone who wants to sell or to buy eggs.


The extent to which the full potential of trade can be realized depends on costs of discovering the differences in marginal worths and of arranging for purchases and sales. A vast array of auxiliary devices, procedures, activities, and arrangements has evolved to reduce transaction costs.

“Transaction costs” is a name for costs of shopping among potential traders, discovering goods and qualities being offered, finding and canvassing alternate possible suppliers, assembling, transporting, and making the goods available at the time desired, providing inventories to enable inspection and prompt delivery, record keeping, advertising, insurance, warranty service, replacing defects, negotiating and recording the terms of trade, and enforcing the exchange and contractual agreements—to name some aspects of exchange.

Rarely is trade conducted directly between the ultimate parties. “Do-it-yourself” Edition: current; Page: [85] transaction costs are not small. They are usually larger than the observed spreads between the retail and wholesale prices of goods. Otherwise, people usually would buy direct from producers rather than retailers. At the retail level for most household consumption goods, the spread between buying and selling price ranges from about 15 percent to 50 percent of the price to the consumer. Some discount houses provide a smaller spread by asking the consumer to bear some of those costs by self-service. The customer receives less retail service, less credit, less delivery and location convenience. To customers whose time is less valuable, that may be worthwhile. To others it is not. So the degree of intermediation varies to suit various customers.

Intermediaries, as in the refugee camp, reduce the costs of finding trade possibilities, of assessing the characteristics or qualities of goods, and of negotiating exchanges and arranging for such legal protection as warranties. The cost reductions permit more of the potential trade to be realized.

How much would you buy if you had to buy your food directly from the farmer, your shoes from the manufacturer or the wholesaler, your gasoline from the refinery, and your milk from the dairy farmer? And how would you feel about being denied the opportunity to sell your used car through a dealer, and being required to find a willing buyer completely on your own? Successful intermediaries make their livings by performing their services at lower costs than feasible for the consumers and producers of the purchased goods.


Both the buyer and seller can benefit by intermediaries’ reductions in transaction costs.

Benefits to the Buyer—Lower Full Price

In table 6.1, consider the buyer of the eggs. Without helpful intermediaries, the cash price is $.08, along with self-service transaction costs of $.01, the full price being $.09. The cash price with intermediaries is 8.5 cents, a greater money charge but less than the full price in the do-it-yourself transaction.

Benefits to the Seller—Higher Net Price

Without intermediaries, he receives a price of $.08, but bears costs of 0.5 cents, yielding a net return of 7.5 cents. With intermediaries, his receipts are 7.75 cents.

Total transaction costs for the buyer and seller are 1.0 + 0.5 = 1.5 cents in a do-it-yourself arrangement; they are only .75 cents with intermediaries.

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Table 6.1 Money and Full Prices without and with Intermediaries
Without Intermediaries
Money Nonmoney Full Price
Buyer 8 1.0 9.0 (paid)
Seller 8 0.5 7.5 (received)
Do-it-you rself costs 1.5¢ 1.5¢
With Intermediaries
Money Nonmoney Full Price Gain Cost Reduction
Buyer Pays 8.5 0 8.50 (paid) 0.50 (=9-8.5)
Seller Gets 7.75 0 -7.75 (received) 0.25 (=7.75-7.50)
Cost Reduction with Intermediary .75 +.75 Gain to Buyer and Seller
Reduction in Transaction Costs
Do-it-yourself Cost 1.50
Intermediary Cost 0.75
Intermediary Cost Reduction .75

The intermediary has earned .75 cents per egg for his services—he saved the buyer .5 cents and saved the seller .25 cents for a total saving of one-half the transactions costs the buyer and seller would have incurred without his services.


Figure 6.3 shows a buyer and seller trade without an intermediary. Both buyer and seller are at X1 before trading. (Remember that Ted’s demand curve is reversed, so for him a move to the right is a reduction.) As trading occurs, both—buyer and seller—move toward X2, the point at which their respective personal worths equal the full price. If the buyer’s (Rae’s) “do-it-yourself” prepurchase search and product inspection costs are the equivalent of $.01 per unit of the good purchased, the buyer’s full price is $.09 ($.08 paid to the seller, Ted, plus the $.01 of Rae’s prepurchase costs).

The seller also has prepurchase search, negotiation, and exchange enforcement costs equal to, say, $.05 per unit of egg. So the seller’s net realized price is only $.075, not $.08. Of the total potential gain from trade, part is dissipated by the prepurchase search and negotiation costs, and part is unrealized because of Edition: current; Page: [87] the reduced extent of trade—trading stops before reaching the intersection of the two demand curves because of the existence of transactions costs.

Figure 6.3

Exchange with Transaction Costs without Intermediaries

Figure 6.4

Exchange with Transaction Costs and with Intermediaries

Figure 6.4 shows a situation with intermediaries doing some of the transaction preparation actions. Both the consumer-buyer and the producer-seller gain from trade when intermediaries reduce the “shopping” costs. The full Edition: current; Page: [88] price paid by the buyer is reduced to $.085 and the net amount received by the seller rises to $.0775. Importantly, the quantity of eggs traded increases to X3—closer to the equilibrium that would have resulted in a world without transactions costs.

Full Price Is the Pertinent Price

Intermediaries reduce the seller’s money receipts (from 8¢ to only 7.75¢) and raise the buyer’s money payments (from 8¢ to 8.5¢). However, both the buyer and the seller are made better off in light of the distinction between the “money price” and the “full price.” The costs of the trading have been reduced and the extent of trade is greater because of the specialized services of an intermediary.

“Buy direct from the manufacturer and eliminate the middleman’s cost.” In fact, it is incorrect to regard intermediaries as interposing extra costs and raising the price for the buyer and lowering the price paid the seller. Successful intermediaries reduce the costs of exchange, permitting benefits to both the ultimate buyer and seller.


The narrowed spread (resulting from competition among middlemen) between the buying and selling prices of intermediaries is a consequence of free-entry market competition, or “open markets.” “Open markets” mean that access to markets is open to all people without arbitrary, contrived barriers—not that there are no costs involved in providing exchange-facilitating services.

Constrained Access to Markets; “Closed Markets”

Open markets are not universal. Constraints are interposed—often at the urging of those already in the business. Existing intermediaries would prefer to restrain newcomers and tend to complain of the new “unnecessary, inexperienced, low-cost, cutthroat, excessive, unfair” competitors. Existing intermediaries or suppliers may be able to protect themselves by closing newcomers’ access to markets. Several possibilities are available, some crude, some refined, but all in use.

Threats of Violence

An intermediary contends to a prospective intermediary, “It was my idea to develop the trade. Why should you be allowed to copy and benefit from my innovative actions?” The initial dealer may warn impending new dealers about a few lost teeth and possibly a broken leg.

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As a desperate tactic, a current intermediary approaches a newcomer and offers to merge, agreeing to maintain the old price spread and divide the profits, which is better than seeing the profits eliminated. But if new entrants joined the collusion, the profits of collusion would be spread among more suppliers until the gain to each was virtually zero.

Compulsory Licensing as a Restraint on Entry

The colluders ask for political help. They offer to contribute to the election campaigns of legislators. They lobby for restrictions on entry, or higher costs of entry by newcomers. Normally, licenses and permits to do business require that performance meet certain standards of safety and reliability. Applicants for entry are often required to have taken costly prior training or education. And incumbents argue there are already enough people in that business. Or consumers should be protected from “fly-by-night, quack, unreliable” dealers—or from imports from foreigners in order to protect local suppliers. Or newcomers could be screened and refused admission under the pretense that the newcomers would not maintain the “highest standard of quality.” However, newcomers may offer the politicians rewards greater than those from incumbents. The cost of the competition between incumbents who are trying to defend restrictions and newcomers seeking to remove or bypass them can exhaust the potential gains to restricting competition. But this tactic is widely used.

Reducing the Pie to Get a Larger Share

Competition for favorable legislation or regulation is often called “political rent-seeking.” “Rent” refers to the “gains,” which are called “rents” because they are obtained not by production of more value, but instead by transferring wealth from one person to another—either directly or indirectly—by altering competitive conditions. Competition for the politically obtained favors differs from market competition for purchase and production of goods and services. In the market, you buy as many units as have marginal worths exceeding the price of a unit, and you compete by superior production, not by attempts to prevent other sellers from producing or selling.

In contrast, when you compete in politics or in nonexchange form, you are using productive resources to increase your prospects of getting protection from competitive market forces. Although market competition among sellers redounds to the benefit of consumers, political competition tends to result in Edition: current; Page: [90] transfers of wealth. Consultants, lobbyists, and lawyers are hired, and contributions are made to political campaigns. Those resources are diverted from producing more goods and services. The politically imposed restrictions on potential competition are equivalent to changing the share of the total pie (national income) going to competitors, while reducing the size of the total pie.


Markets are arrangements and means for facilitating exchanges. To say that the “market” does something is a shorthand way of saying that people, in the process of arranging for and completing mutually preferred exchanges, bring about certain consequences. Don’t think of the “market” as a place, but rather it is people who are doing something—usually seeking, negotiating, and conducting mutually preferred exchanges. In that sense, the “market” is a process by which people’s beliefs, values, and demands are compared, with resultant exchanges of rights at mutually agreeable prices or terms that enable mutually preferred exchanges.

Members of Congress trade votes on issues in the “political market.” Professors trade offices, furniture, and course assignments in an “academic market.” In a family, children trade duties and obligations. Favors are exchanged, and exchanges occur in markets. It is impossible to conceive of a society without exchanges or trades, or of any society without markets—whether they are for personal favors, ideas, private property rights, political favors, family obligations, and so forth. This text focuses primarily on markets for exchanges of goods with private property rights, where money is involved in the exchange. However, we will see also that exchanges still occur in “markets” in which money prices are controlled or are not permitted.


As stated in chapter 1, economic principles are silent on normative issues and questions. The implications of economic analysis are not judgments about whether something is good or bad, desirable or undesirable—no more than are those of physics, chemistry, or biology. Economics deduces only what happens in response to some change in specified circumstances. It says that if you think in terms of preferences of individuals, you can interpret exchanges as mutually preferred exchanges. Each person is seeking a preferred situation, as judged by each. If you believe individual judgments and choices are desirable actions, then you could deduce that markets are “good.”

There is a strong temptation to conclude that economic analysis proves that exchange improves a person’s situation. But some critics of the “desirability” Edition: current; Page: [91] of personal choice attach more weight to the consequences for those who make unfortunate choices, than the weight they place on the “right to make one’s own choices.” Neither the critic nor the defender of the right to make choices is necessarily the more humanitarian.

Everything in life involves a trade-off between alternative amounts of goods and degrees of achievement of goals. The question then arises of who might make better judgments for others. Can you expect other people to act entirely on your behalf? Or could you plausibly argue that people, as a matter of moral duty or propriety, should have to make their own decisions? It is universally the case that some people are not regarded as being capable of properly understanding the consequences of their decisions and therefore should be restricted or controlled “for their own good,” much as with children.

Indeed, in many instances—for example, for medicines, health care, and food—even “mature” adults are prohibited from entering into some mutually agreeable exchanges with whomever they please. Furthermore, it has been contended that people do not always have the appropriate tastes: the contention is that people would place a higher value on classical music, museums, or education if properly exposed to those things, and they would spend less on flashy cars, television, or sports. If these critics had their way they would try to tax more heavily “improper pleasures.” Where and how is the line to be drawn—and by whom?

Warning: Don’t jump to the inference that economic analysis therefore assumes that people do not care about ethics. Quite the contrary: we’ll show later that the analysis includes issues of ethical behavior. The point here is that economic analysis doesn’t tell you what is “good” or “bad”—just what “is” or “is not.”


We have been examining the fundamental forces and features of exchanges enabling people to gain by market activity. We assumed that once a deal is struck, the goods are exchanged as promised. But it’s pertinent to know what tangential features we have been ignoring. One thing, which we’ll explore later, is the reliability of the promised performances by the parties in an exchange. There’s often a temptation to renege and get a quick gain. For example, an employer may promise payment to you after you have worked two weeks, or a retirement pension if you work a specified number of years with that firm. You want assurance the promise will be fulfilled.

Explicit contracts involving binding written or verbal commitments are Edition: current; Page: [92] usually enforced in a court of law. But that can be too expensive. No one can foresee all the possible future events and pertinent details. To help ease that enormous task, the contract is taken to include well-established side conditions, sometimes called “commercial codes,” as completions of the contract by the law. Nevertheless, explicit contracts are difficult to adjust to unforeseen contingencies.

An unexpected change in the availability of a resource may prevent delivery of a product as scheduled. Even before entering into negotiations, you may incur costs preparatory for business with that person. You drive to a distant grocery to get some bargains, only to find out upon arrival the price has changed or the items are sold out. The person you expected to deal with may refuse to deal or may ask prohibitively higher prices.

Most of the time, however, the promises and expectations will be made reliably without enforcement by a legal proceeding. An astounding variety of noncontractual methods exists for increasing the assurance of promised performance—such as publicly preannounced fixed prices, reputations, goodwill, social pressures, ostracism, and the force of “ethics.” We’ll be examining these commonplace, though much misunderstood, “noncontractual” procedures that rely on “natural” consequences of the market. An “exchange,” or “trade,” is more complicated than merely paying money and receiving the good.


  • 1)

    Which of the following are compatible with open (or free) markets?

    • a. A lawyer must get permission of present lawyers before he can engage in that profession.
    • b. Medical doctors must pass a state examination before being allowed to sell medical services.
    • c. Selling is prohibited on Sunday.
    • d. Pure food and drug laws restrict the sale of “impure” foods and drugs.
    • e. Consumption, manufacture, or sale of alcoholic beverages is restricted.
    • f. Securities dealers and brokers must be certified by the US Securities and Exchange Commission before they can act as middlemen in buying and selling stocks and bonds—that is, before they give advice or execute transactions.


    All are denials of open markets.

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  • 2)

    You are campaigning for mayor or councilman in your hometown, in which the taxi service (or garage service, trash pickup, electric power, water, gas, etc.) is provided by anyone who wants to operate a taxi business or drive his own cab. In other words, the taxi service is provided by an open market. You campaign for more government control on taxi drivers in order to ensure better quality of service.

    • a. If elected, would you initiate a system of giving just one company the right to perform the service? Why?
    • b. If so, how would you decide which company?
    • c. Would that company be one of your campaign contributors?
    • d. In some states, the right to sell liquor is restricted by the state government to far fewer stores than would prevail otherwise. Would you be surprised to learn that the liquor dealers are a political “lobby” and source of “power” in state politics? Why?
    • e. What generalization does this suggest about use of political power once obtained?


    • a. Yes, unless all consumers could agree to pay me more than the one seller to whom I gave the monopoly right. (In principle, they could always pay more than a monopolist would gain.)
    • b. The one who helped me most to get elected.
    • c. Answered in b.
    • d. No surprise. Their monopoly rents are partly used to aid (pay?) politicians, and are also dependent on political favors and support.
    • e. Once in office, create favored monopoly privileges by prohibiting entry of competitors to those who support you. As we shall learn later, consumers lose more than the monopolies gain. But the ability of monopolists to pay politicians exceeds that of consumers, who have more difficulty in arranging payment because there are so many consumers, each with only a small amount involved.
  • 3)

    A piece of history: “It is well to remind ourselves from time to time of the benefits we derive from a free market system. The system rests on freedom of consumer choice, the profit motive, and vigorous competition for the buyer’s dollar. By relying on these spontaneous economic forces, we secure these benefits: a) Our system tends automatically to produce the kinds of goods that consumers want in the relative quantities in which people want them. b) The system tends automatically to minimize Edition: current; Page: [94] waste. If one producer is making a product inefficiently, another will see an opportunity for profit by making the product at a lower cost. c) The system encourages innovation and technological change. . . . I regard the preservation and strengthening of the free market as a cardinal objective of this or any Administration’s policies” (President John F. Kennedy, September 1962). It is discouraging that while extolling the virtues of an open, competitive economic system, businessmen and politicians restrict markets—for example, by controlling allowable imports of sugar to maintain sugar prices in the United States above the open-market level—in order to maintain larger wealth for incumbent businessmen and their employees. Confusion between freedom of competition and freedom from competition is suggested. What explains this praise of the virtues of a system of private property and open markets with simultaneous attempts to suppress it?


    Restrictions on entry by new competitors are denials of open or free markets. Those in the restricted industry gain at the time the restrictions are imposed, although their gain is less than the loss imposed on others.

  • 4)

    Some discount stores advertise that they can sell for less because they buy directly from the manufacturer and sell to the consumer, thus eliminating many middlemen. What is the inadequacy in this reasoning?


    It assumes that the middleman performs no service to consumers or producers in facilitating exchange, and therefore he can be eliminated without someone else having to perform the service in which he specialized. Eliminating the middleman is a form of the do-it-yourself principle, and is not necessarily more economical.

  • 5)

    A history textbook might tell you that trade in the Mediterranean Sea developed after the Greeks began to produce a surplus of olive oil and found that the Spaniards were producing a surplus of silver. What would economics have to say about the development of trade of olive oil for silver?


    There was not a surplus of either olive oil or silver. But the worth of additional amounts of olive oil to the Greeks and silver to the Spanish declined Edition: current; Page: [95] as production increased. Greeks became increasingly willing to trade olive oil for a quantity of silver, while Spaniards became increasingly willing to trade silver for a quantity of olive oil. It became economical to pay for boats and crews to transport the olive oil and silver, while still leaving both the Greek olive growers and Spanish silver miners better off than if trade had not developed.

  • 6)

    For most of the items you find in the produce department of your grocery store, the packaging, transportation, and distribution costs are a much larger share of the price you pay than the share of the price that goes to the farmer. Is that a fair distribution?


    Economics does not help in making judgments about what is fair. The farmer cares most immediately about how much he is paid—relative to his costs—not about what share he received of the final selling price. The same is true of all others who participate in bringing food from the farm to the grocery store. Of course, some people enjoy “cutting out all the middlemen” and incurring the personal costs of traveling to “farmers markets” to purchase fruit and vegetables and transport them home. However, personally incurring such middleman costs does not deny that they exist and must be borne by someone.

  • 7)

    It is easy to see how we all can gain by increasing aggregate output—the social pie gets bigger. It is not so apparent that everyone engaged in a trade is made better off—that seems to be just reapportioning the pie. And if there are middlemen involved in the trade, they siphon off some of the pie, leaving less to divide between the traders. What can be “the gains from trade”?


    Preferences—marginal valuations—differ among people, and they change for a given person as his holdings of goods are altered. A has cheese and would like some crackers; B has crackers and wants some cheese. Each would like to get his desired good as manna from heaven, but he is willing in this hard world to give up some of his initial holdings of the one good in exchange for some of the other. Each puts a greater personal valuation on what he gets than on what he gives, so each gains from the transaction. And some of that gain can be paid, if need be, to a middleman who conducts the trade.

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  • 8)

    The text speaks of “money” price and “full” price in trade, with and without intermediaries (middlemen) involved in carrying out a transaction. Distinguish between these price measures.


    The money price is the equilibrium price paid by the buyer and received by the seller when there are no costs of making the transaction. But there can hardly be a costless transaction, and those costs are reflected in a full-demand price greater than the money price and a supply price less than the money price—and there is a reduced volume of trade. Often, intermediaries can arrange and carry out the exchange at a cost smaller than that incurred when buyer and seller deal directly with each other—and which results in trade greater than the volume would be on a transactions do-it-yourself basis.

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The principles of economic analysis require a persistent focusing on marginals rather than on just averages. This chapter illustrates the principle of maximizing a total by equalized marginals.


Suppose you have taken two tests in a class, receiving scores of 80 and 86, for a current total of 166 as listed in table 7.1. Your average score is 83 (= 166/2). You take a third test and score 89, raising your total score to 255. That addition to your total score is your marginal score. Because that marginal score of 89 on the third test is higher than your average (83) of the first two scores, your new average rises from 83 to 85 (= 255/3). The average is a historical measure of the past, whereas the “marginal” is more identifiable with the present. And the present or future is the basis of a current decision.

Table 7.1 Marginal, Total, and Average Test Scores
Tests Marginals Total Averages
1 80 80 80
2 86 166 83
3 89 255 85
Table 7.2 Marginal, Total, and Average Costs
Chairs Made Daily Marginal Cost Total Cost Average Cost
1 100 100 100
2 80 180 90
3 105 285 95
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Table 7.3 Prices and Total, Marginal, and Average Revenues
Chairs Sold Daily Price Total Revenue Marginal Revenue Average Revenue
1 110 110 110 110
2 100 200 90 100
3 90 270 70 90


In table 7.2, a firm producing chairs can make one chair a day, at a total cost of $100. If it makes two chairs a day, the total cost rises to $180. This $80 increase in the total cost when making one more chair is the “marginal” cost of chairs.

Producing three chairs daily raises the total cost to $285. That increase of $105 is the marginal cost at a rate of three chairs daily. The average cost at three chairs is now $95 (= $285/3). Adding a $105 marginal cost that exceeds the former average cost ($90) will pull up the average, from $90 to $95. Looking back at the change from one chair to two chairs daily, the average cost fell from $100 to $90, because the $80 marginal cost at two chairs was less than the preceding average ($100) at one chair.


Suppose you are selling chairs. The sales revenue data are in table 7.3.

You set your price at $150, but you don’t sell any. So you cut your price to $110, and you sell one chair a day. To sell more chairs each day, you cut the price to $100 and sell two. Your total revenue rises to $200. The marginal revenue is $90, the increase in the total revenue. The marginal revenue, $90, is less than the $100 price received for that second chair, because, to sell two chairs per day, you have to cut the price from $110 to $100 on both units. You give up $10 on the one chair you could have sold alone if you hadn’t cut the price to sell the second chair. The $90 marginal revenue is the increase in total revenue when selling two chairs at $100 each, rather than selling just one for $110. The average revenue per chair at two chairs daily is $100.

You could sell three chairs if you cut the price to $90. Your total sales revenue would be $270. The marginal revenue, that is, the increase in total revenue, would be only $70. The marginal revenue is the change in the total revenue consequent to cutting the price on all units enough to sell one more per day. The $10 cut in price in order to sell three chairs at a price of $90 each means the price is cut on two chairs that could have been sold at $100 each. That $20 reduction ($10 on each of the two chairs) offsets part of the $90 price received on

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Table 7.4 Total, Marginal, and Average Sale by Clerks
Clerks Total Sales Marginal Sales Average Sales
1 $1,000 $1,000 $1,000
2 $1,800 $800 $900

the third chair, bringing the total revenue increase to $70. The marginal is the change in the total, not just the amount obtained on the additional marginal unit sold.

Who Did It?

In a retail store, more clerks enable better service and more sales revenue as illustrated in table 7.4.

One clerk alone generates sales revenue of $1,000. With a second clerk, the revenue rises to $1,800. The marginal is $800 and the average is $900. In fact, the second clerk registered zero sales, while the first one’s sales rose to $1,800, because the second clerk assisted customers, and the first clerk recorded the sales. The marginal revenue is $800 with a second clerk. The two clerks as a team added $800 to total revenue. The marginal is the change in the total consequent to including one more unit.


Suppose you were told that the average cost per life saved by expenditures on automobile airbags was $1,000,000 while the average cost of saving a life with seat belts was only $500,000. Should greater safety be sought by spending more for airbags or for seat belts? You shouldn’t answer without knowing the marginal costs for saving lives by airbags and the marginal costs for saving lives by seat belts. That might be $2,000,000 if seat belts are used to save an extra life, while it’s only $1,100,000 with airbags. That comparison of the marginal costs reverses the ranking by the average costs. The average does not tell what the additional effects or additional costs will be. It summarizes only the past—the accumulated—effects, not the next effects. When considering where to put more resources, the marginal effect is pertinent, not the average per unit of input to date.


The total, the marginal, and the average are related to each other. In table 7.5, the first column lists the number of inputs of labor in some productive act. The second column lists the total product at each amount of labor. The third

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Table 7.5 Production and Inputs
Labor Total Product Marginal Product Average Product Per Unit of Labor
(1) (2) (3) (4)
First 6 6 6
Second 16 10 (=16-6) 8 (= 16/2)
Third 24 8 (= 24 -16) 8 (= 24/3)
Fourth 30 6 (= 30 - 24) 7.5 (= 30/4)
Fifth 34 4 (=34-30) 6.8 (= 34/5)
Sixth 36 2 (= 36 - 34) 6 (= 36/6)
Seventh 36 0(=36-36) 5.14 (= 36/7)
Eighth 35 -l(=35-36) 4.375 (= 35/8)

column lists the marginal products, the change in the total amount with an additional unit of labor. The fourth column lists the average product per unit of labor.

The following relationships are: (1) The total products increase by the amounts of the successive marginal products. The total product is the sum of the marginal products up to that level of activity, because the marginal product is defined to be the change in the “total product” with each added input. (2) In this table, a special feature is that successive positive marginal products get larger at first, but then later, beyond the second unit of input, begin to decrease in size. The amount of an input at which the total product begins to increase by diminishing marginals is the “point of diminishing marginal products from that kind of input.” (3) When the “marginal” is negative, the total decreases. (4) If the marginal is less than the prior average, the new average is lowered. Saying the same thing, when an added input lowers the average product per unit of that kind of input, the marginal product must be less than the average product.

In table 7.5, the marginal products first increase, from six to ten. Then they decrease, even becoming negative values. When the marginals are negative the total decreases, because the marginal is, by definition, the change in the total. Where the total is maximized (and then starts to fall), the marginal is zero (changing from positive to negative).

Marginal products rise initially, but at larger amounts of input marginal products begin to decrease. Average products rise initially when marginal products exceed average products, but when marginal products decrease to below the average product, the average products are pulled down.

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Figure 7.1

Graph of Marginal and Average Product Data in Table 7.5

Marginal products rise initially from six to ten. But at amounts of labor input in excess of 2 units, marginal products begin to decrease. Total output is increasing throughout this range up to 6 units of input, but by decreasing amounts after 2 units of input. Average products rise initially, when marginal products exceed average products; but when marginal products decrease to below the average product, the average products also decrease. The total output is greatest (maximized) where the marginal product is zero at 7 units of labor input. The total output is falling where the marginal product is negative, at 8 units of labor.

Figure 7.2
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We can now state a principle that pervades much of Economics. “Allocate resources among alternative uses so as to keep the marginal returns equal, or as near equal as possible.” Or, “if marginal products aren’t equal, there’s a gain to be had by reallocating some resources from the use with the lower marginal product and assigning them to where the marginal product is higher.”

A General Task: The Assignment of Limited Supply among Alternative Uses

In this vale of scarcity and frustration, we are incessantly confronted with problems of how best to assign limited supplies among alternative uses. We have only twenty-four hours each day for working, playing, eating, and sleeping. We have incomes too small to buy all of everything we want, so spending choices are unavoidable.

Imagine you have ten coin-like tokens which you can insert into two “money machines,” A and B, from which dollars will be obtained. Your goal is to maximize the total number of dollars you get. The amounts that can be obtained from machine A and machine B are listed in tables 7.6 and 7.7.

A marginal return is the dollar output from a machine with an added token. The marginal returns decrease with additional tokens. The “average per token” is the total output, the sum of the marginals to that point, divided by the number of inserted tokens. For machine A, the marginal returns decrease from the

Table 7.6 Marginal, Total, and Average Dollar Returns from Machine A
Tokens Marginal Total Average
1 20 20 20
2 18 38 19
3 16 54 18
4 14 68 17
5 12 80 16
6 10 90 15
7 8 98 14
8 6 104 13
9 4 108 12
10 2 110 11
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Table 7.7 Marginal, Total, and Average Dollar Returns from Machine B
Tokens Marginal Total Average
1 15 15 15
2 14.5 29.5 14.75
3 14 43.5 14.5
4 13.5 57 14.25
5 13 70 14
6 12.5 82.5 13.75
7 12 94.5 13.5
8 11.5 106 13.25
9 11 117 13
10 10.5 127.5 12.75
Table 7.8 Aggregated Marginal and Average Dollar Returns from Two Machines
Tokens Machines and Tokens Used in Machine Marginal Returns Total Returns Average Returns
1 1st in A 20 20 20
2 2nd in A 18 38 19
3 3rd in A 16 54 18
4 4th is 1st in B 15 69 17.25
5 5th is 2nd in B 14.5 83.5 16.7
6 5th is 3rd in B 14 97.5 16.25
7 7th is 4th in A 14 111.5 15.93
8 8th is 4th in B 13.5 125 15.63
9 9th is 5th in B 13 138 15.33
10 10th is 6th in B 12.5 150.5 15.05

initial maximum of $20 at the first token. For B, the marginal returns start at a lower value, $15, but the marginals of machine B decrease less rapidly.

In trying to get as much money as possible, you won’t put all ten tokens into machine A. You’d get $110.00. Nor would you put all 10 into machine B, even though its total payoff of $127.50 is greater. Instead, you’d rationally allocate the 10 tokens between the two machines, and get as much as $150.50, ending with essentially “equalized marginals” of the two machines. Table 7.8 shows the sequence of allocation to maximize the total return from the two machines.

You would put the first token in the machine that yielded the highest marginal return, machine A, which pays $20. The second and third tokens also Edition: current; Page: [104] would go into A, for their marginal returns ($18 and $16) are greater than the return of B’s first token ($15). The fourth token in machine A has a marginal yield of $14, but that’s less than the marginal return for the first token in machine B, so the fourth token becomes the first in B.

Figure 7.3

Allocating Successive Tokens between Two Machines to Maximize Total Payoff

The marginal products from machine A start higher but decline faster than those from machine B. With ten tokens, the largest reward can be obtained with four tokens in A and six in B. To maximize total return, the rule is to allocate the next token to the machine with the highest marginal product with that additional token. With continuous inputs, the amounts going to each should be such as to equate their marginal products to each other.

See how the averages can mislead. The average return with a fourth token in machine A would be $17, and the average with one token in machine B is $15. Nevertheless, we put that fourth token in B, because the marginals, not the averages, are pertinent. If we mistakenly used the average to direct where we put the fourth token, and put it in A, our total return would be only $68, rather than the $69 we’d get by using the marginals to direct our tokens. The next token, the fifth, would get $14.5 from machine B, compared to the marginal return of only $14 as a fourth token in machine A. That fifth token does not go into the machine (A) with the highest available average.

The ten tokens would go four into A and six into B. The four tokens in machine A obtained $20 + $18 + $16 + $14 = $68. The six tokens in B obtained $15 + $14.50 + $14 + $13.50 + $13 + $12.50 = $82.50. The aggregate total is $150.50. No allocation other than four in A and six in B will get as much.

If we think of the inputs as perfectly divisible and continuous (like rates of hours of labor input, instead of tokens), the marginal returns of added inputs Edition: current; Page: [105] would be measured by continuous lines, as in figure 7.3. There, the area of all the marginal returns represents the total return from a machine. With two machines, total return is represented by the areas under the combined marginal return lines in the graph. For a maximum total product from the two machines, the amount of inputs to each machine, A and B, should be such as to equalize their achieved marginal returns.


Let’s apply the principle—equalize the marginals—to a production situation. If two plants under common ownership are producing the same goods, we will want each to operate at a rate of production that will minimize the costs of total production. We won’t produce goods in one plant at higher marginal costs than are possible in the other. The idea can be stated as “assigning rates of production to each so as to equalize the marginal costs of the two.” Whether plants are maximizing the total returns from two producers or minimizing the total costs, the rule is to have each produce at rates at which their marginal returns (or marginal costs) are equalized. At any point, adopt the best of the remaining options—the highest remaining marginal return, or the lowest remaining marginal cost.


  • 1)

    Explain or criticize the following statements and questions about the substitution postulate:

    “Every student substitutes some romance for grades when he dates rather than studies as much as he otherwise could have.”

    “The substitution postulate says that a student does not seek the highest possible grades.” Does the substitution postulate deny that water, food, and clothing are more basic or more needed than music, art, and travel? “There is no hierarchy of wants.” What does that mean? Can you disprove it? Is travel in Europe a substitute for formal academic education? For some food? For a bigger house or new clothes or medical care? For what would it not be a substitute?

    “I’d like to play poker with you again tomorrow night, but I don’t think my wife would like it.” Is this consistent with the substitution principle? Is the wife’s utility being compared with the husband’s? Explain.


    Substitution means there are trade-offs. A person gives up some (not necessarily all) of one good or service for some more of another. This applies to all desired things—goods, services, goals, objectives, ideals, morals. Edition: current; Page: [106] People give up some of one ideal for some more of another ideal. All goals and ideals are competitive and substitutable in degrees of achievement or fulfillment. The emphasis is on more versus less—not on all or nothing.

  • 2)

    Suppose that I am indifferent if given a choice among the following three combinations:

    Table 7.9
    (pounds per year)
    Steaks Artichokes
    Options A: 100 and 30
    B: 105 and 29
    C: 111 and 28
    • a. What is my marginal personal worth of steak (between options A and B)?
    • b. What is my marginal personal worth of artichokes (between B and C)?
    • c. If the amount of steak in A were doubled to 200, what can be deduced about the amount of steak required in B to make personal value equal to A?


    • a. One artichoke is worth 5 steaks, or 1 steak has a marginal personal worth of .2 artichokes, given options A or B.
    • b. Between B and C, my marginal personal worth of artichokes is 6 steaks, greater than between A and B, because I have fewer artichokes at B or C than at A.
    • c. Increases the amount of meat that expresses the marginal personal worth of artichokes, because I have fewer artichokes (and more meat).
  • 3)

    Principles of economics are used to characterize some aspects of human nature and behavior.

    • a. Do you think any of them are also applicable to nonhuman animal life? For example, which of the principles would validly apply to the behavior of monkeys, ants, bees, tigers, and birds?
    • b. Which principles, if any, do you think serve to distinguish human from nonhuman behavior?
    • c. What evidence can you cite to support your answers?
    • d. Do you think the human race would survive if it lost the attribute Edition: current; Page: [107] described by the principle “each person is willing to forsake some of an economic good to get more of other economic goods” while some animals retained it?


    • a. Yes.
    • b. We don’t know that any of them do.
    • c. Behavior of bees, ants, and baboons.
    • d. No.
  • 4)

    A parent gives each of his two children some milk and meat. The two children then exchange with each other, one drinking most of the milk and the other eating most of the meat. If the parent does not permit them to make that exchange, which of the principles (if any) is he denying? Or does the explanation rest on some new principle not made explicit in the text?


    Denies none in the text. The implied new principle is that power over other people is a good or a goal.

  • 5)

    If I regard each of the following combinations as equally preferable, which principle is denied?

    Table 7.10
    X Y
    Options A: 100 and 70
    B: 105 and 69
    C: 110 and 68
    D: 115 and 67


    The principle “the more one has of any good, the lower its marginal personal worth” is denied because in the table the marginal substitution rate between X and Y is constant between all the options.

  • 6)

    Explain the difference between the statements, “People act in accord with certain fundamental principles” and “People consult or refer to such principles for guidance in choosing their behavior.” Does either Edition: current; Page: [108] interpretation assume “free will” or independence for other people’s behavior or tastes?


    The first statement contains no implication about any necessary thought process. It would also apply to rocks and water obeying the law of gravity. The second statement suggests some common or necessary mental calculation and choice making. Economics does not have to assume the second statement as a basis for its theory, despite common arguments that it does.

  • 7)

    In testing a person’s preference between two known options, it has been suggested that if a person agrees to let some unknown party choose for him, then he is indifferent between the two options. Do you think that is consistent with the principles listed in the text?


    It is.

  • 8)

    It is a good rule to avoid costs which exceed benefits and to seek benefits greater than costs. But with interactions of two parties, costs and benefits to whom? The longer the stay in a hospital, the greater may be the benefit to a patient, but the higher is the total hospital cost he must pay. If the total bill is $15,000 for five days, the cost of a day to the patient (and the revenue to the hospital) might be said to be $3,000. So is an extra day in the hospital worth the additional $3,000 to be paid by the patient?


    Consider also the marginal cost to the hospital along with the average cost to be paid by the patient. Perhaps the major costs occur in the first several days of care; in the later days, the care, though important, is much less costly—less than the $3,000 average cost. Should the patient be kept in the hospital for an extra day? Yes, says the hospital: It receives $3,000, equal to its average cost, but its marginal cost is less than $3,000. Maybe no, suspects the patient, for whom the marginal benefit may be deemed to be less than the average (daily) expenditure.

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The First Law of Demand is critical: A sufficiently higher price will decrease the quantity demanded, and a sufficiently lower price will increase the quantity demanded. But price is not the only thing that can affect the quantity demanded. With greater income, the quantity demanded at each price is larger for most products. Also age, gender, education, and health, to name a few things, affect the quantity demanded at each price. When so many other factors affect the quantity demanded, why concentrate on price? After answering that question, this chapter explains some measures of the degree of response in amount demanded when the price changes, and why the degree of response is important.


The first question really should be, “Why so much attention to price adjustments?” A major reason is that price adjustments make the aggregate quantity demanded of a good equal the aggregate available supply. Unhappily, our tastes, preferences, or total personal worths don’t change to make us desire to have only as much of a good as our income allows. Prices change so as to reconcile personal conflicts for available goods, they direct production from the less-highly to the more-highly demanded goods, and they affect your earnings and the kind of work you will be doing.


College tuitions have increased in recent decades far more than the average of other goods, while prices of televisions, computers, and travel have fallen. These changes in relative prices are results of events that changed the demand for or supply of one good relative to the demand for or supply of other goods.


We distinguish three demands. (1) There is the demand by one person for a good. (2) Another is the aggregated demand by all people for a good, from all suppliers—the market demand. (3) A third is the demand seen by one seller when Edition: current; Page: [110] offering that good to the market—to people in general. This is the “demand facing a seller.”


A measure of the responsiveness of the quantity demanded of a good to a change in its price is the “elasticity of demand with respect to price,” or “price elasticity of demand.” A seller who contemplates the effect of cutting price expects an increase in the amount demanded by customers. The additional units sold will bring more sales revenue. But, at the same time, the cut in price will reduce the sales revenue on the units salable at the former higher price. Which dominates, a) the added sales revenue of the additional units sold at the lower price or b) the lost revenue on former sales at the higher price?

Elasticity of Demand

“Elasticity of demand” for a good is the ratio of a) the percentage change in the quantity demanded in response to b) a percentage change in the price of the good.


A $1 cut in price from $10 is more important than a $1 price cut on a good from $100. The first is a 10 percent change, whereas the second is a 1 percent change. If quantity demanded increased by 5 units, from 20 units to 25 (a 25 percent increase), that would be more significant than a 5 unit change from 100 to 105 units, only a 5 percent increase.

If a price cut of 10 percent results in a 20 percent increase in the quantity demanded, the ratio of the 20 percent change in quantity to the 10 percent change in the price is 2 (= 20 percent/10 percent).


The increase in quantity demanded is in the opposite direction to the change in price in the denominator, a decrease in price. Therefore, the ratio, the elasticity, is algebraically “negative.” Typically, that’s ignored, and is called 2 rather than –2.

Table 8.1 gives data on selected points (combinations of price per unit and number of units demanded) of a demand schedule. The percentage changes in price in moving down the schedule and in corresponding quantities are indicated,

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Table 8.1 Elasticities of Demand
Price Price Cut % Quantity % Change of Quantity Elasticity Market Value
$10 1 $10
10 100 10 = 100/10
9 2 18
11.1 50 4.5 = 50/11.1
8 3 24
12.5 32 2.6 = 33/12.5
7 4 28
14.3 25 1.7 = 25/14.3
6 5 30
16.7 20 1.2 = 20/16.7
5 6 30
20 17 0.85 = 17/20
4 7 28
25 14 0.56 = 14/25
3 8 24
33 12.5 0.38 = 12.5/33
2 9 18
50 11.1 0.22 = 11.1/50
1 10 10

along with calculated elasticities between successive positions. Finally, market values (seller receipts, buyer expenditures) are provided as products of price multiplied by quantity.

A minor point in table 8.1: The measure of elasticity for a price cut from $6 to $5 is not $1.00, as it should be when the total sales revenue is the same at the two prices. This discrepancy arises because the data represent discrete changes in prices, so that the measures depend upon the prices and quantities used as the basis for computing the percentages. This slight ambiguity could be removed if we had a smooth continuous demand curve rather than widely separated points.

Elasticity Review

Elasticity of demand is a measurement of movements along a demand schedule, not a result of a shift in the schedule. Figure 8.1 presents a straight-line demand schedule. The initial price is indicated by OP on the vertical axis, and Edition: current; Page: [112] the initial quantity by OM on the horizontal. We want to measure how “elastic” the demand is at, or near, price P. Consider the small segment of the demand schedule between OP and OP′. That is, for an increase of price from P to P′, is the relative decline in quantity from M to M′ larger, smaller, or the same?

Figure 8.1

Since elasticity is measured by the proportionate change in quantity divided by the proportionate change in price:


If we are at the midpoint of the curve, then OP = PT, and elasticity at that point is equal to one (unity). At higher prices, OP > PT, that is, elasticity is greater than one; at lower prices, it is less than one. If we are in the upper half of the curve, where OP > PT, elasticity is greater than one; a decrease in price will cause a greater proportionate increase in quantity, so total revenue rises. Caution: Do not confuse elasticity of the demand curve with its slope. In particular, do not presume that a relatively flat curve is more elastic.

It has been noted that elasticity determines whether market value increases,

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Table 8.2 Elasticity, Price, and Total Revenue (Expenditure) Change
e >1 e = 1 e < 1

decreases, or remains unchanged as price rises or falls as we move along the demand schedule. Table 8.2 provides a summary of the relationships:

Figure 8.2

For any combination of price changes and elasticity conditions, the table indicates whether market value is increased, decreased, or is unchanged.

Compare the three demand curves of figure 8.2. Curves 1 and 2 have a common price-axis intercept; curves 1 and 3 are parallel, that is, they have a common slope. Since elasticity = OP/PT, curves 1 and 2 have the same elasticity at price OP. Demand 1 is more elastic than demand 3 at price OP, although their slopes are the same: OP/PT > OP/PT′.

Few, if any, actual demand curves are straight through their entire length. A special exception to a linear curve is a rectangular hyperbola. In figure. 8.3, any price multiplied by its corresponding quantity demand, for example, OP × OM, equals any other price times quantity indicated by the curve, for example, OP′ × OM′—market value is constant as we slide along the curve—for OP/PT = OP′/P′T′ . . . = 1, unitary elasticity.

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Figure 8.3

Elasticity of the curve at price OP = OP/PT, when T is the vertical axis intercept of a straight line tangent to the curve at that price. Similarly, T′ is located by a tangent line at the lower price.


“Elasticity of demand with respect to prices” is a way to refer to effects on a seller’s total market revenue, if a seller changes the price.

With elasticity greater than one, a rise in price of, say, 10 percent will reduce the amount demanded by more than 10 percent. Total revenue will fall, because the quantity was reduced more than proportionally to the increases in price on each unit. And with an elasticity of greater than one, if a seller reduced the price, the total sales proceeds would increase. The percentage increase in the amount demanded would be greater than the price cut.

Suppose, instead, the elasticity were less than one: the price effect dominates the quantity effect. A higher price will increase total sales revenue, and a lowered price will reduce total sales revenue. Look at the drop in price from $4 to $3 in table 8.1. The quantity demanded increases from 7 units to 8. The percentage increase in quantity demanded (14 percent) is less than the percentage fall in price (25 percent). The elasticity is less than one. Total sales revenue is lower. It was $28 (= 7 units at $4 each); now it’s $24 (= 8 units at $3 each). If elasticity is less than one, Edition: current; Page: [115] the total market value of quantity sold decreases at a lower price, and increases at a higher price.

Meanings of “Inelastic”

“Inelastic” demand is in the range of prices where the elasticity is less than one—where the percentage change in amount demanded is less than the percentage change in price along that demand schedule. “Inelastic” does not mean the change in quantity is zero! That would be “complete or perfect INelasticity” or, more commonly, “zero elasticity.” Because the elasticity is generally not the same at all parts of the demand schedule, the expression “elastic” demand refers to the region of prices at which the elasticity is greater than one. And inelastic means it’s less than one.


The price changes referred to here are changes along a given unchanged demand schedule. If, instead, the price change were a result of a shift in the whole schedule, we couldn’t use a measure of elasticity to indicate the resulting change in total market value. The difference is indicated in figures 8.4A and 8.4B. In figure 8.4A, Edition: current; Page: [116] the quantity demanded changes as the buyer slides along an unchanged demand curve in response to changes in available supply. In figure 8.4B, it is supply that is unchanged, and the price changes as a result of a shift to a higher demand curve.

Figure 8.4A

Effects of Change in Price Due to Change in Supply, Not Due to Shifts in Demand

Figure 8.4B

Change in Price Due to Change in Demand, with Unchanged Supply

Why Use the Concept of Elasticity When Its Measures Are Unknown for Almost All Goods?

No one can know the required actual data well enough to compute exact elasticity. But the concept explains several commonly used pricing and selling tactics, identifying situations that are “monopolistic” and “monopolizing,” which are usually, though not always, regarded as “undesirable” and prohibited by law. The concept of elasticity helps in the analysis of effects of government taxes and subsidies. But here we can use it to express the second law of demand.


The fact that adjustments are less expensive—and therefore more fully accomplished—with the passage of time is the basis of the Second Law of Demand: Elasticities of demand with respect to price are greater the longer the time after a price change.

When the price of gasoline first rose significantly after a war in the Middle Edition: current; Page: [117] East, the quantity demanded in the United States fell very little at first, but after a few months the reduction was more noticeable, and after a few years the quantity demanded was reduced drastically. Hastier adjustments are more expensive. Substitution by new types of cars and other forms of, and arrangements for, transportation, such as car pooling, consolidating errands, using buses and scooters, airplanes and railroads, become more economical as older cars wear out. Existing equipment appropriate at the older prices will be replaced in time with equipment designed to use the higher-priced inputs more effectively. Because the immediate effect is often quite small, observers tend to ignore the later extensive and major consequent adjustments.

When wages of labor are raised—say, by a legislated increase in the minimum wage—the first law of demand indicates that less labor will be demanded. But often the reductions in employment occur only many months later after the producer has been able to substitute equipment that uses less labor. By that time, observers forget that the reduction is a response to higher labor costs. With the passage of time, these changes become more difficult to measure because so many other things also change.

A quicker, more complete adjustment is preferred to a delayed adjustment, but the costs of faster adjustments are greater than slower ones. The Second Law of Demand says that in the “longer-run” more adjustments are completed.

Short and Long Runs

The terms “short run” and “long run” roughly separate the more immediate from later adjustments. Not all responses to every event occur immediately. The timing depends on a) the costs of determining the appropriate changes and in making the changes earlier rather than later and on b) the benefits of doing so earlier rather than later.

Sometimes, “short run” is taken to mean the length of time before all desired adjustments are completed. This is often summarized by saying that the “short run” is that period in which some things are “fixed” but which are “variable” with the passage of time. Saying they are “fixed” is a way to recognize that faster adjustments are too costly to be worth doing immediately. Categorizing the adjustments in just two stages, the more immediate “short run” and the delayed “long run,” is convenient and usually adequate.

We could think of long-run adjustment to mean the “completed” adjustment, which will persist only until there is another change in events that affect the demand or the supply. Considering the effects during both the initial adjustment actions and the subsequent adjustment, it would be tempting to think that the long run means “later and ultimate,” while the short run means Edition: current; Page: [118] “sooner and temporary.” However, there’s no basis for presuming later adjustments will long persist, as if there were no more shocks to which to adjust.

Figure 8.5

Effect of Time on Price Elasticity of Demand

The longer the time after a price change, the greater the effect on the rate of demand—shown by the flatter, more elastic curves for more elapsed time after a price change.


One demand curve alone, representing the adjustment to a change in price after some interval, is not capable of completely representing “demand.” For every succeeding moment, the demand becomes more elastic or less inelastic. A single demand curve is one of a set of demand curves, like a fan, radiating from the initial price. Figure 8.5 illustrates the idea.

The fan of demand curves shows the general pattern of the various quantities demanded at successive moments after the price falls from P1 to P2. The price effect on quantity demanded increases over time until it reaches its ultimate full “long-run” adjustment shown by the flattest curve.


Many and possibly most goods are “normal,” as defined in chapter 5: a higher income raises demand, as represented by an upward (rightward) shift of the demand curve, roughly proportionally to the increase in income. For “superior” goods, increases in income or wealth result in shifts in demand that are more than proportional. For “inferior” goods, increases in income result in proportionally smaller increases in demand. A good may be “superior” for someone Edition: current; Page: [119] in the low-income range and “inferior” for someone in a richer range. Cheap wine may be a superior good at low incomes, but with greater wealth people may consume more expensive wines. We usually will be investigating situations in which the goods are believed to be normal.

Income Elasticity

Analogous to “price elasticity of demand,” “income elasticity” is the percentage change of the quantity demanded divided by the percentage change of income. But which income?—transient momentary income or expected longer-run “permanent” level of income? A 20 percent increase in quantity demanded in response to a 10 percent increase in “permanent” income at an unchanged price means the income elasticity of demand is two at that income range. A momentary rise in income probably will have little effect.

Definition: Income elasticity of demand for a good is the ratio of the percentage change in quantity demanded to the percentage change in income that caused the change in the demand schedule.


The quantity demanded depends on price, as reflected by a movement along the demand curve. However, a change in the price of a good can shift the demand curve for that good—in addition to causing a movement along the demand schedule. This can happen when the demander already owns a very large amount of the good. The rise in its price makes that person wealthier. The increased wealth can shift the demand curve upward to larger amounts demanded at each price.

This is a situation in which the price change affected both the position of the demand curve and the position on the demand curve. (1) One effect is the slide along a demand curve. This “substitution” effect is the movement to a smaller amount of a good at a higher price, and to more of other goods the prices of which have not increased. (2) The other effect on amount demanded is through the effect on a person’s wealth when the price of a good changes. This is the “wealth” effect of a change in the price of some good of which a person owns a substantial amount. That resulting increase in wealth tends to shift the demand curve upward. The two effects of a price change—substitution and wealth—are in opposite directions.

When the price of oil first rose sharply in response to a smaller supply available from Middle East oil producers, the owners of oil wells in the United States became enormously wealthier, and that increase in wealth increased their demand for bigger cars and for oil products, such as gasoline. The effect of that increase in wealth shifted up their demand curves for gasoline more Edition: current; Page: [120] than enough to offset the substitution effect of a higher price along the higher demand curve. But there seem to be few instances in which this wealth effect is important enough to be noticeable in individuals’ responses to price changes.1


For most things, we purchase bulk amounts at convenient shopping times, while consuming more smoothly at some rate per unit of time. Usually, the “demanded amount” refers to the average rate associated with a price, and around which there are momentary random deviations.

At any given price, for each person the quantity purchased (and consumed) by that person would vary around the average amount associated with that price. The transient fluctuations in sales from day to day usually don’t call for adjustments in prices or production. However, they cause difficulties when the seller can’t reliably distinguish between the temporary deviations and a change in the underlying rate around which deviations occur, and the fluctuations around the mean are important in explaining some pricing policies, which we’ll be exploring later.


The difference between the “rate” and the “volume” demanded is parallel to a distinction between speed of travel and distance traveled. “Rate” is a “speed” while “volume” is like a distance. For demand and for supply, there’s a rate (speed) of purchase and of production, such as 5 units per hour. That is the same as “40 per 8-hour day” or “200 per 5-day week.” Each of these expressions denotes the same rate, or speed, of “amounts” or “quantity” demanded (or supplied). But they do not tell how many (the volume) are demanded.

A grocer may have a customer who buys at a low rate, but who continues as a nearby resident to buy for a long time at that low rate. Another customer may buy at a very high rate but for only a couple of days and then disappear. From Edition: current; Page: [121] the point of view of the seller, which buyer reveals the greater demand? Is it the total anticipated volume of purchases over time, or is it the current rate of quantity demanded that determines how a seller will respond, or is it some weighted combination? Later, we’ll return to this question.

This distinction between the rate of activity and the total aggregated volume over time is important both in analyzing demand and also in considering production. If production at the rate of 5 an hour continued for only 2 hours, the volume would be 10. If production continued for 8 hours at that same rate of 5 per hour, the volume would be 40 units. When referring to “quantity” or “amount” of production or “amount” of demand, we must know whether we are referring a) to the rate, without specifying how long that rate continues, or b) to a volume, which won’t tell us at what rate or speed that volume is produced over some period.

How Can We Compare Demands Differing in Rates and Timing?

Consider some different patterns of amounts demanded over time at a given price. One buyer purchases 10 per week for 2 weeks (a visitor at a vacation site). A local resident buys an average of 1 per week every week of the year. From the point of view of the seller, which is the “bigger” demand? Which is more important in its economic effects on production and price?

This kind of problem about the “temporal length of demand” by a customer faces every producer, whose planned or possible production, cost, and revenue patterns vary over time.

Some variables are at higher rates for shorter spans of time, and slower for longer spans. Which is bigger or more important in the effects on prices, production, and income? In choosing among them, the producer has to convert the varying and varied streams of costs of production and the streams of revenues from customers to comparable single-valued measures.

Miraculously, there is a way. It’s being done all the time, with “capital values,” one of the most important procedures and principles in all economics. Later we’ll devote several chapters to it. In the meantime, we’ll set aside the potential volume- and time-related effects, because they’re not pertinent for the illustrations of the simple but realistic demand and supply analysis in the next chapter.


  • 1)

    Are the following statements correct or incorrect? Explain your answers.

    • a. “A 1 percent rise in price that induces a 3 percent decrease in amount taken indicates elasticity greater than one.” Edition: current; Page: [122]
    • b. “A 1 percent fall in price that induces a 3 percent increase in amount purchased indicates an elasticity of greater than one.”
    • c. What is wrong with asking whether a 1 percent rise in price induces a 3 percent decrease in demand?


    • a. Correct.
    • b. Correct.
    • c. It is conventional to call this a decrease in amount demanded, not a decrease in demand—which would refer to a shift in the whole demand relationship.
  • 2)

    “Elasticity is a measure of the percentage increase in demand for a one-cent change in price.” There are two errors in that statement. What are they?


    Elasticity is the ratio of percentage change in quantity in response to a small percentage change in price. It is “percent,” not one-cent. And it is “quantity demanded,” not demand.

  • 3)

    In the graph below, which of the three demand curves has the greatest elasticity at price P1? At price P2? Does the elasticity change as the price changes along each curve? Is the “slope” of a demand curve equal to the “elasticity” of the curve?

    Figure 8.6
    Edition: current; Page: [123]


    Demands a and b have the same elasticity at any common price. But the elasticities of a and b decrease at lower prices. Remember: With O as the origin, P as the price, and T as the vertical-axis intercept of the demand curve, elasticity = OP/PT. Demand c has lower elasticity at any price than demands a or b, and its elasticity decreases at lower prices. Demand c has the same slope as a, but its quantities are larger at any price. Hence, for any small price cut, the absolute change in the amount demanded on line c and a is the same, but for c the increase is a smaller percentage of the amount demanded (at that price). Elasticity = ΔQ/Q × P/ΔP = ΔQ/ΔP × P/Q = 1/slope × P/Q.

  • 4)

    Price and demand:

    • a. If the price of gasoline rose 100 percent, automobile manufacturers would make changes in the designs or operating characteristics of automobiles. True or false?
    • b. What effect would that price rise have on gasoline consumption?
    • c. Would the effect be more extensive at the end of one year or at the end of three years?


    • a. True. Economic theory says they would. Compare cars in countries with higher gasoline prices with those in countries with relatively low gas prices.
    • b. Reduced gasoline usage.
    • c. Effects would be more extensive in three years than in one year.
  • 5)

    Price and amount demanded:

    • a. Because we represent a demand curve with precise numbers, does that mean that people have these numerical schedules in their minds?
    • b. What essential property illustrated by the demand-schedule data does characterize their behavior?


    • a. No.
    • b. The negative functional relationship between price and amount demanded—at a higher price a smaller amount is demanded and in the reverse direction, at a lower price a larger amount is demanded.
  • 5)

    If the price of candy rises from $4 to $5 per pound while the price of ice cream rises from $2 to $3 a quart, in what sense is that a fall in the price of candy?

    Edition: current; Page: [124]


    It is a fall in the price of candy in ice-cream units. Candy is cheaper relative to ice cream than formerly. The percentage increase in the price of candy is less than the percentage increase in the price of ice cream.

  • 6)

    “If the price of gasoline rose by only 10 percent, many people would not immediately change their consumption.” Explain why this does not refute the law of demand.


    The law of demand does not say that every person will instantly respond, and respond fully, to every price change no matter how slight. It says a sufficiently high price will induce a response now, and it also says the response will be greater the longer the time allowed. In the case at hand, some people will respond quickly though some will not. Even for a small price rise the aggregate amount demanded over all people will respond because some will respond. In time, all will respond to a sufficiently large price rise.

  • 7)

    Income and demand:

    • a. As your wealth or income increases, what happens to your demand (schedule) for gasoline?
    • b. If you owned a dairy farm and the price of milk went up, would you consume more or less milk?


    • a. Demand increases. Schedule shifts upward (to the right).
    • b. Can’t tell. Milk production may be so important a source of your income that you consume more when its price rises (despite the higher price, because you are wealthier). But you consume less than if your wealth had increased for other reasons and without a rise in milk prices.
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The universal principles of demand apply to most human activity—much more than merely the prices of goods sold in markets.


Many speak of “needs,” calling them “vital,” “basic,” “urgent,” “critical,” “crying,” “minimal.” Such words are appropriate in a letter to Santa Claus, not in economics. They are challenged by the concept of the demand function. There is scarcity. Command over more is better, and less is worse. We all want more of every good. The price of “more” is what must be given up to get more of the “needed” thing. If we “need” more police protection, more schools, or more housing—then what is it that we need less of, which we will give up?

Potential production is limited. Choices must be made. Poor people are poor not because they “need” or are “satisfied with” or are “accustomed to having” less. Some shamefully contend that the cost of labor is low in poor foreign countries because the people there “don’t need as much as we do.” But they haven’t been fortunate enough to be born in an economy where they can earn as much as others do. We’ll look at the reasons a person’s labors are worth more in one place than another.

Direct Implications of the Laws of Demand

Because greater amounts can be sold at a lower price, prices of fruits and vegetables are lower at harvest time when the supply is larger. Merchants have clearance sales at lower prices, not higher prices. Still, public opinion polls report that many say they would not reduce their use of gasoline just because the price went up—they bought no more than they needed and would not buy less than they needed. In fact, when gas prices rose there was a reduction in the amount demanded—apparently the amount they “needed” fell when the price went up! That was in accord with the first law of demand. Further, the reduction has been greater in the long run, in accord with the second law of demand.

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Demand for Beef

If beef prices rise in response to a reduced supply, people buy less beef and more of other types of meat or sources of protein—eggs, cheese, poultry, fish, tofu—which are now less expensive relative to beef. In time, they adjust still more as they learn new ways to use the cheaper product.

Demand for Wood

If wood prices rise, less wood will be demanded. We substitute some plaster, plastics, steel, aluminum, copper, glass, paper, coal, oil. You and I may not consciously respond to a 10 percent rise in the price of wood, but industrial product designers shift in varying degrees to substitutes.

Demand for Water

Although we cannot live without water, we reduce (not eliminate) water usage when prices are higher. In arid regions, the very high price of water induces people to demand less; it is not that they don’t “want” or “need” less water. At that high price for water, they reduce the amount of water they use, and spend more on other things.

Per capita daily water usage has varied from 230 gallons in Chicago to 150 in New York and Los Angeles, down to 120 in San Diego and 110 in Boston. Among the reasons are differences in industrial uses. Chicago has steel and oil refining industries that use a great deal of water; New York City businesses—finance, retail, apparel—are light water users. And the cost of water had something to do with determining the locations of those industries! In many cities, industrial users take about half the water. Their demands are probably more elastic with respect to price than the demand for domestic uses. Further, there can be enormous differences in water use within the same industry. The amount of water used in production varies with the local price, as it does in consumption.

In Arizona or Nevada—with high prices of water—people have smaller gardens and lawns or just rock gardens. Sidewalks and autos will be swept or dusted, rather than washed. Softened water will be used because soft water washes cleaner with less water in flow-restricting shower heads. More houses will have circulating hot-water systems so as not to waste cold water waiting for hot water to reach the faucet.

In New York City, about 10 percent of the total water consumption has been estimated to be leakages; at higher prices, it would pay the water supplier to install meters as an incentive to reduce waste. Agriculture in California uses 70 percent of the water in the state—at prices of water to farmers that are Edition: current; Page: [127] far lower than prices to city users, even after adjustment for purification and distribution costs. If prices to farmers were as high as for water in the cities, farmers would more accurately bear the costs of farming. The extent of farming in California would be reduced. Water to grow watermelons, lettuce, rice, grapes, and alfalfa would be diverted to more valuable city uses, and more of the farm products would be produced in other states or countries where water is cheaper.

The growing population pressing on the available supply of water will require some strong means of allocating water use. Will it be similar to the method for controlling use of land, food, oil, and electricity—by market prices—or will it be political control?

Learning How to Adapt

When the price of water rises, people may not initially know how or to what extent to adjust. One way they learn is by being informed by sellers of substitutes or devices that economize on water. They sell water recycling equipment, water softeners, automatic faucets, fertilizers, irrigation and sprinkling equipment, air conditioning machinery, hardtop patios, chemicals that reduce evaporation from reservoirs, washing machines that use less water, and so forth. More expensive water creates market prospects for their production, and they will eagerly provide guidance to those trying to adapt.


The power of the laws of demand can be demonstrated by indirect, less obvious implications.

Good and bad grapes: larger proportions of relatively good quality California oranges and grapes are shipped to New York than the proportions that remain in California. Are New Yorkers richer or more discriminating? Possibly—but the quality ratio is higher also in the poor districts of New York and the whole East Coast. The question can be posed for other goods: Why are disproportionately more expensive foreign cars and other “luxuries” exported than are purchased in the home country? Why do young parents go to expensive plays rather than movies on a higher percentage of their evenings out than do young childless couples? Why are “seconds” (slightly defective products) more heavily consumed at the site of manufacture? Why do more of the better, rather than the mediocre, students attend more distant colleges? Why should a tourist be more careful buying leather goods in Italy than when buying Italian exports in other countries? Why is most meat shipped to Alaska “deboned”?

The answers to these questions are based on an implication of the first law

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Table 9.1 Better Quality Is Shipped Away
Prices of Grapes in New York = Transport Costs + Prices of Grapes in California
Choice $1.50 = $.50 + $1.00
Standard $1.00 = .50 + .50
Relative Prices in New York Relative Prices in California
1.5 Standard for 1 Choice 2 Standard for 1 Choice

of demand. In table 9.1, suppose California grapes a) cost 50¢ a pound to ship to New York, regardless of quality, and b) in California the choice grapes sell for $1 a pound and the standard grapes for 50¢ a pound. Since the cost is the same per unit of shipping either quality to New York, the price in New York is 50¢ higher than in California for both types. But in New York, a consumer of choice grapes sacrifices only 1.5 pounds of standard, whereas in California, one pound of choice costs two pounds of standard.

New Yorkers have a lower cost of choice grapes relative to standard grapes, and, therefore, in accordance with the first law of demand, they will demand a larger fraction of choice grapes than do Californians. In California, where standard grapes are cheaper than in New York relative to choice grapes, a larger fraction of standard grapes will be consumed. We don’t need to resort to conjectures about differences in “consumer tastes and preferences” to understand this phenomenon.

A general effect of an added cost to related products: an addition of a constant value to a high and to a low value will reduce the resulting ratio of the new values. The prices of high- and low-quality meat might be $10 and $5. Now, add $10 to each, which become $20 and $15. Though both absolute prices are increased equally, the high-quality meat becomes cheaper relative to the low-quality; or, in reverse, the low-quality becomes more expensive relative to the high-quality. Formerly, a purchase of high-quality meat was equivalent to giving up twice as much low-quality meat. But, with $10 added to both prices, the new price of the high-quality is lower relative to the low-quality—being only 1.33 rather than two times as expensive.

So the amount of high-quality meat demanded increases relative to the demanded amount of low-quality meat, when the price of each is increased by the same absolute amounts. The percentage reduction in demanded amount of low-quality meat is greater than for the higher-quality. Of the total demanded amount of meat, a larger proportion is now the higher-quality meat.

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Some say you could conceivably be wholly insensitive to price or that you buy just as much of a good when its price rises because you “need” that amount. Really? We have already illustrated how the “need” for such life-supporting goods as water conforms to the first law of demand. Evidence indicates also that goods like insulin are not exceptions. Diabetics can stretch intervals between injections, use lower dosages, and modify food intake. These are hazardous, unpleasant, and risky actions. But at high enough prices for insulin, that’s what happens. Again, this does not mean the substitution leaves one equally well off. But the ability to substitute makes one better off than if no adjustment were possible or utilized. Another alleged exception to the laws of demand is a prestige or “conspicuous consumption” good like Mumm champagne, Chanel purses, Cross pens, Mercedes Benz cars, Waterford crystal, or whatever the products for which the “elite” competes. Desire for prestige goods shifts upward the demand schedule, resulting in a higher price. But this says merely that a higher demand curve leads to a higher price, not that the demand curve is sloped upward. The pursuit of prestige is perfectly consistent with the laws of demand. Let the price of the prestige good be even higher, and less will be bought; else what prevents its price from going infinitely high?

Also alleged as contradictions to the laws of demand are occasions when a low price makes a potential buyer hesitate because of doubt that it could be the genuine article at that low a price. That is a sensible doubt given the fact that price commonly reflects quality. (Expensive, genuine Rolex watches sell better than curb side knock offs.) But for a given degree of belief about the quality of a good, a lower price will induce more purchases, not less. Higher-quality goods sell at higher prices to restrict the greater amount demanded of those better goods to the available supply.

The nearest thing to a real exception is the previously explained “change in wealth” effect when a person holds a large amount of the good whose price has changed, for which the oil price change was given as an example. This effect is a shift in the demand curve, not a change in the sign of its slope. Though a person’s wealth may have increased substantially when the price of some good rises, it’s still true that the amount demanded, though larger than before, is smaller than it would have been if that person’s wealth had increased by the same amount without a rise in the price.

Some people may act contrarily, giving no heed to the price of an action, no matter how costly. Such a person may well be declared “incompetent.” In fact, one basis for determining competency, according to legal standards, is the Edition: current; Page: [130] extent to which the person’s behavior is consistent with the laws of demand. If someone pays no attention to price and buys regardless of price, or throws away valuable things, these actions are inconsistent with the laws of demand, and such a person is likely to be regarded as basically confused.


  • 1)

    Why is it when a couple goes out, the probability is greater that they will attend an expensive theater if they have infants than if they are childless?


    Hiring babysitters at, say, $10 an hour and staying out for four hours will cost $40. Add the cost of two movie tickets at $10 each. Theater seats are priced at $40. So the theater costs $120 (= $80 + $40), and movies cost $60 (= $20 + $40). Taking all costs into account, the $40 theater tickets cost only twice as much as the $10 movie tickets for parents who must pay babysitters. But if a couple has no babysitter fee, the theater will cost $80 and the movie $20—a ratio of 4 to 1: theater going is relatively more expensive in real terms, that is, in terms of other goods given up for childless people.

  • 2)

    Let P1 be the price of a higher-quality version of a good, and P2 be the price of a lower-quality version. Both prices are the prices in the United States. Let T1 and T2 be the transport costs of these goods to a “foreign” market. Show that if T1/T2 < P1/P2, then relatively more of good “1” will be shipped; if the inequality is reversed, relatively more of good “2” will be shipped. “Relative” to what?


    If T1/T2 is less than P1/P2, (P1 + T1)/(P2 + T2) will be less than P1/P2. Therefore, the price (including transport) of good 1 in the more distant market will be lower relative to the price of good 2 in the more distant market. More of good 1 will be demanded than of 2 relative to that in the domestic market, because the relative price of good 1 is lower in the distant market.

  • 3)

    Explain how each of these is a denial of the law of demand and the basic postulates of economics:

    • a. “The budget of the Department of Defense covers only our basic needs and nothing more.”
    • b. “Our children need better schools.”
    • c. “Nothing is too good when it comes to education.”
    • d. “America needs more energy.”
    Edition: current; Page: [131]


    • a. There is no such thing as a basic need. We could use more security, and we could also get by with less. It’s a matter of what price we are willing to pay, and a matter of more or less, not all or none.
    • b. We “need” more of everything that is not free. The amount of any economic good we choose to have is a function of its price. To say our children need more schools ignores what we propose to give up to get more schools.
    • c. It depends upon the price, whether it is good enough to have at that price. If this says simply that more is better than less, OK. Otherwise, it seems to deny relevance of alternatives.
    • d. Same as comment to b.
  • 4)

    Diagnose and evaluate the following news report: “Our city needs more golf courses, according to a report submitted to the City Recreation and Park Department by the National Golf Foundation. The survey discovered that many people do not play as often as they would like because of the lack of courses.” Does this differ from the situation of filet mignon, champagne, and autos?


    The difference is that price is ignored in determining how many golf courses would be demanded (needed?).

  • 5)

    A competitor of the authors of this text claims his text is “invaluable.” Does that sound consistent with economic analysis?


    What does “invaluable” mean? We are reminded of a news item. “This priceless necklace is now in the possession of Mrs. Lovely, who bought it for $85,000.” Rarely do we find such an incongruous juxtaposition of obvious inconsistencies. However, in fairness to those who often use the term “priceless,” we suspect they usually mean that it is not reproducible or replaceable. Thus, a Grecian urn or an original Dufy cannot be replaced at any price if destroyed. At the same time, one should be careful not to think it can’t be bought at a finite price, or that a nonreproducible item is necessarily valuable.

  • 6)

    Economics asserts that people prefer more to less. Yet there are waiting lists of people seeking small apartments in slum areas while bigger, better apartments do not have a list of applicants. How can people want smaller, less luxurious apartments rather than bigger apartments Edition: current; Page: [132] without violating our postulates about people’s preferring more economic goods?


    If this happened with equal prices for slums and for high-quality spacious apartments, we would be stumped. In fact, however, we find that the prices of the high-quality dwellings are higher, which reduces the amount of the high-quality apartments demanded. Given the law of demand, with a sufficiently higher price of higher-quality apartments, the amount people want or demand is reduced so that it does not exceed the amount available.

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When the supplied amount of a good is less than the demanded amount, that’s usually called a “shortage.” The suppliers seem to be blamed for not supplying enough, or other demanders are accused of having too much. It is more appropriate to wonder why the price of the good failed to rise enough to clear the market and eliminate the “shortage.” “Shortages” and “surpluses” are results of a failure of an adjustment in the market price.


The “market-clearing price” is a price at which the amount demanded equals the amount supplied. All mutually desired exchanges at that price will be accomplished. It’s also called an “equilibrium” price. That is an idealized—but exceedingly useful—concept.

For the real world, market prices are pushed toward the market-clearing price—that at which all mutually preferred exchanges can be “cleared,” that is, accomplished. This presumes that people who propose exchanges are reliable and do what they say they will. (We defer analysis of less reliable behavior to later chapters.) In saying that “price depends on demand and supply,” the analysis pertains to what changes in price are induced by changes in supply and demand.


How do changes in price help people adjust to new mutually preferred situations? This can be most easily illustrated first in situations where the supplied amount is a fixed total despite a change in the market price, as it is for houses, at least for a few weeks. Any increase in the amount available is so small, relative to the existing total, that we can treat the supply amount as given. A fixed supply situation applies to many goods, even if only for a very short interval. For some things, such as land or Michelangelo statues, it’s constant for a very long time, at least for increases. Land can be considered as fixed in amount, though level land can be created from hilly land by hard work. Setting aside those refinements, we’ll look first at fixed supply situations—meaning the amount Edition: current; Page: [134] supplied does not respond to changes in price. More might be produced, but we’ll confine our initial analysis to effects of price adjustments in the interval before the total supply is affected. That interval is the “market period.”


It can be misleading to say “the market sets the price.” The market is an arrangement and process for comparing people’s demands and offerings and for conducting exchanges of private property rights. People search for and compare options prior to agreeing to an exchange, and that competition drives the prices of all the exchanges toward the same price—the market price. Saying the “market” sets the price is a superficial way of recognizing that all who buy and sell in markets have an influence in the determination of prices.


Table 10.1 describes a society of four persons, A, B, C, and D, and seven automobiles. The number of cars initially owned by each person is in the top row. The demanded amounts for each person at various possible prices are listed in

Table 10.1 Auto Ownership Demands of A, B, C, and D
Price A has 4 cars B has 3 cars Chas none Dhas none “Market Demand”
A initially owns 4 cars. At price $2,000, he will be satisfied with only 3, that is, he is willing to sell 1 car for $2,000. B starts with 3 cars, and is willing to reduce his holdings to 2 by selling a car for $3,000. C would pay as much as $10,000, but he can bargain to buy from A for $2,000. And D also values a car at $10,000, but he may find that B will sell for $3,000. As trading goes on, the price in the uncleared market approaches $7,000. At $7,000, each of the four people has the number of cars he wants at that price, the total demanded being 7 cars, equal to the total number available, and the market is cleared.
$10,000 1 0 1 1 3
9,000 1 1 1 2 5
9,000 2 1 1 2 6
7,000 2 1 2 2 7 Equilibrium
6,000 2 2 2 2 8
5,000 2 2 2 2 8
4,000 2 2 2 3 9
3,000 3 2 2 3 10
2,000 3 3 2 3 11
1,000 4 4 2 4 14
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the columns for A, B, C, and D. The extreme right-hand column lists the total amounts demanded by the community at the alternative prices. It’s the “market demand,” the sum of all the individual demands. We presume that no person’s wealth, and hence demand schedule for cars, is changed significantly by the sequence of trades.

The market price is established by competition in the market although no one acts as if the market price could be affected by that person’s demand or amounts offered of the good. What’s the final “equilibrating” distribution and market price if the cars can be sold among the members of this community?


Many different sequences of purchases are possible from the initial allocation, when A has 4, B has 3, and C and D each have none.

C and D are each willing to offer up to $10,000 for a car, but they discover, after some shopping, that they can for only $2,000 buy a car from A and one from B at $3,000. A would then have 3 cars, B would have 2 cars, and C and D would each have 1 car. C could buy another car by offering $4,000 to A, leaving him with 2 cars. C then has 2 cars, with the second car being worth $7,000 to C, though it was bought for $4,000. D would offer up to $9,000 for a second car, but can buy it from B for $7,000. After that transaction, A has 2 cars, B has 1, and C and D have 2 each, for a total of 7 cars.

No one could buy another car at any price less than $7,000, and no one would demand another at $7,000, which is therefore the clearing price. The amount each person has equals the amount each demands at that price, and the total amount demanded equals the total supply of cars. At every step in the sequence of trades, each party was moved to a personally higher-valued, “more preferred,” situation.

No matter what the initial allocation of cars among the public, the cars will end up in the same allocation among the demanders. We assumed this re allocation does not affect anyone’s wealth enough to alter his demand. If it did, some market-clearing price still would be achieved, with everyone having as many cars as demanded.

If a car were destroyed, the resulting series of exchanges would depend on whose car was destroyed. But the resulting pattern of ownership of cars would not depend on who suffered the initial loss of a car, assuming that the loss does not affect that person’s demand. In every circumstance, competition in the market for cars results in a distribution and market price at which each person owns the number each demands at the resulting market-clearing price.

Resources will be pushed toward their highest market-valued uses, no Edition: current; Page: [136] matter who initially owns the income-producing resources as private property. That’s a consequence of everyone’s desire for more wealth.


“Shortages” are not results of too little being supplied to the market. They are results of restrictions on prices. And a shortage should not be confused with universal, inescapable, pervasive “scarcity.” As we’ll explain later, “ceilings” on higher rents as part of a rent control program create “shortages” and wasteful forms of competition. These shortages often provoke a surplus of complaints that “needs” aren’t being satisfied. And surpluses of goods are the result of legislation or regulation prohibiting transactions at prices below the free-market price.

Neither a shift in the supply curve nor in the demand curve is required to eliminate a shortage or a surplus. Instead, they are results of laws that restrict prices. And yet, there is persistent agitation by “housing consumers” to impose “rent controls” with too-low rent ceilings for apartments. In the opposite direction, farmer “food producers”—in almost every nation—have successfully lobbied for governments to prohibit sales of agricultural goods below a price “floor.” The result has been a “surplus” of production in excess of the amount demanded at the legislated higher price.


The operation of a market depends critically on the kind of rights that can be traded. What’s traded are titles, or rights—not the goods themselves which may be located someplace else and immovable, such as land and buildings. We have been concentrating on exchanges of private property rights in a “capitalistic” market. A “political market” would refer to trades of government actions.

Young people—usually defined as less than eighteen years old—are considered by the law as “legally incompetent” to know the implications of the rights being transferred. “Minors” don’t have rights to buy or sell many specified rights—for example, tobacco, alcohol, guns, specific movies, marriage licenses. On the day after age eighteen or twenty-one, the legal system presumes that individuals become fully competent and aware of the rights being transferred. But “rights” in exchanges are not always clear-cut.

Does the “seller” really confer the rights you think you will be getting? Why are you asked to sign some papers? You don’t have to sign papers when paying cash—but do not throw away the “bill of sale” receipt handed you by the seller, because you might have to establish your ownership rights to the goods when you walk out of the store.

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When paying tuition to attend college, did you sign a contract specifying what rights you and the college have with respect to each other? Probably not. Are the rights you got as simple as those for “attending” a movie by paying the ticket price (tuition)? It’s astounding how often we buy a “pig in a poke,” not knowing what rights are specified, or what rights the seller obtained with respect to your future actions.


Some markets are created and organized as business ventures. The range of “formal markets” extends from stock, bond, and commodity “exchanges” to shopping malls and weekend flea markets and garage sales. While not all are equally reliable, the owners of the market institutions provide more than a convenient place or means of exchanging information. They also provide assurance that what you get is really what you were told you would get. And the seller is guaranteed that the money you agree to pay is actually paid.

The buyer or the seller may not care who are the intermediaries in an exchange. The owners of the major stock exchanges are highly reliable intermediaries who pay money to the seller and deliver to the buyer ownership rights of the purchased stocks and bonds. That reliability is strengthened by surveillance of federal regulatory commissions.

In a well-functioning market, the prices of a good asked by sellers and offered by buyers are sufficiently close together that there’s no way remaining for anyone to make a profit by purchasing from a lower-price seller and selling to a higher-priced buyer. In other words, “arbitrage” assures that there are no certain opportunities to profit remaining in a well-functioning market.


For durable resalable goods, such as land, houses, and corporation stocks and bonds, it’s helpful to think of a “demand” schedule that measures the amounts a person demands to own, or have, depending on its market price. The amounts to purchase would depend on the amount already owned and the amount a person wants to own at alternative prices. If at the existing market price of the good, you own 3 units, but you want to own 5 units at that price, the purchase amount demanded is 2. Your total “reservation” demand amount at that price is 5 units, and your additional purchase demand amount is 2 units. For price behavior of a durable good of which there is a large amount in existence, the reservation demand for amounts to own can be more important than the rate of production and purchase of additional or new items.

Stocks and bonds, existing houses, used cars, and land are common examples Edition: current; Page: [138] of items being bought and sold without any change in demand or supply or in production and consumption of the good. You buy some when the amount you demand exceeds the amount you have. The law of demand still is operative in that the higher the market price of a good, the less of that good a person will want to own.

Variations in extent of market transactions may reflect merely some adjustments to shuffling individual demands, increasing for some people and decreasing for others, while the aggregate “market” demand for ownership may be unchanged. If Jack’s demand to own rises by an amount that exactly offsets Jill’s decline in demand to own, that will create sales from Jill to Jack, but not necessarily a change in price, because aggregate demand to own has not changed. The extent of market transactions of durable goods reflects adjustments to changes among people in their demands for that kind of good, not necessarily a general rise or decline in aggregate market demand.

When referring to a “demand,” be clear whether you mean 1) the amounts a person wants to own at different prices or 2) the rates of purchase and consumption at alternative prices or 3) the amount to be bought or sold at a moment in time. More often, we’ll be using the rate of purchase demand, such as when thinking of goods that are consumed or used in production at a fairly stable rate.


Finally, consider some meanings of the word “rent.” Fortunately, the context of use usually will reveal the meaning. Often, “rent” means the “value of services of a durable resource.” It can mean the user’s payment made to the resource owner, such as the “rent paid” to the owner of a rented apartment. It can mean also the service value from some resource you own and use yourself, though you don’t pay yourself.


Rent often means the excess of the value of services over the current costs of using existing durable goods. The service of land is almost universally called “rent,” because land tends to be “permanent,” or very long lasting, and with little damage to the value of the land when it’s used. With “insignificant” costs of wear and tear and replacement, all the payment could be called a “rent”—an excess of what is obtained over the costs of maintaining the existing resource.

A physician who starts practice will receive an income that contains some rent, because once educated as a doctor, some of the doctor’s services would be provided even at an income lower than that which would cover the sunk cost of the education. A person contemplating becoming a doctor would not view Edition: current; Page: [139] that large anticipated future reward as a “rent.” The anticipation of that reward is necessary to induce the investment in becoming a doctor. However, once educated, those costs are sunk and irrelevant for the existing doctor to provide the services.

This is the same for paintings, books, and for every good that has some durability. The concept “rents” is necessary for avoiding confusion when considering the otherwise mysterious relation between “costs” of the current service and the effects of price changes on future supply.

A price change of an existing good or asset does two things: 1) it influences the allocation of goods or assets to their most valued uses and 2) it affects the future supply of those goods or assets that can be created.


When the value of services of an existing resource has no effect now or in the future on the services supplied by that resource, the service (or the price received by the owner if used by someone else) is called “pure rent.” The supply curve of the land services is vertical at the existing rate of service. If the land is considered “permanent,” the service value is called “rent.” If the amount supplied in the future responded, though not soon enough to affect its current rental or use value, the rent for its current services is a “quasi-rent,” to indicate it won’t last long.

More generally, “rent” for an existing house or a building is a “quasi-rent,” because the resource yielding the service is not permanently durable. The earnings to Tiger Woods for playing golf contain “quasi-rent,” being more than necessary to induce him to compete, but perishable in time. Almost everyone has obtained some “quasi-rents” or hope they will. Though not altering the immediate amount supplied, reallocating the presently existing supply toward higher-valued uses maximizes the “rent” component of earnings. The effect of an increased prospective quasi-rent is to speed revision toward prospective higher-valued uses, though not in the immediate amount of the good yielding the quasi-rent.


A modified use of the word “rent” is the phrase “political rent-seeking,” often shortened to “rent-seeking.” It means attempts to obtain political influence for special government benefits that cost society more than the worth of the benefits obtained by the “rent-seeker.”

Tariffs on imports of automobiles reduce consumer worth more than the gains to the political rent-seekers—the domestic automakers. Contributions Edition: current; Page: [140] made to political parties to obtain legislation or regulations that handicap competitors are a form of “political rent-seeking.” Government administrators inevitably are targets of “political rent-seekers.”


Market: An arrangement, place, or device where or by which offers and bids for goods can be communicated and sales-purchases are being made.

Market Price: The price agreed to by both the seller and the buyer in actual market transactions.

Market-Clearing Price: Price at which amounts demanded equal amounts offered. Same as “equilibrium” price.

Shortage: Excess of amount demanded over the amount supplied at the existing, non-market-clearing price. Always a result of price controls.

Surplus: Reverse of shortage. An amount supplied that exceeds amount demanded at the existing non-market-clearing price is always a result of too high a price.

Demand: The schedule of amounts demanded for purchase at various possible market prices.

Demanded Amount: The amount demanded at a specified price.

Market Demand: Schedule of amounts demanded by all demanders from all suppliers in a market at possible market prices.

Reservation Demand: Schedule of amounts already owned and which, depending on the market price, would be retained rather than offered for sale.

Rent: The value of the services of a durable resource.

Economic Rent: A rent that does not affect either the present or the future amount of that good.

Quasi-Rent: A payment or service value that does not affect the amount currently available, but affects the future amount.

Political Rent-Seeking: Attempts to obtain political influence for special government benefits that cost society more than the worth of benefits obtained by the “rent-seeker.”

Communal Government Ownership: Every person in the society bears some of the consequences of changes in values of all durable goods, whereas in a private property society people can each choose which goods they own and which risks to bear as a consequence of changes in market values. This is discussed at greater length in later chapters.

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  • 1)

    The demands to own by A and by B for good X are:

    Table 10.2
    Price A’s Demand B’s Demand Market Demand
    $10 0 0 ______
    9 1 0 ______
    8 2 0 ______
    7 3 1 ______
    6 4 2 ______
    5 5 3 ______
    4 6 3 ______
    3 7 4 ______
    2 8 5 ______
    1 9 6 ______
    • a. What is the market demand by A and B?
    • b. If six units of X are available, what will be the resulting allocation between A and B if open-market exchange is used?
    • c. With six units available, if price were legally imposed at $4, would there be a shortage, a surplus, or exchange equilibrium?
    • d. If the price were legally imposed at $9, would there be a shortage, a surplus, or exchange equilibrium?
    • e. How can there be a change from a shortage to a surplus without any change in supply or demand?


    • a. 0, 1, 2, 4, 6, 8, 9, 11, 13, 15 for prices from 10 through 1.
    • b. 4 to A and 2 to B.
    • c. Shortage.
    • d. Surplus.
    • e. There is a change in the stipulated or imposed (disequilibrium) price.
  • 2)

    In the previous question, increase the amounts demanded by B uniformly by two more units at each price.

    • a. What will be the new open-market price?
    • b. What will be the allocation between A and B?
    • c. If the price is held at the old level by law, will there be a surplus or a shortage?
    • d. How can that surplus or shortage be eliminated?
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    • a. $7.
    • b. 3 to each.
    • c. Shortage.
    • d. Remove the price control.
  • 3)

    Distinguish between the law of demand and the law of market price (which says price equates the amount supplied to the amount demanded). Which holds more generally?


    The law of demand relates purchase rate to price. The law of demand and supply states price is at the intersection of supply and demand. The law of demand holds generally; the law of supply and demand at market price may be made ineffective by governmental suspension of the open market.

  • 4)

    A Petroleum Crisis? Occasionally, charts are published plotting quantities of so-called demand and supply of something against future time. If the anticipated demand is greater than the supply (perhaps for petroleum), we supposedly will be facing an oil crisis; if supply is greater (maybe for engineers), we are to expect a glut of such specialists. Why are such diagrams fallacious and just plain wrong?


    The price is ignored in its effect on amounts demanded and supplied. Past balance or equality reflects the simple fact that the price was allowed to adjust up or down so as to equate amounts demanded with amounts supplied. Any particular forecast path of amount demanded must presume some particular price in each year. A higher projected price would reduce the amount demanded and raise the amount supplied, keeping them equal. An appropriate path of price over the future will affect the amounts demanded and the amounts supplied so as to keep the two equated. Every such projected future imbalance of amounts demanded (probably labeled “needs,” “requirements,” or “demand”) with amounts supplied of any good (probably labeled “supply,” “availabilities,” or “stocks”) is merely a prediction that price will not be allowed to move to equate amounts demanded with amounts supplied.

  • 5)

    When prices on the stock market fall, the financial pages report heavy selling; yet every share sold is bought by someone. Why don’t they refer to heavy buying?

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    They probably use the phrase “heavy selling” to mean increased supply—or so we hope.

  • 6)

    Which tactic would be more likely to get you a lower price on a new car: going to just one dealer and acting like a tough and aggressive bargainer or going to several dealers and mildly asking for their selling price while letting it be known that you really intend to buy a car and are shopping around? Explain why.


    Shopping several sellers is better because alternatives are what sellers must beat. It’s sellers who compete against other sellers, not buyers who compete against sellers.

  • 7)

    Are the words “scarcity,” “reduced supply,” and “shortage” synonyms? If not, what is the difference?


    Scarcity is pervasive, for we have available less than is desired, but what people call shortages are simply the result of prices that are kept too low. A reduced supply is not a shortage. A reduced supply is a reduction in the amount available—pictured as a shift to the left of the supply curve.

  • 8)

    “Under open-market, private property pricing, a person is allowed to make any kind of appeal to a seller to get some of the good. Under price controls, the buyer is told that there is one appeal he cannot use—that is, offer a larger amount of other goods.” True or false?


    True. “A larger amount of other goods” is an increased price offer, which is precluded by the price control.

  • 9)

    You are collecting data for a cost-of-living survey. For each of the cases below, which “price” would you report as the price? Why?

    • a. “List price $125. Special discount to $90!”
    • b. “Get a $1 box of Kleenex for only 29 cents.”
    • c. “One cent sale. First for $1. Second for 1 cent.”


    Sales price, if goods were available at that price at the time of sale. Price means actual exchange prices.

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  • 10)

    “Allowing the prices of goods to rise when more of the good cannot be produced is immoral, because the higher prices do not induce a larger output. They merely give unwarranted profits to those who are lucky enough to own the goods. Either prices should be prevented from rising, or the government should take over ownership in order to prevent unjust enrichment.” Do you agree with this analysis?


    You should disagree. A higher price permits a reallocation of existing goods—a reallocation that would not occur in the absence of higher prices. The higher price serves a rationing function even if the amount of the good is fixed and more of the good cannot be produced. Higher prices do have a consequence—reallocation—moving resources from one use or user to another.

  • 11)

    “The community’s demand to own houses may remain unchanged; yet the market demand to purchase and to sell houses may change enormously.” Explain how the demand to hold houses (in a two-person community) could be unchanged while the demand to purchase and sell houses increased.


    When the demand of some people to purchase houses is exactly offset by other people’s supply of houses for sale, overall demand and supply remain unchanged. Exactly offsetting shifts in the demand to purchase the supply for sale are rare, so the market price moves to adjust the mismatched demands and supplies.

  • 12)

    “It is wrong to profit from someone else’s misfortune.”

    • a. Explain why, if that were taken literally, we would all be poorer.
    • b. Does the doctor profit from your illness? The farmer from your hunger? The shoemaker from your tender feet? The teacher from your ignorance?


    • a. All voluntary exchange benefits both parties.
    • b. Yes.
  • 13)

    An open-market system presumes enforcement of certain institutions or rules. What are they?

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    1) Open access to markets with rights to trade or exchange; 2) private property rights in goods and services; it’s also presumed that 3) each person has a desire to achieve a more preferred situation—in this case through increased profits and lower costs of getting the products.

  • 14)

    When you hear, “Everyone is selling, and driving down the price,” you should respond, “For each sale, there is a buyer! Why aren’t the buyers driving up the price?”


    Of course, what is sold is bought. But in an open market, each trader ends with the amount he demands at the resulting market-clearing (equilibrium) price.

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Prices commonly adjust rapidly to clear the market. However, several marketing arrangements and processes that help make markets work better also slow the pace of price adjustments, and that tends to mask how markets work. In this chapter, we first explore how two of these arrangements—inventories and productive capacity—delay price changes and obscure the source of these changes. Then, we’ll use demand and supply analysis to deduce land price adjustments to a tax on land, and who actually pays the tax and who benefits. Last, we extend the analysis of land values to some consequences of pollution reduction and see a reason landowners play so strong a role in governments.


Stable and Predictable Prices

Imagine a restaurant in which the price of food and service is adjusted instantly to avoid any waiting. With uncertain prices, planning by diners would be more difficult. Willingness to wait a bit for a table can permit more convenient planning and action on the basis of predictable prices and costs.

Some degree of price stability—as a means of producing price predictability—is desired, despite the resulting transient imbalances between amounts demanded and supplied. The extent of price stability depends, in part, on the cost of holding inventories and on the value of timing of delivery of the product. It depends also on the value to customers of reliably predictable prices, when potential customers are making investments preparatory to purchases.

Because the costs and benefits of predictable or stable prices vary among customers and types of services, some sellers hold prices steady despite increased general demand and ration in favor of certain customers. Others let the price vary to clear the market to the highest demanders at the moment, without any favoritism. We’ll see why each of these occur for “sensible” reasons appropriate to particular circumstances.

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Why do sellers hold inventories of goods? One reason is that shoppers can then inspect and compare goods before deciding whether or not to buy. A second is that customers’ purchases fluctuate daily. Neither consumers nor suppliers know exactly who will want to buy how much of what in any given hour, day, or week. Inventories act as buffers to accommodate the variations in transient, unpredictable fluctuations in amount demanded.

Consider the options of a newsstand selling a daily average of 100 copies—but not exactly 100 each day. The seller could: (1) require buyers to place advance orders; (2) buy fewer than 100 copies and rarely have unsold copies; (3) buy more than 100 and usually have copies left over; (4) buy 1 copy at a time, replenishing a stock by special delivery service when the copy is sold.

While each of these alternatives has been used for various goods, in the case of newspaper sales, the third option, inventories, is common. Customers are willing to pay a slightly higher price, which covers the cost of unsold copies, in order to have immediate availability at a predictable price. The cost of inventories may result in a smaller paper or fewer retail outlets, but this will result also in a lower full cost/price to consumers than will the other options. Thus, a third reason for inventories is that they help a seller maintain stable, reliably predictable prices despite minor fluctuations in demand and supply, thereby helping customers plan their shopping.

Reserve Capacity

Capacity is a form of inventories—of productive resources. It’s sometimes called “excess” because it is almost never fully used. But Palm Springs, Sun Valley, and Orlando do not have “too many” hotel rooms for rent just because some are unused at almost any given time.

Nor are empty apartments necessarily wasteful if demand is not perfectly predictable. Though rents may be higher to cover costs of buffer vacancies to accommodate shifting demands, vacancies permit lower search costs and enable people to move without committing themselves long in advance. Housing costs seemingly could be reduced by building fewer houses with fewer vacancies, but that would increase the inconvenience of advance planning and commitments, and thus increase the full cost of housing.

Imagine what it would be like to try to move into a community with no current vacancies and have to wait until someone moved. The inventory of vacant housing serves a useful purpose. It has been estimated (we don’t know how reliably) that something like 5 percent of the rent paid by apartment dwellers Edition: current; Page: [148] covers the cost of providing vacancies to accommodate the unpredictability of amount and timing of demand. Neither second bathrooms and toilets, nor extra dining room chairs, nor fire extinguishers are wasteful just because they aren’t always in use.

We turn to examining how some markets work in various situations. Often cause and effect are easily reversed. The next chapter will derive some (probably surprising) implied effects of price controls.


Buffer stocks, inventories, and reserve capacity help make it appear as if prices are sluggish or inflexible and are determined by costs, instead of by competition among consumer-demanders. Suppose that for some reason (possibly higher incomes) demand for meat increases. As sales and consumption increase, butchers’ inventories are unexpectedly depleted. Normally, as with any retailer, inventories are large enough to accommodate transiently increased sales without producers having to raise prices. Inventories larger than an average day’s sales help assure that supplies are immediately available to demanders at predictable prices.

One day’s above-average sales is not regarded instantly as a persistent increase at that price; nor is it viewed as a long-term sales increase that requires a higher price to keep inventories from being further depleted. When the increase in sales reflects a higher average demand, no seller will be able to detect the increase in demand immediately. A high transient deviation may induce retailers to purchase more for replacement of normal inventories, but they would buy even more if they knew the long-term demand had increased.

If the public’s aggregate demand really had increased (not just toward this one butcher and away from other butchers), the demand by all butchers to restore inventories would increase the demand facing the meat packer-suppliers. Packers will see their inventories declining as they supply more meat to retailers.

To replenish their extraordinarily depleted inventories, packers will compete with each other for more cattle than before. But with an unchanged supply of cattle, some packers must get less than the increased amount they demand at the old price. They bid up the price of cattle. The packers are, in this scenario, the first to see a price (cattle cost) rise consequent to the increased consumer demand, and they will correctly interpret that as a rise in their costs.

The existence of inventories in the chain of suppliers from producer to consumer can cause a delay during which the increased consumer demand is communicated Edition: current; Page: [149] from retailers to initial producers. That delays the price increase until the cattle-producer stage.


Packers raise their prices to retailers, saying their prices are higher because their costs are higher. But we know that costs are higher because it was the increased consumer demand that prompted a higher price of cattle at the feedlot. Because of the increased consumer demand, a higher price is obtained and maintained in the consumer market. When consumers complain about the higher price of meat, butchers say it isn’t their fault. Their costs have gone up. And the packers can say the same. To see who really was responsible for the higher prices, the consumers can look in the mirror behind the butcher’s counter and see themselves.

Not all prices adjust instantly to the new equilibrium price to clear the market, as they do in the organized stock and commodity markets. In fact, a lag occurs between the time some demand or supply situation has changed and the time people detect and distinguish that from a random, transient, reversible change in the current purchase rates or in supply conditions.

As emphasized earlier, the amount demanded may refer to the underlying average amount demanded in an interval, with momentary random offsetting deviations taking place around that average value. Because of the transient variations around the average, a shift in that average may be hard to detect quickly. An increase in sales may be interpreted as only a randomly high sales rate, rather than as a new higher normal sales rate. And once a seller begins to suspect that demand has shifted, difficulties exist in knowing what are the best adjustments to make in supply response.

If the demand is believed to have fallen, should a supplier shift to some other production activity or should the price be lowered and work continued at a lower rate? Should an employer attempt to reduce wages of employees immediately when sales fall?

So-called delays and lags in adjusting price or output are the result of inability to foresee the future perfectly and to understand what really is happening. They are not results of some inherent inflexibility in, or inability to change, prices. It takes time to decide that an underlying change, rather than a random, transient deviation has occurred. And the time it takes to discover what is the most appropriate adjustment misleads outside observers into thinking that prices are “rigid.” Prices actually are instantly flexible—as instantly as it is discovered that a change is appropriate.

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A universal rule of economic analysis is: Without a shift in the demand (curve) or the supply (curve), the price won’t change. So when price changes, or when asking what is the effect of a price change, first ask what made the price change. Did that initiating event shift the demand curve or did it shift the supply curve (or possibly both)?

Did a price rise because of a reduction in supply, or was the cause an increase in demand? And why did that initiating event occur? Then, investigate the effect of a change in price. Don’t confuse a) the many effects of the change that caused the price movement with b) the effect of the price change.

A second rule of analysis is that if both supply and demand shifted, you must know in what directions they shifted. Thus, before you assert that a rise in the price of wheat will reduce the amount of wheat demanded, be sure the event that raised the price of wheat didn’t also shift the supply of wheat.


A developer proposes to buy some land and construct apartment buildings. As a condition of granting the building permit, the local government requires amenities (like parking spaces and green areas) to a greater extent than the developer would find it profitable based on how much the occupants would be willing to pay for those amenities.

If the rental value of those required additions had exceeded their costs, they would have been voluntarily provided without the law. When they don’t, who bears the excess of added costs over the value of the added amenities to the occupants? Neither the developer nor the occupant. These mandated costs are borne by the original owner of the land from whom the developer proposes to buy the land.

Being aware of the requirement for a building permit, potential developers would offer less for the land because of the costs of added amenities that exceed their worth to renters. But suppose there are benefits to other people who will not become renters. The increased parking spaces may reduce congestion on the streets and thereby make local travel safer and faster. Would that added “public benefit” imply that the “excess” cost of “excessive” parking space may not have been a waste? If not a waste but a net gain to the community, the question would then be: Is it “desirable” that the original land owner should be the Edition: current; Page: [151] one who bears the costs for better travel on streets, or should it be the users of the streets? Later chapters on property rights will discuss such questions.


Sometimes it is contended that land should be taxed, because land rent value is a social surplus in the sense that its receipt by the landowner has no effect on the supply or use of the land. This used to be called a “single tax” by people who believed that that tax alone would be sufficient to finance all governmental actions. It has been argued that the supply of land is fixed and won’t be diminished whether a “landowner” or the government collects the rent. The land will still be used in its most valuable ways. The only difference is in who gets the rent. That’s correct analysis—so far.

Of course, not all land is really costless to maintain or protect from erosion. In addition, filling in bays and swamps can create more land, and no one would do that if the resultant rental value were all taxed away. Nevertheless, compared to a tax on anything else, a land tax has relatively small diversionary effects in the sense of affecting the supply. The immobility of land is a reason it’s heavily taxed. The fact that it’s fixed in amount is less relevant, as can be seen in comparing land to Picasso paintings. His paintings are in fixed supply, but they can be moved to areas where taxes are lower.


As another application of demand and supply analysis with fixed supply, imagine that the authors of this text possessed a magic capsule, which, if crushed, would permanently and costlessly cleanse the air of smog over the city of their residence, Los Angeles. The improved air would lead current residents to place a higher personal worth on land in the area. That would increase the demand for land and raise the price of the land.

Those people who were repelled by the smog and refused to move to Los Angeles will now do so and add to the demand for Los Angeles land. The increase in demand would result in a higher rent to occupy land and a higher price to purchase it.

Better Air versus More Other Goods

Renters would be paying higher rent for the land, sacrificing other goods with the equivalent market value of the better air. (As a result, they would not necessarily achieve improvements in their overall situation.) However, the original landowners unambiguously gain wealth (equaling the value of the improved air Edition: current; Page: [152] captured in the increased rents paid by the renters). There has been a transfer of wealth or income from one group to another. Is it worth removing the smog, even if costlessly, for that result? If we were major landowners the answer would be, “Yes.” If we had been renters, the answer might be, “No.”

Existing Resident Renters versus Newcomers

Consider the newcomers. They had not moved to Los Angeles earlier because the old air quality was not worth the land rent they would have to pay. The existing residents in Los Angeles did not consider the former smog level so bad as to prevent their living in that area. The potential newcomers placed a higher personal worth on cleaner air than did the existing residents.

After we crush the capsule, the newcomers will bid up the rents for the now smog-free land to reflect their higher marginal worth of the cleaner air—higher than the marginal worth obtained by the prior existing residents. The newcomers, from the Midwest and East, attracted by the now better air, will certainly be beneficiaries, as will be the landowners. Some of the prior resident renters, faced with higher rents, will lose. No one knows whether the prior renters will gain or lose on net.

Which Land Values Increase?

The authors own land near the Pacific Ocean in the fringe area where there is no smog. Removing all smog in the region would lower our ocean-area land values, because people would tend to move closer to the center of Los Angeles that used to be smoggy. We are like landowners of the Midwest, who would suffer a land value loss as people migrated toward the now less-smoggy west coast.

We, therefore, would not crush the magic capsule to remove the smog. We would lose, despite the gains to others. Or so it would seem, at first sight. However, if we possessed such a capsule, we would be induced to crush it and improve the air, regardless of the loss of value of our land. Why? The landowners in the area now heavily infested with smog would offer us a large part of the potential increase in their land values that would occur if the capsule were crushed. They could “bribe” us with part of their gains and still be better off than before. That’s an offer we couldn’t refuse, and so the capsule would be crushed.

Actually, only costly methods are available for reducing smog. Considering the implications of the preceding analysis, who should bear the costs of reducing the smog? That question is more complicated than most suppose.

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Improved Air over Entire Nation

Let’s now extend our example of improved air from an improvement of the air in one locality to an improvement of the national area. If the crushed capsule removed smog from the entire nation, landowners in some regions would benefit more than those in other areas. People living in the Great Heartland are living there now partly because there is less smog in that area. With all smog eliminated everywhere, Los Angeles would gain relatively in attractiveness. There is less smog everywhere, but land values rise more in places that formerly had more smog. And they rise because the smog-disliking residents of the Great Heartland prefer Los Angeles without smog to the Midwest without smog.


  • 1)

    “The rent for land in New York City is not a payment necessary to produce the land. It is a necessary payment to obtain use of the land. From the first point of view, it is an economic rent; from the latter point of view, it is a cost.” Do you agree?



  • 2)

    It has been estimated that carrying a spare tire on automobiles costs the public millions of dollars every year. Is this a waste of idle resources? What would be the cost if that figure were cut to zero by not carrying any spare tires?


    A spare tire—idle resources—is a way of adjusting to uncertainty and unanticipated future changes or “emergencies.” If no spare tires were carried, other more expensive adjustments would be made at the time the flat occurred. For example, a taxi or emergency road service could be called—both of which could involve not only the price of the service but additional costs of delay (such as missed or late meetings, appointments, and deliveries). Uncertainty is a fact of life, and information and adjusting to unanticipated changes is costly. Costs are higher for more rapidly acquiring information and adjusting to physical changes.

  • 3)

    You are constructing an apartment building. You can build one with many units and have vacancies sometimes, or you can build a smaller unit and have a no-vacancy sign virtually all the time. If the latter behavior Edition: current; Page: [154] is profitable, can the procedure of having vacancies sometimes be even more profitable?


    Yes. It pays to have some vacancies in order to satisfy unpredictable fluctuations in demand rather than instantaneously changing rents and keeping the apartments fully occupied. In maintaining some vacancies, the apartment owner is accommodating renters desiring to be able to move when they want to rather than having to make costly advance preparations, such as matching a departing tenant’s move-out date with the incoming tenant’s move-in date. Maintaining some vacancies economizes on the high costs of predicting the future and of immediately producing whatever a person wants. Alternatively, we could reduce housing costs by more advance planning of people’s activities and by refusing to allow them to change their minds; to do this would reduce housing services and convenience and raise other adjustment costs. And it would reduce liberty.

  • 4)

    Idle resources buffer against uncertainty. Consider the amount of money you hold; items in the medicine cabinet; food kept in the refrigerator, freezer, and in canned goods; fire extinguishers; general education. Are these idle, unemployed—and thus wasted—resources?


    It is efficient to hold some resources in inventory for ready access when wanted for use; some inventory—for example, fire extinguishers—you hope never to have occasion to use.

  • 5)

    Economics suggests that if cheap enough methods are invented for metering the extent to which each motorist uses a street, streets are rationed more with a price system. Do you know of any such cases now in use?


    Tolls on bridges; parking meters; tollways; “turnpikes” with usage charges. In some countries, cars using highways must be equipped with transponders and the motorist is charged for distance driven, based on day of week and time of day.

  • 6)

    Shopping centers often provide free parking spaces, some of which are used by nonshoppers. Perhaps the free spaces provided are more than would be required to clear the market if a charge is levied to cover the construction and maintenance costs. However, policing “pay” Edition: current; Page: [155] parking space involves costs of estimating charges, collecting fees, and prosecuting violators. With such costs, might it be better to provide “too much” parking space than to provide the “right” amount with a price-rationing system?


    While it is not possible to know what is necessarily better, the total cost of providing parking space could be cheaper if it were not policed as carefully as a park-for-pay lot. A free lot would impose the costs on those who purchase from the persons who provide the free parking lot, but not on those who use the lot without doing any business with the providers of the space.

  • 7)

    The Council of Economic Advisers (to the president of the United States) once argued that keeping down the price of cattle could keep down the price of meat to the consumer. The Federal Energy Agency once asserted that holding down crude oil prices reduces the price of gasoline (made from crude oil). Explain why economic analysis rejects these contentions.


    Holding down the wholesale price of cattle to the meat processors increases the spread between purchase price and selling price for processors. The price to consumers would rise anyway if there is increased demand for meat. The wealth that would have been available to cattle growers is instead given to the cattle processors. The reasoning is analogous for oil.

  • 8)

    “Higher prices cause higher costs.” Explain.


    Price increases often appear to be set by rising costs rather than by competition for consumer goods. This occurs because the way prices rise in response to increased demand is often hidden by inventories in the distribution process from manufacturer to wholesaler to retailer. When demand increases, sales at the existing price rise. Retailers often hold inventories to accommodate uncertainty about consumers’ purchases (rather than by requiring advance orders, prepayment, or instantly raising prices). When their inventories are depleted faster than expected, the result is passed along to their wholesalers, then to manufacturers who turn to suppliers for additional raw materials. Prices of raw materials are bid up, which manufacturers see as higher costs. Those higher costs are reflected in the higher prices manufacturers charge wholesalers and that wholesalers charge retailers and are ultimately reflected in higher prices to consumers. Hence, although it appears to be higher costs that cause higher prices, it’s Edition: current; Page: [156] the increase in demand that causes the higher costs and subsequent higher prices. Earlier in this chapter, we considered how increased meat demand raises the price of cattle, which appears as higher costs to meat packers, butchers, and ultimately higher meat prices for consumers.

  • 9)

    “Demand-and-supply is not simply a classification that is applicable only to private property market exchange. It is applicable to any problem of allocating scarce resources among competing uses. In any given possible use, the usefulness of the resource in that use is what is meant by its demand, while its usefulness in all alternative uses (against which this particular use must compete) is the supply.” Do you agree?


    Yes, demand reflects the worth or value of a resource in a specific use while supply reflects the value of the resource in all other uses. All systems for determining who gets what resources are discriminatory through some process or mechanism. Under private property and open markets, competition for resources is heavily influenced by money—the amount of other goods offered. Under a non-private-property system—such as the socialist system—nonmoney criteria such as persuasion, personal connections, personality, appearance, and cultural features become more dominant.

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In chapter 10, we noted that shortages and surpluses are not caused by changes in the supply of a good. They are caused by failure of the market price to adjust to changes in demand or in supply. Sometimes the adjustment is prevented by a law or regulation that restricts market prices. And sometimes the seller refuses to change the price. Those restraints on price adjustments increase the weight of nonmoney forms of competition, including such things as personal characteristics and the social and political status of the buyers.


To compare holdings of housing space before and after a demand change for housing, we start with an increased demand for housing space. Perhaps some people have become wealthier. Their increased demands for housing shifts their original housing demand curve, Db in figure 12.1, to D′b. The demand by people whose incomes have not increased, Da, is unaffected.

The aggregated line Da + Db is the community’s initial demand. The associated initial market-clearing rental price, P1, is indicated by the intersection of the total demand, Da + Db, with supply S, the existing amount of housing space. The increased total demand curve, Da + D′b, intersects supply S at price P2.

If rents were not allowed to rise as group B people seek more housing, the amount demanded would exceed the amount available at all rentals below P2. When cities have restrained rents below the market-clearing price, the resulting excess amount demanded, FG, is perversely called a “housing shortage” rather than an “excess demand at the restrained price.” There is not enough housing to satisfy the amount demanded, or as it is misleadingly called, “housing needs.”

If there are no rent controls, price is bid up to P2. As the price rises, both the A people and the B people move up their respective demands, and thereby reduce the total quantity demanded by the amount of the original “shortage,” and the housing market is cleared.

Almost everyone would blame the owners for raising rents, but in fact the B group’s increased demands caused the higher rent. Housing owners are merely intermediaries, like auctioneers, letting the demanding tenants compete for Edition: current; Page: [158] space. The market for housing would be called “tight” or “strong” or a “seller’s market.” However, the owners gain by a wealth transfer in the form of higher rents, and those renters whose demands have increased also gain from the right to compete for more space by offering higher rents, while the displaced renters are worse off. The gains to the owners and to the increased demanders may exceed losses to the displaced. That is small consolation to the displaced, but it is a reason for permitting people to compete by offering higher prices in the market.

Figure 12.1

Demand of group B increases from Db to D′b, with aggregate demand rising from Da + Db to Da + D′b, creating a shortage of FG at price P1. The amount demanded would be equated with the amount available by allowing rent to rise to the market-clearing level, P2. The B people’s quantity demanded initially increased by AC (= FG) at the original price, P1; it then fell by BC as the price rose to the new equilibrium, with a net increase of AC − BC = AB. A people reduced their quantity demanded by DE (= AB) with the price increase. These reductions—BC + DE—eliminated the shortage of FG.


When any prices are legally restrained so as not to exceed some value (less than what the new market-clearing price would be following an increase in demand), the amount demanded exceeds the amount available, and people shift to nonmoney forms of competition as they seek the price-controlled goods.

People then complain both about a “housing shortage” and about “capricious, discriminatory behavior” by housing owners, who in selecting renters Edition: current; Page: [159] discriminate more by gender, marital status, age, creed, color, pet ownership, eating and drinking habits, personalities, and so forth. The full rent now is more heavily loaded with nonmoney features. Laws passed with the intention of preventing the resulting discrimination are impossible to enforce. “Shortages” require selective allocation, and however conducted, whether by income, willingness to pay, or color of eyes, the selection is “discriminatory,” meaning that it ignores money competition.

Rent controls are popular with people already in a rented unit who expect not to be moving. But newcomers will compete in any permissible ways to get more space from the present occupants. No frustrated demander or newcomer will idly let others get or keep something worth more than the restricted money price. Their marginal personal worth of space in excess of the permissible market price is how much cost—beyond payment of that money price—they are willing to incur in other forms of competition to curry the supplier’s favor and to displace or reduce the space for existing occupants. New demanders will drive up the full rent paid for the higher worth of housing space. At the same time, the landlords will, if they are restricted from accepting more money, begin to solicit or accept more of the other forms of value or rewards offered by competing demanders.

Formerly, with unrestrained money competition, the people who are less well endowed with personal and cultural attributes could offset their disadvantages by offering more money. With price controls, nonmoney features necessarily have greater weight. Price controls don’t hold down the full price; they change the form in which the competitive price is paid.


The supplier would prefer to be paid with a transfer of money, rather than have the demanders compete in costly ways—such as going on waiting lists or standing in lines—worth less to suppliers.

That’s a reason the increase in nonprice competition caused by price controls is usually considered wasteful. But people whose time is of lower value may be benefited by price controls. (Warning: don’t jump to the conclusion that what is wasteful is necessarily “wrong” by all criteria.)


Rationing with coupons entitling a person to buy a specified amount of the good can avoid some of the wastes of nonprice competition under price controls, if the coupons can be traded. The sale would benefit the person selling Edition: current; Page: [160] the coupon (who values what could be obtained with the money more than what could be had with the coupon) and would also benefit the purchaser of the coupon. The worth of the ration coupon is the excess of the worth of the good obtained with the coupon above the restricted price of the good. Therefore, the full price for every consumer (money price plus coupon value) equals what the free-market price would be. The rationing does not lower the full price of the good; instead the form of the payment of the price is changed, from all money to some money plus the value of the coupon if sold to someone else.

Changes in Supply over Time

Typically, price controls have been placed on housing when the cost of maintaining and producing housing has increased, as in times of inflation. The controlled rent is almost always less than the cost of maintaining the existing supply and quality of housing. In general, rent controls would lead not only to an immediate “shortage,” but also an eventual reduced growth in the stock of housing, and therefore an even greater shortage. Ultimately, the quality of housing may deteriorate to where it’s worth only the lower rent-controlled value, as in a slum. That would eliminate the “shortage.”

The Energy “Crisis”

A few decades ago, the amount of oil supplied to the United States and other oil-importing countries was suddenly reduced by major crude oil–producing countries. (The same kind of situation can occur on a smaller scale when there is sudden news of a crop failure, such as for coffee.)

A leftward shift of the vertical supply line in figure 12.2 portrays the reduction in the supply of oil. A vertical supply line indicates the amount supplied will not respond to the price—for the interval we’ll be examining. As the market price of oil began to rise, the permissible legal price was restricted at P3 by governmental price controls. The highest permitted price—the ceiling price—was below the new equilibrium price, P. The result was a “shortage” of oil.

It was the price control, not the reduced supply of oil, that caused this “shortage.” If the price had been allowed to rise, it would have reduced the amount demanded to where the amount demanded matched the reduced amount supplied. As with every other good, people could then buy as much as they demanded at that new (higher) price.

The initial supply, S, with demand D, determines a market-clearing price of P1 at the quantity Q1. If supply falls to S1, market activity would generate a price of P2 at quantity Q2. However, if price is governmentally restrained at OP3, Edition: current; Page: [161] the quantity demanded will be Q3, greater than the Q2 available. The excess of quantity demanded over quantity supplied at the controlled price, Q3Q2, is a “shortage.”

Figure 12.2

Reduction in Supply and Price Ceiling below Market-Clearing Level

Price ceilings often have been placed on gasoline in domestic markets. When the money price of gasoline has been kept down by controls, everyone has a marginal worth of another gallon higher than the legal price. So people begin to compete more by nonmonetary methods. Some in the United States hire students (whose cost of time is low) to take their cars to the service station and wait in the lines. Tie-ins of overpriced car washes with every fill-up become more common. Everyone has to engage in additional nonmonetary forms of competition for the gasoline—just as they do for price-controlled housing. They wait in line meekly and longer, tolerating shorter hours, poorer service, and paying the seller more for other things (e.g., an oil change or tire rotation)—up to where the full price (money plus these other costs) equals the higher marginal personal worth of the reduced amount of gasoline.

To repeat, price controls—not a reduced supply—create a shortage and change the form of the competition and the full price. People incur costs of engaging in more of the distasteful, less preferred competitive activity. People who can engage more cheaply in those nonmoney forms of competition tend to benefit. Almost all the nonmoney competition to get favored status will be of trivial value to sellers relative to a payment of money, and the time customers Edition: current; Page: [162] waste in lines could be used for production. Competition is not eliminated; its form and components are changed, and they become part of the higher full price.


The president, Congress, and news media sometimes argue, incorrectly, that the price of gasoline could be lowered by restricting the price of petroleum, the major input in gasoline-producing refineries. But a low, controlled price of petroleum couldn’t reduce the price of the product (gasoline) unless it increased the supply curve of gasoline relative to the demand curve for gasoline. Holding down the input price won’t increase, and may reduce, the amount of that input, thereby raising its full price.


The value of a productive input is derived from the sales value of its final products. The cost or value of inputs does not determine the final product price. Paying a star athlete an enormous salary does not require the team’s owner to raise ticket prices. That has the causation in reverse. There is great demand to watch the athlete in competition. In anticipation of being able to sell tickets at a high price, the team owners compete for the athlete’s services, pushing the price to the public’s high value placed on seeing that athlete’s service.

This is the same as star actors who attract a large audience and therefore get a higher income. The higher demand for their performances raises the price of admission, and the larger box office receipts influence what the actors get. The higher costs of actors and athletes are the response to the higher demand for their performances. The costs which consumers deem worth incurring for a good reflect—rather than determine—its value.

Similarly, you hear that housing developers force up the price of land when bidding for land on which to build houses. In fact, the high demand for houses on that land induces higher values of the land on which to build the houses. The resulting price of housing then depends on the supplied amount of housing on that land. The effect of the developers supplying more houses makes the prices lower than they otherwise would be.

Suppose that the products derived from a barrel of crude oil (gasoline, diesel, jet fuel, kerosene, fuel oil, plastics, asphalt, chemicals, drugs, rubber, etc.) have a free-market value of $65. Assume the producers of nongasoline products derived from a barrel of oil are willing to pay $20 for their share of the oil. If gasoline is selling to the consumer at $2.60/gallon and 25 gallons of Edition: current; Page: [163] gasoline can be obtained from each barrel, that’s $65 in revenue for the companies selling the gasoline. However, if the average cost of refining gasoline from oil and distributing the gasoline to retailers, including taxes, is $35 per barrel, the part of the oil in a barrel that is used to make gasoline is worth only $30/barrel to the refinery. Given the $20/barrel value for the crude oil used to produce nongasoline products, the derived market price of crude oil will be $50/barrel.

The demands for both gasoline and nongasoline petroleum products will be subject to both short- and longer-run shifts, like any other consumer products. The consequence will be that the derived demands for oil to make those products also will shift. A further consideration in the market for crude oil is that it is a worldwide market. The supply comes from many places, while the demand for final products is everywhere. Past political responses to consumer complaints about “high gas prices” have resulted in ceilings being placed on domestic crude oil prices. But that only reduces domestic production of crude oil and increases the derived demand for imported oil that is not subject to the ceiling.

Holding down the price of any input cannot increase the supply of consumer products derived from the supply of that input. Indeed, the input supplier is being induced to produce less! Because curtailing the price of petroleum does not increase the supply of petroleum, the supply of refined products—gasoline, heating oil, plastics—does not increase, and thus it does not hold down the price of the refined products. The final product’s price will still rise to the market-clearing price.


When the question of whether to remove price controls on petroleum was raised, it was fallacious to argue that removing the controls on petroleum (an input) would result in a rise in the price of gasoline (a product). First, not even the money price of gasoline had been kept down by price controls on petroleum. Second, price controls on petroleum had tended to reduce the amount of petroleum extracted from domestic oil wells. When price controls were removed on domestic petroleum, more was produced, so the price of gasoline, instead of rising, actually fell.

The so-called oil industry fought both for and against price controls on crude oil. The “oil industry” is not a monolithic group. The crude oil producers (e.g., drilling companies and “wild cat” exploration companies) fought against price controls on crude oil. The users of crude, the refiners (who were Edition: current; Page: [164] allotted crude oil at that low price and refined gasoline from it) loved the price controls—except that they, too, suffered from the “shortage” of crude. They demanded more than was available at the controlled price. So they, like consumers of gasoline, competed in new ways to get a larger share of the supplied petroleum. Some refiners, arguing they were small and therefore more deserving of help, were allotted quotas (some of which were promptly sold to other refiners at the higher worth of the crude).

Refiners began to compete more intensively in the political market for allocations by the federal government agencies that were assigning the supply. Since there was a shortage (caused by the price controls), someone had to allocate the oil among the refiners who were demanding more than was available. The refiners funded politicians’ election campaigns in order to maintain price controls and get larger quotas. The crude producers contributed to the same politicians, trying to eliminate the controls. Politicians knew that with price controls they would acquire valuable authority to determine who gets the price-controlled goods.

Why Are Water Prices Kept So Low?

As population increases and rainfall does not, in some areas water supplies don’t match the amounts demanded at the existing price of water. At a higher price, people will demand less water, eliminating lower-valued uses of the water according to each person’s worth of water for various purposes. It does that more effectively than if the price of water were held down and water rationed by decree, used according to politically derived opinions about the best uses of water.

From time to time, California suffers from a reduced supply of water as a result of lower than normal rainfall. But the price of water is not raised whenever there is a drought, so a “shortage” develops. Immediately, political authorities impose “rationing” on quantities and permissible uses by governmental edicts, such as prohibiting watering of gardens, washing cars, using fountains, and so forth. However, in Arizona, where the supply of water is far less, no shortage exists, and no rationing rules are imposed. Instead, the price of water in Arizona has been allowed to rise to a market-clearing level at which the public can use however much water for whatever purpose it wishes. The higher price fosters conservation.


What is typically called a “surplus” is a situation in which the price is not allowed to be as low as the market-clearing price. A limit on how low the price may be is often called a “price floor,” in contrast to a “price ceiling,” which Edition: current; Page: [165] is an upper limit on legally allowable prices. A minimum or floor price may result from government policies to curtail supply or cause a bloated demand, as illustrated in figure 12.3.

Figure 12.3

The specified price P′ (higher than the market equilibrium price, P) is attained either by reducing supply to S′ (tax “excessive” production or subsidize producers to reduce output) or by bloating demand to D′ (government buys “excessive” output and holds it or uses it in welfare programs and foreign aid).

As illustrated in figure 12.4, a surplus is the result of the price control, not of some physically “excessive” supply. The disequilibrium in the case of a surplus stems from the controlled price below which transactions are not allowed. Yet, commonly, a “surplus” will be interpreted as if the supply were “too large,” greater than the “demand”—as if price didn’t matter. It’s even been contended that the producers are so “efficient” that they’re producing “too much,” hence the surplus! It’s then contended that production controls have to be placed on the producers to eliminate the “excessive” production (rather than letting the price fall).

Perhaps the most common price floors are for agricultural products. In almost every nation, farmers have induced legislation controlling some farm product prices at a high level—above the market-clearing level. The resulting surplus is then commonly solved by limiting the permissible amount of production.

There are three options in a surplus situation: 1) a lower permissible price or 2) the output and the amount that is offered for sale must be restrained Edition: current; Page: [166] or 3) the excess of the amount supplied over the amount demanded must be destroyed or disposed of “elsewhere.” Since the first alternative is contrary to the purpose of the policy—a high market price—the other two are the pertinent alternatives. The surplus at that controlled price (often called the “support price”)—SO – DO—is usually purchased by the government.

Figure 12.4

Price Floor above Competitive Equilibrium Creates Surplus

One response is to force the producers to reduce production, commonly by putting a tax on “excess production” or paying producers to curtail production. The permissible production is restricted in an attempt to have a sufficiently small supply to maintain the desired high price in the otherwise free market (at the cost of higher prices to consumers).

In the case of milk, the surplus is stored as cheese or powdered milk or distributed as “aid” to poor countries or as “free” cheese to senior citizens and school lunch programs. The cost is borne by the purchasers of the higher-priced milk products sold in the markets and by the taxpayers who finance the purchase of the “excess” milk products.


With the price-induced surplus, suppliers compete in ways other than the dollar price alone. The price restriction is usually on just the money amount paid, but the “product” being sold can be improved. The sellers offer more side benefits and amenities, thereby increasing the “full product” worth to match the high price the buyer must pay. Free delivery, free credit, stronger guarantees, and free supplementary goods and services are examples.

Edition: current; Page: [167]

When the airlines colluded with the federal government to control airfares at a high level, almost every flight had “surplus” capacity—empty seats. Each airline competed in other than explicit dollar fares. They increased services, size of planes, frequency of flights, free companion flights, better dinners, and free drinks. Once the airfares were freed from lower limits, the surplus capacity disappeared, and the “free” amenities were reduced.

With too high a fixed price, if amount produced is not limited, suppliers will compete by offering “better” goods, or by concealed or camouflaged price reductions. The price-controlled products can be bundled with other non-price-controlled goods and services—as a “tie-in” in which the added goods are offered at less than their competitive price. The whole package then has a competitive price.


The implications of all the preceding examples are that imposed price restrictions: 1) make the amount demanded at the money price exceed or fall short of the amount available; 2) restrain exchange from lower-to higher-valuing users; 3) reduce the quality and quantity of goods; 4) induce wealth-wasting forms of competition by altering the full-price components; and 5) increase nonmonetary discrimination in competing for goods. Finally, 6) imposed price ceilings do not keep the full price low—they change the composition of the full price, increasing the nonmoney costs until the full price is an equilibrium price more heavily weighted with nonmoney types of discrimination.

We may note situations in which it seems markets do not work as heretofore explained. However, it’s not that markets cannot work. Instead, they aren’t allowed to work. That happens when private property rights to some goods are not well specified or enforced and therefore can’t be bought or sold. That’s not a “defect” of markets. It’s an absence of markets for those goods.

It is sometimes impossible or prohibitively costly to define and enforce private property rights over some goods, such as the air, and for land with respect to noise and views. So, in the next chapter, after exploring markets for goods controlled by private property rights, we’ll examine some of the consequences for the uses of resources that are not controlled by private property rights.


  • 1)

    Do you think the rent controls that have existed in many cities were good or bad for each of the following: a) middle-aged couple who do not contemplate moving, b) young married couple with two children moving Edition: current; Page: [168] to a new town, c) black person or other minority moving to a new town, d) young person receiving a raise in salary, e) old person in retirement, f) person who likes to drink and smoke, g) beautiful young woman, h) homely immigrant, i) Muslim in a Jewish community, j) Jewish person in a Muslim community, k) woman who likes to work around the house and care for gardens, l) old couple who have saved wealth and invested in an apartment house.


    Rent controls establish a maximum rent, a ceiling above which rent cannot be legally raised. When the market-clearing rental price rises above the legal maximum, forms of competition other than money prices become more important—such as cultural, ethnic features, political connections. People who have more of the “desirable” features will acquire housing more easily than those that don’t. Meditate on how well each of the groups listed above might fare in nonmoney competition for rental property.

  • 2)

    It has been argued that politicians tend to gain from price controls, and hence they advocate them. What line of reasoning would support that argument?


    Price-controlled goods are distributed with more political and government influence and authority: government officials set the prices and enforce the program—and take credit for supposedly keeping down the living costs of constituents.

  • 3)

    The military draft of the US government involved a form of price control—in which the maximum price (compensation) that could be paid by the military services was set by law. As a result, the number of personnel demanded exceeded the supply at that price, but the buyers (the army), instead of accepting the amount sellers (young men) were willing to provide at that proffered price, resorted to a compulsory draft to satisfy their “excess” of demand. Who gains and loses what by this system of price controls?


    The military draft was collusion by employers against employees, with the draftee obliged to work at tasks and at wages stipulated by the government. A limited segment of the population received less than market wages, which minimized budgetary government expenditures, but with draftees paying a great tax in-kind. Monetary taxation required to finance a Edition: current; Page: [169] volunteer (free-market) military is less than the real, unevenly borne costs of a drafted military.

  • 4)

    News item from the past: “Seoul, Korea (AP). The city government ordered the capital’s 1500 restaurants not to sell any meal containing rice during lunch hours. The measure is designed to encourage the customers to take other food. South Korea is experiencing a serious food shortage because of a poor rice crop.” Would open-market prices achieve the same result? How effective would this measure be?


    The poor rice crop is not corrected by the price control. The temporary reduced supply has to be dealt with by curtailing consumption. The curtailment can be accomplished by permitting the market price to rise, thereby conducing to individual decisions which in the aggregate will restrain amount demanded to the amount available.

  • 5)

    “With open-market pricing, housing units are scarce or expensive, whereas with rent control the housing market is characterized by shortages.” Explain.


    All economic goods are scarce; shortages result from prices below the market-clearing level. Possession of nonpecuniary attributes will now play a greater weight in allocative decisions. Over time, housing quality and quantity will deteriorate.

  • 6)

    At the same price for each, you choose an internet-ready television over a standard flat-screen television, but when the standard flat-screen television costs 50 percent less than the internet-ready television, you choose the standard flat-screen television. In which case are you “discriminating”?


    Both. Choice is an act of discrimination.

  • 7)

    A distinguished professor of law has said: “Some people believe that every resource which is scarce should be controlled by the market. And since, in their view, all resources except free goods are scarce, all resources—even rights to radiate signals—should be so controlled. But surely some resources are ‘scarcer’ than others, and thereby possibly merit different treatment. It doesn’t advance the argument very much to Edition: current; Page: [170] place a label of ‘scarcity’ on everything.” Do you think economics should be studied by professors of law?


    Yes. The problem of economics—scarcity—involves how to determine who gets how much of which goods. What forms of competition are used to resolve these questions? It does advance the argument (analysis?) to grasp the meaning of scarcity and to understand that economics says nothing about which scarce goods ought to be allocated through the exchange-market form of competition and which scarce goods should be allocated by other forms of competition, such as physical force (violence), first come first served, waiting in line, who you know, appearances, personality, personal favors, cultural features. We leave it to you to try to figure out why the “degree of scarcity” should affect the form of competition that should determine how a scarce resource is allocated among alternative uses and users. In any case, scarcity implies competition to resolve who gets how much of which goods. If money competition is suppressed, other forms of competition must occur.

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“It is sufficiently obvious, that persons and property are the two great subjects on which Governments are to act; and that the rights of persons, and the rights of property, are the objects, for the protection of which Government was instituted. These rights cannot well be separated.”

james madison, Speech at the Virginia Convention, 1829

Apples on a tree in a public park are picked before ripe. Public beaches are littered. Garbage is dumped in rivers. Pollution of the air is prevalent. Mistakenly called “market failures,” such phenomena reflect absence of private property rights. Markets are places or methods whereby demanders and suppliers can communicate to buy and sell private property rights. This chapter identifies key features of private property rights and how they determine the uses of resources. And we will see why no matter who owns a resource, private property rights help deter “waste,” “pollution,” and “abuse.”

You propose to construct a building that would block the view from my neighboring apartment building. A “market transaction” between you and me can settle that dispute without a lawsuit—if we first know who has what rights. A judge could toss a coin to determine that. But that decision would affect only who is made richer, not whether the proposed building would be built. To explain, we’ll run through the two alternatives, where I initially have the rights to the view, and then where you have the rights to block my view.

If initially ownership of my building includes the rights to the view, I could prevent your construction of a building without my permission. However, if your profit on the proposed new building would exceed the value to me of the view, you could buy from me the rights to the view. You would then construct your building, and the view would be lost to renters in my building. You would have an added expense, and I would be richer in money (but poorer in view), because you had to pay me to give up my rights. While I’d lose some rental value of my apartments (the occupants of my apartments would enjoy less view, but they’d have a compensating lower rent), the amount you pay leaves me financially better off. So, you’d pay me and construct your building. Both of us gain from the transaction.

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In the alternative situation, you have the right to build. You could proceed with your construction without compensating me. But there is again a possible (initially beneficial) transaction. If my valuation of the view is greater than your anticipated profit, I could bribe you to forgo building. You thereby gain, and I minimize my loss.


The choice of ingredients used in the preparation of food in a restaurant shows how an indirect force channels resources to the highest market-valued use. For example, the restaurant owner can decide whether or not to use a cooking ingredient such as MSG (monosodium glutamate), or in Europe whether GMF (genetically modified foods) are allowed. However, it is the customers, through revealing their preferences, who determine whether restaurants advertising that MSG or GMF is not used will be successful.

Without ordinances or regulations prohibiting smoking in bars or restaurants, the preferences of nonsmoking customers versus those of smokers will determine whether the restaurant owner will find it more profitable to restrain smoking. These are the same market forces that determine whether or not a restaurant offers alcoholic beverages, or how long it is open, or whether it is quiet or has loud music, or has tablecloths, or air-conditioning, or quicker service.

While smoking is permitted in most casinos in Las Vegas, some attract patrons by advertising that they offer a “smoke-free environment.” Instead of competing by direct payments to have or not have smoking, the patrons merely choose among restaurants, bars, and casinos that do or do not restrain smoking. Owners are umpires between customers who have different preferences. The owner collects a reward in the greater revenue from patrons for a more highly valued environment. That’s true for every business.


Both preceding examples illustrate how the ability to buy and sell enforceable private property rights pushes resources toward highest market-valued uses no matter who owns them initially. The result is independent of how wealthy is the owner. A deep pocket does not increase the willingness to invest in unprofitable ventures.

Imagine an investor in a proposed oil refinery or a wood processing facility, which would spread odors for miles around. Negotiation for purchase and sale of many individual rights to satisfy the whole surrounding population would Edition: current; Page: [173] be much too expensive. As the population has increased with more interdependence in larger cities, problems formerly individually or privately handled, such as for water, sewage, personal protection, and roads, have become duties of a government, often by new regulatory agencies. If they alter private property rights in scope or value, the US Constitution, Amendment V, states “nor shall private property be taken for public use without just compensation.”

The scope of that stricture on government power over private property has been the subject of much dispute and different interpretations in the courts of law. Were the rights that have been taken truly private property rights, or were they public property rights that had been used privately? Were the uses proposed really for “public use” or for private benefit? Was the amount of compensation “just” or too little?

Market Exchanges of Rights to Use Air Can Measure a Worth of Pollution Rights

When anyone mentions buying rights to pollute the air, the typical immediate response is, “You can’t place a price on the environment. You economists assert everything can be reduced to money—as if market values could be placed on aesthetics and the environment.” Look at what economic analysis actually says.

Purchase and Sale (Alienability) of Rights to Pollute the Air

“Alienable” is the legal word for “salable.” In major metropolitan areas, air quality control agencies of the local government monitor the amount of pollutants, such as sulfides and oxides, emitted from commercial firms in an area defined by a “bubble” of airspace within which not more than a specified amount of pollutants is permitted.

Some years ago, the City of Los Angeles established a limit on the total amount of pollutants emitted by all commercial firms. The limit to be allowed ten years later was set at 25 percent of the total amount emitted in the first year. Either production of goods had to be reduced or more expensive methods of production with less pollution were necessary.

Each firm’s permissible amount (“rights”) of emitted pollutants was determined (usually set at the amount it had been emitting previously, establishing an initial cap on emissions). Each was allowed to sell to other firms its rights to emit pollutants. A market for pollution rights immediately developed. Incidentally, anyone could buy rights even for the purpose of reselling at what they hoped would be a higher price.

Our interest here is less in what the prices were or how much they fluctuated than in what alienability of property rights permits. Owners of some firms Edition: current; Page: [174] found it profitable to replace older equipment with less-polluting types of facilities, because their unused pollution rights could be sold to other firms where the rights to emit pollutants were more valuable.

Figure 13.1

Mutual Gains from Trading Pollution Rights

Clarkson and Martin differ in their marginal values of production. Clarkson’s additional value from expansion of output is greater than the cost of buying the marginal pollution rights. He will wish to buy rights from Martin, for whom the price of rights is greater than the value of his reduced output.

The effects of alienable pollution rights are the same as for tradable eggs between Ted and Rae (chapter 6), with “pollution rights” here replacing “eggs.” The polluters can be the Martin Refining Co. and Clarkson Paint Co. Instead of “personal worths” of Ted and Rae, we compare the “marginal market values” of products.

In figure 13.1, both Clarkson and Martin initially emit 20 units of pollution. But the marginal value of further output for Clarkson is greater than the cost of buying pollution rights to generate the greater production, and the cost of buying pollution rights is greater than the value of more output to Martin. So both gain by Clarkson buying 10 pollution units from Martin, with each equating his marginal worth of output with the price of polluting. Salable, privately owned pollution rights result in maximum product value for a given total permissible amount of pollution. The rights to emit pollutants are attracted to Edition: current; Page: [175] their highest market-valued uses. As with Ted and Rae, the initial holdings of rights do not determine the final allocation, if the rights are salable.

Altering Production Techniques or Volume to Reduce Pollution

There can be reduction of pollution by a reduction in production with the initial technologies. But the price of polluting can affect the choice of methods of production, possibly encouraging less-polluting techniques.

The sites of production and pollution will be affected by choices of residence as well as by moving production. People may choose to live in places where pollution is less even when that is more expensive. Lower-income people tolerate more pollution and lower-quality living space in order to have more food, furniture, and health care. Poorer people buy cheaper used cars. They cause more pollution. But they prefer that to having better cars and less of other goods. All behavior involves and reflects choice among trade-offs.


1.: Fairness and Amount of Wealth?

Opponents of allowing sales and purchases of pollution rights have argued that the richer firms will get pollution rights from the poorer ones, and that is unfair. However, the wealth of a firm has nothing to do with the marginal value of pollution rights. Greater wealth does not mean a person will, nor should, be foolish. Some believe (or argue as if) trade yields a benefit to only one party at the loss of another. Selling, as well as buying, can benefit a trader.

2.: The Myth of “Economics versus the Environment”

There is no conflict between economics and the environment. Everyone prefers a cleaner, safer environment. Everyone prefers more income. Some regard visits to the mountains, wilderness, and communing with nature more highly than do others. What economics emphasizes is that more of “this” means less of “that.”

Arguments persist about whose benefits should dominate. But it’s not a question of dominance. It’s a question of trade-offs. Members of the Sierra Club and Audubon Society would prefer to have more natural resources preserved. Others, less interested in “nature in the raw” relative to other things, would like to have more development of public lands for homes and easier access (roads rather than hiking trails) to mountains. Economic analysis is not biased for or against either, nor does it indicate what the relative preferences should be. Instead, economics recognizes the necessity of choices among the alternatives.

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Alienability of private property rights rests on (1) control of the resource and its services and (2) clear specification of the rights and the object.

1.: Control: The Cost and the Worth

What’s the value of a private property right to the North Star? You couldn’t control its condition or its services as a directional guide. If you were declared to have a “private property right” to a tagged whale last seen in the Alaskan region of the Pacific Ocean—good luck.

You may perform beautifully at the piano. You can say the music is your private property, but you’d have to control the sound as private property. Once the music is created, anyone in the room can hear it. But you can arrange to play the piano in an auditorium and sell rights to people to be in that room. You “tie” two rights: to be in a room, and then to hear the music at no extra cost. You could advertise that there will be “free music” to anyone who rents a seat in the auditorium from you.

You pay for the right to sit in the theater at the time a specified movie is shown. A sporting event, unlike one in a public park where anyone can watch, often is played in an enclosed arena. Spectators must pay to enter; control is effective.

Private enforcement of control abounds. Locks, fences, burglar alarms, safes, barred windows, home and office security devices, and security service firms protect control of the object. The private enforcement depends, as you would expect, on the costs relative to the benefits. Hardly anyone bothers to enforce limits on parking time on low-valued land (in suburban shopping areas). For midtown parking, a price is charged, and times are monitored. Some formerly almost free and unowned resources can become more valuable as populations increase.

Lakes, rivers, oceans, and the air are being subjected to more extensive control either by establishing private property rights or by direct controls by governments. The higher the potential worth of use of a resource, the greater is the cost that’s worth incurring to control it. Airport landing rights and moving cocoons of airspace for commercial flights are bought and sold among airlines.

As the cost of effective surveillance over the ocean decreases, or as the worth of the control increases, greater distances from shore (200 miles instead of the old 3-mile or 12-mile limits) are being claimed by nations as their “property.”

Whether currently disputed areas (for example, deep-sea floor minerals and Antarctica) will be established as private or government property of one or more nations remains to be seen. Even the western states in the Edition: current; Page: [177] United States have sued each other in federal courts for Colorado River water rights, and surely would consider military action if they were separate nations.

2.: Specification of Rights

No matter how well controlled are the objects, the rights to the good must be verifiable. The more complete, unambiguous, and reliable is the specification of the good and of the rights to the good, the more cheaply will the private property right be alienable.

As a buyer, you’ll want assurance the seller does own the rights and that they are alienable, without unknown encumbrances and claims by other people, such as creditors or other partners. Verifying that is a major part of the “costs of transactions,” especially for land and durable resources. Ownership of property rights to houses, land, and automobiles are recorded in government files. They are usually the most authoritative, reliable records. In almost all parts of the United States, private firms also record the information, the reliability of which is usually guaranteed by “title insurance” companies.


English courts have for centuries crafted and preserved alienable (marketable, salable) private property rights to resources. You may be told that with private property rights no one else can affect what you do with what you own. But others can and do affect the market value of what you own—an owner’s wealth, as will be explained in following chapters, reflects its “capital value.” The values (prices) of resources you own (except for money) depend on what other people think about your uses of resources you own. If they don’t like what you are doing, they punish you. They do that in ways and to an extent to be explained. Nor are you are allowed to dictate all the future uses of the resources you leave to future generations. No “dead hand of the past” is allowed exclusive control.

So great is the value of alienability, the law has preserved it at the cost of other potential benefits. For example, shared private property rights among several people decreases the ready salability of shared resources. The law has generally been framed and interpreted so as to reduce the costs and difficulties of reaching decisions to sell or buy property “of the sharing group,” as we’ll show later.


Sharing of private property rights is prevalent, even though it tends to weaken control, definiteness, and alienability of the shared rights. A form of sharing is marriage and the family. Methods of sharing have been devised that tend Edition: current; Page: [178] to protect the objectives of sharing ownership against diverse interests of the sharing owners.

A family may own a newspaper publishing company. Negotiation for sale of the rights to publish the paper can be hindered by disputes within the family about the wisdom, price, and sharing of the proceeds. There is also the uncertainty of who is a member. For a family, are all people born into the family sharing owners? Do descendants of members inherit rights of members? Does marriage into the family make the newcomer a member?

Unless these questions are answered appropriately, buyers will not be sure of what rights are being purchased or whether a sale is really a completed sale, or is challengeable by people claiming to be members.


A predominant feature affecting the rights and behavior in shared groups is how membership is obtained. May you enter at will with no payment or contribution to the group and without requiring permission from the existing members? If so, that could be called an “open” group. If a payment or contribution must be made to another member or to the whole group, that group would be a “closed” group. Entry into a political party is “open,” as it is in most religions and cities. You do not have any salable rights of shared membership. Being a member (citizen) of the United States does not require a purchase from an existing member, although the government controls entry.

The meaning and worth to a member of what the “group owns” depends on how entry and membership are determined and on the behavior of members. If entry is open, congestion awaits. For “closed” groups, wherein membership must first be purchased from the group or another member, the members are guided by other members.

Stockholders own the modern corporation. Admission to that class is by purchase only. Anyone can enter the membership by purchasing a share (membership) from an existing owner. No one can object, or even know who are the other stockholders. It’s called an anonymous society by the French. It’s a limited liability corporation in the United States.

Many Swiss corporations have two classes of stockholders. In one class, any shareholder can sell to whomever that shareholder chooses. The other class of members must first obtain approval by the administrators of the corporation. A share of each type of stock typically has the same claim to dividends and assets of the corporation, so they differ primarily in confidentiality of who are the owners.

The incentives for the members to maintain the benefits of membership Edition: current; Page: [179] in open groups are less strong than when members own salable rights to membership. Market sales of membership rights in closed groups increase incentives of members to help maintain the advantages of membership. This is evident in different types of “country clubs.” The members own some clubs as a closed group with entry only by purchase. Some grant only daily rental rights.

Courts have tended to judge and decide issues of ownership so as to preserve and facilitate reliable alienability of well-identified property rights. The general belief is that this tendency to maintain alienability reflects a social consensus to maintain the influence of market values as guides of future actions—by limiting who in the future will be recognized as a member.

Corporations can have thousands of members—stock or “share” holders. But how does that group sell or buy property rights to what the group shares in ownership? At one extreme, unanimous agreement of the members might be required. More commonly, the sharing members of a corporation are allowed to delegate to some one person or small group the authority to sell what the whole group owns, or to buy for the group and also to direct the use of those resources. An obvious difficulty with this method is the “principal-agent moral hazard,” in which the agent may act more in accord with self-interest than the promised interest in the group, as will be explained later.

The other extreme way permits each member alone to sell or buy for the group. That’s close to a family in which the husband or the wife can decide to sell what the family owns or to buy for the family. It’s similar to some forms of business partnership. We’ll explore later why in a business corporation the alienability of rights is among the shareholders and not among the employees.


Although a member of a college student body, you can’t sell that membership “right” to anyone else. It’s nonalienable.

Your attention to what happens at your college might be more serious if you had an “alienable” (resalable) right of membership whenever you dropped out or graduated. If you are inclined to believe a system of salable rights would ruin the college’s reputation, recall that similar rights are used for membership in the group of “owners” of Hewlett Packard, Ford, AT&T, and Apple, but they aren’t “ruined.” What, if anything, is different about a college? Most likely, none of its resources are held under private property rights.

What is meant by the “college’s resources”? No one owns them; no one can treat the resources as private property. Instead, the college has an administrator with authority to control and to buy and sell the college’s resources. Why Edition: current; Page: [180] are private property rights and responses to market values suppressed, when almost everywhere else efforts are made to strengthen responses to market values?

What can a person or a group do if a board of trustees administers the college? The board can use gifts of money donated to the college to buy things that then become “owned” by the college. The board of trustees can buy private property rights to goods, as when they buy automobiles or labor or building materials. But no one can legally let anyone use the college’s resources as if they were private property. The college bought the private property rights to goods, but the board is bound by laws saying that not all the components of private property rights to those goods would be exercisable by the board.

Why would anyone ever establish a college that had to give up those features of private property rights? For two reasons: first, the government gives favors—the school is exempted from some taxes that would have to be paid when using private property, and people who donate to the college avoid taxes; second, and more important, the incentives of the trustees are directed away from profit and wealth maximizing. And it’s considered good when the purpose is to help students obtain an education without paying the full costs.

A college is somewhat like a charitable organization. You might wonder why successful privately owned, profit-seeking schools exist at the elementary level. And private, for-profit schools exist for engineering, foreign languages, electricians, computer programmers, hairstylists, golfers, driving autos, and flying.


Although consequences to the owner dominate decisions about the use of privately owned goods, we are allowed to act in ways that affect other people. These effects are called “externalities.” When you wear clean, pleasant-appearing clothes, or cultivate a pretty garden, which other people enjoy, that’s a “positive externality.” Living in a nation where everyone has at least a high school education is a positive externality benefit for everyone.

Many actions you take benefit other people, even though you are not paid to do so, in contrast to explicit exchange. If permissible actions are disliked or harmful to other people, the actions create “negative externalities.” If other people are slovenly garbed and dirty, and speak in a rude fashion, we suffer negative externalities. Informal rules of social etiquette and social customs motivate positive, and suppress negative, social behavior externalities. This is sometimes labeled “internalizing external effects.”

We typically don’t offer to pay neighbors or friends to behave in some way, Edition: current; Page: [181] yet methods of compulsion exist. Probably the major forces are social ostracism and governmental force. Social ostracism is a subtle and powerful force. Etiquette in social conformity with custom helps internalize externalities. If you behave otherwise, friends begin to snub you, your reputation falls, and life becomes more lonely and confined. The line between “innovative leadership” and “disgusting nonconformity” is not bright and clear, but it does exist.

A society of generally educated people who read and write and speak the same language is generally advantageous to everyone. This “externality” effect is so important that compulsion by law to acquire those features is commonplace. Every child must attend school, whether governmentally provided and financed or a private school. Adults are not compelled by law to know the common language, but the economic and social penalty often is persuasive.

Physical externalities, if harmful, are usually declared illegal. However, pecuniary (financial) losses on competitors (negative pecuniary externalities) do not necessarily make an action illegal. Our better textbook reduces a competitor’s earnings. That’s not illegal, and is regarded as benign, in that more preferred goods are allowed to displace less favored goods. The analysis of the preceding chapters is consistent with, and not upset by, externalities or public goods.


So far we have dealt primarily with goods that are useful for only one person at a time. If I eat an apple, I alone get the benefit. Goods are “private” goods if one person is the consumer or user. But for “public” goods, the amount of worth to one person does not reduce the amount of the good or its worth to other people. More for me does not mean less for you, once the good is produced.

Examples of goods almost exclusively composed of public-good attributes are mathematical theorems, TV and radio programs, melodies, poems, vaccinations, basic education, technology, ideas, and some public parks and wilderness. One person’s access to, or knowledge of, an idea does not reduce the worth anyone else could also get with it. One viewer of a TV program does not displace another. Mosquito control districts, air pollution controls, flood controls, garbage and sewage disposal, streets, and police patrols are, or have some characteristics of, public goods. The same holds for some forms of national defense: if there is more for me, there is also more for you, unless it is a local antimissile defense for your town rather than mine.

What are called “commons” often are areas to which everyone in a community has a right of access. Some goods have mixtures of private and public-good attributes. The space around a musical band concert is limited, and a better Edition: current; Page: [182] space for me means a poorer space for others. The only worldwide public goods we can think of are the sun, moon, and stars.

Why are public goods specified and treated as different from ordinary goods? What are the economic aspects and problems posed by public goods, other than those posed by private goods? One major feature is that the creation of public goods is hindered because a reward for creating and maintaining them is difficult and expensive to provide. Two common procedures for such provision are (a) by governments with financing by taxation and (b) formation of private voluntary clubs for services to the members (its public). One widely applied process relies on the community of users voluntarily agreeing to rules of use and care. The control of abuse is both informal and formal. The community may establish a voluntary patrol or may rely on ostracism of abusers. Later, we’ll explore a few of the means of controlling behavior.


Governments can apply force to obtain payment and to restrain free riding. Governments can use force that cannot be employed privately (such as jailing or imposing a fine on a detected nonpayer). Sometimes, if the government charges a fee for access to the public good, a complaint is voiced against charging an admission price. But the price can be used as a rationing device, to prevent the public good from being so over used as to be destructive of benefits.

What has been a public good now can become a nonpublic good. A public good (more for me does not mean less for you) can become a shared good. We share in having equal rights to access, and in having equal shares, but the shares can diminish with open entry. Public goods yesterday become congested goods tomorrow, and methods of control of entry or access will change. The oceans are ruled by the doctrine of freedom of the seas—except that what are called “seas” is being reduced as nations claim that more of the oceans are within their expanded national boundaries.


Whatever the group, large or small, the prospect of free riding by someone in that “public” is likely to shrink the investment in production and maintenance of the public good. This initial free riding on the original investment could be reduced if the potential beneficiaries had to bear the cost of creating the public good. The investors would then be the subsequent beneficiaries.

A private yacht club facility, a privately owned golf course with owner-members only, or a fraternal organization used and owned exclusively by members, provide public-good services to members who pay the cost of both the investment and the subsequent service to the members.

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A “club” can be defined as a “firm” in which both the investors and customers are the members. The public-good aspect of associating with those who are allowed to be members, not monetary profit, is the objective. For that, excludability is critical.

Even with entire nations, the residents have a club-like relationship and tend to object to newcomers who are “strange in behavior” and haven’t paid for entry to obtain the privately supplied public goods.


Several ways have been devised to supply services privately and profitably despite, or because of, free riding. Private provision of some public goods occurs for which exclusion of nonpayers is “impossible.” Paradoxically, in some cases, the more free riders, the better it is for the private supplier.

Examples are typical television and radio programs. You pay “nothing” to watch or listen, but it’s not free. You pay a price—the time during which advertising is displayed. No charge is made, and no one is excluded. As a concert pianist does not force the listener to sit in a specified room for which an entry fee is charged, television and radio broadcasters and the suppliers of the internet services cannot compel you to devote some of your time watching advertising. However, when you want to obtain their services, this tie-in is the price of admission.

Forcing the viewer to see advertisements uses some of the viewer’s time, which has alternative use values. To hold the viewers’ attentions, the advertising is made attractive rather than only informative of the advertiser’s brand name. The same method (advertising) of paying for underpriced (or “free”) services is true for almost all newspapers and magazines, which are grossly underpriced relative to the costs of creating and supplying them. The payments for advertising in the magazine and newspaper serve the same purpose as advertising on “free” television for covering the costs. In several European nations, each television set is taxed to prevent free riding. In the United States, advertising provides funding and sidesteps free riding—that is, getting the benefit without paying any cost. In some nations, both advertising and government taxes on owning TV sets are common.


Another form of allocation of existing goods is by gift or charity. You may be at a college founded by charity of the founder. At some time you have used a library built and maintained by the charity of the Andrew Carnegie Foundation or by government use of tax money to create a “free library.” Some television Edition: current; Page: [184] stations are financed by charity. Hospitals are probably the most prominent example of charity-supported organizations. Why is charity devoted primarily for schools, hospitals, and churches? Who gains what? Are the intended effects also the achieved effects? We’ll see that some, but only some, of the principles and consequences of market exchanges apply to charity.

Who Gains What from a Gift?

Whatever the motive and intent, gifts (not in cash that can be spent, however much that is preferred) usually have some “waste” from the giver’s point of view.

The US government grants aid to foreign governments, ostensibly for specific purposes. If a foreign government is given $100 million to build a dam which it would have built or bought even without the gift, what has it gained? The recipient’s resources are released for other purposes. So the gift gives the recipient government some wealth with which to do more of whatever it wants.

To operate a television station in the United States, a license is required from the Federal Communications Commission (FCC). The law forbids assigning licenses on a first applier, first served basis. The winner is the applicant deemed most fit (based on responsibility, dedication to public service and education, etc.). Competition in establishing and comparing fitness is expensive; the combined costs incurred by all competitors in that competition can even exceed the value of the license. Much is expended in competing for the award—using lawyers, lobbyists, and political donations—because once obtained, the license is transferable at the market value. The cost of competing for the license is high because there’s much to be gained by winning.

Governments have moved toward selling rather than “awarding” licenses or valuable rights, such as rights for oil exploration, use of a portion of the radio spectrum, or for “monopoly” rights to operate liquor stores, taxis, dairy herds, and tobacco farms. All these rights are salable once they have been awarded.

Nontransferable Aid and “Earmark” Financing

Some other gifts cannot be legally reallocated or resold. Examples are rights to enroll in a college or medical school, to move to the United States from another country or join some unions, adopt a child, camp in a national park, or be bused to school. Nevertheless, gifts received for what you would have done or received even without a gift release more of the gift for other purposes.

One dollar, no matter from where, is the same as any other. Money is fungible. So when children are bused to school “free of charge to the parents,” Edition: current; Page: [185] who gets what benefit? Once relieved of buying transportation they otherwise would have provided, the parents are able to divert their expenditure from transportation to something else. The children whose parents would have had them walk get a gain in the form of a ride. The principle is simple: to the extent that recipients would have purchased the services now provided by a gift, they can use an equivalent amount of wealth for other purposes.

Governments levy a special tax for a specific purpose. Though the tax receipts are earmarked for that purpose, city officials can release equivalent amounts from other tax sources formerly allocated to that purpose. The net increase in the activity will be less than the earmarked tax receipts. Proceeds from the California lottery are assigned to public schools, but some of the money formerly assigned to schools is diverted to other uses. The net addition of the lottery to schools is smaller than the funds from the lottery by an amount equal to the reallocated funds.


  • 1)

    M owns and lives in a home near an area where a series of 20-story apartment buildings are to be built. M sues to prevent the construction on the contention that it will create extra traffic hazards and congestion. In court, M proves to the judge’s satisfaction that his allegation is correct. How should the judge rule?


    M is suing for property rights to uncongested streets. Under current law, this kind of right seems not be recognized, and presumably the judge would rule against him. Who owns the streets, with authority to determine how heavily they can be used?

  • 2)

    A California city prohibits construction of any building whose shadow will fall on some other person’s land between 9 a.m. and 3 p.m. Is that a restriction of private property or a strengthening of it?


    If you define access to sunlight as an aspect of landownership, then it is a strengthening of private property rights. But other property rights of building construction are being curtailed.

  • 3)

    A city passed a zoning ordinance prohibiting the owner of a large parcel of land from constructing homes on it because of a fear that the noise of a nearby airport owned by the city would be so disturbing to the new tenants that airport operations would have to be curtailed.

    Edition: current; Page: [186]
    • a. Whose rights were being curtailed by the zoning ordinance?
    • b. Under the definition of private property rights, were the landowner’s rights being taken from him?
    • c. Can you suggest some other solution to the problem?
    • d. If you were a taxpayer in that town and did not live near the airport, what solution would you have voted for?


    • a. If the zoning at the time the owner purchased the land included the right to build the homes, then his rights are violated by a subsequent change in zoning that forbids the building of homes. If there was no zoning at the time the current owner purchased the land, the new zoning or ordinance clarified, defined, and allocated the rights for the first time.
    • b. If there was a question of what rights were included with the land, a potential buyer of the land could ask for a clarification of those rights before purchasing the land.
    • c. Possibly require that the contract of sale of land to intended home builders provide acknowledgment of the proximity of the airport; this would reduce the value imputed to the land to a level which informed buyers are willing to pay.
    • d. Taxpayers in the town would probably want the homes built so that there would be more homeowners paying property taxes to help pay for schools and other city services. Best for taxpayers would be if the new homes near the airport were restricted to seniors only so they would be paying property taxes but not have children to send to the schools.
  • 4)

    Ralph Nader, a well-known exposer of product defects, complained that a person who relieves himself in a river is fined, but industries that pollute the same river are not. Muggers are punished, but smoggers are not. These he cited as illustrating the inequities and irrationalities of our society and economy in its attitude toward big corporations. What has Nader overlooked?


    He ignores the social gains provided by activities that produce smog and pollution as a by-product. As automobiles and airplanes produce “risk of death”; as travel takes up land for roads; as making sheet-steel involves less of other desirable things like leisure, quiet, and rest; as oil wells create an offensive odor in the neighborhood—so all productive activity involves some undesirable by-products. All of these pollutions of our environment are part of the costs of production and could be avoided if we were willing Edition: current; Page: [187] to have a less convenient, more Spartan life. We should not look only at costs and think that something is wrong with those economic activities that involve the largest costs, for they may also yield the greatest benefits. Relieving oneself in the river may be less valuable than the value of output from a factory that creates equivalent pollution and may be avoidable at lower cost. Similarly, smoggers are producing other services in the process, whereas muggers produce no social service.

    The complaint that Nader should have developed is that governments and courts had not introduced a system of making people pay for the right to pollute, thereby bearing the full costs of their actions. Such a system would induce people to pollute less if the gains obtained from activities that yield pollution are worth less than the pollution damage. As we could produce less oil or less paper by having less pollution, there is a trade-off between more or less clean air or cleaner water and more or less other desirable goods output. Efforts to expose that trade-off rate and to induce the pollution costs to be taken into account by a system of prices for the right to pollute (by fines) rather than with zero prices or absolute prohibitions (infinitely high prices) are what Nader might more usefully have recommended.

  • 5)

    Camping fees in almost all state and national parks are so low that people want more space than is available, at certain times of the year.

    • a. Why is the price for camping not at a market-clearing level?
    • b. How much space would people want at a market-clearing price?


    • a. Camping sites are not privately owned.
    • b. Less space per person.
  • 6)

    In Los Angeles, two closely situated golf courses, one privately owned and one publicly owned, are both open to the public.

    • a. Which do you think charges the higher price, and which do you think requires less or no advance reservation?
    • b. Who is benefited in what respects by each course’s policy?
    • c. As land values rise around the course, which one do you think will be converted to housing or business first?


    • a. Privately owned courses charge more and require less or no advance reservation. More amenities are provided to those who are willing to pay for them.
    • b. More proceeds go to identifiable owners of the private course. Edition: current; Page: [188]
    • c. Owners of the privately owned course will compare the return they could get from selling the land and investing the proceeds in alternatives—versus the fees they can charge from continuing to operate the course. Because individuals cannot benefit financially from selling the public-owned course, the political authorities may compare the property and other tax revenue that might be gained by selling the land, versus the fees generated by the golf course. Probably the privately owned course will be sold first.
  • 7)

    “Californians are crazy. Near a beautiful California beach, there is a luxurious motel and a state-owned camping area. Despite the greater luxury of the motel facilities, scores of cars are lined up for hours each morning seeking camping sites, whereas at the motel there is hardly a day that the rooms are all taken. This shows that Californians prefer outdoor, dusty camps to the luxuries of a motel with pool, TV, room service, and private bath.” Do you agree?


    Tendency to price public parks and services at less than a market-clearing price is the explanation. Motels, priced higher than facilities in parks, rely on the law of demand to keep the amount demanded in line with facilities available.

  • 8)

    Churches are typically nonprofit institutions. Can you think of a problem in allocation of church facilities that is solved without use of the price system?


    Seats are allocated first come, first served rather than sold to worshipers—except in some churches, where a person donates a large sum and is given a special pew as a token of appreciation.

  • 9)

    The college you now attend is most likely a not-for-profit institution. Are any of its resources allocated at less than market-clearing prices? (Library facilities? Athletic facilities? Counseling? Course admission? Campus space?) Who gains by the power to select admissible students?


    Administrators have little incentive to maximize profits in a not-for-profit institution. On the other hand, they can gain personal and institutional popularity (with enhanced donations and charging of higher tuition) by providing attractive amenities and admitting children of the right sorts of families.

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  • 10)

    Tickets to sporting events:

    Why do college athletic conferences chronically have an enormously larger number of people wanting tickets than are available for the playoffs and important games?

    Why are admission tickets for the Masters Golf Tournament (a prestigious golf tournament) fewer than the number demanded by the public?


    Receipts and returns are not wholly in the form of money revenue from selling tickets. And maximizing the money revenue does not enhance salaries of the administrators. The administrators and their organization can gain social and community stature by pricing tickets below the market-clearing level.

  • 11)

    “The imbalance between governmentally and privately provided services is evidenced by the fact that the family that vacations in its air-conditioned, power-braked, power-steered car passes through cities over dirty, badly paved, congested streets, not to mention the billboards. When the family picnics with excellent food provided by private business, they must sit by a polluted stream and then spend the night in a public park that is a menace to health and morals and littered with decaying refuse. Private abundance and public poverty are facts that assail every observant person. A plentiful supply of privately produced goods, and a shortage of publicly provided services, is inescapable testimony to the lack of a social balance between private and governmentally provided services.”

    Why are these arguments—taken from a popular book advocating more governmentally provided services—faulty and do not indicate anything about whether there is too little of such services? (Hint: Note the use of the term “shortage.” How are governmentally provided services rationed?)


    Ignores prices at which government goods are distributed. Price of such goods is so low as to create a shortage and appearance of insufficient amount.

  • 12)

    You are running a university, and the faculty is asking for higher salaries, some of which you would be able to grant only by reducing funds available for buildings and activities such as sports. Now, the foundation of a rich alumnus gives your university a grant of millions of dollars, with Edition: current; Page: [190] the condition that the donated funds be allocated exclusively to faculty salaries. Who gains what?


    Building and nonfaculty purposes gain, and faculty also gains to the extent faculty salaries are raised more than they otherwise would have been raised. Money from other sources that would have been spent for faculty salaries now can be spent for other purposes.

  • 13)

    The faculty of many colleges are given free parking space.

    • a. Who gains what?
    • b. What would be the effect if the faculty could sell their space to students?


    • a. Those professors who obtain a desired space receive a gift (nonsalary compensation) in kind. But the university is giving away something of value, and it is forgoing money revenue it could have collected through renting the spaces.
    • b. If the faculty is permitted to rent spaces to students, the spaces would be allocated more fully in accord with revealed preferences of the academic community, with proceeds going to the teachers rather than to the institution. An alternative would be for the school to leave the space vacant as scenic lawn.
  • 14)

    Immigration-quota rights to the United States are priced at “zero” instead of being sold at a market-clearing price to “acceptable” types of people. Who gains what? Why are these rights not sold at the highest price to acceptable people?


    The immigration administrators are salaried and do not receive money beyond their salary. Their motivation on the job is not to maximize profit, leaving them open to seek fulfillment of other personal and policy goals.

  • 15)

    “More of a public good can be produced without the production of other goods being curtailed.” Evaluate.


    False; it is the consumption of the good that is referred to in the definition of a public good. Once the good is produced, any person can have as much as he or she wants without reducing the amount to anyone else.

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  • 16)

    Public goods are those for which (choose the correct statement):

    • a. several people can simultaneously enjoy the good;
    • b. it is impossible to exclude some customers;
    • c. no consumer reduces the amount of the good available to others by his act of consuming the good;
    • d. prices should not be charged;
    • e. the government should provide the goods.


    Answer c is best.

  • 17)

    A theater performance with a group of viewers is not a public good. Why?


    Each spectator displaces someone on the outside who might wish to enter—and the theater presumably cannot seat everyone who wishes to attend.

  • 18)

    “Economic theory is applicable only to a capitalistic society.” Evaluate.


    The market-exchange system characteristic of private property (capitalism) has been the dominant institutional context of the preceding chapters. But the economic theory used there is applicable to any system of competition—resolving conflicts of interest among people arising from the fact of scarcity. In fact, the analysis of allocation with prices at less than the market-clearing prices is an application of economics to a socialist society in which free-market prices are not used. If the money price is below the free-market price, how will goods be allocated among the competing claimants? The use of nonpecuniary “discrimination” should come as no surprise.

    Many Communist systems have relied on money prices and private property to ration existing stocks of some consumer goods. In Russia under communism, many goods were sold for money, and individuals got money income from wages and salaries—but not from ownership of productive physical capital goods and land. Given a person’s money income, he was allowed to choose among a variety of consumption patterns by voluntary exchanges with other people via controlled (as distinct from open) market prices.

    The principles are not idiosyncratic to capitalist systems. They hold for all known societies. The laws of demand and production hold also, whether or not exchange of resources via a private property exchange system is used.

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    Keep in mind the distinction between economic theory and analysis, on the one hand, versus, on the other, the institutional (legal and political) circumstances or conditions to which they are applied.

  • 19)

    In a public park an apple tree yields excellent apples, which may be picked by the public. When will the apples be picked? If the American bison had been owned by someone, do you think the animals would have been so nearly exterminated? Do you think seals and whales would be faced with extinction if some person or group were able to buy, as private property, the right to catch whales and seals?


    The apples would be picked and the bison slaughtered prematurely, for, with no designated and enforced ownership rights, the taking would be first come, first served. If you do not take now, some other greedy person is likely to beat you to the prize. If assets are privately owned, the owners have much incentive to protect and preserve them until optimum harvest time and then to harvest them at the optimal rate for the long run.

  • 20)

    Contrast socialism and private property as means of distributing risks of profits and losses.


    Socialism does not permit discretionary (optional) selection of wealth holdings by each individual. Gains and losses are borne in accord with taxes, rights to use government resources, and powers of political office. In a system of private property with open access to trade, consequences—value-change of resources, profits, and losses—are borne by the owner. By selectively purchasing and selling goods, people can adjust the combination of risks they bear. The right to buy and sell facilitates or permits profits and losses to be revised in accord with consumers’ personal preferences.

  • 21)

    A wealthy industrialist has a stable of race horses and a breeding farm. The two, although operated as a business, lose over $500,000 annually. Yet that continues year after year because the owner enjoys the activity more than spending a similar sum for travel or conventional types of consumption activities.

    • a. Is the owner maximizing wealth in that business?
    • b. Is that behavior maximizing personal worth?
    • c. Would an increase in the losses induce a decrease in that kind of activity? What does economic theory say about that?
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    • a. Probably not.
    • b. Probably yes.
    • c. Yes. The higher the price, the less will be demanded.
  • 22)

    A large lake is stocked with excellent fish, but no one owns the fish or the lake. Only by catching the fish can you acquire ownership in the fish.

    • a. What do you think will be the average age of fish caught as compared to the age of the fish in a privately owned lake?
    • b. Which system will induce overfishing in the sense that more resources will be devoted to catching fish than the extra fish caught are worth? Why?


    • a. Fish will be younger and smaller, for the same reason that apples don’t ripen in a public park. No one owns the fish (or trees in a public park), and the only way to capture the value of the fish is to catch the fish (or to cut a tree on public lands and take the wood).
    • b. When no one owns all fish in the lake, the extra value of the fish taken will be judged by each separate fisherman according to his catch rather than by the total catch in the lake. Absence of property rights in the lake causes competition to acquire property rights in the fish by catching them first.
  • 23)

    Someone invents a new type of sail for a boat to capture the force of the wind. The inventor makes some sails and offers to rent them to a boat’s owner. Instead of accepting this offer to rent sails, the boat’s owner estimates that by taking a year off from fishing and investing one year of his crew’s time in making their own sails, he and his crew could then catch more cod. He also estimates that the value of the additional cod caught in the subsequent three years of fishing will be greater than the cod sacrificed while making the sails plus the cost of renting sails. The boat’s owner puts the decision whether to rent sails now or take a year off from fishing while they make their own sails to a vote by all the people on the boat. The decision is against the proposal to take the year off and make their own sails. Why is that result not surprising?


    Nonowners are less interested in the future effects than are owners, who are interested in the present value of the longer-run gains from current investment, as explained in chapter 30 on capital values. Ownership of a resource forces attention to capital values, which reflect the full long-run Edition: current; Page: [194] effects, and the owners bear the effect in the salable capital value. Employees bear less significant effects. “Employee ownership” does not give an employee any rights to sell a portion of that “ownership,” as can be done with one’s ownership in a stock corporation. What an employee “owns” is a right to vote on a decision about who will manage the “employee-owned” enterprise, but not the right to sell shares “owned” by the employee. Management is under less extensive policing by shareholders, who can sell their shares.

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The pricing and allocation of existing goods was the primary topic of earlier chapters. But what determines who produces which goods, and how much of each? You will not produce everything you consume, as a Robinson Crusoe would have to do. Somehow, we are persuaded to produce and sell goods demanded by other people, and in doing so we become richer than if we were self-sufficient. We start by explaining (a) the difference between productive ability and cost and (b) the meaning and typical pattern of marginal costs.


Bill and Susan each can produce cake and jam. Table 14.1 lists a) their productive abilities and b) their costs of producing cake and jam. Superior productive ability does not mean lower costs.


Costs, by definition, reflect the relative productive abilities—for making cakes relative to making jam, or making jams relative to cakes. Bill’s productive ability is such that he could produce up to ten cakes or five jams in a ten-hour day. His cost of making one jam is 2 cakes (= 10 cakes/5 jams), which is the amount of cake forsaken if 1 jam is produced. Each jam not produced releases time and resources to make 2 cakes. Bill’s cost of making a cake is half (.5) a jar of jam (= 5 jams/10 cakes), the amount of jam not produced in order to make one cake.

Susan’s cost of making a cake is .67 jam (= 10 jams/15 cakes). Each cake forgoes .67 jam she could have made that day. She is twice as productive as Bill in making jams (10 jams/5 jams), and she is 50 percent (1.5 times) more productive in making cakes than is Bill. It’s tempting to conclude that Susan therefore is a lower-cost producer overall. But she does not have lower costs in both jam and cake: she cannot produce cakes as cheaply as Bill can.

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Table 14.1 Production and Costs
Daily Productive Ability Daily Costs
Producers Jam Cake Jam Cake
Bill 5 jams or 10 cakes 2.0 cakes. .50 jam
Susan 10 jams or 15 cakes 1.5 cakes .67 jam


Absolute productivity abilities do not tell us anything about the costs of producing goods. Suppose some miracle causes an increase of Bill’s productivity in both goods by 10 times—to 50 jams and to 100 cakes daily. Bill’s marginal and average costs of making one cake would be unchanged, 2 jams (= 100 jams/50 cakes), and the marginal and average cost of jam would still be .5 cake (50 cakes/100 jams). The cost of jam is the trade-off in the amount of other goods forgone when producing a jam; that is, the amount of other goods necessarily forgone. Superior absolute physical productive ability in every good does not mean lower costs in everything.


No one can have a lowest cost in every good. No matter what numbers you put into table 14.1, Susan cannot have lower costs in both activities, though she could be capable of producing more of each than Bill. This is true no matter how many different goods a person could produce, or how many people are involved. A greater absolute productive ability will result in greater production and earnings or in greater wages per day of work. But differences in costs reflect differences in comparative production ability between goods.


Absolute advantage refers to greater absolute productive abilities such as Susan’s in both cake and jam. But Susan’s relative ability in cake compared to her ability to make jam is inferior to Bill’s. Susan is a lower-cost producer of jam. She has a comparative advantage in making jam; similarly, compared to Susan’s abilities, Bill has a comparative advantage in making cakes. So, even if Bill is inferior in his absolute ability to make cakes, he is superior to Susan in his relative ability to make cakes.

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There are measures of cost which should be separated. One is the average cost of cakes (no matter how many), and another is the marginal cost of a cake. The average daily cost of making cakes is the total cost of the cakes divided by the number of cakes. For Bill, that average is .50 jam per cake (= 5 jams/10 cakes), no matter how many cakes he makes daily. Similarly, Susan’s average cost of cakes is constant at .67 jam daily.


Bill’s marginal costs of cake are .50 jam at every possible rate of daily output of cake, because each added cake raises costs by .5 jam. That increase in cost—the marginal cost—happens here to be numerically the same as the average cost. No matter how many cakes Bill produces, the added cost for one more is .5 jam. And when the added cost equals the previous average, that is, when marginal cost equals average, the average remains unchanged.

Susan’s daily marginal cost is .67 jam. Each added cake diverts her productive effort from jam, resulting in a reduction of .67 jam. That’s the increase in total daily cost of making one more cake.


Three arithmetic simplifying assumptions have been made which we’ll remove later. The first is that there is no initial set-up investment, for example, an oven or dough-making equipment. Second, there are only two goods of interest, cake and jam. Third, the marginal and average costs of cakes and of jams are constant—the same at every possible rate of daily production.


If superiority is a result of a natural superior productive ability (achievable neither by investment nor training), it is often labeled Ricardian superiority. (The name is for David Ricardo, the eminent economist of the early nineteenth century who formulated the conception, and who undoubtedly had some.) That natural superior ability can be distinguished from ability obtained by (a) investment and training in enhancing one’s productivity or by (b) restricting or prohibiting other people from competing (a contrived monopoly rent). Muhammad Ali, Milton Friedman, and Whitney Houston undoubtedly had Ricardian superiority and became rich and famous because of Ricardian rents; they did not benefit from monopoly rents.

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It is important to distinguish between (1) the rate, or speed, of production and (2) the total amount, or volume, to be produced when referring to costs. Cost of production depends on the rate and volume of production in ways similar to the way cost of travel depends on speed and distance. These are guides about relations between costs and rates and volumes of production of a good:

  • 1) The larger the volume, the higher will be total cost.
  • 2) The faster the rate of production of a specified volume, the higher will be the total cost of producing that volume.

Usually, the marginal cost of volume is lower at a larger volume. (But if some exhaustible resource is being produced, such as iron ore, oil, or coal, the cheapest is extracted first.) And that means the average cost per unit of volume falls. And marginal cost may fall as a result of learning by doing or experience.

There are two different amounts of production to consider. One is the rate per time period; the other is the total number to be produced, whatever the speed at which that volume is produced. When Ford prepares to make a new model, the process selected will depend on estimates of how many it will make and also upon how fast it plans to make them. Certainly, the volume will make a difference in the method of production to be used and in the average cost. Typically, the faster the cars are produced with any given method of production, the more each will cost. But with larger total numbers to be produced, mass production techniques will permit lower cost per unit produced.

In traveling, you don’t confuse miles per hour with total distance. So, when referring to more, or greater, or higher production, distinguish between (1) a greater speed at which some fixed volume is produced, and (2) a greater volume at some fixed speed. In this chapter, we’re concentrating initially on how costs are affected by the speed of production—rate per day—of some given total planned volume. That’s similar to concentrating on how the cost of driving an assigned distance depends on the speed and how the amount of gasoline required increases at higher speed.


Realistically, marginal costs (increases in total cost) tend to be higher the faster the rate of production. Adam is producing cakes, but we don’t know what he might be able to produce instead. In the Bill and Susan example, there were

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Table 14.2 Adam’s Daily Production Costs (in Units of Y)
Daily Output of Cakes Total Cost Marginal Cost Average Cost Alternate Product, Y (Dollars) Marginal Worths of Cake
1 2 3 4 5 6
0 - - - 13.50 -
1 .90 .90 .90 12.60 1.15
2 1.90 1.00 .95 11.60 1.05
3 3.00 1.10 1.00 10.50 .95
4 4.20 1.20 1.05 9.30 .85
5 5.50 1.30 1.10 8.00 .75
6 6.90 1.40 1.15 6.60 .65
7 8.40 1.50 1.20 5.10 .55
8 10.00 1.60 1.25 3.50 .45
9 11.70 1.70 1.30 1.80 .35
10 13.50 1.80 1.35 0.00 .25

just two possible products, jam and cake. In the world of Adam, cost means the highest forgone value of many alternative possibilities. We’ll call that highest-valued production alternative Y, and measure it in dollar values, as $Y. The dollar value measure of the cost is a measure of the value of forgone real goods or services, without having to know which particular goods are forgone. We need only note its dollar value measure, $Y. All the data are in table 14.2.

The first column lists the number of cakes Adam could produce daily. The next to last column lists the dollar value of the bundles that Adam could produce instead of producing the indicated amounts of cakes. If no cakes were produced, Adam could produce 13.5Y; if he produced one cake, 12.60Y could still be produced; he could produce two cakes and 11.60Y.

The second column, Total Cost, lists the largest daily value that must be forgone. If 1 cake is produced, .9Y cannot be produced; so the total cost of one cake is .9Y. If 2 cakes are produced daily, 1.9Y are forgone. That’s the total daily cost of 2 cakes; the addition to total costs at 2 cakes rather than just 1 is 1Y (= 1.9Y − .9Y). That’s the marginal cost at 2 cakes, listed in the third column. The fourth column lists the average cost. For 2 cakes, it’s .95Y per cake (= 1.90Y/2 cakes). Finally, the last column on the right lists marginal worths of cakes for Adam’s own consumption. As explained in chapter 5, a person’s worth of something is defined as the amount of other goods that person would be willing to give up to get it.

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Marginal daily rate of cost is the increase in the cost of a one unit greater daily rate of production. Marginal pertains to a double margin—the added unit of production and the added cost. At three cakes daily, the total cost is 3Y—the most of other products that could otherwise have been produced. If a unit of Y has a market value of $1, then we can refer to dollars, rather than units of Y, as the measure of the cost. The 3Y total cost of the 3 cakes would be $3. That’s $1.10 more than the 1.90Y ($1.90) total cost of two ($1.10 = $3 − $1.90). Therefore, the marginal cost of the third cake is $1.10.


Since we have assumed there is no initial set-up investment cost, the marginal cost for one cake per day added to the marginal cost of the second will give the total daily cost of two cakes per day. If the marginal cost at three cakes is added in, the sum will be the total cost of three cakes per day. In dollar equivalents, that’s $3 (= $.90 + $1 + $1.10).

Figure 14.1

Adam’s Marginal and Average Daily Costs at Various Daily Rates of Production

The total cost of producing at the rate of six cakes daily is the sum of the successive marginal costs—0.90Y + 1.00Y + 1.10Y + 1.20Y + 1.30Y + 1.40Y = 6.90Y. That’s represented by the sum of the marginal cost bars out to six cakes. The total daily cost at six units per day is 1.4Y more than at five units per day.

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The relationship between the marginal and average costs is not immediately obvious. Notice that the marginal cost for seven exceeds the average cost at six. The average cost for seven cakes is pulled up above the average cost at six, because marginal cost—the added cost—in making seven ($1.50) is higher than the average at six ($1.15).

Bruiser Bill, the star fullback on the football team, has an average of five yards per carry coming into today’s game. On the first carry today, he plows ahead for six. His marginal yardage being greater than the initial five-yard average, the average rises a bit, though not to six yards. Then he is stopped after a two-yard gain, which pulls down his average.

The marginal-average relationship can be summarized: A marginal that is lower than the average will decrease the average; a marginal greater than the average raises the average; if the marginal equals the average, the average will be unchanged.


Rising cost is tied to the faster speed, or rate, of production, not to an increased quantity produced. But there is learning by accumulated experience. Production of a larger fixed volume, whether at a slow or fast speed, permits and motivates learning by doing. Discovered lower-cost methods will be adopted. And larger volumes can be produced with a larger variety of methods than are optimal for small volumes. A hand hammer is more economical than a power hammer for a few nails, but not for thousands of nails.

The marginal costs of added units decline with larger volumes, whatever may be the rate of production. And marginal costs of increased speed rise with faster rates of production of whatever may be the volume. In the example of Adam’s activities, we looked at the speed, or rate, of production, not the total quantity or volume of cake or Y that Adam could produce. The amount of the planned total volume will strongly affect the chosen method of production, which we’ll consider later.


Now, we can identify a principle characterizing Adam’s choices of how many cakes to make daily and consume as a self-sufficient person. The principle is personal worth maximizing. Adam produces as many cakes as have marginal personal worths in excess of his marginal costs of cakes. The cost is the most worthy thing that could otherwise have been produced. Adam’s marginal worths of Edition: current; Page: [204] cakes, expressed in units of Y, are listed in column 6 of table 14.2. We don’t have to know the numbers. It’s sufficient for our purposes to know that Adam’s (a) marginal worths of cakes diminish at more cakes per day, and (b) the marginal costs in column 3 increase at higher rates of production of cakes.

Figure 14.2

Adam’s Marginal Costs and Marginal Worths at Various Rates of Daily Production

As shown in table 14.2 and figure 14.2, Adam’s marginal worths for cakes start at 1.15Y for 1 cake per day, diminish to 1.05Y at two cakes per day, and fall to .95Y for a third cake. Adam’s marginal costs start at .90Y at 1 cake per day, and increase to 1.0Y at 2 cakes and 1.1Y at three. For 3 cakes per day, the marginal cost of 1.10Y exceeds the marginal worth of .95Y. Therefore, Adam will produce and consume only 2 cakes daily and 11.6 units of Y (the other goods). The marginal worth of the good falls to, but not below, its marginal cost.


Why are marginal costs higher at faster (greater) rates of production? Basically, there are two reasons. One is that to produce more per day, more equipment is used, usually of the less productive, reserve equipment used only for the extremely high rates. But there’s a far more prevalent universal force—the law of diminishing marginal returns.

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The law: “As more units of one of the resources being used are added to a fixed amount of other inputs, the marginal returns with the additional units will, beyond some amount of that kind of resource, begin to decrease.” No exceptions.

The data in table 14.3 illustrate the law.

With none of the variable input being used, the output is zero. With one unit of the variable input, the total output is 6. With 2 units, the total product increases to 16, giving a marginal product of 10 units (10 = 16 − 6). The average output per unit of input is 8 per unit of the variable input (8 = 16/2)—but the average is irrelevant so far as the law of diminishing marginal returns is concerned.

The point of diminishing marginal returns is where the marginal products thereafter decrease—at 2 units of the variable input. Beyond that amount of variable input, the marginal product of an additional unit diminishes, even to becoming negative and reducing the total product.

If there were no diminishing returns to additions of one kind of input, we could grow the entire world’s wheat from one flowerpot of soil. We’d add seeds to that one pot and get as much wheat as desired from a small, fixed amount of soil. Or instead of seeds, we could add fertilizer and grow as much as desired.

The law of diminishing marginal returns doesn’t deny that at the initial

Table 14.3 Law of Diminishing Marginal Returns (Marginal Products)
Uniform Inputs Total Products Marginal Products Average Products
(1) (2) (3) (4)
0 0 0 0
1 6 6 6
2 16 10 8
3 24 8 8
4 30 6 7.5
5 34 4 6.8
6 36 2 6
7 36 0 5.14
8 32 -4 4
9 27 -5 3
10 21 -6 2.1
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amounts of the variable input, the marginal products may increase. But beyond some amount of that kind of input—holding the other inputs constant—the marginal returns (marginal products) will decrease, and continue to decrease, at all larger amounts of that input.

Figure 14.3

The Law of Diminishing Marginal Returns

In producing some product, when more units of one input employed in making that product are added, while all other inputs are fixed, beyond some point—here at input number 2—the addition to the output produced, the “marginal product” of that output, will decrease. The relationship between marginal and average continues to hold. As the marginal product decreases, it pulls down the average product.


It is often said that foreign labor gets lower wages per hour—thereby yielding lower costs per unit of output than the cost of producing with higher-wage labor in the United States. But this is a difference between the price of labor (wages) and the labor cost per unit of product.

The relationship is:

(1) Labor cost per unit of output = (2) Wages per hour / (3) Product per hour.

High wage rates per hour for one worker can reflect higher productivity, which can more than offset a less productive worker paid a lower wage. A higher-wage worker can be a lower-cost input per unit of product, as illustrated in table 14.4.

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Table 14.4 Wages per Hour and Labor Cost per Unit of Output
Nation Wages per Hour Units of Output per Hour Labor Cost per Unit of Output
With a US labor wage rate of $20 per hour and a productivity of ten units per hour, the labor cost per unit of product is $2. If wages in another nation were the equivalent of $10 per hour, but the hourly output were only 3, the foreign labor cost per product would be higher. Within the United States, a $100 per hour computer programmer is lower cost per program produced than is a $20 per hour programmer producing less than one-fifth as much per hour. High wages per hour can be low-cost labor per unit of output.
US Labor $20 10 $2
Foreign Labor $10 3 $3.33


  • 1)

    “A businessperson’s costs for material, labor, and equipment are measures of the other most valuable output the businessperson could produce with the resources he buys or hires.” Evaluate.



  • 2)

    Why are costs not measured in terms of labor hours?


    Hours of labor have different uses with different values for different quality of labor as well as for different uses of labor. How would you value one labor hour of a skilled surgeon in comparison to one labor hour of a supermarket stocker? Which one would you use as a basis for measuring cost? Hours cannot be used. The best forsaken use value of an hour is the cost of any hour of use of labor.

  • 3)

    What is meant by efficient production?


    Production is efficient if the output of one of the possible products is maximized for stated amounts of the other products. Or production is efficient if an increase in output of one of the products can be achieved only by reducing the output of some other product. Roughly, it means no waste of potential output.

  • 4)

    What is meant by a subsistence, self-sufficient, economy as contrasted to a specialized interdependent economy?

    Edition: current; Page: [208]


    A subsistence economy is one in which people consume only what they produce. Specialization means people produce more of a good than they consume, and consume more of a good than they produce. Specialization also generally means that producers do not produce complete consumer goods, but instead concentrate on components or portions of assembly tasks.

  • 5)

    A premier of a new emerging country bragged that he was going to make his country self-sufficient and independent of foreigners. Do the principles of this chapter suggest anything about how you, as a native of that country, might be affected?


    The boast suggests that you will be poorer and engage more in “do-it-yourself” activity. Reduced opportunity to trade limits the extent to which gains from trade can be achieved.

  • 6)

    Some years ago, India proposed to build a steel mill, and asked the United States government to finance the project. In defense of the request, an economist serving as American ambassador to India wrote: “There is no doubt that the steel is needed. While the plant would be costly, it would soon pay for itself in the imports that it would save. To import a million tons of steel products would cost the Indians about $200 million. The proposed mill with an annual capacity of 1 million tons would cost $513 million to build. Three years of operations would thus recover the dollar cost of the mill and more. Since India combines her pressing need for steel with an equally acute shortage of dollars, the economic attraction is obvious. She could not, in fact, afford to import the steel that the mill could supply.” Explain what is wrong with every sentence of that quotation except the third and fourth.


    First consider the costs and benefits of steel relative to other products that could be produced. How much steel is “needed” depends on costs as well as the relative benefits. India “needs” more of many things. Cost measures the value of other products that could be produced with the resources used to produce the steel mill. Are those other products more valuable relative to costs? Would you produce the steel mill that’s less valuable relative to costs? Next, consider whether it’s more economical (cheaper) for India to acquire steel by importing or building a steel mill. If it’s cheaper to import Edition: current; Page: [209] the steel, India can have the steel as well as more of other valuable products (such as more housing, schools, roads) that could be produced with released resources that would otherwise be used to build the more expensive steel mill. Imports are not costs.

    Present values (which we consider later) are ignored in the three-year calculation. “Need for steel” and “shortage” of dollars are rhetoric. India also has a “pressing need” for and an “acute shortage” of many other products, as do other countries. The issue is for which of those “pressing needs” and “acute shortages” the resources will be used. And what forms of competition will be utilized in determining what to produce and how to produce it.

  • 7)

    A lower-cost producer can produce more than a higher-cost producer. Do you agree?


    Can’t tell. Cost—marginal cost—reflects the cost of producing an additional unit of the product. But the total amount which might be produced by the lower (marginal) cost producer could be either more or less than the total amount which might be produced by the higher (marginal) cost producer.

  • 8)

    “Someone always has a comparative advantage in the production of some good.” Explain.


    Comparative advantage pertains to relative production-efficiency (output/input) ratios of different producers of more than one good. With two producers, unless one is absolutely superior by the same degree in two goods, each will be relatively superior in one good and inferior in the other.

  • 9)

    To incur a cost is equivalent to saying that one has sacrificed an opportunity. Do you agree?


    True by definition. Cost is what’s given up to get something. In production, cost measures the most valuable of the other products that could be produced with the resources.

  • 10)

    “Unfettered world trade would tend powerfully to reduce all workers (and other resource owners) to the world’s lowest level. For a nation with lower wages—and all nations do have wages lower than those in the Edition: current; Page: [210] United States—could then undersell us, not only in third markets, but in our own country. Thus, American producers would be ruined; or, in order for us to be able to sell and thus to survive, our wages would have to be cut to the lowest level of our competitors. It would be ridiculous to expose our high standard of living to the ruinous competition of the poorer rest of the world.” How could you dispute this?


    Confuses the price of labor (wages) with the cost of producing per unit of product. Cost is the value of output given up per unit of product. American wages of $20 per hour reflect the productivity of labor; they do not measure cost, which involves labor productivity per unit output. At 10 units of output per hour, cost is $2.00 per unit of output. Foreign labor with wages of $5 per hour may produce only 1 unit of output per hour. In this case, higher-wage, more productive American labor is a lower-cost producer than the low-wage, less productive foreign labor.

  • 11)

    Different dimensions such as rate and volume can be used to describe the amount of a product that’s produced. Although in the text we usually refer to both rate of output and the volume of output, in any actual problem different dimensions of output are relevant. If you are analyzing costs of operating an airline, for example, what measure or measures of output could you use?


    You could use rate and volume as we did in the text. Costs will be affected by, among other things, the size of the operation (type of planes, terminal accommodations, maintenance facilities and personnel, routes served) and the daily frequency of flights.

  • 12)

    Rates and volumes:

    • a. If every mile you travel at 40 miles per hour costs you 32 cents, while at a higher speed of 45 miles per hour each mile of travel costs you 34 cents, what’s the marginal cost of one more mile per hour increase in speed?
    • b. Does it mean that if you travel for one hour at the steady speed of 41 miles per hour, your costs will be higher than if you had traveled an hour at 40 miles per hour? Why not?
    • c. “If all the inputs could be increased as if by clones, they’d be available for use here only by attracting them from productive activities elsewhere. The more resources that are attracted away from producing Edition: current; Page: [211] other goods, the higher will be the resulting prices of those goods because less of them will be produced. That means the prices of the inputs demanded here will be increased, resulting in increasing marginal costs.” Right or wrong?


    • a. It’s a cost accruing at the rate of 2 cents per hour—no matter how far or how long your travel. If your time is worth $10 an hour, which speed is more economical for you?
    • b. That’s an increase in both speed and distance traveled, 41 miles compared to 40 miles and 41 miles per hour compared to 40 miles per hour.
    • c. Wrong. Diminishing marginal returns are not results of higher prices of the inputs, which may or may not be happening. Diminishing marginal returns are physical effects of not increasing all the inputs appropriately.

    Note: In chapter 2 we introduced the concept of the production possibility boundary; the following several questions build further on that concept.

  • 13)

    Smith’s daily production possibilities are indicated by the following table:

    Table 14QA.13
    Oats Soybeans
    10 and 0
    9 and .2
    8 and .4
    7 and ____
    6 and ____
    5 and ____
    4 and ____
    3 and ____
    2 and ____
    1 and ____
    0 and 2
    • a. Compute the missing data, assuming linear interpolation.
    • b. For each increment of oats, he incurs a uniform sacrifice of an amount of soybeans. The ratio between these two changes is the marginal rate of transformation between oats and soybeans. This rate also yields his marginal cost of oats (in terms of soybeans). What is the marginal cost of a bushel of oats? Edition: current; Page: [212]
    • c. Of a bushel of soybeans?
    • d. If that marginal cost is constant at all combinations, the production is said to involve constant costs. Does this example reveal constant costs?
    • e. Graph Smith’s production possibility, with oats on the horizontal scale.
    • f. On the graph, label, as point I, the output that has an equal number of bushels of oats and soybeans.
    • g. What is the number of bushels of each?
    • h. Which is the larger output—1.67 bushels of each, or 5 bushels of oats and 1 of soybeans?


    • b. 2 soybeans for 1 oats
    • c. 5 oats per 1 soybeans
    • d. Yes
    • g. 1.67 of each
    • h. Question is ambiguous. Are we to measure in units of number, weight, value?
  • 14)

    On the graph of the preceding question, plot the production possibility of Baker.

    Table 14QA.14
    Oats Soybeans
    3 and 0
    2.5 and .5
    2 and 1
    1.5 and 1.5
    1 and 2
    .5 and 2.5
    0 and 3

    Label this line BB and mark the point of equal numbers of bushels of oats and soybeans (that is, 1.5 of each).

    • a. What is the maximum amount of oats that Mr. Smith and Mr. Baker jointly can produce if they produce only oats?
    • b. Only soybeans?
    • c. What is the maximum amount of soybeans and oats they can produce Edition: current; Page: [213] if each person produces as many bushels of oats as he does of soybeans?
    • d. What is the total output of each if they divide their time and resources equally between oats and soybeans?
    • e. Which output is larger—where (i) each divides his time equally among the two products or (ii) where each produces as many bushels of oats as of soybeans?


    • a. 13
    • b. 5
    • c. 1.67 of each good for Smith; 1.5 of each for Baker
    • d. 5 oats and 1 soybeans for Smith; 1.5 of each for Baker
    • e. Meaningless question, comparing (i) 6.5 oats and 2.5 soybeans with (ii) 3.17 of each
  • 15)

    Introducing prices of the commodities with the tables given above:

    • a. If the price of a bushel of soybeans is $1 and the price of a bushel of oats is 50 cents, which good should Smith produce if he wants to maximize his wealth? Which should Baker produce?
    • b. If the price of a bushel of oats rises above $1 while soybeans stay at $1, what should Baker do if he wants to maximize his wealth?
    • c. At what ratio of prices would Smith be induced to produce soybeans?


    • a. Smith grows oats and Baker grows soybeans.
    • b. Switch to oats.
    • c. If the price of oats is less than one-fifth the price of a bushel of soybeans, Smith should switch to soybeans.
  • 16)

    What is meant by efficient production? Try two different versions of the definition.


    • a. Production is efficient if the output of one of the possible products is maximized for stated amounts of the other products.
    • b. Production is efficient if an increase in output of one of the products can be achieved only by reducing the amount of some other product.
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Unlike Adam, you’ll not be self-sufficient. You’ll provide some service to earn income, and you’ll be dependent on others to produce and sell to you many goods to consume. You’ll be richer as a result. This “specialization” avoids unnecessarily higher marginal costs of production. It’s an efficient allocation of production among producers. Specialization also permits concentration on one task, which can increase individual productive skills and the technology used.

We start with a two-person economy to indicate, first, the gains from specializing in production of a good for trade. In our imaginary economy, we find Adam of our preceding chapter joined by Baker. We’ll focus production on cakes and Y, as before. Baker’s productive abilities, marginal costs, and personal marginal worths of cakes are given in table 15.1. Baker’s personal worths of cakes are measured as the most of Y that would be given for a cake. Our attention will be on differences in marginal costs, which are the source of gains in production by specialization and exchange.

While self-sufficient, Baker produces and consumes 2 cakes (and 7.80Y) daily, with the marginal worth (.80Y) greater than the marginal cost (.60Y). At 3 cakes, Baker’s marginal worth of cakes would be .70Y, less than its marginal cost, .80. This is illustrated graphically in figure 15.1.


Table 15.2 reproduces table 14.2, which shows Adam’s self-sufficient costs of production and his (demand) personal worths of cakes.

Graphically, Adam’s marginal costs and personal worths are shown in figure 15.2. Like Baker, he will not produce a third cake for his own consumption, because the marginal cost would be greater than the personal worth.

Baker is less productive “absolutely” in both goods—cakes and Y. He can make only eight cakes daily (compared to ten cakes by Adam) or only 8.80 of other goods, Y (compared to 13.50Y by Adam). Adam has an “absolute advantage” in production of both goods. But that does not mean Adam is a lower marginal and total cost producer of both goods—as we discovered in the Susan

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Table 15.1 Baker’s Daily Potential Output and Costs of Cakes
Daily Output of Cakes Total Cost Marginal Cost Average Cost Alternate Product, Y (Bundles) Marginal Worths of Cakes
1 2 3 4 5 6
0 - - - 8.80 -
1 .40 .40 .40 8.40 .90Y
2 1.00 .60 .50 7.80 .80Y
3 1.80 .80 .60 7.00 70Y
4 2.80 1.00 .70 6.00 .60Y
5 4.00 1.20 .80 4.80 .50Y
6 5.40 1.40 .90 3.40 .40Y
7 7.00 1.60 1.00 1.80 .30Y
8 8.80 1.80 1.10 0 .20Y

and Bill example. Absolute productive abilities indicate how wealthy a person will be—not a person’s costs of production. It’s the differential abilities in one good relative to other goods that defines costs of production of the good.

Figure 15.1

Baker Being Self-Sufficient with No Trade or Specialization

Despite having less absolute productivity in every good, Baker has lower marginal, average, and total costs of cake in the range of production of 1 through 5 cakes daily. Above that range, Baker’s marginal costs of cakes (for-gone other potential product, Y) exceed Adam’s marginal costs.

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Table 15.2 Adam’s Daily Production Costs (in Units of Y)
Daily Output of Cakes Total Cost Marginal Cost Average Cost Alternate Product, Y (Bundles) Marginal Worths of Cakes
1 2 3 4 5 6
0 - - - 13.50 -
1 .90 .90 .90 12.60 1.15
2 1.90 1.00 .95 11.60 1.05
3 3.00 1.10 1.00 10.50 .95
4 4.20 1.20 1.05 9.30 .85
5 5.50 1.30 1.10 8.00 .75
6 6.90 1.40 1.15 6.60 .65
7 8.40 1.50 1.20 5.10 .55
8 10.00 1.60 1.25 3.50 .45
9 11.70 1.70 1.30 1.80 .35
10 13.50 1.80 1.35 0.00 .25
Figure 15.2

Adam Being Self-Sufficient with No Trade or Specialization

In figure 15.3, Baker’s marginal costs at the lower rates of producing cakes are less than Adam’s, but Baker’s marginal costs rise more rapidly at the faster rates of production to an equality with Adam’s at a daily rate of 6 cakes. Above that rate of production, Baker’s costs of producing are greater than Adam’s. When thinking of costs, think of “at what rate of production”?

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Figure 15.3

Adam and Baker’s Marginal Cost Curves for the Production of Cakes per Day


Both being self-sufficient, Adam and Baker each produces and consumes two cakes per day (they do not produce partial cakes/day). However, they can do better. The difference in their marginal worths at the amounts of cake they can produce implies there can be gain to both by trade. Baker will not produce a third cake for his own consumption, for the marginal cost of .8Y is greater than the marginal worth to him of only .7Y. But Baker making a third cake and selling it to Adam is beneficial to both so long as the price is less than Adam’s marginal worth of a cake and higher than Baker’s marginal cost of making the cake.

As the data in tables 15.1 and 15.2 show, it would cost Adam 1.10Y to produce a third cake, but it is worth to him only .95Y, so he won’t make it. But Baker offers to sell him a cake for only .90Y—less than it is worth to Adam—and they both gain.

Adam ends with 3 cakes and 10.7Y (= 11.6 − .9 expenditure), instead of the original 2 cakes and 11.6Y. After selling his produced third cake, Baker still has 2 cakes with 7.9Y (= 7.8 − .8 marginal cost + .9 receipts from the sale), instead of 2 cakes and 7.8Y. Under self-sufficient production, Adam and Baker produced and consumed a total of four cakes. By cooperating and engaging in Edition: current; Page: [218] exchange, they are able to consume a total of five cakes. Side-by-side, the data from tables 15.1 and 15.2 are shown in figure 15.4.

Figure 15.4

Mutually Beneficial Production and Exchange: Baker Produces Extra Unit to be Sold to Adam


Though the preceding exposition relied on a two- person economy producing two kinds of goods—X and everything else, represented by Y—the analysis applies to the real economy with many goods and millions of people concentrated in cities with both small and giant firms engaged in international trade.

In a two-island economy, the lower-cost island can catch more fish than is demanded by its own population, and sell the extra fish to those on the higher-cost island. The individual and combined wealths of the islands will be increased. It will be profitable for the first island to expand production beyond its own demand as long as the marginal cost of production is less than the demand for, or marginal worth of, additional fish to those in the second island. The equilibrium price is where total quantity demanded is equal to total quantity supplied.

Where just two people are involved in a trade, the trade that occurs must be mutually desired, else it wouldn’t take place. But when more than two people are concerned, as with international trading, some people in each nation are likely to be adversely affected. There are appeals such as, “Keep the money at home,” “Buy American,” “Be self-sufficient.” And, of course, “Don’t buy Edition: current; Page: [219] products from greedy corporations selling goods made by exploited, low-wage foreign workers.”

Are the opponents to trade confused? Possibly some are. But is there a valid basis for some of their objections?


Two substantial objections are voiced to admitting more people to buy and sell in an economy. One pertains to national defense. An import may be a military item which would make the country’s defense dependent on another nation. This objection is obvious, but deciding when a component part—such as for a computer—might have a military application is not always obvious.

Another objection is the reason for most of the raucous demonstrations in favor of maintaining barriers to international trade. Domestic incomes are threatened! The imports, whether shipped in or produced by an immigrant worker, would compete as substitutes for goods made by those already in the market. Into the Adam and Baker economy we introduce Carter, a foreigner who proposes to be allowed to enter (either as a person or as products from Carter living abroad). Carter’s production data are in table 15.3 and shown in figure 15.5.

Like Adam and Baker, Carter produces in isolation only two cakes for his own consumption. He does not produce a third cake because the marginal cost is .60Y while the marginal worth to him is only .30Y. Carter then learns about the Adam/Baker economy in which Baker is selling a cake to Adam for .90Y. Carter realizes that he can produce a third cake more cheaply than can Baker, so he offers to sell a cake to Adam for .65Y, less than Baker’s marginal cost of producing a third cake.

Table 15.3 Carter’s Daily Production Costs (in Units of Y)
Daily Output of Cakes Total Cost Marginal Cost Average Cost Alternate Product, Y (Bundles) Marginal Worths of Cakes
1 2 3 4 5 6
0 - - - 3.00 -
1 .20 .20 .20 2.80 .50
2 .60 .40 .30 2.40 .40
3 1.20 .60 .40 1.80 .30
4 2.00 .80 .50 1.00 .20
5 3.00 1.00 .60 0 .10
Edition: current; Page: [220]
Figure 15.5

Carter Being Self-Sufficient with No Trade or Specialization

Adam, the major consumer of cakes, gains by buying cakes at the new lower price from Carter. Baker must reduce his production back to only two cakes, forgoing the extra income he had earned by producing and selling a third cake to Adam. The reduction in price of a third cake to Adam reflects part of what Baker lost as income when Carter entered and supplied more cake. The gain to Adam is partly a transfer from Baker, not part of the increase in social income. Some resources formerly used by Baker to make the third cake will have to move to make more of other goods, Y. This increased production by the released resources is the social net benefit consequent to Carter’s entry, and is shared by everyone to the extent they buy goods produced by Baker’s resources in their new activity.

The effects of Carter’s entry are a lowered price of cakes with a benefit to Adam, a loss to Baker, and a higher income to Carter. If Baker’s released resources were people, rather than physical resources, they would object to having to find new jobs, possibly with a lower wage, but with some chance of a higher wage. It is the owners of the displaced human or nonhuman resources, as competitors to the new entrant, who object to Carter’s entry.

The opportunities for improved economic well-being of Adam, Baker, and Carter are the same as for Atlanta, Boston, and Chicago and also the same as for Argentina, Brazil, and Chile. Specialization and trade allow productive resources to be employed in their most cost effective uses, and neither the size of Edition: current; Page: [221] the trading partners nor political boundaries alter these basic economic principles.

In considering disputes about enlarging access to any market, economic principles say there’s always a total net economic gain, though there are likely to be some who lose, but less than the others gain. There is a net gain in worth of aggregate national production by the release of resources to their next best production alternatives. That is what is meant when it is said that freer, more open trade is beneficial.


Suppose an existing investor produces a product at a cost of $10 a unit. The selling price is $12, generating a profit of $2 per unit. You see an opportunity for you to copy his technique and start production at the same cost of $10 a unit. You can cut the price to almost $10 and still make a small profit. The prior investor-producer responds by matching your price, rather than losing everything. The price is competed down to the $10 cost, leaving you with no profits. The profit stream was competed away to consumers through lower prices when the new competitor’s output increased the total supply. There was gain in social output, and transfer of that increase in social output to consumers as a result of entry by a competitor.


Innovations might be quality improvements instead of cost reductions of existing products. The same general consequences occur. Suppose you had improved the quality of the product, making it worth $1 more than the existing product, but you can still make it at the same $10 cost. You might try initially to sell your improved product for a price $1 higher—$13 instead of the prevailing $12 price. However, your competitors could respond by cutting their price below $12 to retain sales.

You might then counter by lowering your price to $11—reflecting the worth of your products’ $1 greater quality to consumers. You’d still receive $1 profit (your cost is $10). Competitors would receive only $10, matching their costs. To recap: consumers used to pay $12, leaving the producers with a $2 profit. Consumers would have been willing to pay $13 for your improved product, but your entry into the market increased total supply and competition drives down the prices of both the older product and the improved version to $10 and $11, respectively.

All profits the prior producers would have obtained in the future are transferred Edition: current; Page: [222] to the consumers by the lower prices. Your profits of $1 ($11 price minus $10 cost) reflect and constitute your contribution to the increased worth and value of output.

National Development

These examples outline the basic elements of actual economic development in a nation. If there were any additional investments that would be profitable, whether by foreigners or domestics, competition in the production and sale of the product would increase the supply and lower the product price. That permits everyone to have more at unchanged money earnings. And competition to hire people would drive up wages.

These are the two fundamental ways in which societies develop: (1) initial saver-investors get all of the first investment gain; (2) subsequent competing entrants (a) lower the cost of living, and (b) drive up (real) wages. In each step, competition from newcomers is essential. Competition from foreign or local investors increases output, lowers product prices and the cost of living, and thereby raises standards of living. The initial investor’s prospects of profits attract and motivate these two forces of gain to the entire population.

The gains from foreigners’ investment are as real and large to the rest of the public as are gains from investments by local investors, although it is often complained that foreigners invest and “take all the profits” away. Note the similarity of this analysis to how, in the refugee camp (of chapter 4), the second intermediary reduced costs and further benefited the refugees.

Development of a nation into a richer society requires profitable investment. Competition in investments distributes the gains over the society through higher (real) incomes and lower product prices. Natural resources like land, rain, and sunshine are desirable, but they don’t produce income without labor and investment.

Without labor and investment, there is no way for more to be produced, and without competition, the gains are distributed less rapidly and extensively. The large benefits popularly attributed to greater internationalization are the effects of increased competition involving other nations, where security of property and rule of law prevail.

To object to domestic corporations investing abroad on the grounds that they are exploiting foreign employees (who are less educated people working at lower wages) is to condemn those poorer people to continued poverty. Those who might benefit from curtailment of foreign investment and trade are domestic higher-income workers whose productivity is not great enough to offset the competitive pressures of lower foreign wages.

The losers from limiting foreign investment and/or trade include a) the Edition: current; Page: [223] domestic consumers who would lose the benefits of lower prices on products made by foreign workers and b) the domestic workers who would have made products that could be exported and sold to the foreign consumers who are now enjoying rising standards of living.

Local Residents instead of Foreigners as the New Entrants into Production

Existing domestic competitors incur a loss as a result of new investment (as did Baker in the preceding example) while consumers of that product (Adam) get a benefit. If Carter—the owner of the new firm—is a resident of the nation, there’s rarely any protection or compensation for the already existing producers. But if he is a foreign producer, there may be a call for protection from competition. But no matter who is the new investor, the profit stream to the new firm will later be eroded as it’s passed to consumers by competition from other producers.

To be fully effective as a competitor, Carter doesn’t have to migrate personally into the Adam-Baker economy. Instead, Carter could have been a foreign investor who installed manufacturing equipment and hired local laborers to work in the new bakery. The effect is not different when the new investors bake cakes abroad and ship them to Adam-Baker, rather than produce down the street from them. The only difference would be that Baker would object to the imports, claiming the investors were exploiting low-paid foreign workers—who should be protected by not buying the products they make.

You can’t blame the Bakers for espousing those self-protective, illogical contentions. But you can blame people who believe these faulty contentions. The foreign laborers would prefer that even more of them should be “exploited” by foreign investors. The surest way to aid foreign workers is to encourage purchase of more, not less, of the foreign supplied goods, and also to advocate more internationalization of investment for more products from the less-developed nations.


1.: Avoiding Unnecessarily Higher Marginal Costs

There is specialization in production of just one or a few kinds of goods for sale while consuming a variety of purchased goods. In a modern market economy, everyone specializes in production, because we can buy most goods at less cost than producing them ourselves. Think of this as an avoidance of unnecessarily higher marginal costs for what one consumes.

A society that permits markets to direct the production of various goods to their lower-cost producers will become increasingly richer. Economists in Edition: current; Page: [224] the eighteenth century—such as David Hume and Adam Smith—first emphasized this higher-cost avoidance when analyzing the reasons for promoting international trade.

2.: Increased Absolute Productive Ability, or “Learning By Doing”

A different form, or meaning, of specialization is producing one good or doing one task more efficiently, regardless of whether the product will be sold in a market. “Practice makes perfect” and “learning by doing” are ways of expressing it, increasing facility in that specific task. It often results in discovery of new ideas and new methods.

Individual productive skills are increased by practice and repetition. Since we cannot concentrate on everything, we are bound to specialize to some extent and to develop superiority in some tasks relative to others. This effect increases our dependence on other people to produce more of what we consume. Graphically, this is represented as a downward shift of the marginal, total, and average curves of costs of production.

This gain in absolute productive ability and technology is expected by almost every producer. It’s been quantified into something called a “learning curve” or “progress curve” representing declining costs per unit of product—perhaps as large as 20 percent with every doubling of the amount produced.

But of course you also would learn to be better at each of many tasks if you don’t specialize. So what’s the benefit of learning to be a lot better in one, rather than somewhat better in many tasks? Why specialize in being better in just one task?

3.: Avoiding Wasteful Investments

A reason people specialize in learning certain skills—rather than learning many things less intensively—is that they avoid wasteful investments in learning tasks they might later use only rarely, if at all. Not all attainable skills would prove to be very valuable.

4.: Greater Specialization and More Productivity the Larger the Population in a City

The larger the city in which you work, the more you are likely to be able to use your specialty all the time. Your investment and learning in one specialization will be more profitable. With only one doctor to supply a town, that doctor would be supplying a variety of health care services as a generalist. If the population is large enough for several doctors, each could concentrate on a narrower specialty that would result in greater knowledge and skills.

Specialists know a lot about one thing, rather than a little about many Edition: current; Page: [225] things. Similarly, a restaurant chef in a small town couldn’t concentrate on one kind of food—a specialty restaurant—as a chef could in a big city. Teachers in the little red schoolhouse in the smaller towns taught every subject. The same is true of repair shops, hairstylists, and antique stores. Average income and wealth of residents of the larger cities tend to be greater than in smaller towns, though on the margin the benefits of big and small cities tend to be the same.

In recent decades, electronic communications have reduced the costs of communicating among dispersed people. This effect reduces the value of being physically closer together in cities, and tends therefore to permit more specialization among the physically dispersed.

5.: Larger Volumes in Larger Markets Reduce Total Costs of Production

An additional gain associated with a larger population is the lowered cost of mass production of a larger volume of a good. The technological procedures for larger volumes of output are cheaper per unit. Larger volume of the same product can be produced at both lower average and marginal costs. Imagine what clothing would cost if every garment were unique, with a very small volume of each type, or if every automobile were specially handmade.


Industries tend to concentrate (specialize) in regions. Obvious cases are agricultural products that grow best in certain climates and terrains. Historical cases have been Detroit for automobiles, Los Angeles for movies, San Jose, California, for electronics, and of course, major seaports for international shipping. In recent decades, new auto assembly plants have been in southern right-to-work states with more flexible labor laws.

Concentrations of production can depend upon the site of some raw material—coal, iron ore, timber, weather, a confluence of rivers, or oil deposits. But if demand for a product falls, many of the jobs in that area fall in value. Cities that are more specialized in particular industries have a higher risk of swings in employment, but wages are higher as a compensating adjustment.


  • 1)

    Increased output resulting from more efficient specialization is distributed via what means in a capitalist open-market system?


    Open access to exchange of the products, property rights to products and services. Also assumed is the desire of each person to obtain a more preferred situation through additional profits or lower costs of obtaining the product.

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  • 2)

    “It is better to buy from a firm that is losing money than from one that is making a profit, because the former firm is charging too low a price while the latter is charging more than costs.” Evaluate.


    Not necessarily correct. Losing firm may have higher costs than the profitable firm.

  • 3)

    In the discussion on pages 214–18, let Mr. C be a resident of Japan, while the others are residents of the United States. Mr. A is a tuna-boat owner and fisherman; B are American workers in other American industries. Let Y be “tuna” and X be “other products.” Mr. A persuades his congressman to induce other congressmen to join him in passing a law prohibiting the importing of Japanese tuna—product Y produced by Mr. C. Who gains and who loses by a tariff or embargo on Japanese tuna? (This example captures the essence of the purposes and effects of tariffs and embargoes.)


    B loses compared to what he would have been able to purchase with his income had C been able to produce Y and sell to A. A keeps wealth compared to what he would have had with open access to markets by C. That C lives on an island across the Pacific rather than on the American continent does not change effects.

  • 4)

    The three-person problem can also be interpreted as a case in which admission to the market for sale of one’s production of Y requires a license from the state, and this license is given only if the current output from those now in the production of Y is deemed “inadequate to meet current demands.” Who gains and who loses? Can you give some real examples of this situation?


    There are literally hundreds of products and services that require licenses, certificates, or permits in order to produce and offer for sale. In some states, even home decorating advice and braiding hair a certain way can require a license that might require hundreds or even thousands of hours and dollars to obtain.

  • 5)

    Would the three-person, new entrant problem also serve as an example of the effect of apprenticeship laws that prohibit a person from acting as a “qualified” carpenter, meat cutter, and so forth, until he has served a specified number of years as an apprentice? Explain.

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    Yes. Such requirements delay entry.

  • 6)

    “The increased output of specialization is distributed as profits and as a lower price to consumers.” What determines the portion of each?


    Speed of entry of new resources and their similarity to existing resources.

  • 7)

    Does efficient production assume that perfect knowledge exists? Explain.


    No. It assumes that existing knowledge can be used and subjected to performance tests. It assumes no restrictions on rights to purchase or exchange knowledge. Knowledge is a valuable (economic) resource. To assume it is free is, for example, to deny that teachers perform a useful and desired service. A substantial fraction of our wealth is devoted to gathering information of one kind or another. Do not suppose that ignorance is always irrational, ridiculous, or the result of inefficiency or wastefulness or lying.

  • 8)

    Do you think specialization will be carried to a greater extent in a large city or a small one? Why? Give examples of what you mean by greater specialization.


    Large. Greater variety of relative talents and training so that differences between people’s relative abilities are more common. Further, the larger market enables a person to sell more of his special output at profitable prices.

    Greater concentration of time on same repeated subtasks. For example, hair shearing for poodles only; architects specializing only in certain types of buildings; greater number of specialty shops such as medical specialties—foot specialist, ankle specialist, knee specialist.

  • 9)

    Evidence of the great, but not always helpful, extent of specialization of knowledge is provided by Albert Einstein’s assertion (Socialist International Information): “The economic anarchy of capitalist society as it exists today is in my view the main cause of our evils. Production is carried on for profit not for uses.” Expose his error in economic analysis.


    Capitalist society does not restrain production. Production for profit is production for higher-valued uses—not just anything for any use. Einstein Edition: current; Page: [228] didn’t seem to understand what value and costs meant or how they affected profitability.

  • 10)

    A steals from B successfully. Is that “production”? Why? If you say “No, because someone is hurt,” what would you say about the case in which a new invention displaces some other producers? Are there some kinds of production that you think should not be allowed?


    Usually “production” refers only to activity that is not illegal. We wish we knew a better answer. The question helps to reveal the hidden normative content of concepts that at first seem to be objective and free of ethical presuppositions.

  • 11)

    If it were illegal to sell automobiles outside the state in which they were made, would cars be cheaper or more expensive in the United States? Give two reasons for your answer.


    More expensive since we would lose the gains of a) volume and b) greater specialization.

  • 12)

    Why do manufacturers produce a few standardized models rather than a much larger variety of custom-made, custom-designed models?


    Public prefers lower-cost standardized models rather than greater variety of higher-cost custom models.

  • 13)

    When a group of Soviet officials touring American farms asked, “Who tells the farmers how much to produce in order to supply the appropriate amounts of goods?” the host farmers said that no one told them. But the Soviet visitors were convinced the American farmers were concealing something. What would you have told the Soviet visitors?


    Private property rights plus knowledge of the market prices of various alternative crops make rational individual decision making feasible.

  • 14)

    A former president of the Rockefeller Foundation said after a trip to China, “China is now able to meet all of its energy needs and is even in a position to export energy.” Is that a meaningful statement? If so, does it mean China is better off than if it imported sources of energy? Why?

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    How much energy does China “need”? China also “needs” schools, roads, hospitals, and teachers. At what price? Which sources of energy and how much—coal, gas, electricity, nuclear—and what is the cost relative to value of each? Would China be better off (wealthier) producing energy domestically if it were cheaper to import energy? Why? If it imported cheaper foreign energy, China could produce products using fewer resources than if it used more expensive domestic energy sources. With the released resources (from using cheaper imported energy) China could produce more of other valuable products.

  • 15)

    Evaluate and compare the following statements on the immediate source of the “gain from trade” by an eighteenth-century economist and a nineteenth-century economist:

    “Foreign trade . . . carries out that surplus part of the produce of their land and labor for which there is no demand among them, and brings back in return for it something else for which there is a demand. It gives a value to their superfluities, by exchanging them for something else, which may satisfy a part of their wants, and increase their enjoyments.”1

    “The only direct advantage of foreign commerce consists in the imports. A country obtains things which it either could not have produced at all, or which it must have produced at a greater expense. . . . Adam Smith’s theory . . . was that it afforded an outlet for the surplus produce of a country. . . . The expression, surplus produce, seems to imply that a country is under some kind of necessity of producing the corn or cloth which it exports; so that the portion which it does not itself consume, if not wanted and consumed elsewhere, would either be produced in sheer waste, or if it were not produced, the corresponding portion of capital would remain idle.”2


    The nineteenth century wins. We gain from what we get, not from what we give up. We gain from imports embodying foreign resources; exports are Edition: current; Page: [230] a cost, a drain, for our economy, with American production utilized by the rest of the world.

  • 16)

    Why are plans to reduce restrictions to foreign trade commonly protested?


    Proposals to open a nation’s market to producers of just one kind of product provoke intense opposition by the few projected losers. The many projected beneficiaries, though gaining more in total, individually gain too little to induce united dominating pressure for approval. That appears to be a reason why attempts to reduce world trade barriers are often in the form of general agreements covering many commodities and many nations.

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We’ve seen how negotiation among demanders and suppliers in a market determines a market price that allocates the existing supply among consumers (chapter 10). And we identified (in the preceding chapter) gains from specializations and exchanges. Now, we look at how market prices influence production decisions and market activities, along with the role of profit-seeking and how profits are surprisingly converted to costs.


When making investment decisions, wise investors distinguish between the initial amount spent and the portion that will be sunk—not recoverable. If you buy a $100,000 machine that you could quickly resell for $95,000, your sunk investment would be only $5,000. That is not recoverable, so it’s irrelevant for any future decisions.

Sunk cost does not determine whether you stay or leave if the movie you attend starts poorly. If you have paid a nonrefundable $1,000 in advance for a vacation at what turns out to be a miserable place, your sunk cost should play no part in deciding whether or not to leave. It’s not the total initial expenditure that can be a barrier or obstacle to entry. It’s only the nonrecoverable, sunk amount that is a cost of entry.


After completing an investment, the price and the rate of production must be chosen so as to maximize profits. Why assume maximum profit is the objective? No matter what the personal objective may be, competition ensures that firms that fail to make profits will not survive.

For the Ford Motor Company, competitors are more than other automakers. The resources employed by Ford are purchased in competition against manufacturers of all other products. Competition appears in the prices paid for inputs on the production cost side as well as on the product sales side—where Ford competes for customers against sellers of everything else. Competition is everywhere even though we tend to think of our competitors as only those who are selling the same goods.

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It’s useful to separate sellers into two categories, price-takers and price-searchers. The distinguishing feature is the difference in the nature of the demand facing the producer/seller. In this chapter, we’ll deal only with price-takers, who face a market price that is not affected by the amount of product that any one seller offers to sell.

A certain price is observed to prevail in a market for some good or service. If any one price-taker (seller) were to try to sell in that market at a higher price, all customers would choose other suppliers. But at the prevailing market price, every seller can sell as much as would maximize profits. Each of the suppliers in such a market accepts the price and chooses how much to supply. We want to see how the price influences production and coordinates production among the producers.

Examples of price-taker’s markets are plentiful. No one grower of crops such as corn, wheat, or soybeans can affect the prices of those crops. The same is true of cattle ranchers and chicken farmers. Prices of gold, silver, coal, oil, and natural gas are all determined in international markets, and often change minute to minute.

For most corporation stocks and bonds, the financial markets determine the prices; share prices are not posted by the corporation. The rates of interest on instruments such as commercial paper and money market funds are not set by any one borrower (or lender). No one bank dealing in foreign exchange perceptibly affects the prices of foreign currency.

In brief, the features of a price-taker are: (1) there is a market price that is unaffected by any one of the suppliers of that product, and (2) a price-taker/seller can sell as much as the seller desires to sell at that given market price. Very few wage earners can affect the prevailing wage rate by altering the amount of services offered; most income-earners are price-takers.

What would make a seller a price-taker? Customers regard what is offered by other sellers as essentially identical, and don’t care who is the seller. For products easily standardized or classified into similar grades of quality—wheat, cotton, soybeans, shares of common stock of Apple or Chevron, labor to pick strawberries, units of foreign money—all that matters is the price. Any seller charging more will lose all sales; anyone charging less will be swamped with orders.

Contrast that with a different situation (examined in chapter 19) such as buying a dinner in a restaurant, or an automobile, or a movie, or shoes. For these items, the price alone is not all that counts. Lowering the price below that of a rival won’t attract every buyer, because there are competitive differences in Edition: current; Page: [233] the qualities of offerings. Competition occurs in prices, qualities, and varieties for customer preferences. A price higher than a competitor’s won’t lose all customers, nor will a lower price attract all customers.

For homogeneous goods supplied by several sellers, the price is set in a market, and each producer has no alternative but to accept that price, and then decide how much to produce and sell. Also, customers choose only on the basis of price, without brand names or knowledge of who is the producer-seller.

If customers don’t care who is the supplier of some good, no seller can charge more than any other. This doesn’t mean many suppliers must exist at every moment. Imagine a village with only one seamstress, who raises the price. Within a few days, several other people who know how to sew could enter the market. The price would fall back.

Both conditions are necessary: (a) homogeneity of services from the suppliers and (b) sufficiently quick entry to dissuade existing suppliers from raising the price. The speed and cost of entry or departure of new equipment or sellers is what matters, not the number of sellers now.


Two market characteristics of a price-taker/seller situation are: (1) each seller can sell as much as that seller wants to sell, and (2) the market price will remain the same whether he decides to sell none or a great amount.

Although both the aggregate market demand and an individual consumer’s demand for the product are negatively sloped, the demand seen by a price-taker looks like a horizontal line at the existing market price. Because any amount a seller offers to sell can be sold without any effect on the market price, the demand appears to him to be infinite at that price. However, if a price-taker tried to sell at even a slightly higher price, all customers would switch to other sellers who already exist or would quickly enter into production with an offsetting supply. And an individual price-taker could not cause the market price to fall by offering more, because that seller is too small a supplier of the total market supply. In terms of the elasticity of the demand facing a price-taker, that demand is infinitely elastic. (Review pages 109–17.)


Price-takers do not regard other producers of the same product as rivals. A wheat farmer doesn’t regard a neighboring farmer as a competitor whose actions will affect the price of wheat or the amount that can be sold at the market price. They are more like colleagues subjected to market forces that none of them affect individually. They see prices for wheat that fluctuate daily or even Edition: current; Page: [234] hourly, and no one of them has any effect on it. They are not like a grocer, gasoline station operator, hairstylist, or antique storeowner who regards a neighboring seller as a rival, a competitor.


A market is a place or arrangement wherein potential buyers and sellers can exchange information about offer prices and qualities of goods. It’s sometimes called an exchange—thus, the New York Stock Exchange.

Organized markets exist for many agricultural products and basic industrial goods. The Chicago Mercantile Wheat Market is a highly organized arrangement, owned by the members, who are the traders. They are responsible for reliability that transactions are completed as agreed. The members buy and sell in that market in behalf of other people. When acting as agents for others, the members are brokers. Members also can act directly for themselves as dealers.

Competition among members in that marketplace (as agents for others or as dealers for themselves)—seeking low asking prices by potential sellers and seeking high bid prices by potential buyers—tends to bring the prices of each of the competing dealers together. Sellers flock to buyers who are offering more, and buyers flock to where some sellers are asking less. The prices of all the trades tend to be clustered together, depending upon how rapidly and cheaply the potential offers of other people can be observed.

The major forces in a price-taker’s market can be summarized by the market demand curve and the market supply curve, as in figure 16.1. At the market-clearing price, the amount demanded and the amount supplied are equalized. It is an equilibrating price. Each buyer and each seller decide how much to buy and how much to produce at that given market price. They don’t haggle over the price, because they can’t affect it.

What every individual seller sees as the demand for that seller’s products can be described as a horizontal line at that market price, not the downward-sloping market demand curve. If the market price changes, the demand line as seen by each seller shifts up or down with the market price. A price-taker/buyer sees only the prevailing price. At any moment, there is only one price. At a higher price asked by a seller, none will be sold. And offering to sell at a lower price is pointless, since a seller can sell all that a producer would care to produce at the market price.

The consumer/buyer chooses to buy the amount of a good that brings the consumer’s marginal worth of that good down to match the price. More would be worth less to the consumer than the cost. On the supply side, the presumption Edition: current; Page: [235] is that maximizing profits is a key objective determining each producer’s behavior.

Figure 16.1

Though the market demand for every good is negatively sloped, the demand facing a given producer/seller of some good is characterized as a horizontal line at the prevailing market price. The demand is horizontal at that price (rather than downward sloping), because if a seller tries to raise its price above that market price, all buyers will switch to other sellers of the same kind of good. A price-taker/seller can, at the market price, sell all that he desires to sell without having any noticeable effect on the market price. Similarly, a price-taker/buyer sees only the market price and can buy as much as desired at the prevailing price.


Every seller’s marginal revenue is the change in total revenue when one more unit of the product is sold at the best price available for that unit. But a price-taker doesn’t have to cut price to sell more. Therefore, the price-taker/seller’s marginal revenue is always the same as the market price. This is merely a different way of expressing the fact that at the given market price, a price-taker/seller can sell as many units of the product as the seller chooses, without having to lower the price. If the market price is $25, an additional unit can be sold at that price, bringing in $25 more revenue, so marginal (and average) revenue is $25. We will see later that for most producer/sellers, price is not equal to marginal revenue.

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Table 16.1 Costs at Various Daily Rates of Production
Rate of Production Constant Costs Variable Costs Total Costs Marginal Costs Average of Constant Costs Averages of Variable Costs Averages of Total Costs
1 2 3 4 5 6 7 8
0 10 0 10 - - - -
1 10 9 19 9 10.0 9 19.0
2 10 17 27 8 5.0 8.5 13.5
3 10 23 33 6 3.3 7.7 11.0
4 10 28 38 5 2.5 7.0 9.5
5 10 35 45 7 2.0 7.0 9.0
6 10 48 58 13 1.7 8.0 9.7
7 10 70 80 22 1.4 10.0 11.4
8 10 100 110 30 1.25 12.5 13.8
9 10 140 150 40 1.11 15.5 16.7
10 10 191 201 51 1.0 19.1 20.1
11 10 256 266 65 0.91 23.3 24.2
12 10 336 346 80 0.83 28.0 28.8


Marginal cost, not average cost, is the key cost to consider when determining the rate of production. In the following examples, we are concentrating only on the rate at which some product is being produced, rather than on the volume that will eventually be produced.

Increasing Marginal Costs at Faster Rates of Production

Marginal costs ultimately become higher at greater (faster) rates of production. This was shown in the cost data for Adam, Baker, and Carter; we show it again in table 16.1.


Constant Daily Costs

The costs listed in column 2 are the constant total daily cost, regardless of the daily rate of production. Examples are rent paid for land or a building, insurance, custodial and security services, and administration (back-office or other contractual costs that cannot easily be reduced or eliminated).

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Constant cost doesn’t enter into marginal cost. If the constant cost were $50, instead of $10, the marginal costs would be unaffected. All that counts in marginal costs are the variable costs, those that change with changes in the rate of output. Warning: the constant costs listed here are not sunk costs, which are costs incurred in the past.

Total Daily Cost

The total daily costs are listed in column 4. They are the sums of the costs in columns 2 and 3, the constant and the variable daily costs.

A second kind of constant cost, not listed in table 16.1, would accrue at a constant rate per unit of output. A cost of emblems on shirts, at $1 for each emblem, would be a constant $1 per shirt. The total cost of a shirt would be $1 greater than if no emblem were attached to the shirt.

Marginal Costs

Marginal costs—the additions to total cost—are greater at the higher rates of production. Marginal costs (column 5) are changes in total costs (column 4). As already noted, constant costs (column 2) don’t change with a change in the rate of output, and therefore don’t affect the marginal costs. The remaining columns of data (6, 7, 8) are the averages of constant, total, and variable costs, but they don’t affect production decisions.


The firm’s owner, the investor, estimates the product’s anticipated market price will be about $25. So he invested in a building and machinery for a designed rate of daily output that would be most profitable at a price of $25. Upon starting production, happily the price happens to be $25.


What is the profit-maximizing rate of output at the $25 market price? From the data in table 16.1, seven units is the profit-maximizing (daily) output. Producing eight would bring in $25 more revenue daily, but the marginal cost for the eighth unit is greater, $30. Daily profits would be reduced by $5 (= $30 marginal cost − $25 marginal revenue). At a smaller output of six units, increasing production by one unit would add more to revenue (MR), $25, than to cost (MC), $22.

All output rates other than seven units daily would yield smaller profits or bigger losses. For a price-taker, maximizing profits is the same as producing at a rate where the marginal cost matches the market price, because the market Edition: current; Page: [238] price is the marginal revenue—each added unit sells at that price and therefore brings in that much more revenue.

Figure 16.2

Marginal Cost, Price, and the Profit-Maximizing Rate of Output

Total costs are indicated by a rectangle over the base of seven units of output and an average total cost of $11.40. The total cost of 7 units is $79.80 (= 7 × $11.40). The profit, $95.20, (= [25 × 7] – [11.4 × 7]), which is total revenue minus total cost, is represented by the rectangle above the cost rectangle and with a vertical height of $13.60 (= $25 − $11.40). So long as price exceeds $7 (the lowest average variable cost), production with the existing facility would continue until time for replacement. At the time equipment renewal is contemplated, operations would cease unless the expected price were then at least $9, the full cost of production with a new facility.


Figure 16.2 is based on the cost data for our firm, with the market price, $25, represented by a horizontal line. At that price, the firm can sell all it finds worth producing, the rate at which the marginal cost equals the price—which for a price-taker is also the marginal revenue.


For any firm in any market, the profit-maximizing output rate is that at which marginal cost equals marginal revenue. If the market price were only $13, the profit-maximizing rate or production would be 6, rather than 7 units, with Edition: current; Page: [239] profits of just $20, the excess of total revenue of $78 (= 6 × $13) over total cost of $58.20 (= 6 × 9.7).


When circumstances change (a change in aggregate market demand or supply), it’s the effect on marginal costs that enables us to deduce the direction of the resulting change in production. A rise in rent paid by the firm (column 2, constant costs) won’t change the marginal costs, but it will increase average cost. That will not affect the rate of production in the short run, although it will affect the long-run (later) production when replacement of equipment is considered.

Changes and adjustments that are maintainable under the new circumstances are dependent on their effects on the marginal costs. If we know in what directions the initiating changes will affect the marginal costs (and the marginal revenues), we can deduce the direction of change to the most appropriate—most survivable—rate of output. Anything that raises the schedule of marginal costs will reduce the firm’s profit-maximizing rate of output. If the marginal costs for a large number of firms rises (perhaps because of rising fuel costs), the result would be reduced aggregate market supply and raised market price.

Producers don’t have to understand consciously these economic principles. Those firms that happen, whether willy-nilly or by superior management, to be best suited for the new conditions will prosper more. That differential survival in business and production, as in all other life, is a result of competitive winnowing of the less appropriately adjusted firms—regardless of how some firms came to be those that are more appropriate for the new circumstances.


We have said that the sum of all the producer’s marginal cost curves indicate the amount supplied to the market at each price, but we have to be more precise. In the long run, a producer will continue to produce only if the price is above the producer’s minimum average cost. But there are two minimum average costs: one for long-run production, and a lower one for short runs with an existing production facility. In the short run, production will continue as long as price is above the variable cost.

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For initial investment decisions, the anticipated market price must be at least as high as the minimum average of total costs of production. In table 16.1, that is $9. If that price were to prevail for a long time, the investment and subsequent production would break even: no profit, no loss. It is the lowest price at which the firm could survive.


Suppose, however, that the investment on special machinery, factory, or building has been made, and the firm now exists. We’re in the short run—lasting until new replacement investments would be made. If the price falls below $9, the initial investment would have been unprofitable. But once the investment has been made, it would pay to continue producing so long as the price is above $7—the minimum average variable cost—until the equipment wears out.

By producing five per day, and getting $8 for each ($40 total), it will more than cover its short-run average variable cost of $7 ($35 for all 5 units). The extra dollar ($8 price minus the $7 cost) for five a day will be more than the nothing the firm would earn if it stopped production. While there is still a loss, at a price over $7 production will lose less than not producing and shutting down.


We’ve assumed the existence of a market price to which a price-taker/supplier responds. What determined it? Supply and demand, of course. The aggregate supply—the market supply—is the sum of the supply curves of all the producers. Each producer has a supply curve representing its rates of supply at various prices. Adding (horizontally) the supply curve of each of the suppliers gives the aggregate (or industry) supply curve.

Each supplier offers more at a higher market price, as indicated by the marginal cost curve. A supplier tends to produce at a rate at which that supplier’s marginal cost equals the market price. Since for each producer a higher market price increases that firm’s profit-maximizing rate of production, for the aggregate of all producers a higher market price prompts a larger output.

Thus, a price-taker chooses the amount to produce and sell, without individually affecting that price. A price-taker’s guiding signal of a change in demand is a change in the given market price. Price-takers do not watch other producers of the same goods as competitors or rivals. Each is facing the same (given) market price regardless of what any of them does.

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Figure 16.3

Determination of Total Output and Market Price in a Price-Taker’s Market

The market supply is the horizontal sum of the individual marginal cost curves, here labeled as MCA, MCB, and MCC. The rise in the market-clearing price from $20 to $30 is the result of an increased market demand, from DLow to DHigh. Its intersection with the market supply sets a higher market-clearing price, which induces a larger output by each producer. The graph indicates B entering the market at price $18, and C begins production when the price rises to $28.


As indicated in figure 16.3, for the industry, or market as a whole, the horizontal sums of the outputs of all producers at the respective prices form the market supply curve. The higher the market price, the larger the profit-maximizing rate of production by each producer in the industry. Each firm’s marginal cost curve (above its lowest average variable cost) is the firm’s supply curve to the market.


Wealth-seeking producers are guided to an unintended beneficial effect—the minimization of cost for the industry-wide output. Maximizing profits for an individual firm means that the firm would be producing at a rate at which its Edition: current; Page: [242] own marginal cost is equated to the market price. To say that the marginal cost is equated to the market price is to say that profits are maximized.

Since every price-taker in the industry sees the same market price, every firm produces at a rate of output that brings its marginal costs toward equality with that same price. An equality of marginal costs of each of the several producers is a necessary condition for minimizing the total cost of the aggregated output of all firms in an industry. Competition for profits drives each firm toward that situation.

With individual producers at their profit-maximizing rates, the aggregated amount will be produced at the minimized aggregated cost of the entire market supply. The equalization of marginal costs across all the producers of the product (and the consequent cost minimization) is achieved without anyone intending or controlling that effect. This process is part of what Adam Smith called the economy’s invisible hand.

Achieving profits is a condition of survival. Consumers leave no alternatives for producers. If the products don’t satisfy consumers, producers won’t cover costs and won’t survive. The drive for profits is compelled by consumer preferences for better or more economically produced goods. Over time, competition displaces less satisfactorily performing producers—those who don’t earn profits.


Economic analysis implies only what happens and why it happens, not its desirability. Suppliers can continue to produce only if they create at least as much value to consumers as could otherwise be produced. They will not continue if they fail to make profits or avoid losses. Competition in the market is competition to create goods worth more than the costs.

An argument has been advanced that the profit-maximizing rate of output in open markets is a socially optimal rate for each good. The argument is simple.

  • a. If the market price exceeds the marginal cost, producing more of the good would increase both profits and personal worth. The marginal personal worth of some good supplied to the market is at least as great as the price paid for it—else it wouldn’t be demanded at that price.
  • b. Producing more than the profit-maximizing rate would increase total personal worth (measured by the price) by less than the personal worth of other goods given up (measured by the marginal cost).
  • c. Producing less than the profit-maximizing amount would mean producers are failing to produce goods that have a marginal personal Edition: current; Page: [243] worth (market price) greater than the marginal personal worth of goods that are being made instead.
  • d. Therefore, the rate of production that maximizes profits—marginal cost equals price—maximizes the aggregate consumer personal worth.

A conclusion that maximizing total personal worth is good rests on the criterion that what a person is willing to pay for something is a more appropriate standard for what is good than is the judgment of some other person. But since how much a person is willing to pay (personal worth) depends in part on that person’s wealth, this rationale accepts the current relative earnings and wealth as a given.

This rationale about the desirability of maximizing profits by equalizing marginal costs to prices was initially developed by socialist economists, who were trying to decide what “should” be—in some socially desirable sense—the criterion to determine the appropriate amounts to produce of various goods. When trying to determine such amounts, the desirability of profit maximization by the equality of marginal cost to market price was implied. The socialists were embarrassed, because the rationale proved to be a rationale for private property and markets.

Maximizing Profits: A Result, Not Necessarily a Goal or a Guide

No manager knows enough about conditions of demand and of production to know what will maximize profits. Even if managers could know, it is not necessary to assume that they strive for the last possible additional cent of profit. When earnings and profit streams are high, they might relax and still survive, like members of a team who might relax with a big lead.

But it’s each person and each firm against all the others. Losses will be suffered by those who can’t put resources to uses of equal or higher value than if used elsewhere. And profits will be earned by those who can. Newcomers are always entering. When one firm changes members or tactics, others respond lest they lose their profitability.


Rivals compete for the resources and managers who can earn profits. That competition raises the prices of the resources earning that profit. What had been profits are converted into normal future earnings of more valuable resources. What are profits one day become costs of future use of the resources.

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When people see a profitable firm, they look for the secret of its success. They search for the responsible resource, and their offer to buy it capitalizes the future profit into a higher present capital value of the resource. The profits are converted into someone’s wealth. That person is not necessarily the owner of the firm.

If the source of the profit were an idea that had been patented, competition for the right to use it would drive up its market value to absorb the profit. If the profits were due to a manager with talents greater than formerly foreseen, competition for that person’s services would drive the salary to match the profits, transferring the profits to that responsible person. The competition capitalizes that profit into the responsible person’s higher salary.

The profits disappear, or more accurately, the profits are now converted to costs of use of the resource. For every firm, competition for ownership of its profit-creating resources—or avoidance of those yielding losses—brings resource values and costs to a level matching their contribution to the product’s value.

Consider a firm that became worth $600,000 because of its novel equipment. Without that special equipment, the firm would make no profits. If the equipment could provide 100,000 units of service before replacement, the present capital value cost of its use per unit of output would be $6 (= $600,000/100,000 units). That would raise the total costs enough to reduce the profits to zero.

All the profits will be computed into the value of that equipment and the cost of its use. That’s imputing the current market value of its services into its current cost. That now higher value is the correct base of depreciation (cost) when that equipment is used. The owner of the equipment is richer, but the profits are now zero—just the normal rate of interest on the $600,000 equipment.


Many a winery is successful only because of the superior talent of its vintner. That person’s value is the basis of the profits of the winery. Any other winery owner who wants to hire that vintner would have to pay wages that match the profits; that is, competition for that person’s services will force up the wages to match the previous profits. By this process, what had been viewed as profits has become part of the costs of doing business.

Changes in relative values of jobs and kinds of products mean people will begin to shift away from now lower-paying to better jobs. International trade has grown tremendously as trade barriers have been lowered. As the workers Edition: current; Page: [245] of other countries become more affluent as a result of manufacturing goods for export to US consumers, they can afford to buy more US products such as grains.

The result has been that the production of wheat and corn for export has become more profitable, so the quantities produced have grown. Some laborers who would otherwise work in nontradable services or skills, such as barbers, carpenters, or gasoline station attendants, shift to planting, harvesting, and transporting wheat and corn. Their former jobs may be filled by people drawn from still other jobs, but it is unlikely that a connection will be drawn between job openings for barbers and corn exports to China.


The profits of producers are not transfers of wealth from consumers, and the losses of producers are not transfers from producers to consumers. The profits are the economy-wide increases in wealth as a result of more valuable uses of resources.

Profits are the unpredictable, but now discovered, increases in values of the responsible resources. The former lower values underestimated the future use values. No one knew earlier what the value of the resources would prove to be, else their market value would already have been that high. The earlier value, or cost of use, was the highest value that anyone formerly was willing to bet it would yield. The fortunate buyer of the resource at that earlier price was able to get the resource’s more valuable services before others (or possibly even that buyer) knew what it would ultimately be worth.

A profit is obtained by the innovator who creates value. But the initially lower cost of utilizing those resources for any purpose will not continue to be low once final products are revealed to be worth more to consumers. Resource values and costs of use are derived from the demands for final goods and services, so they will be revised upward when new or more valuable uses are discovered. The owner will then receive only a normal rate of return on that greater wealth. Whether profit was a result of luck, better foresight, quicker perceptions, or whatever, is irrelevant.

These profits by competition in the market should not be confused with gains in wealth obtained by imposing restrictions on competitors’ access to markets. Those gains are contrived-monopoly rents—obtained by restricting other people’s access to the market. A monopolist may get rich, but not from profits.

The conversion of profits into costs is not merely a matter of definitions. Because the concept of costs in economics refers to the highest valued alternative Edition: current; Page: [246] use of resources, discovery of a new, better, or more valuable use for a resource raises the cost of continuing to use it in the former way. The “profit” that is observed when the resource is revalued to a higher capital value becomes greater wealth to the resource owner.

Prior to the revaluation, an investor who had acquired ownership of land or equipment, or had contracted for a person’s services, at a price that was less than its later revealed market value, is certainly richer. However, the competition for that resource raises its value to where the rate of return on that higher value is brought down to the rate of interest—with no subsequent profits. At the end of the process, what can be observed is the greater wealth on which only the competitive rate of return will be received.

Any manager or owner who failed to respond to the higher costs of continuing to utilize in the former way the now-discovered-to-be-more-valuable resource would lose in competition with those who offer to pay that higher value to get the person, equipment, or service that is creating more value to consumers.

The stock market helps business managers know how valuable the firm is, and it also warns them that their equipment costs are not depreciation based on an initial purchase price. A new, higher value is what is depreciated by continued use of the equipment. Or if it were some person, the higher wage bid for that person’s now-perceived-more-valuable services becomes the cost of his services.


To Invest or Not to Invest?

We start with an initial decision to spend $10,000 for purchase and installation of a machine in a business. Once this machine is installed, it’s worthless for any other use, and it has no salvage value. We assume the machine can produce 5,000 units before it loses all productive ability. Costs of all other required material and labor are $1 per unit. Added to that would be the $2 per unit depreciation of the machine (= $10,000/5,000 units). The total cost of production would be $3 per unit (= $2 depreciation plus $1 cost of other inputs). At any market price less than $3, the investment would not be profitable. Suppose that the anticipated product price is $4.

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Table 16.2 Summary of Costs, Values, and Depreciation
Purchase Price $10,000.00
Sunk Cost of Investment 10,000.00
Product Price of $4 $4.00
Unit Cost of Associated Inputs 1.00
Net Unit Earnings $3.00
Machine Use Value $15,000.00 = 3 × 5,000
Cost of Machine Use $3.00 per unit = $15,000/5,000
Decision: Invest Profit = $5,000.00 (= $15,000 - $10,000)
Possibilities after Investment
(B) If Product Price Were $3.50 $3.50
Unit Cost of Associated Inputs 1.00
Net Unit Earnings $2.50
Machine Use Value $12,500.00 = $2.5 × 5,000 units
Cost of Machine Use (Depreciation) $2.50 = $12,500/5,000
Decision: Produce Profit = $2,500 (= $12,500 − $10,000)
(C) If Product Price Were $2.00 $2.00
Unit Cost of Associated Inputs 1.00
Net Unit Earnings $1.00
Machine Use Value $5,000.00 = $1.00 × 5,000 units
Cost of Machine Use (Depreciation) $1.00 = $5,000/5,000
Decision: Continue to Produce Profit = $0 (= $10,000 − $10,000)
If Product Price Is Below $1.
Value of Machine Is Zero.
Decision: Terminate.
Rule: If a resource’s value falls to zero, terminate its use.

A. If Market Price = $4

The product price proves to be $4. That permits $20,000 total revenue (ignoring, for arithmetic convenience, interest over the time the units are produced and sold). A $4 price gives an excess of $3 per unit over the $1 unit cost of other inputs. That makes the machine’s value in use $15,000 (= $3 × 5,000 units). The business could be sold for that price, now that it is seen what it will earn. The excess of $15,000 over the purchase price of $10,000 is a profit of $5,000. At the product Edition: current; Page: [248] price of $4, the machine is worth $15,000. When it is used, depreciation cost is $3 per unit of use (= $15,000/5,000 units), not the former anticipated $2 per unit ($10,000/5,000 units).

You might contend that since you could replace the machine for only $10,000, its purchase cost, the cost of using up this machine is really only $2 per unit (= $10,000/5,000 units). But don’t forget the meaning of “cost”—the highest sacrificed alternative value—and the presence of competition. The cost of using that particular machine is now the erosion of its $15,000 value. That’s how much the machine’s value falls with each unit of output. Depreciation is the reduction in value (not of the purchase cost) when something is used.

Further, if you think you’ll be able to buy a replacement at the earlier $10,000, you’ll be disappointed when others bid the price up to $15,000 for the machine to duplicate what you are doing. If it happens that they can’t duplicate what you do with the machine, then it’s not the machine that is worth more, it’s you. The cost of using you will be $5,000 higher as people compete for your demonstrated ability to take $10,000 and turn it into something worth $15,000—assuming you really had that talent, and weren’t just lucky.

B. What If the Product Price Falls?

In Part B of table 16.2, as the investment is completed and production is started, the product price is $3.50, not $4, and is expected to stay at $3.50. The yield is $2.50 per unit above the $1 per unit costs of other inputs (= $3.50 − $1) for each of the 5,000 possible units of service. The machine’s market value would be $12,500 (= $2.50 × 5,000 units). The investment would yield a profit of $2,500. Use of the machine now costs $2.50 per unit (= $12,500/5,000 units)—the depreciation.

C. What If the Price Happens to Be Below the Anticipated Long-Run Average Cost of $2?

In Part C, the market price proves to be only $2 as our product hits the market. With the $1 cost of other inputs, that price leaves only $1 for each unit of the machine’s services, or $5,000 (= $1.00 × 5,000). Costs and revenue both are $10,000, so profit is zero.

D. At What Initial Price Would Production Be Abandoned?

Part D shows that at any price below $1, it would be better to abandon production, because $1 is the minimum average cost of all the other associated inputs.

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Investments in new equipment, after a tax change or a new tax on production, will be made only if they are expected to be profitable under the new circumstances in which the price is sufficiently high to cover the tax.

The losers are 1) the owners of existing equipment that becomes less valuable and also 2) any employees whose available wages elsewhere are lower than the wages they were getting before the change.

Whether the costs that later potential investors know they must cover are higher because of taxes, or higher wages, or higher material costs, makes no difference. New investments will be made only if they are expected to yield at least the competitive rate of return available elsewhere. But the higher costs reduce the probability and expectation of getting a significant yield.


A reduction in the value of a machine (or any productive resource) caused by its use is depreciation. That cost must be distinguished from a fall in the market value of the machine caused by an unexpected decline in its service value, which is a loss—pure and simple. In reports issued by corporations about their financial situations, the two are commonly confused. And changes in values of resources—because of changes in values of their services—are not mentioned.

Every business firm calculates depreciation of a resource on the basis of the original purchase price—not its current value. Firms report the wrong data—the historical record—but usually harmlessly. The accountant’s task is to record expenditures, receipts, and accumulating debits and credits to monitor the behavior of managers. Accountants do not try to estimate or explain current values of equipment or of the business. They let the rest of the world do that in markets for capital goods and in stock markets, where the stock prices reveal the new values and implicit value based on revised information and anticipations.


Depreciation is the reduction in the machine’s value because of use. Depreciation is not dependent upon the purchase price of the equipment. It’s dependent on the current value of the resource. Obsolescence is the change in value of a resource when its product value falls for reasons unrelated to its use. Better resources or a reduced demand for its services caused possibly by higher costs of associated inputs are sources of obsolescence. In our example, the price of the product fell. That product price decline immediately resulted in a change in Edition: current; Page: [250] the resource’s value, an obsolescence, not depreciation. In the other direction, a rise in resource value is appreciation—a windfall profit.


In financial reports of business firms, the purchase cost, not the current market value, of the equipment is listed. Why? The accountants don’t know the values of resources in the firm. The resources aren’t sold, so there’s no objective market value.

Accounting records are not maintained as a basis for making decisions about output and inputs. Instead, such data reveal what the firm spent and received as money. Included are data on liabilities to, and claims on, other people. Accounting data help owners monitor financial actions of the firm. Accountants do not record current values of resources, nor costs of their use.

Trying to estimate the current market values of the firm’s resources would introduce subjective personal opinions. To avoid such judgments, accountants record only past known outlays and receipts and initial purchase costs. Calculations of depreciation or other costs are done in accord with tax rules, which often have no relation to the market values of the resources.


Look forward over a span of one year, with daily output of 7 and 200 days of production per year, at a product price of $25. That would bring a total revenue of $35,000 (= $25 per unit × 7 units per day x 200 days). Assume annual total cost would be $16,000 (= $80 per day × 200 days). The annual profit rate would be $19,000 (= $35,000 − $16,000), or $95 daily (= $19,000/200). Capitalize that annual profit of $19,000 to a present value, assuming that the profit rate would persist for, say, ten years. At 10 percent per year interest, that’s $116,660 (= $19,000 × 6.14), as verified in the present value tables in chapter 30. If this firm were a corporation with 10,000 shares of common stock, each share would have a market value of $11.67 (= $116,660/10,000).


  • 1)

    The current market price of wheat is $2 per bushel.

    • a. You have 1,000 bushels. If the rest of the suppliers provide 9,999,000 bushels, could you detectably affect the market price by withholding any of your supply from the market? Edition: current; Page: [251]
    • b. If you offered to sell at $2.25, while the market price was $2, would anyone buy wheat from you? Would you be tempted to sell at $1.75?
    • c. From your perspective, what does the demand curve for your wheat look like?


    • a. No.
    • b. No. No.
    • c. Horizontal line.
  • 2)

    In a price-taker’s market, does the marginal revenue of each seller virtually equal the average revenue (price)? Why?


    Yes. Trivial effect on price by offering more by any one seller, and if the average is not affected, the average equals the marginal.

  • 3)

    Explain why the marginal-cost schedule above the lowest average variable cost is the supply schedule of the firm in a price-taker’s market? How low a permanent price would make the firm stop production permanently? How low could price be in the short run without the firm suspending production?


    The portion of the marginal cost curve above the minimum point on the average variable cost curve is the supply of the price-taker. (Remember the marginal/average relationship.) When price is above the minimum variable cost, but below total per unit cost, the producer is losing money but will continue to produce since he is covering more than the current operating costs. However, when equipment wears out, the producer faces new acquisition and repair costs. He will shut down, since the projected receipts will not cover the new costs.

  • 4)

    “Marginal costs serve as a guide to how much of a good to produce, while average costs help indicate whether to produce the good at all.” Explain.


    Marginal costs along with marginal revenue indicate maximum wealth output, while average costs in relation to price indicate whether the profits are positive or negative.

  • 5)

    Is there a short-run cost and long-run cost for a given output program, or are there two different contemplated output programs, each with its own cost?

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    Two different programs, each with a different cost.

  • 6)

    Suppose the marginal cost of the resources in producing an X is $5, where cost is interpreted as the highest sacrificed use value. If these same resources had been used elsewhere, their sacrificed value of output Y would have been $6. What would make these two different “costs” of the same resources converge to the same value?


    Resources would be withdrawn from the production of Y, moving back down its marginal cost curve; the cost of an extra value of output of Y falls. Some resources withdrawn from Y can be added to the production of X, where marginal cost of production was lower, but rising. The cost of producing an additional Y and an additional X converge at the margin to the same value—between $5 and $6.

  • 7)

    “The free-enterprise, capitalist system is a system of consumer sovereignty. Consumer preferences determine what shall be produced and how much shall be produced.” Evaluate.


    “Individual sovereignty” is more accurate than “consumer sovereignty.” Individuals make choices both as consumers (buyers) and as producers (sellers). An individual expresses choices about working conditions as well as about consumption goods. If mining is unpleasant compared to cutting timber, so that individuals are more willing to work at the latter, the amount of lumber relative to coal will be larger than if individual preferences as producers were reversed.

    With so many other people, each of us is usually powerless to affect output or market demand significantly. This does not mean we cannot choose among available alternative purchases or products to produce. Nevertheless, because we can hardly change the range of offers made to us, each open-market producer thinks the consumer (a personification of the market) is sovereign, while the consumer believes that producers (personification of supply) decide what consumers can have.

  • 8)

    What constitutes or determines the market supply curve of a price-taker industry?


    Each of the numerous firms maximizes profit by equating marginal revenue and marginal cost, producing at the output where the upward-sloping Edition: current; Page: [253] MC curve intercepts the horizontal MR curve. At each feasible price, the amount supplied by the industry is the sum of the individual firm outputs at that price.

  • 9)

    If a business firm finds its selling price and output so related that larger output is associated with lower selling price, is this an indication that it has lower costs with larger volume or that the demand is such that more can be sold only if the price is lower?


    The latter, regardless of the relationship between output and cost.

  • 10)

    “New business firms can underprice older firms, because the newer firms can buy the latest equipment and are not burdened with the older, less economical equipment which older firms must retire before they can economically adopt the new. This is why continued technological progress contributes to maintaining a competitive economic system.” Explain the errors in both sentences.


    Old firms are not burdened by old equipment. That they don’t simply shut down or switch to producing other goods means they can compete by using old equipment, whose value is recapitalized to whatever level will enable it to continue to be used—unless its value drops to zero, in which case it will certainly be retired. The first sentence is typical of a very common error—an error that ignores the market’s revaluation process of existing productive resources. What is relevant for production decisions is current market value of equipment and resources, not the historical value or initial purchase price.

  • 11)

    Evaluate this assertion: “Suppose that at an additional cost of 3 cents per bottle, Coke is made better than Pepsi. And suppose that improvement is worth 5 cents to a consumer. A consumer switches from Pepsi to Coke when each is priced at $1/bottle. Therefore, the customer who gets only 5 cents more value imposes a one dollar cost on Pepsi in a lost sale. That’s wasteful, for the loss to Pepsi is far greater than the gain to the consumer.” Is that correct?


    No. The loss to Pepsi is not the lost $1 of sales revenue. The lost profit is what is lost to Pepsi. That’s a lot less than $1 per bottle. The resources not used by Pepsi, when making less product, worth $1, are transferred to making other products. A loss to Pepsi would be the reduced value Edition: current; Page: [254] of resources that are not transferable to other uses without some drop in their value, which is something we will explore later. The moral here is that a transfer from one person to another (loss to one person and gain to another)—if not a loss of resource values—is not a social loss.

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Most adjustments to new events take time. It took a few years to make automobiles smaller and more fuel efficient after the price of gasoline jumped during an early “oil shock.” Later, when the price of oil fell, it took several years to return to bigger cars. Some responses are so long delayed that it’s hard to remember the cause.

Economists usually categorize the timing of completed adjustments: the immediate, the short run, and the long run. The immediate responses tend to be in prices before production is altered. The short run includes adjustments in the rate of production, but before altering the amount of durable productive resources. The long run refers to the completed final adjustments, including reductions or increases in the stock of productive facilities.


When analyzing the effect of a tax or arbitrary change in cost, first identify the effects on the supply curve and the demand curve. Price and quantity are not affected by an extraneous event without an effect on demand or supply—or both.

Suppose there’s a new 10 cents a gallon tax on gasoline. Whose wealth is reduced by the tax? And what adjustments are made in the price, production, and consumption of gasoline and related products? In any case, it makes no difference whether it’s the consumer or the seller who hands the tax to the government, except possibly emotionally and politically.

One way to interpret the tax on gasoline is that it leaves less revenue for the suppliers, so we deduce the effects on supply. Alternatively, we can interpret the tax as a rise in costs to the buyers, and then deduce the effects on demand. These alternative views of the situation imply the same results in the prices and amount of gasoline consumed, because the same event is being interpreted with the same principles. Figures 17.1A and 17.1B guide the analysis with each point of view.

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Figure 17.1A

Tax on Gasoline: Tax Shown as a Rise in Supply Cost

In figure 17.1A, the tax is interpreted as a 10¢ rise in the cost of each gallon supplied to the market. That shifts up the marginal cost curve, including the tax, by 10¢. The intersection of the demand curve with the new market supply curve (based on the new marginal cost curve including the 10¢ tax) indicates the new short-run price, $1.03. The consumer price inclusive of the tax is higher by 3¢, and the cost to the producers is higher by 7¢. The area above the initial price line and below the new price represents the total tax collected from consumers. The total tax collected from the suppliers is the area below the initial price and above the net-of-tax price received by the suppliers.

The actual division of the tax will depend on the slopes of the demand and market supply lines.

Figure 17.1B

Tax on Gasoline: Tax Shown as a Reduction of Demand

The tax is interpreted as a 10¢ reduction in gasoline demand facing the sellers. The lower net of tax demand curve results in a lower after-tax price to the seller. The resulting price and quantity of gasoline is the same as in figure 17.1A using a shifted supply curve.

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a): Tax Viewed as an Increase in Producers’ Costs

Interpreting the tax as a rise in the cost of supplying gasoline, marginal cost is raised 10¢ a gallon, because 10¢ must be paid to the government for each gallon produced. The aggregated market supply curve also rises by 10¢. How much will be supplied? A smaller amount—an amount at which the marginal consumer worth on the demand curve will be high enough to equal the 10¢ higher marginal cost, which includes the tax. With less gasoline being produced, and an unchanged demand curve, the market price will rise to where the amount demanded equals the reduced production.

Suppose the resulting price including tax is $1.03. The consumers pay 3¢ more per gallon, and the producers receive, after paying the tax, 7¢ less per gallon. That is, the consumer has paid 3¢ and the seller 7¢ of the tax. The amount of gasoline being produced is reduced to where its marginal cost is 7¢ less than before the tax, that is, to 93¢.

The approximate triangular area between the demand and supply curves for the range of reduced amounts consumed represents a social welfare loss. That’s the reduction in consumers’ personal worth when resources are transferred to other goods yielding lower personal consumer worth. That reduction is the burden of the tax.

b): Tax Viewed Alternatively as Reduction in Demand Seen by the Seller

In figure 17.1B, the lower net-of-tax curve is pertinent to the seller. Of the basic demand price, $1.03, 10¢ goes to the government. The net-of-tax portion is smaller by the unit tax of 10¢ a gallon. The cost of producing gasoline and the supply curve are unchanged. The net-of-tax demand curve intersects the supply curve at the price of 93¢—7¢ less than before the 10¢ tax. The consumer pays the additional 3¢. At that lower net-of-tax receipt of 93¢ a gallon to the supplier, less gasoline will be produced. This is the same result as implied by raising the marginal cost curve in figure 17.1A. The short-run effects on prices and supply are: a) a reduction in amount supplied and consumed, b) a higher price to consumers, and c) a lower net price (price minus the tax) to the suppliers.


Some resources that would otherwise be used to make the taxed good are shifted to make goods worth less to consumers than the gasoline no longer produced. The forgone gasoline was worth between $1.00 and $1.03 for each gallon. What’s produced instead is worth less than that, else it would already have been in production.

That loss of (a) the worth of the forgone gasoline in excess of (b) the worth of the goods now being produced instead is (c) a deadweight social loss, a burden Edition: current; Page: [258] of the tax. There is forgone personal worth borne by everyone using less of the taxed good. Those who buy the other goods now being produced (instead of gasoline) get a gain that is worth less than the lost worth of the forgone gasoline.


Resources that are perfectly mobile—able to shift elsewhere and earn as much as before—move and suffer only the cost of moving. The crude oil formerly used for refining gasoline can almost instantly be used to make other equally valuable products or gasoline for other less taxed areas. The refinery equipment is less valuable elsewhere, so its value falls (capital value of the reduction in its earnings). The past costs for building the refinery’s immobile items are sunk and irrelevant for future decisions about use of the refinery or for its value.

You’d be regarded as perfectly mobile if your best alternative job were as good as your present one. You’d be very immobile if your next best option were worth a lot less. A resource would be completely immobile if its best alternative use value were zero. This can happen when the moving cost to an alternative job is too high to make the move worth the cost.

The taxes reduce the earnings to the less mobile resources, which thereby bear some of the tax. With passage of time, more resources will move away or be eroded and retired and not replaced. The supply of gasoline will fall toward a quantity at which the market price of the gasoline will cover the entire refinery and refining costs plus the tax. From that time, consumers will pay all the tax. But in the interim (the short run) before the full long-run adjustment in refineries, the reduction in wealth will be borne in part by the owners of the productive resources and by some of the employees who are laid off.

The $.10 per gallon tax collected by the government can be categorized into two parts: (a) the rise in price to consumers (from $1.00 to $1.03) and (b) the 7¢ per gallon loss imposed on the owners of immobile refinery resources that are less valuable in alternative uses. These two losses, as well as taxes collected, should be measured in capital values (discussed in part 3), which would take account of the various lengths of time for the adjustments to be completed. The loss in capital values when some of the resources are transferred to next highest uses is a measure of productive loss, as distinct from the wealth being transferred to the government by the tax. The loss of value pushes resources away from refining to next best options.


To derive and compare the temporal sequence of the price and quantity responses to the tax, look at figures 17.2A and 17.2B, which portray the short-run and long-run demand and supply conditions, respectively.

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Figure 17.2A

Short-Run Effects

Figure 17.2B

Short- and Long-Run Effects of Tax

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The tax is here viewed as an increase in the costs to the refiner, though it could as well be viewed as a reduction in demand net of the tax. The crucial differences are in comparisons between the elasticities of short- and long-run demands and of short- and long-run supplies. The elasticities of demand and of supply in the short run are smaller, because faster adjustments (short run) are more expensive than if made less rapidly (long run). The greater elasticities in the long run make the quantity effects greater than in the short run. More of the tax is borne by consumers, rather than by suppliers, the longer the tax has been in effect, except for taxes on constant, fixed-supply resources, such as land sites.

Figure 17.2B shows the long-run effects with the more elastic demand and supply curves. The tax’s long-run negative effect on the quantity is larger than the short-run effect. This graph shows how the tax affects the price, no matter what the pattern or size of the costs and the tax. But the resulting changes in the price and quantity depend on how much the costs change.

Longer-run adjustments in productive facilities are more extensive, easing pressure to produce gasoline in more costly fashion with existing equipment. That investment in new facilities or retirement of worn facilities makes the long-run supply curve of gasoline more elastic than the short-run curve. The long-run effect of a tax per gallon of gasoline is a larger reduction in quantity and a smaller rise in price than in the short run, as indicated in figure 17.2B.

In the longer run, some refining capacity would wear out and not be replaced. That would reduce the supply curve (shifting it leftward) and result in a higher price. That’s why a tax on a product seems at first to be paid by the producer with little effect on production, but later, as the greater supply and demand elasticities take effect, the price to consumers rises and the quantity demanded and produced falls. But by the time that happens, who remembers it was caused by the tax?


Ultimately, as the immobile resources for refining gasoline from oil wear out, it won’t pay—with that tax (and price that has risen by less than the tax)—to replace all the refining capacity as it deteriorates. Gasoline production will fall further and its price will rise further, up to where it covers long-run costs and taxes of producing. (We ignore growth of demand over time to concentrate on the tax effect.)

At that long-run higher price, consumers of gasoline will be paying all the tax, which leaves enough after-tax profits of refining to make it worthwhile Edition: current; Page: [261] to build new refineries, once the existing refinery wears out and needs to be replaced. The investors in new refineries, with a smaller total capacity than before, will be bearing none of the taxes.

The portion of the tax initially borne by the owners of existing immobile refinery resources has been shifted fully to consumers, because the price will have been pushed up enough to cover the long-run average cost of creating and operating refineries. That’s why owners of new refineries will bear none, and consumers will bear all, of the tax thereafter.

New investments in refineries will be made only if they are expected to yield the same rate of return as any other new investment. Competition tends to equate the rates of return, as explained in later chapters on capital values. The long-run higher price paid by the consumers to producers will cover the tax, as it covers all other costs.


Subsequent to a reduction of the supply and the higher price of gasoline, if the price more than covers the future costs of production, the refinery appears to be earning a profit. Actually, it’s earning a profit on only the continuing costs of production, which do not include replacement costs once it wears out.

Consider a common analogous situation. You own a car you decide to use as a taxi, but the revenue from operating it doesn’t have to cover the prior purchase price of the car. You already own the car. To continue to use it, the revenue must cover (a) subsequent remaining operating costs or (b) what you could get from an alternative use of the car. However, when the car wears out, your taxi service will end if you have not created a reserve sufficient to purchase a new car.

Since the refinery is immobile and has no use for anything but refining, it will continue to operate so long as the revenues cover its operating costs. The earnings may be too small for the initial investment to have been profitable. But once the investment has been made, any earnings in excess of the operating costs are a surplus—until the equipment wears out. Economists apply the label quasi-rent to that temporary excess. Quasi emphasizes that it’s a surplus over its current operating costs, for continued, but temporary, operation (until replacement or transfer to other uses).


An existing house will be used even if the stream of monthly rents in the future would not be large enough to cover the costs of repairing it or building a new one. Quasi-rent indicates that the current rate of service value will not maintain Edition: current; Page: [262] that resource permanently. The asset will render current services, but not into the indefinitely long future. It’s only a temporary surplus. The initial cost is sunk and therefore irrelevant for future decisions about use of the resource—except, of course, it might be a predictor of future costs if a replacement were contemplated.

The concept of quasi-rent can be applied also to earnings of people. You invest in professional education as an electrical engineer, which would be profitable if you then earn $60,000 a year. But after your education is obtained, the sunk cost of your education is irrelevant. Suppose you are earning $60,000 a year, and your next best job is only $40,000. The $20,000 difference is unnecessary to keep you at your present job, because that’s the amount your current earnings could be cut before you’d shift to the $40,000 job. That $20,000 is a quasi-rent in your earnings at your present work.

Later we extend the analysis of a tax on gasoline into the future by using the more inclusive capital value concept of wealth—the present value of all the future tax payments—rather than just the current rate of tax payments. Thinking and measuring in terms of wealth rather than current flows is more complete and informative—though less common!


Consider a long period in which the long-run supply is represented by a horizontal straight line, a schedule of infinite elasticity. This could be valid if the productive resources are sufficiently similar so that all the refineries have the same average cost. The tax is shown as an addition to the costs, shifting up the supply line in figure 17.3.

The quantity of gasoline will be reduced. The price would rise in the short run until some refineries were shut down, leaving the reduced rate of production at the initial average cost. At the lower rate of production, the higher price would cover the unchanged average cost plus the tax. Production falls more when the supply is perfectly elastic than when it is less elastic.

As an exercise, repeat the analysis by lowering the demand curve by the amount of the tax, rather than raising the supply line. (The implications are the same.)


If the supply in the long run were perfectly elastic, it would, in our preceding example, be horizontal at $1.10, that is, the long-run price would be $1.10. All the tax would then appear to be borne by consumers. But there is a loss of Edition: current; Page: [263] wealth to owners of refinery equipment, which fell in value and was therefore removed from production. That hits them as a one-time loss of wealth. The consumers suffer a series of purchases of gasoline at higher prices. That series of future higher payments has a present capital value, which measures how much of their wealth is taxed, even though the payments are strung out over time.

Figure 17.3

Infinitely Elastic Supply

The reduced rate of production is achieved at lower average and marginal costs. That reduction in costs at a lower rate of production offsets part of the tax. As a result, the net effect is a long-run price that is not raised as much as in the short run, with a horizontal long-run supply curve. Also, the long-run equilibrium output rate would be smaller, since production is reduced more in the long run than in the short run.


We are not to ignore what is done with the collected tax. It might finance more and better streets. You might say that the worth of the streets is greater than the worth of what’s not produced. That would mean a social gain—greater total personal worth, not less. That is the public policy basis for taxes—to finance worthwhile activities that would not otherwise have been possible.

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Some gasoline is converted to noxious fumes with negative worth to the rest of society—a negative worth that is generally ignored by the user. That’s a negative externality. The market price of the gasoline overstates the worth of the gasoline use.

The tax, by raising the price of gasoline, would make the traveler bear at least some of the cost of the negative worth of the pollution. The reduced amount of gasoline used would be closer to where its marginal worth for travel matched the marginal cost (the worths of the forsaken alternative products and cleaner air).

Unfortunately, no one knows whether the present gasoline tax (or any tax) is too high or too low. That is, no one knows whether the cost of further reductions in air pollution is worth the higher cost of travel. But economic analysis helps to deduce some effects of a market for rights to pollute—to use the air—similar to the way we buy rights to dump garbage in a garbage disposal site.


Consider the timing and persistence of some responses to an anticipated change in demand.

  • a. Demand for transport to skiing resorts predictably increases spectacularly during the winter. Response: special (seasonal) airline flights are quickly supplied.
  • b. In Washington, DC; Hong Kong; Manila; and many other cities, hundreds of people with full-time jobs become taxi drivers during rush hours.
  • c. Steel mills use their higher-cost furnaces during peak demands, as do electrical power suppliers; employees work overtime at higher wages.
  • d. Barber-shop and hair-salon chairs that are idle most of the time are maintained for use when demand is transiently high.

None of these involve excess capacity. These so-called higher-cost resources are the cheapest ways to meet predictable peak demands quickly. The temporarily high demands make such extra (not excess) capacity profitable. That available extra capacity, like a second car in a family, is idle most, but not all, of the time. Resources for temporarily high demands are often called marginal resources or marginal firms. Every firm is always on the fringe (margin) in terms of its Edition: current; Page: [265] rate of production, because it generally could produce more, and it certainly could produce less.


Prices sometimes seem to change before or without any change in demand or supply conditions. At other times, they seem not to change when demand and supply have changed. The price of gasoline, for example, is said to rise too soon when supply falls, and to fall too slowly when supply increases. Some existing producers are said to restrain new competitors by premature price-cutting, sometimes labeled predatory pricing. But competitive pricing and supply situations commonly are misinterpreted.

Gasoline prices rise quickly when crude oil prices rise, but they do not fall as quickly when crude oil prices fall. The same asymmetry occurs for frozen orange juice, coffee, cotton, and meat. Why?

  • a. Gasoline, along with several other refined products like plastics and fuel oil, is made from crude oil.
  • b. Gasoline is expensive to store, compared to the cost of storing crude oil; gasoline stocks at refiners are very small, about a couple of weeks’ worth of consumption.
  • c. Most critical for the present question about the speed of responses is the fact that future goods can’t be brought backward to the present, while existing goods can be carried forward to the future by storing them. The fall crop of apples cannot be brought backward to the previous spring, but they can be stored for the winter by canning or drying.

These facts—especially item c—help explain the asymmetric timing of response of product prices to changes in supplies of inputs. News that an oil-producing country in the Middle East has been invaded by a neighbor creates an expectation of a reduced future supply of oil. It would be foolish to sell current inventories of petroleum at a price far below what is expected in the near future. Crude oil available now above ground in storage tanks can be withheld for use in the future at the expected higher price. The current price rises immediately. But the reverse is not the case. Expected larger future supplies of oil (or any other good) cannot be brought to the present—although current producers who have excess capacity can produce now at a higher rate in order to sell more at today’s higher price, before the new supply comes on stream and results in a lower price.

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The adjustment process is eased by spreading it over time. Some oil that would be consumed today if prices were kept low by price controls is held for the future when supplies of oil will be scarcer and more valuable. The higher present prices reduce consumption now. More is withheld for future refining, when it will be worth more. Prices of oil in the future will then be lower than if more oil had not been withheld from the present.

This immediate price rise does not reflect or presume monopoly or collusion of refiners. Indeed, conserving more of the present inventory for future use helps to offset the future reduction in supply.

The same thing happens with the price and consumption of wheat, cotton, oats, soybeans, and so forth. When the future crop begins to appear smaller than formerly expected, the newly expected higher future price is instantly reflected in a higher price of present supplies. (Of course, if it were some nonstorable good, the future higher price would not be reflected in a big jump now: current strawberries cannot be held as fresh strawberries for a future higher price.)

Yet members of Congress sometimes complain that oil refiners are acting improperly when the price of gasoline immediately increases in response to news of a new war in the Middle East. Regardless of the motives of oil refiners, the conservation and the higher price ease the task of adjusting to a smaller supply. The immediately higher price is a messenger. Punishing the messenger doesn’t change the message or aid in adjustment to the decreased supply.

Changed present anticipations and forecasts of prices or supplies of future goods affect current prices if present stocks can be saved and carried to the future. If they can’t be saved, the present price of the existing supply would not rise significantly when a future decrease is expected.

Some years ago, the federal government, in response to environmental concerns, mandated that gasoline had to emit fewer pollutants. One state, California, went further and enacted relatively severe requirements for refiners of oil to invest in expensive technology. The air would be cleaner for each gallon of gas burned, but each gallon of that cleaner-burning gasoline yielded fewer miles per gallon.

The California price of gasoline did rise as expected. Nevertheless, the public bought more gallons of gasoline to obtain their desired miles traveled, and the refineries profited. Does this go against the law of demand that says that less is demanded at higher prices? No, because the supply of gas also shifted.

The persisting higher price was the result of government-imposed conditions on the refiners, equivalent to results of an effective conspiracy by the Edition: current; Page: [267] refiners. In a privately attempted conspiracy, the refiners would have to agree to reduce production or require each to raise its price. But each would then try to gain by secretly lowering price or increasing quality, or both. Here, the government helped enforce both requirements. No refiner could ignore the official mandate and sell the old kind of gasoline that cost less.

Figure 17.4

Shift of Supply of Gasoline and Demand for Gasoline and Mileage

The cleaner-burning gasoline is more expensive, indicated by the leftward shift of the supply curve in figure 17.4 from Sold to Snew. People demanded more gallons of the new gasoline to help offset reduced mileage per gallon. Both the shift of supply because of higher costs of production of cleaner-burning gasoline and the upward shift in demand for gallons of the new gasoline resulted in a higher market-clearing price of gasoline and increased profits for the refiners.


Predatory pricing suggests that the intent of price-cutting is to impose losses on competitors in order to drive them out of business and also to dissuade potential entrants. Then, it is alleged, the price is raised above this predatory level. It is uncertain that this has ever been effective in competitive markets. The initial price cut would cause losses to the predator, and it would be costly to repeat that behavior to deter all future entrants. More to the issue here, what looks like predatory pricing can be something that is economically efficient, and not motivated by predation.

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Table 17.1 Existing System s Long-Run and Short-Run Costs
Annual Depreciation per Channel = $1,000
($1,000,000/50 channels equals $20,000, which for a 20-year life is $1,000 annually.)
Operating cost [Short-Run Cost] $200
Annual Long-Run Cost per Channel $1,200

Suppose Old owns a telephone service capable of carrying 50 simultaneous calls—we will call these channels of service. When the copper-wire line, expected to last 20 years, was purchased and installed at a cost of $1 million, all the initial investment cost became sunk, with no salvage value in any other use. The cost of operations is $200 per year per channel. When the initial investment of $1 million was made, say, 15 years ago, it was expected that enough revenue would be earned to provide at least $1,200 per channel, which is the annual 20-year equivalent of the $20,000 initial investment per channel (ignoring interest rate discounting) plus $200 per year for operating costs. The expenses are summarized in table 17.1.

Once the initial investment had been made, revenue exceeding the $200 per channel annual operating costs is enough to warrant continued operation for the short run—though not enough to recover the initial investment cost, nor warrant reinvestment in the future. We suppose that the present price of service is $1,200 for a year’s service per channel, which is just enough to recover the entire initial investment cost plus the continuing operating cost. (We could have supposed demand was high enough to yield $1,500, which would have made the original investment very profitable, but, as we’ll see, that wouldn’t change the issue involved here.)

New, a potential entrant into the business, announces the intention to invest $1.5 million in a fiber-optic system that can handle 50 telephone channels, lasting 50 years. Once built, the entire investment would be sunk. The pertinent data are summarized in table 17.2.

New must expect minimum revenue of $675 annually for 50 years for each of the 50 new channels; otherwise the investment would not be profitable. Because of new, low-maintenance technology, annual operating cost per channel is estimated at $75, which would cover the continuing costs of operation, and

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Table 17.2 New Proposed Investment (We conveniently assume a zero interest rate.)
Investment = $1.5 million for 50 channels, which is $30,000 ($1.5million/50 channels) per channel for 50 years, or $600 annually per channel ($30,000/50 years)
This results in:
$600 annually (= $1.5 million/50 channels/50 years = $30,000/50 at zero interest rate)
+$75 = annual short-run operating cost
$675 = annual long-run cost perchannel

anything above $75 would be left to go toward the initial investment of $600 per channel. Therefore, $675 will be the long-run costs, with $75 of that covering the short run—if the investment were made.

Upon hearing about the proposed investment by New, Old warns New: “If you invest in new equipment, the price will be cut below your cost.” While the new system, at an anticipated revenue of $675, would be considered economical, once the investment is made (and therefore sunk), revenue could fall to as low as $75 without forcing the newcomer to cease operations.

Suppose that before the New investment, revenue is $1,000 per channel per year. That might look as if the new investment would be profitable. However, if the new fiber-optic system were installed, which would double the total market supply to 100 channels, all those channels would be demanded only at a lower per channel price. Perhaps the price would fall from its present $1,000 down to $500 as the two systems compete for customers.

At that lower price, the old system would continue to operate (so long as the price didn’t fall below $200). But New would have regrets, because the revenue would be less than the $675 needed to cover long-run cost per channel. New would suffer a loss, the actual amount depending on how long Old continued to operate and what the revenues would be after Old ceases operation. New would continue to operate, because its continuing costs are only $75 annually per channel, and although losing money—not recovering its sunk investment—New would be minimizing its losses by operating at any price over $75.

So the investment by New would have been premature and therefore wasteful. The resources needed to invest in creating and operating more channels so soon are worth more elsewhere (which is what the cost measures) than they are worth here (which is what the revenue measures).

If Old’s earlier warning to New were taken as a threat, New might allege Edition: current; Page: [270] predatory intent. But if New foresees the competitive effects of a larger supply on the price and the irrelevance of sunk, initial investment costs for existing operators, New will refrain from, or postpone, the investment. New will wait until the demand for services is large enough to support 50 additional channels (for a total of 100) at a price of at least $675 per channel, or until the old copper-wire system is closer to wearing out.


  • 1)

    A tax of 1 cent is levied on each pound of peanuts grown by farmers.

    • a. What effect will this have on the output of peanuts?
    • b. How will it induce that effect?
    • c. What will happen to the price of peanuts?
    • d. Will the land on which peanuts are grown fall in value—in view of the facts (i) that peanuts are grown from plants that must be seeded every year, and (ii) that the land can be used for other crops?
    • e. What will happen to the value of existing machines used for harvesting, shelling, roasting, packaging, and crushing peanuts? Why?
    • f. Explain why these changes in value will not be permanent even though the tax is permanent.
    • g. Does the temporary drop in value (of land and equipment) mean that the wealth-reduction effect of the tax is only temporary? Why or why not?
    • h. The proceeds of the peanuts tax are used to finance purchases of this book for free distribution to college students. Who is paying for the books so distributed? (The answer is not that those who lost wealth from the revised valuation of existing resources are paying for books. That loss of wealth is not offset as a gain to anyone else.)
    • i. Who gains what as a result of the tax and expenditure of the proceeds?


    • a. Reduce the output.
    • b. At first, if output is not reduced but taxes are paid, the wealth of peanut growers will fall. Higher marginal costs indicate a lower output as the new wealth-maximizing output. Or some who formerly made a profit or broke even will now have a loss and be induced to abandon or reduce peanut production.
    • c. Reduced supply, shown by shift of the supply curve to the left, implies higher price.
    • d. Land will fall in value only to the extent it was worth more for peanut growing than for next best use. Edition: current; Page: [271]
    • e. A tax imposed on the output—peanuts—will reduce the value of specialized equipment used to produce the product.
    • f. As marginal peanut farmers cease production in favor of some alternative crop, remaining peanut farmers will be able to restore profitability by charging higher prices; total market supply will be less and the value of resources that continue to be used to produce peanuts—land and equipment—will be restored.
    • g. The wealth loss to peanut farmers that exited the business in favor of the next best alternative is real and permanent.
    • h. Peanut consumers.
    • i. We would have to know how the government uses the proceeds of the tax on peanuts to know who may be gaining.
  • 2)

    Suppose that the tax in the preceding question is levied against only one producer of peanuts.

    • a. What will happen to the price of peanuts?
    • b. To the output?
    • c. To the wealth of the various peanut producers?
    • d. Whose wealth will be affected by this tax?


    • a. Nothing noticeable.
    • b. Nothing noticeable, since the one producer yields a trivial part of industry supply.
    • c. This taxed producer will lose wealth of resources specialized to growing peanuts on his farm. Other peanut producers are unaffected.
    • d. See answer to c.
  • 3)

    In question (1) above, after full adjustment to the new tax on peanuts, has there been a “deadweight loss”? What does that mean?


    Yes, a deadweight loss occurs as a result of the eventual decline in the total production of peanuts. The difference in the lower value of alternative crops that are produced instead of peanuts versus the value of peanuts is a social loss and a measure of the burden of the tax. Nothing in this answer helps to know whether the society is worse off or even better off because the uses of the proceeds of the tax are not known.

  • 4)

    Long after the tax on peanuts has been put into effect, the demand for peanuts has increased and existing peanut farmers have become more Edition: current; Page: [272] profitable. An investor is considering whether to acquire some land and enter the business of growing peanuts. If he does, how much of the burden of taxes on peanut production will he incur?


    A new entrant into the business of growing peanuts will not incur any of the tax burden imposed on the production of peanuts. The prices he will have to pay for land and equipment to grow peanuts will already reflect the existence of the tax.

  • 5)

    Pittsburgh put a 20 percent tax on gross receipts of private commercial parking-lot operators while exempting competing publicly operated lots. The US Supreme Court held the tax constitutional even though its enforcement may destroy particular businesses. The Court also concluded that, in any event, a shortage of parking spaces in Pittsburgh would enable private lot operators to pass the 20 percent gross receipts tax on to their customers. The burden of the tax thus will fall upon customers. Is the Court’s economic analysis correct? Explain.


    Ability to “pass tax along” to consumers will depend upon relative elasticities—slopes of demand and supply curves. The Court’s ruling assumes the price of parking in the privately operated lots will rise by the full amount of the tax because of a “shortage” of parking spaces. Such an opinion implies that the private parking lot operators were charging less than a market-clearing price prior to the tax. It also implies that even in the longer run, visitors to the city will not choose to switch from driving to use of buses or trolleys as a result of the higher cost of parking.

  • 6)

    It is learned that there has been very bad weather in regions that are major coffee growers, so supplies of coffee will be smaller. The result is an almost immediate increase in the price of coffee. Alternatively, it is learned that there are expected to be bumper crops in coffee-growing regions next year, but the current price of coffee does not decline in spite of the expected increase in supply. Explain the asymmetry.


    In the case of expected future smaller supply, current stocks of coffee beans can be stored (at some cost) in expectation of even higher prices of coffee in the future. That adjustment causes the current supply for sale to be less than otherwise—hence the higher current price. However, future coffee beans cannot be brought forth for current consumption, so the only effect Edition: current; Page: [273] on current prices will be if current coffee bean holders decide to carry smaller inventories forward and thereby increase current supply for sale.

  • 7)

    “The government decides to levy a tax on a commodity. It could tax the sellers of the good and thereby induce a reduction in supply, or it could tax consumers and thereby reduce demand. It is better—fairer and less disruptive—to tax businesses rather than individuals and households.” Is this sound public finance?


    As illustrated in figures 17.1A and 17.1B, it does not matter how the analysis is couched. It can be stated in terms of reducing supply or of reducing demand. In either case, the effects on quantity bought and sold and price are the same, with quantity reduced and the price paid by the consumer rising (by less than the unit tax) and price received net of tax received by the seller falling (by less than the unit tax)—with a deadweight loss to society, because the resources released from reduced production of the good will be less valuable in an alternative use.

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An experienced business manager’s opinion about the analysis and presumptions in the preceding chapters is likely to be:

“First, you’ve overlooked the entrepreneur, the risk-taking experimenter, innovator of new and improved products, techniques, and lower costs of production.

“Second, hardly any producer makes a complete product and gets the entire price paid by the consumer. Receipts are divided among producers of components of the final product. That division has been ignored.

“Third, business managers don’t know or record costs in terms of marginal costs. Indeed, they don’t calculate marginal costs and marginal revenues and then select some price. They can only try to make some profits, not fine-tune to maximize profits.

“Fourth, in almost every firm some equipment helps produce several products at the same time. An airplane carries both passengers and freight. It’s impossible to know what part of the cost of the crew, airplane, and fuel is caused by freight and which part by passengers. This is the pervasive problem of allocating costs of several jointly produced products.

“Fifth, there’s a big difference between rate and volume produced. The volume effect on cost was ignored. The marginal cost of additional units of volume falls when larger amounts are produced, in contrast to higher marginal costs at higher rates of production. Producing things at a faster rate is not the same as producing more of the goods. A higher speed of a car is not the same thing as more distance traveled. One can drive slowly for a long distance or rapidly for a short distance, and similarly for rates of output and aggregate volume.

“Sixth, on the demand side, too, the aggregate volume and the rate per day are important differences. One customer buys three today; another buys only one today but will do so every day. The volume that will be demanded is as important as the rate demanded now.

“Seventh, almost all business firms, big and small, are not price-takers who must choose how much to produce and sell at the given market price. Instead, they each set some price and advertise for customers who choose how much to buy.

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“Eighth, some goods are more highly demanded the more widely they are used by others. The more people using that kind of good, the more valuable it is to a user, such as telephones, internet, fax machines, credit cards, and computer operating systems and application programs. This is a network effect. It traps, or locks in, all the users into that one network, and restrains successful entry of improved networks.

“Ninth, repeated transactions take place in markets with other specific persons—not with people in general. If a person who is relied on doesn’t do what was expected, the results could be far different from mutual benefit of exchange. These dependencies on another specific person and the actions taken to ensure reliability of the dependency to avoid losses by disappointments have been ignored.

“Tenth, often when demand increases, sellers prefer to not raise prices and instead tolerate a shortage in supplying some customers. The supply is then rationed among more dependent customers. Your analysis is not consistent with this fact.

“Eleventh, firms are far more complicated than pictured here. They usually are corporations with owners, most of whom hardly ever do anything except invest and hope for dividends and higher stock prices. They have long-time employees, working in teams, directed and supervised by a boss, and paid wages, rather than by some market prices and daily negotiations about wages.

“Finally, unlike a fishing boat, where only the number of people on board is important and all employees receive the same wage, in many if not most firms wages differ because the employees are not identical. Differences in personal abilities and traits upset the law of diminishing returns, which applies only if the added inputs are identical in every respect. Not just numbers of workers, but also who they are, affects production and wages.”

We’ll attend to the first six objections in this chapter, and we will deal with the others in later chapters.


Fortune does not hand down information and guidance to discover improved techniques of production and distribution of better products. It’s obtained by investing in risky exploration and experimentation with one’s own wealth. Some experiments, perhaps most, fail. The failures disappear with little publicity.

An entrepreneur is more than an investor. Entrepreneurs think of new ideas and make investments in research with trial and error in the hope of finding profitable products or methods of production and distribution. Entrepreneurs, Edition: current; Page: [276] though trying to augment their personal wealth, have improved the well-being of the populace, and not merely by competing in prices of goods. They have invested in attempts to discover better goods and methods of production and distribution.

Innovators can’t rely on rules. But it seems clear that entrepreneurship is stimulated and enabled in a private property capitalistic society, where each person can experiment without prior approval or permission and where the rewards and failures are more concentrated on the experimenter.

The successful ideas or products of entrepreneurs typically displace inferior products and procedures. Entrepreneurship is both creative and destructive. But it creates more worth than it destroys if the entrepreneur is profitable. The successful entrepreneur captures some of the net gain in the profits obtained. If the creative worth is less than the destruction, the entrepreneur suffers a loss.


As we saw earlier, if at an additional cost of 3 cents per bottle Coke is made better than Pepsi, and that improvement is worth 5 cents, a consumer will switch from Pepsi to Coke when each is priced at one dollar. Pepsi loses a whole dollar of sales. Therefore, the customer, who gets only 5 cents more of worth, seems to impose a one-dollar cost on Pepsi.

But the loss to Pepsi is not the lost $1 of sales revenue. Instead, it’s Pepsi’s profits that Pepsi loses, and that’s a lot less than $1 per bottle. And the loss to Pepsi is not a social loss; it is a transfer from Pepsi to consumers.

The resources not used by Pepsi, when making less Pepsi, are worth up to $1 in other uses. The loss to Pepsi could include reduced value of resources that are not transferable to other uses without some drop in their value. The gain to Coke consumers exceeds the reduced value of resources specialized to Pepsi production, since Pepsi producers could otherwise have offset that gain through lower Pepsi prices or better quality.

A transfer from one person to another (loss to one person and gain to another) is a loss of resource values, not a reduction of consumer worth. Creative destruction is that which results in a creation of wealth exceeding any destroyed wealth. Accompanying creative destruction is a reallocation of wealth, but the gains exceed the losses.


The second objection was that several people are involved in the process as a series of links in a sequence of production from raw materials to finished products. For wheat to be converted to pasta on the table, a farmer grows wheat; a Edition: current; Page: [277] miller mills it into flour; a pasta maker makes it into pasta; and a grocer sells it to the consumer.

From the final consumer price, the grocer takes some, the pasta maker takes some, and then the miller takes a portion, with the farmer getting what’s left. Or maybe it’s the other way around. Initially, the miller—when buying the wheat—pays the farmer. After the wheat is milled into flour, the pasta maker pays the miller, the grocer pays the pasta maker, and finally the consumer pays the grocer. The grocer keeps any excess of the price of the pasta over the cost of the pasta. The risks are borne differently in the two approaches, but the basic process is the same.

The pasta was sold for $1, its market value. The grocer competitively obtains $.05, leaving $.95. Competitively obtained does not mean the grocer competed against the pasta maker, the miller, and the farmer for some of the $1 final product value. The grocer competed against other grocers. The grocer willing to pay the largest amount, $.95 out of the $1, to all the other producers in the successive stages, was the winner—the surviving grocer, who settled for $.05, with $.95 going to the other stages.

The winning baker, who paid the miller $.35 for flour, was able to obtain, or derive, only $.60. The miller was left with $.35 from which he competitively derived $.20, while the winning farmer competitively derived the remaining $.15. This competitive derivation is also called competitive imputation of values. They are typically called added values, though they are also subtracted values—subtracted (derived, imputed) from the final product value.

If the cost in each firm is greater than the competitively derived added value, the firm will not survive. If some firms obtain more than enough to maintain their services, others will begin to enter, competitively reducing the amount taken at each stage. That will result in larger outputs at each stage, which increases the supply and reduces the market prices of the intermediaries’ services and of the pasta.


The third objection was that hardly any manager knows the cost data or future market price sufficiently precisely to move to the profit-maximizing rate. That’s true, but it does not falsify the economic analysis or make it uninteresting.

Managers are not totally ignorant. They know enough to curtail use of inputs whose prices have increased and to shift to lower-priced ones. They know that increased sales of products suggest that increasing output would be better than reducing it. They know that higher prices of inputs raise costs—which we represent as an upward shift in marginal costs. That means Edition: current; Page: [278] the profit-maximizing output is smaller. They may not know the amount of the best change, but they usually know the direction. And they experiment through trial and error. If adjustments aren’t made after rational calculation, they are confronted by inescapable force and incentive—survival of the fittest.

Even if managers were totally passive and acted randomly or just stayed put, those that happened by chance to make a change, or had already been doing what is now most appropriate to the new circumstances, might cover costs and reap profits. They’ll be the lucky survivors and grow. Those that don’t make the right adjustments, or didn’t happen to be in the right situation, are less likely to survive.

Whether the successes are those who deliberately and consciously knew the correct adjustment, or were closest by chance, is irrelevant. The managers who, for whatever reasons, were nearer the marginal-cost-equals-marginal-revenue situation will be the competition survivors. All that economic analysis can do is help us deduce whether a larger or a smaller output, or a smaller or larger amount of some inputs, will be more profitable when circumstances, such as demands or prices, change.

Of course, some producers, by compiling data with which to estimate costs, may increase their probability of being nearer the wealth-maximizing output rate. They know that when demand rises and sustains a higher price, an expanded output becomes more profitable, even if they may not know how much larger the output should be.

We all notice successes—the survivors—rather than the failures. The magazine Fortune is popular, but there is none called Misfortune. Some people are relatively successful because of better information, better ability, or better luck—or a combination of all three. Economic analysis does not depend on the basis of their decisions, or methods of calculation and reasoning, or whether they think in terms of marginal costs and adjusting output accordingly. What finally matters is who is in, or nearest, the profit-maximizing situation—not how they got there. Both informed rational calculation and good luck can play a role.


The fourth complaint of the practical business owner was that some costs can’t be allocated among products that are produced together, such as the cost of feed for meat and hides of cattle, or fuel costs for passengers and freight on an airplane.

This objection is correct but not significant. It is not necessary to distribute Edition: current; Page: [279] common costs accurately among the jointly produced products. To know how much feed to give the cattle, all that’s necessary is knowing whether the marginal value of an extra dollar spent for feed brings in more than a dollar of revenue, no matter whether from hides or meat.

With airliners, it’s the marginal costs of a passenger or a pound of freight that is pertinent. That decision doesn’t involve accurately distributed common cost. Just ask how much the total cost of all inputs is increased when carrying more passengers or freight in the cheapest way—total costs, without regard to whether the costs are more for common inputs, or for costs of services used only by passengers, or only by freight customers.

Getting data to estimate the marginal costs will be hard, but what is to be estimated is unambiguous and pertinent. In contrast, attempts to distribute the common costs accurately among the joint outputs must be arbitrary. For purposes of efficiently managing a business, there’s no point in trying—hopelessly—to find the correct allocation of those costs that are common to many products.

Consider a situation in which the event for which the cost to be estimated is ambiguously identified. A baker supplies cookies to a retail grocery chain, called A. Later, along comes retailer B, desiring a small number of cookies from the baker. Data in table 18.1 show how confusion can arise—and be avoided.

Ovens and other equipment will have to be used to produce the cookies for A, whether or not cookies are baked for B. Producing cookies only for A has a cost of $90. The baker can bake the extra cookies for buyer B, and the total cost for both A and B will be $140.

The cost of baking cookies for B on the condition that some are going to be baked for A in any event is $50 ($140 − $90). However, if baking for B alone

Table 18.1 Costs of Joint Products?
Production only for Customer A $90
Production only for Customer B $60
Production for Customers A and B $140
Production for B, on condition that cookies are being produced for A $50 ($140 − $90)
Production for A, on condition that cookies are being produced for B $80 ($140 − $60)
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were already under contract at cost of $60, then the extra cookies for A would have cost $80 more ($140 − $60). On one basis, we get a cost of $50 for B (with cookies also being baked for A), but on another we get $60 (without cookies for A). Similarly, we get two different costs for A: one with B and one without B. Which is correct? They both are.

Finally, maybe the situation is, “Cookies are going to be baked for both A and B, with no cookies being baked otherwise. What is the cost of baking for both?” The answer is $140, and there is no implied unique allocation of that cost between the two.

The more pertinent question is what price could be charged to each. The answer is a price of $90 to A, for that is the price formerly being charged to A. And $60 is what B is willing to pay. But the answer is at least $90 and $60. The best prices depend on factors we investigate in the next chapter. At present, the moral is: Do not confuse the question of what price to charge with the question of what the costs are. And be sure the act whose cost is being measured is precisely identified.


Larger amounts, or volumes, of output cost less per unit of output. The marginal and average costs of volume decrease at greater outputs. That’s true for virtually all goods produced.

There is an important distinction between (a) the rate, or speed, of production, and (b) the volume, or amount, of output. Until now, we have measured output almost always with respect to the rate of production. But producing beer at the rate of 60 barrels per day doesn’t tell how many barrels are brewed, unless you know how long that rate is maintained. And knowing only the total volume doesn’t tell how many per day are being produced.

When referring to greater output, we must specify at least two of the following three dimensions of amount of output: (a) the rate of production; (b) the planned volume; and (c) the length of the time production will continue. Any two of those will imply the third.

It’s probably true also that the larger the volume to be produced, the lower will be the marginal costs at various possible speeds of production. Stepping up the rate of production from 30 to 31 units per day—when the total volume to be produced is 5,000 units—is probably less expensive per bottle than if the total volume to be produced were only 100 units. The techniques of production for larger volumes are usually also techniques appropriate for speedier—higher rates of—production.

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Learning, Progress, Experience Curves

For at least two reasons, average and marginal costs are lower for larger volumes. One is that people learn from the experience of production, of trial and error. As more units are produced, people discover better component designs and production methods. Producing a larger volume, at any given rate, takes longer, so general knowledge-enabling imitation of discoveries elsewhere is more likely, the longer the time. So the larger the volume—and the longer the time over which to acquire new knowledge—the lower will be the unit and average cost.


Another reason for lower unit costs with mass production is that a wider choice of techniques is available for larger planned volumes. Larger volumes could be produced using the best of small-volume techniques and repeating the process, but not all large-volume techniques are economical for small volumes. To paint automobiles, you could use large, paint-dipping vats and heating ovens to dry the paint. That technique could be used for just one car at a very high cost, but it would be much cheaper per car in painting a thousand cars.

Learning during production is so pervasive and reliable that cost engineers in many large firms refer to a learning or experience or progress or 20 percent learning curve, indicating (with exaggerated precision) the percentage reduction in marginal unit cost with each doubling of the volume of production. It’s also called an 80 percent curve, meaning a doubling of volume reduces marginal costs to 80 percent of what they were at the smaller volume.


Subsequently, we’ll be relying on the following propositions about how costs are related to rates and volume of production.

  • a. Total costs are higher at faster rates of outputs, for a specified volume, in both short- and long-run operations.
  • b. Marginal costs and average costs of rates of output may fall at very low rates of production, but they will rise at higher rates of production. This is true for short-run and for long-run production. For virtually any specified volume of production, faster rates of production will have higher total, average, and marginal costs.
  • c. The average and the marginal costs are lower for production of larger volumes.
  • d. When both the rate and the volume are increased, the net effects on the Edition: current; Page: [282] average and the marginal costs are impossible to generalize, except that the rate effect will ultimately dominate.


These propositions about cost and production are quite reliable, but they are not all based on some known physical law of nature. It is possible that in some situations, the product and its rate, or its volume, of production will exhibit patterns of costs different from these standard relations between costs and rate and volume of output.


Once the importance of volume and the rate of production is recognized, it’s easy to see that a seller or producer must be influenced by how long a buyer/demander is expected to purchase at that rate. The longer the duration of that rate of purchase, the greater is the volume. A buyer demanding ten a day for just today can be far less important to a supplier than a buyer demanding one a day for a year.

The Two-Dimension Demand for a Good:

  • a. the stock demand, as the amount to have on hand or owned; and
  • b. the flow rate of demand, for the rate of current consumption

The demand for computers can be thought of as: (a) the quantity of computers the public wants to have on hand—a stock, and (b) the rate of demand for more computers—a flow—measured as the number per day purchased for current use as well as for building or maintaining the stock on hand. As discussed in earlier chapters, economists sometimes distinguish between a good’s value-in-use and its value-in-exchange. The price for which a person might be willing to sell something already possessed and in use is likely to be different than the price that same person would be willing to pay for something desired and not already possessed.


The relatively wealthy are the first demanders of a new product. We often observe that the initial market prices of new products are viewed as quite high to the average consumer. Quartz watches, cell phones, and high-definition televisions are recent examples. Then, as the rate of purchase declines when demands of high-worth buyers are satisfied, prices will decline to cater to demanders with lower marginal worths. Prices will be lowered also because of a Edition: current; Page: [283] larger output at lower costs of production resulting from learning and production by new firms—competition from new entrants.


  • 1)

    Heat and light are joint products of an electric light bulb that uses electric power at the rate of 1,000 watts. In one hour the cost of the power is 5 cents.

    • a. How much does the light cost? How much does the heat cost? How much do the light and the heat together cost?
    • b. If you were selling the heat to someone, how much would you charge him? And if, at the same time, you were selling the light to someone else, how much would you charge him?


    • a. Can tell only that both together cost 5 cents an hour.
    • b. No way to distinguish the buyers with cost data only. With open markets, the price of the package will be competitively lowered to a level where receipts from the joint products are just sufficient to cover the costs of production.
  • 2) Meat, wool, and hides are joint products of sheep.

    • a. What assurance do you have that the prices paid for meat, for wool, and for sheepskin are just adequate to cover their cost of production?
    • b. What assurance do you have that meat users are not paying a disproportionate share of the common costs?


    • a. None. That they will not far exceed it for long is a result of open markets.
    • b. None.
  • 3)

    A filmmaking company once advertised, “The price of a new organic chemical depends on how badly it is wanted—precisely as conceived by classical economic theory, except for reversal of direction. The bigger the demand, the lower the price. A 1,000-pound-per-day process operates more efficiently than a 1,000-pound-per-month process—which is obvious to you but wasn’t to Adam Smith. Old Adam set down the rules for our game in ignorance of elementary chemical engineering and advanced advertising.” Explain wherein the ad writers for the company are doubly confused—on both the demand and the supply side.

    Edition: current; Page: [284]


    The ad writers have mixed up rate and volume effects on costs. A greater supply—volume—implies a lower unit cost and also a lower price. Bigger volume demand yields lower price because it evokes a greater supply (in volume sense). But in the rate (or speed of production) sense, higher demand yields a higher price. When demand increases in both the volume demanded and the speed at which that volume is demanded, price may fall (in response to volume effect), but it will be higher than otherwise in order to increase the rate of production. What advertising can do is to affect the volume demanded, but if it also increases the rate at which the good is demanded, it leads to higher prices.

  • 4)

    A firm plans to produce 2 million cameras in the next six months. What is the volume and what is the rate of output?


    2 million is volume. Rate is 4 million per year.

  • 5)

    If that rate in the question above is continued for one year, what will be the volume?


    4 million units produced in the year, with rate of production unchanged.

  • 6)

    What happens to marginal and average cost per unit for larger rates of output with constant volume?


    They begin to increase.

  • 7)

    What happens to marginal and average cost for larger planned volumes with unchanged rates of output?


    They decrease.

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Hardly any business firm is a pure price-taker, although the price-taker model explains important features and operations of the economy. The next step up the analytic chain is explanation of price-searchers, often called sellers with market power or monopoly power.


Price-takers can sell as much of their good as they choose without having to cut the prevailing market price. But price-searchers cannot sell as much as they want at their announced selling price. Even if each price-searcher is offering the same physical product, the convenience, service, and personality of the sellers may result in some customers preferring one seller over all others. Sellers are not perfect replicas of each other.

Customers’ preferences may be sufficiently strong that at a slightly higher price many customers continue to buy. Some rivals offer better services, or are more reliable than others, at least in the opinion of some buyers. Some are located closer to the consumers; some are more pleasant. Neither the seller nor the offered goods are identical among competing sellers. A slightly higher price will not push all customers to a rival seller. Nor will a slightly lower price attract all customers from a close competitor.

For a seller lowering the price to attract an additional buyer, marginal revenue is less than the price. Unlike a price-taker who can sell more without having to cut the price, the price-searcher knows that he cannot, and as a result, he concentrates on the marginal revenue—the added sales value when the price is lowered. The lower price on all the units sold offsets some of the sales value of the added units sold. Marginal revenue is the net effect of: (1) the additional revenue from the added units that are sold minus (2) the revenue lost by the lower price on the units that could be sold without the price cut.

Though we call them price-searchers, these sellers search all aspects of the goods and services and conveniences provided to their buyers. Price-searchers endeavor to sell more, not merely by price reductions, but also by marketing tactics, such as discount coupons for groceries, senior citizen discounts, special sales, free parking, free delivery, return privileges, rebates, quantity discounts, Edition: current; Page: [286] and college tuition scholarships. Price-searchers advertise and have brand names, which enable buyers more readily to identify preferred sellers, but price-takers don’t.


There are differences in customer behavior because price-searchers sell products that customers do not regard as virtually equivalent among the competing sellers. And the prices and products of rivals affect the demand facing a price-searcher seller. This contrasts with price-takers, who sell identical products at the same price.

Price-searcher/sellers respond to changes in the amount demanded by customers at the existing offer price. This imposes an additional problem for the price-searcher—distinguishing between: (1) random daily changes around an unchanged average amount and (2) a change in the average amount around which the daily sales vary randomly.

No price for a seller’s goods is announced in a central market, so a price-searcher has to set his own price, at which potential customers choose how much, if any, to buy. The first law of demand is effective: at a lower price determined by a price-searcher, more will be sold. And marginal revenue is the change in total revenue when the seller reduces the price on all units, reducing it enough to sell one more unit.


A price announced by a price-searcher reflects that seller’s estimate of the demand for its goods. Some customers would buy from a higher-priced seller who provides more service, or is easier to find, or are sellers in whom many buyers have more confidence of getting what they want. They would not depart at the slightest increase in the price, but would demand less because of the higher price. This persistence of some, but not all, customers is why the demand curve facing the seller is a negatively sloped line, rather than horizontal at the market price.

The negative slope of the demand facing a price-searcher causes the marginal revenue to be less than the price—which explains almost all differences between the selling tactics of price-searchers and those of price-takers. One effect is that the price charged by a price-searcher will not be the same to all customers, because the customers of a price-searcher differ in the amount demanded and differ in their elasticities of demand for that seller’s goods.

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Even if sellers offered identical goods and services, not all potential customers would know the items were identical, because getting information is costly. To reduce customers’ cost of getting information about various sellers, price-searchers advertise and have brand names (while price-taker/sellers don’t).

A difference in only the price is not always decisive in buyers’ choices among price-searcher/sellers. Automobiles are the same in that they transport you. But not everyone buys automobiles from the lowest-priced seller. Buyers are choosy about competing sellers, and they differ with respect to which features of the seller are more important. Some customers will buy from their favored seller despite that seller’s higher prices. This behavior is consistent with a price-searcher facing a negatively sloped demand for its products.

A price-searcher must also engage in market search to determine the best price to set while weighing the effects of (a) a higher price on each unit sold against the (b) reduced number sold at that higher price. The change in total revenue resulting from these two conflicting effects is the marginal revenue.


Price-takers, such as farmers, face a price at which they each decide how much to produce and sell. However, for a price-searcher, customers choose how much to buy at the price set by the price-searcher.

Presumably, the price a price-searcher should announce is the price that maximizes the seller’s profit. But determining that price is not easy. Competing producers offer similar products and advertise their offerings to help customers search the market. Though the products of different sellers are the same in a rough sense, they are not entirely the same.

A difference in the prices is not the only thing that counts in a customer’s choice among sellers. But potential buyers do not know the differences in qualities of goods and services of competing sellers before shopping, nor are they known with certainty even at the time of purchase.

Shoppers squeeze bread, smell cheeses, heft oranges, sniff perfumes, shake walnuts, choose among shoes, slam car doors, bounce on mattresses, and test the fit and appearance of clothes. Shoppers are attracted by warranties and special services. They rely on a seller’s reputation and brand name. There’s no given market price facing each price-searcher/seller.

Though the attributes of a product may not be tailored to each customer, the price can be tailored, so not all buyers of the same product pay the same price. Negotiations, bargaining, dickering, and bluffing are part of the business for many price-searchers.

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Unlike price-takers—who do not regard other producers of similar goods as rivals—price-searchers recognize other sellers as competitors. A price-searcher is affected by, and takes account of, the prices of rivals. Since there is no given market price for the price-searcher, evidence pertaining to demand conditions includes changes in the amount demanded at that seller’s current offering price. But changes in amount demanded can vary from day to day at random, complicating assessment of the market and the activities of the other sellers.


The negative slope of the entire public’s demand facing a seller (1) permits certain pricing and selling tactics, and (2) leads price-searchers to adjust price as well as production in response to changes in amounts demanded. Whereas price-takers adjust only production in response to a change in the given market price, price-searchers are responsive to changes in amounts demanded at whatever price is posted.

An important effect of a negatively sloped demand is that the marginal revenue is less than the associated price, as in table 19.1.


Though the amounts demanded and sold are greater at lower prices, that’s not invariably the case for the total sales revenues (the total market value of the purchase), as illustrated in column 5. Marginal revenue is the change in the

Table 19.1 The Demand Function and the Associated Marginal Revenue
Price Daily Quantity Personal Worth Marginal Personal Worth Total Revenue Marginal Revenue
(1) (2) (3) (4) (5) (6)
$1.00 1 $1.00 $1.00 $1.00 $1.00
.90 2 1.90 .90 1.80 0.80
.80 3 2.70 .80 2.40 0.60
.70 4 3.40 .70 2.80 0.40
.60 5 4.00 .60 3.00 0.20
.50 6 4.50 .50 3.00 .00
.40 7 4.90 .40 2.80 -0.20
.30 8 5.20 .30 2.40 -0.40
.20 9 5.40 .20 1.80 -0.60
.10 10 5.50 .10 1.00 -0.80
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total sales revenue when the price on all units is lowered enough to sell one bottle more each day.

Note the change in total revenue when the price is lowered to $.80 (from $.90) in order to sell 3 rather than just 2 bottles. Total revenue increases by only $.60, not the $.80 price at which the third bottle is sold, because the price was lowered on all bottles sold. So long as an additional unit is sold by lowering the price on all units, marginal revenue will be less than the price at which the additional unit is sold.

If the price is lowered enough to sell 4, rather than just 3, the price would have to be reduced to $.70. The total revenue at that price would be $2.80 (= 4 × $.70), only $.40 higher than the $2.40 (= 3 × $.80) when three were sold at a price of $.80 each.

If 5 per day were being sold at $.60 each, lowering the price to $.50 to sell six leaves total revenue ($.50 × 6 = $3.00) unchanged. This price, $.50, is the revenue-maximizing price, at which marginal revenue falls to zero. Going to a still lower price, $.40, to sell seven, reduces total revenue by $.20, from $3 to $2.80, which means marginal revenue is negative. The $.10 reduction in price on each of the six inframarginal units more than offsets the $.40 price received on the marginal unit.

The relationship between average revenue (demand) and marginal revenue is illustrated graphically in figure 19.1.


Next, we identify the price and the associated demanded amount that maximizes a price-searcher’s profits, not the total sales revenue. Surviving firms are more likely to be those that somehow had prices and outputs that were closer to the profit-maximizing price and output, no matter what may have been the owners’ objectives and tactics. Profit is increased by expanding output and sales as long as expansion increases revenue (MR) more than cost (MC). The profit-maximizing quantity and the price for the product are determined by where marginal revenue is brought to equality with the marginal cost. This is illustrated in general in figure 19.2, where marginal cost is shown as a straight line.


For most producers, marginal costs of additional units produced rise while marginal revenue for additional units sold is falling. In table 19.2, assume a fixed cost of $.20 at any level of production. The best profit-making output and associated price are revealed by comparing marginal revenue and marginal cost: expand output as long as that adds more to revenue than to cost.

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Figure 19.1

Marginal Revenue and Demand

Total revenue (price x quantity) is the area OPP′Q. It is measureable also as the area under the MR curve to quantity OQ. OPP′Q = OTVQ, so triangles PTR and RP′V are equal, with equal area and equal corresponding angles. Therefore, PR = RP′: the MR curve bisects any horizontal line from the vertical axis to the AR curve.

Figure 19.2

Demand, Revenue, and Cost

The quantity sold, OQ, is determined where the marginal revenue intersects the marginal cost line, point C′. Going up from that quantity to the average revenue (demand) curve gives the profit-maximizing price, P. Total revenue at that price and quantity is the rectangle OPP′Q; total cost is the rectangle OCC′Q. The difference, profit, is the smaller rectangle CPP′C′.

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Table 19.2 Demand, Revenue, and Costs for Water Sellers
Price Daily Quantity Personal Worth Marginal Personal Worth Total Market Revenue Marginal Revenue Marginal Cost Total Cost Total Profit
$1.00 1 $1.00 $1.00 $1.00 $1.00 $0.10 $0.30 $0.70
.90 2 1.90 .90 1.80 .80 .20 .50 1.30
.80 3 2.70 .80 2.40 .60 .30 .80 1.60
.70 4 3.40 .70 2.80 .40 .40 1.20 1.60
.60 5 4.00 .60 3.00 .20 .50 1.70 1.30
.50 6 4.50 .50 3.00 .00 .60 2.30 .70
.40 7 4.90 .40 2.80 -.20 .70 3.00 -.20
.30 8 5.20 .30 2.40 -.40 .80 3.80 -1.40
.20 9 5.40 .20 1.80 -.60 .90 4.70 -2.90
.10 10 5.50 .10 1.00 -.80 1.00 5.70 -4.70

The optimal output is 3 bottles, with price of $.80. Total revenue is then $2.40, and total cost is $.80, so profit is $1.60. Adding a fourth unit of output would pointlessly increase both cost and revenue by $.40, leaving profit unchanged. And output of five would actually reduce profit. The average cost plays no role here. It does not tell what price to charge, nor whether you are making profits or incurring a loss. (Notice that the sum of the successive marginal costs for each of the rates of output gives the total cost of that output. And the rise in marginal cost means that the average costs increase at the higher rates of production.)


Marginal costs are higher at faster rates of output. At the maximum profit output and price, the marginal cost matches the marginal revenue and exceeds it at faster rates of production. In figure 19.3, the profit-maximizing rate of output is indicated by the intersection of the marginal revenue curve and the upward-sloping marginal cost curve.


Rarely, if ever, does the seller know the data required to state the exact profit-maximizing price. Instead, some price, usually close to some competitor’s price, is set in the hope it’s optimal. The nearer the chosen price to the profit-maximizing price, the greater the probability of profits and survival.

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Figure 19.3

Average Revenue Minus Average Cost Equals Profit per Unit

Figure 19.3 shows total costs, total revenue, and total profits as three rectangles. The smooth lines of the graph, in contrast to the lumpy data of table 19.2, reflect continuous function of infinitely small variations in output. Total revenue is the rectangle with a base measuring the output rate and a height equal to the price at the profit-maximizing output, OPP′Q, the equivalent of price multiplied by output. Total cost is the rectangle with the same base, a height given by the average cost curve at that output, OCC′Q. Profit is the excess of the total revenue rectangle over the total cost rectangle, CPP′C′. The profit per unit is indicated by the distance of the price above the average cost at the profit-maximizing rate.


We said that the profit-maximizing rate of production for price-searchers is the rate at which marginal cost matches marginal revenue. But another kind of pricing strategy can get higher marginal revenue than would be obtained by cutting the price on all units. A greater marginal revenue and greater profit possibility exists if the seller can lower the price on only the additional units sold.

An airline advertises, “Take along your spouse at half fare,” which lowers the price on just the second unit. Lower prices to children avoid a cut in price to parents. Discounts to seniors in barbershops and theaters lower the price for only some customers. An offer such as “$5 each, or 3 for $10” lowers the price on only the second and third units, not on the first, because the price is $5 for one, while the prices for the next two are $2.50 each.

Discount coupons give reduced prices on some, but not all, units to a customer, and also to some, but not all, customers. A “free” shuttle ride from an Edition: current; Page: [293] airport to a hotel is a method of lowering hotel prices to some, but not all, customers of the hotel. For movies, ticket prices are not constant over time, starting high when the new movie is released, then lower a few months later. With such price offers on some additional units, total revenue is greater than it would be if the price were cut on all units. The customer achieves more of the consumer surplus worth, though in all these pricing tactics the seller’s interest is in his profit.

It’s tempting to judge that such pricing must be nefarious. In the next two chapters, we’ll explore some examples that are especially pertinent when considering national antitrust laws affecting what business firms can or cannot do legally.


In addition to the distinction between price-takers and price-searchers, we categorize markets according to the extent to which they are open to everyone without restrictions. Restrictions mean contrived, nonnatural, and costly obstacles limiting (or raising costs of) access to customers. They may be minor business taxes and cleanliness standards, not always to be regarded as undesirable or inefficient in the sense of unnecessarily reducing achievable aggregated personal consumer worth.

The contrived restrictions can be mild or severe. A restriction can be as complete as permitting only specified sellers to have exclusive right to sell. Markets are closed to those who don’t pay added costs or meet more expensive conditions of entry. All taxes on goods and tariffs on imports from foreign nations are examples, if we define restrictions to be any imposed cost or physical barrier to trade.

Patents, copyrights, exclusive public utilities, and the one cable TV company in your neighborhood are examples of restrictions on potential rivals. Similarly, there are acreage limits for growing tobacco, on sizes of dairy herds, and in local bus transportation. Not all are necessarily undesirable, but they are contrived restrictions.

Monopoly Rents

Classic early examples of closed markets were the English Crown’s grants of exclusive rights to favored persons to import and sell wine in England, or to manufacture playing cards, or to print books, or for whatever the Crown decided to grant an exclusive privilege, with resulting higher prices to consumers. Economists call these gains to the protected sellers monopoly rents.

Monopoly emphasizes that the seller is the only permitted seller, and rent Edition: current; Page: [294] suggests that it’s a price higher than necessary for the service to be rendered. The combination means a payment in excess of cost and obtained as a result of government closure or restriction of access to the market by competitors. Even where more than one seller is permitted, contrived barriers such as tariffs, quotas, and other restrictions of imports result in some monopoly rents to benefited parties.


Usually, market limitations are expressed as restrictions or fees or higher costs on sellers. However, there are instances where the objective of the restrictions is intended to limit potential buyers of a product or service. The difference usually is whether the buyer or the seller will be punished if a sale is made. If you are underage and buy beer, who is punished by the law? If you buy a concert ticket from a scalper, who is punished by a law against reselling tickets? While the intent is to prevent a purchase from being made, it will be the seller who will be punished by the transaction.


We have seen that whether sellers are classified as price-taker or price-searcher is based on the extent to which the marginal revenue is less than the associated price. If they are equal, the seller is a price-taker. If marginal revenue is less than the associated price, the seller is a price-searcher.

In a large market economy, business organizations are found in vastly variegated forms and appearances. They differ enormously in size, from street vendors to massive institutions. They produce both personal services and physical goods, some specializing narrowly and others offering much variety. Some sell to final consumers, others to other firms and to government. Traditionally, most firms are privately owned, but there are significant government enterprises, some joint arrangements of private and government control, and much government regulation throughout the economy. And, of course, some prosper some of the time while others fail and disappear.

How can we usefully categorize and generalize in analyzing this business world of such complexity? One approach is to specify a continuum of market structures:


By usual definition, a “monopolist” is a single seller of a good, while “competition” requires so many sellers that no one of them can perceptibly affect Edition: current; Page: [295] the market. “Duopoly” refers to a market of two sellers. “Oligopoly” involves more than two, but only a “few,” sellers. But the respective classifications are not functions only of the number of sellers. Especially in contrasting “monopolistic competition” from “competition,” there is the consideration of product differentiation: we have monopolistic competition with many sellers offering products which are deemed by consumers to be somewhat differentiated.

There are still further complications. Duopoly is designated as a two-firm industry. But there is much substitutability among most products. Might we consider a third firm sufficiently similar to the first two to constitute a three-firm “industry”?

And how few are a “few” in an oligopoly? Is there an oligopoly when only three firms dominate the product group—or should we include four or five dominators? And what constitutes “domination”? Twenty percent or 30 or 40 or 50 percent of something? Percent of what—sales revenue, profit, assets, customers, employees?

Interdependence and concern for strategies and tactics of other firms bulk large in most segments of the market. A price cut that would be profitable if other sellers did not also reduce their prices could be a disaster if competitors do cut their prices. Even the monopolist takes note of advertising and innovating and investing and government taxing and regulating and subsidizing elsewhere—or he may not long remain a monopolist.

All is not hopeless in trying to comprehend the essence of things. Economic concepts and techniques of analysis provide much system and order in our thought. But we cannot realistically expect complex classifications always to be perfectly clear-cut and unambiguous.


One widely used pair of labels is seller with market power and seller with monopoly power. A seller with market power may be simply a price-searcher, someone who must select a price. A seller with monopoly power might mean a seller whose products are so widely and so strongly demanded (say, Apple iPads) that this seller’s price and offering significantly affect the demand and hence prices of other sellers.

Congress has been unable to specify what it meant when legislating that, “It is illegal to monopolize or attempt to monopolize or be a monopoly.” The resulting confusion among lawyers, legislators, judges, and the general public is almost sure to be found in any lawsuit alleging monopolistic behavior. Probe beyond emotive names and look, for example, at such things as whether contrived restrictions (like patents or copyrights) are affecting competitors’ access Edition: current; Page: [296] to markets, and whether a seller can affect only its price, or also the demand and price of other sellers.

For price-takers, we could choose the label competitor. Similarly, instead of price-searchers, we can say monopolists, sellers with monopoly power, monopolistic competitors, imperfect competitors, price-setters, or sellers with market power. At any rate, the seller must try to find the best price, whether that seller is your local grocer, gas station, clothier, plumber, shoe-repairer, restaurant, or college.


A cartel is a group of sellers who manage to act jointly, as if they were one big firm, by arranging for the many sellers to act as one price-searcher. In some nations, the government permits or promotes otherwise independent competing firms to coordinate their actions. (“Collude” would be the word, if the action were secret and illegal.)

In the United States, cartels are common. Producers of milk, tobacco, raisins, wheat, cotton, and peanuts are some who are allowed and encouraged by the government to determine aggregate production jointly as if they were a single firm as part of the farm support program.

The entry of one more supplier imposes a very small and unnoticed downward pressure on the market price and profits to all the others. The federal government suppresses “excessive” production. Everyone must be prevented from privately and secretly expanding. The group wants to concentrate attention on the group’s marginal revenue rather than on just the price.


The pertinence of the price-taker/price-searcher distinction is unclear for personal services of an individual. Almost anyone can get some work at different earnings. Everyone is unique, even twins. We have to choose between thinking of people as price-searchers with a choice of jobs producing different earnings (thus selecting a price for one’s services) or of individuals as price-takers with no influence on earnings. We’ll use this classification exclusively for business firms although it is applicable to unions, some of which are closed while some are open.


The procedures and objectives in litigation have spawned a language adapted to dispute, emotional appeal, and confusion. In the sciences, language is oriented toward explaining and testing evidence objectively with no regard to a preferred goal, result, or beneficiary.

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In a notorious antitrust litigation against Microsoft, when Bill Gates was asked, “Is Microsoft a monopoly?” a useful answer would have been: “Yes, in the sense that Microsoft faces a negatively sloped demand curve for its products. And so are almost all the other merchants in the economy. If you mean that Microsoft is protected from some competitors, it is, because it holds patents and copyrights, both of which are legal. If you mean something else by monopoly, tell me what you mean.”

Federal law says only that it is illegal to monopolize or attempt to monopolize, but the law doesn’t say what monopolize means. Presumably, it didn’t mean negatively sloped demand curve. One meaning would be: “You compete in ways that don’t maximize total consumer worth though your fine products have increased consumer worth. It’s illegal to compete in a manner that reduces total consumer worth below what you otherwise could have created.” But the law has never used this last test, because every seller and buyer would be acting illegally, unless they were acting as price-takers with no bargaining about the price.

We now look at the objection to price-searcher behavior and the praise for price-takers—usually and misleadingly characterized as objection to monopoly and praise of competition. We start with the simplest, strongest case, the closed-market monopolist.


We note three reasons why closed markets are considered to be bad. First, they restrain potential competitors from exploiting their production abilities. That reduces the potential total productivity, as illustrated by the gain in total output when the Adam-Baker economy was opened to Carter (in chapter 15).

Second, resources and effort are diverted from productive uses to attempts to obtain and maintain political support for constraints on competitors’ access to markets. Competition, being inescapable, moves from markets and price competition toward political arenas, and that altered and restricted competition is a waste.

Sellers who are protected by contrived restrictions devote much attention and effort to maintaining the restriction. Once obtained, closure must be maintained with continued costly political pleadings for continued protection. Competition for government favors is political rent-seeking. Such rent-seeking is regarded as a subversion of the democratic process with resultant corruption of the government.

Third, the discipline of market competition is reduced. A competitor spurs your ingenuity—in wooing a mate or playing on a team or competing for Edition: current; Page: [298] grades. Similarly, producers are more alert to discern and seize opportunities to reduce costs, improve products, and better serve customers.


Consider a (normative) proposition about what is good or bad about price-searchers and restrictions on access to markets. To guide the policy of what are acceptable (i.e., not illegal) competitive actions, there must be a criterion of what are good and what are bad effects. The criterion is fairly well identified by the consistency of actions of government agencies responsible for surveillance of marketing and organizational actions. The two agencies are the Antitrust Division of the US Department of Justice and the Federal Trade Commission (both examined later). The goal appears to be that of maximized consumer worth, expressed also as consumer sovereignty or open markets. But the real problem is to know which actions have undesired effects.

The culprit is that price-searchers pay attention to marginal revenue, not to price. The price-searchers’ profit-maximizing rate of production is that at which marginal cost is brought to equality with marginal revenue. Because marginal revenue is less than the price, the profit-maximizing rate of production is a rate at which marginal cost is less than the marginal worth of the product to consumers. That is, the rate of production that maximizes profit to the seller is smaller than the rate at which marginal cost would equal the price, which measures the consumer’s marginal worth.


The reduction in personal worth resulting from producing an amount at which marginal cost is lower than the price (marginal worth to the buyer) is occasionally referred to as monopoly waste. Avoiding that loss is regarded as one of the major objectives of national antimonopoly policy embodied in federal and state laws, especially the federal Sherman Act of 1890 (considered later in chapter 26).

So price-searchers are said to produce too little. And because the label monopolist has been attached to every seller facing a negatively sloped demand, this is commonly called monopoly inefficiency.

In figure 19.4, the profit-maximizing price-searcher’s output has a marginal cost equal to marginal revenue, and marginal revenue is less than price. The value of an additional unit to consumers is the price, not the lower marginal revenue to the seller. But the seller heeds the smaller marginal revenue, because Edition: current; Page: [299] that is what he would get if he sold an additional unit (and all his output) at that new price.

Figure 19.4

Price-Searcher’s Profit-Maximizing Output and Price

A price-searcher, whose marginal revenue is less than price, has a profit-maximizing output where marginal revenue equals marginal cost, at five units of output. The price is $16, which yields a one-dollar net above the costs of $15 per unit.

An additional unit would be worth $16 to consumers; the resources required to produce it are elsewhere producing products whose value to consumers is only about $12, the marginal cost at six units. That is what marginal costs measure. Resources are then used elsewhere to produce products worth only $12 when they could have produced here a product worth $16 to consumers—a sacrifice of a potential social gain. This lost value is often misleadingly called the result of monopoly distortion, although it is not a result of “closed” or restricted markets. The distortion arises because the seller rationally heeds the marginal revenue rather than price of the last unit produced and sold. Since the extra receipts to the producer would not equal the price, but instead would equal the lower marginal revenue (because he must cut the price on all the units sold in order to sell more), he declines to produce more. If he could somehow sell more for what they are worth to consumers—the prices at those Edition: current; Page: [300] outputs—without at the same time having to cut prices on all the former rates of output, the extra revenue would then be equal to the price of those extra units rather than to the lower marginal revenue when prices are cut on all the units sold.

By the maximum-consumer-worth criterion, the rate of output should be that at which the marginal cost rises to equal the price, rather than equality with the lower marginal revenue at the smaller rate of production. But a price-searcher/producer who wants to survive must maximize profits, not consumer worth.


Though the preceding misdirection of some resources is called “wasteful,” think a bit further. Waste or inefficiency is only what can be avoided at a cost less than the waste. If the cost of avoiding some seeming waste is greater than the waste, it’s not really a waste.

In a supposedly ideal world, would we eliminate the price-searcher situation? We then would eliminate variety and everything that made one seller’s goods and services different from those of other sellers. All automobiles, clothes, shoes, and restaurants would have to be uniform. But price-searchers are ingenious, and use pricing tactics that actually do tend to increase output toward the consumer-worth-maximizing output, as we’ll see in the next chapter. Some of these actions are challenged as anticompetitive, because they are not normally seen in price-taker markets. Another reason they are challenged seems to be some confusion and ambiguity about the meaning of consumer worth.


So far the analysis has concentrated on the response of existing firms to changed demand: existing firms expand with higher demand. But increased wealth of existing firms cannot be long concealed. Firm salesmen know who is doing well. In various ways, the word gets around. Other firms imitate this firm. Employees organize their own company, taking with them part of the company’s know-how. Hundreds of firms have been created by former employees of older electronic-computer companies. If the production of electronic organs, pianos, Cokes, or Arrow shirts becomes more profitable, others will produce close substitutes and dissipate the profit of the first producer as some customers switch to the substitutes.

Profit streams of innovators and lucky firms are reduced as competing producers enter this market and bid up prices of resources: assemblers, supervisors, Edition: current; Page: [301] designers, production engineers, salesmen, managers, and research staff. As these employees respond to competitors’ offers, their wages rise, and hence their current employers’ costs of keeping them rise. Formerly under-valued inputs are paid more, absorbing the profits into costs and terminating the undervaluation of resources. Their owners are richer. This is as true for land, buildings, and labor—whether the labor be plumbers, managers, or teachers—as it is for resources owned by a business. Even the cost of an owner’s own services in his business must be valued at a higher figure; the more he can earn in his own business, the more others are willing to offer for his superior managerial skills. Those sacrificed options in other jobs with higher pay are costs of continuing in his own business. Figure 19.5 is a sample of a zero-profit long-run equilibrium, with price equal to average total costs.

Figure 19.5

Price-Searcher’s Output, Price, and Profit at Long-Run Equilibrium

No other price than P* and its output Q* would avoid losses. Imitative competition, making similar products available, pushes demand toward this situation. Innovative activity can push the situation away from this result, then initiating forces tending to restore it.

If demand falls, the events are reversed. Values imputed to currently used resources fall. Those resources will be shifted to other activities where the values of their services are not so low. Business owners and all other resources whose values are affected will be poorer because consumers’ demands for their prior services are lower. To keep them at their old jobs at the former income would require compelling consumers to continue to buy things they no longer value Edition: current; Page: [302] so highly. And that can’t be done in a free-enterprise open-market system. But it can be done if sufficient government authority can be exerted by special taxes to subsidize those producers—a topic we explore later.

The zero-profit solution shown by figure 19.5 assumes that no special services are given to some customers to achieve the output at which marginal cost equals price.


Consumer worth is the most a buyer would be willing to pay for a good. If the consumer gets a good for less, the consumer gets a gain, a consumer surplus. “Consumer surplus” may suggest that it belongs to the consumer. If you place a personal consumer worth of $100 on something I offer to you at my cost of only $60, should that $40 differential have been obtained by you? Is there reason for believing that if I had charged $75, instead of only $60, I’d be inappropriately taking some of your consumer surplus?

You might contend it’s your consumer worth. You insist that the market price should just cover costs because consumer worth belongs to the consumer. A seller could respond, “I produced that good. I created that consumer worth, which you verified by being willing to offer its full worth in order to get it. If I were the only producer, the price could be high enough that I would reap the full gain.

“Nowhere in Economic principles is there any implication as to who should get how much of the worth of the product. You want more of what I created, and you think I deserve no benefit or only enough to keep me working with all the benefit going to consumers. Consumers are merely passive opportunists. Producers are the real contributors to welfare.”

Whatever your opinion, economic analysis has nothing to say about the best or most appropriate or fair division of the total personal worth of a good.

This chapter introduced several distinctions, categories, and concepts. The first was in the demand facing the seller. In chapter 16 we saw that for price-takers, the marginal revenue to each seller always is the same as the given market price. But when a seller does not face a given market price, we must focus on the associated marginal revenues.

The second distinctive feature between price-takers and -searchers is in the market signal that guides production decisions. (a) For price-takers, prices are determined by all demanders in the organized commodities spot and futures markets. For each price-taker, a change in the market price of the good guides that producer’s production decisions. A price rise motivates a larger output. (b) There are no such markets for price-searchers, except possibly producers Edition: current; Page: [303] who specialize in commodities that do have central markets, such as copper, gas, and petroleum products (heating oil and gasoline).

For a price-searcher, the guide to a change in the rate of production is not a price change. Instead, it’s a change in rate of demand for the product. An unexpected rise in quantity demanded at an unchanged price motivates a larger output, because that will be profitable. The price tends to be changed only later when the increase in demand appears to be longer lasting than just a transient increase.


  • 1)

    Product differences:

    • a. Can you suggest some goods for which the differences among various brands are insignificant? (Hint: sugar, flour, aspirin, white bread, milk, soap, corn flakes, canned peaches.)
    • b. What do you mean by an insignificant difference?
    • c. What makes you prefer one brand over another at the same price?
    • d. Can you name any good and two of its brands for which you believe “no one in his right mind” would have a good reason for preferring one over the other?
  • 2)

    Answer the questions concerning the following demand schedule. Complete the total revenue, marginal revenue, and average revenue data.

    Table 19 Q&A
    Price Quantity Total Revenue Marginal Revenue Average Revenue
    $20 2
    19 3
    18 4
    17 5
    16 6
    15 7
    14 8
    13 9
    12 10
    11 11
    10 12
    Edition: current; Page: [304]
    • a. What happens to the difference between the selling price and marginal revenue?
    • b. How many units would you want to produce and sell if you could produce as many as you wanted at an average cost of $8 per unit and if you wanted to maximize your net receipts (revenue minus costs)?
    • c. What price would you charge?
    • d. Could you charge $18 if you wanted to? What would be the consequences?


    • a. It goes to infra marginal purchasers at a lower price. For example, between a price of $18 and $19 with sales of 4 and 3 units, respectively, the marginal revenue, $15, is less than the average revenue, $18, by $3. This amount is distributed to buyers of the three units by a price that is $1 lower than formerly.
    • b. Seven units.
    • c. $15.
    • d. Yes. But profits are less than if the price were set at $15.
  • 3)

    Searching for price:

    • a. How can a price-searcher be searching for a price, when in fact there is available an infinite range of prices—any of which he can charge?
    • b. What happens if he is not good at finding what he is searching for?


    • a. He is searching for the wealth-maximizing price.
    • b. He is likely to find himself losing money as others enter the business and reduce the price-cost spread.
  • 4)

    A theatrical producer expressed delight that tickets for his play had been sold out for the next four months. Explain why he might have cause to be sad, rather than happy.


    A higher price would have induced a smaller quantity demanded. If the price was below the market-clearing level, some increase in price would simply reduce the “shortage” of seats, and all the seats of the theater could still be sold. If the price were raised enough, some seats would remain empty, but if demand were inelastic, total revenue from ticket sales would increase.

  • 5)

    What is the wealth-maximizing output for a producer with zero costs? At the price to be charged for that output, what is the elasticity of demand (average revenue)?

    Edition: current; Page: [305]


    If costs are zero, then marginal cost is zero, and marginal revenue will equal marginal cost at the output where the marginal revenue curve intercepts the horizontal axis. At that output, revenue is maximized, so elasticity of demand equals unity.

  • 6)

    The difference (for pricing and output behavior) between price-taker’s and price-searcher’s markets can be characterized by a difference in the demand curve facing each seller. Describe the difference in the demand curves.


    Price-taker’s demand curve is horizontal at highest price at which seller can sell any of his product, while in price-searcher’s market his demand curve is a negatively sloped function.

  • 7)

    For some products, you prefer one brand over the other if both have the same price, but if there is any price difference between them, you will take the lower-priced one.

    • a. Would you say that you discriminate among brands?
    • b. Is that justifiable, rational discrimination?


    • a. Yes, although the strength of your preference may sometimes be very small.
    • b. It is, when I do it.
  • 8)

    Compare and evaluate the following two assertions:

    • a. “Advertising and brand names create impressions of differences among competing brands where no significant difference really exists. As a result, because of consumer ignorance, sellers face a less elastic demand and can raise price without losing all sales to competitors. Creation of impressions of significant product differentiation by advertising is a social waste.”
    • b. “Advertising and brand names identify rather than create differences among products. They permit customers to know more surely, cheaply, and fully the differences among various products. Otherwise, customers would select blindly, letting the price difference be their only reason for choosing one over the other, much as people would choose purely on the basis of price among superficially identical goods. By identifying products and their makers more fully prior to purchase, brand names and advertising permit customers to be more, Edition: current; Page: [306] and not less, discriminating about qualities with less costly other investigation into product details. Hence advertising and brand names make demands less elastic because they identify more fully differences in product and quality assurance as a social benefit.”


    Doubtless, there is truth in each statement. Advertising can consist largely of fiction and exaggeration. But where there is virtually no overt advertising, consumers are denied much useful information.

  • 9)

    “Sony announces a new 55-inch flat-screen television for $1,000.” “Apple iPads are sold at an announced price of $495.” “Sunbeam appliances are sold at retail prices set by the manufacturer.” If prices are pronounced by sellers, why aren’t these prices set perhaps three times as high?


    Price that maximizes sellers’ wealth depends on demand, not simply on their desire for more wealth. Prices three times as high would, in the judgments of sellers, yield smaller wealth or profits.

  • 10)

    Suppose a $5 tax is levied on your business—an annual license tax of a flat $5 regardless of how much you produce.

    • a. What will this do to your price and output?
    • b. What does it do to profits?


    • a. Nothing. While the flat tax doesn’t affect current output and price, it does affect profits. If the tax raises total costs (by raising average fixed costs) above marginal revenue, the price-searcher will not reinvest and will go out of business.
    • b. Reduced by $5.
  • 11)

    As a superior student, you provide a tutoring service to other students. The higher the price you decide to charge, the fewer the hours of work you get.

    • a. Are you a price-taker or a price-searcher?
    • b. The daily demand for your tutor services varies at “random” around a mean rate of daily demand which depends on the price you charge. If, at the price you currently charge, you find that all your available time is always used, and there are occasional applicants whom you must reject because you are fully booked up, do you think you are charging the wealth-maximizing price? Explain. Edition: current; Page: [307]
    • c. If you are charging a price at which you occasionally have idle time, are you charging too low a price?
    • d. Given a fluctuating demand, how can you be sure that you have charged the right price?


    • a. Price-searcher.
    • b. If you could serve as many, or virtually as many, customers at a higher price, you have not been charging enough.
    • c. If raising the price appreciably reduces the number of customers, we have a question involving elasticity of demand. If demand is inelastic, raising the price will increase the revenue.
    • d. You can’t be sure. You appeal to observation, experimentation, estimation, and tea leaves.
  • 12)

    In what sense can the marginal cost curve of a price-searcher be considered a supply curve?


    In the sense that it indicates the amounts of the good that the productive resources would be willing to provide through the intermediary of the businessman. But it does not present the supply schedule of the amounts actually forthcoming at each potential selling price of the good, because the intermediary businessman is heeding marginal revenue rather than price (average revenue). Only if marginal revenue is essentially equal to price, or very close to price, will the marginal-cost schedule approximate the supply schedule, and no significant difference will exist between price and marginal costs.

  • 13)

    Suppose you could live in a society in which trademarks were not protected by law and anyone could imitate the trademark.

    • a. As a consumer, would you prefer to live in that world or in one where trademarks were exclusively reserved for a particular manufacturer as a part of his property? Why?
    • b. As a producer, which would you prefer?


    • a. As a consumer, I welcome aids in identifying and remembering producers I have found attractively reliable—and those I wish to avoid in the future.
    • b. If you worked to develop and produce a reliable product, would you want to have some way customers could distinguish your product from Edition: current; Page: [308] those of competing producers? If the consumer cannot readily identify which product you produced, how would that affect your incentive to produce a product of a high quality?
  • 14)

    Tentatively classify the following, on the basis of your present information, as a) price-takers, b) closed monopolists, or c) open monopolists. (Remember, market closure does not necessarily convert a price-taker’s to a price-searcher’s market.)

    Electric company

    City bus line


    General Motors Corp.

    Corner drugstore

    Prescription pharmacist


    Lettuce grower


    Pop star


    Distinguish between open-market price-searchers and closed or restricted market access. That is, how difficult/costly is it for potential competitors to enter a market if the incumbents are either unusually profitable or operate with high-cost inefficiency. Closed markets imply higher price. Also, government-sanctioned monopolies have less incentive to operate at lowest-cost efficiency.

  • 15)

    “Retail grocery stores are monopolies.” In what sense is that correct and in what sense is it false? “The medical profession is a monopoly.” In what sense is that true and in what sense false? Which kind of monopoly implies a higher price?


    If a grocery store raises prices, it will sell less; at lower prices it will sell more. At a given location, a grocery store has an exclusive right to offer products to customers, but there is not restricted entry, and so potential competitors will enter the market if they can do so profitably. The medical profession restricts entry through licensing, which implies higher prices than if there were no barriers to entry.

    Edition: current; Page: [309]
  • 16)

    Higher costs have induced a firm to reduce output and raise price.

    • a. Is this to be interpreted as an example of the power of the price-searcher to raise price?
    • b. If your answer is no, how do you reconcile your answer with the President’s Council of Economic Advisers, who, some years ago, regarded the attempt of Alcoa to raise the price of aluminum as an “unjustified” use of the power to set prices?


    Greater final demand for a product causes greater demand for the resources to produce the product. Any one producer will see his own costs of production rise, and will justify his “need to raise prices” as a reflection of his higher costs of production. If Alcoa justified its higher prices as reflecting the higher costs of bauxite or natural gas to produce aluminum, it may be that the demand for those inputs had risen.

  • 17)

    “Every profit represents the gain from moving resources to higher-valued uses.” Do you agree?


    No. Fortunately, this is commonly the case, but the statement ignores cases of monopoly rent and government-imposed restrictions of entry.

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Noting the difference between price and marginal revenue, several common but often misunderstood pricing tactics can be explained. The effects of some of the tactics are criticized as undesirable, while others, which do exactly the same thing, are praised.

Basically, some of the tactics attempt to equate marginal revenues to marginal costs to maximize normal profits. But a few do more—transfer more of the value of the consumer surplus to the seller, even though the output may not be increased. Underlying this entire search is the presumption that the demand for the seller’s goods will be high enough to result in a price that covers the cost—but most firms starting in business don’t last more than three years.


Though all customers of some seller’s goods may be charged the same price, the marginal revenues from each customer will almost certainly be different. There can be two customers with different demand schedules for the product. Differences in received marginal revenues from selling to them result, though both pay the same price.

Differences in marginal revenues mean the seller isn’t maximizing the revenue from the amount being sold. Less should be sold to the lower marginal revenue customer and more to the higher marginal revenue customer—even though that may require different prices. The kind of situation shown in table 20.1 illustrates the demands for two customers and the resulting prices and quantities to each.

Suppose a seller has 8 units available for sale. What’s the maximum total revenue the seller could get? (We here ignore the cost of producing them.) At $7, customer A would demand 6 units, and customer B would buy 2, selling all 8. That would bring a total of $56 (= $7 × 8) to the seller, $42 from A and $14 from B.

At that price of $7, marginal revenues are different. Marginal revenue at the sixth unit demanded by A is $2, while it’s $6 at the second unit bought by B. That suggests that more revenue might be obtained by shifting some of the units from the lower to the higher marginal revenue customer.

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Table 20.1 Equalization of Marginal Revenues among Customers by Different Price to Each Customer: “Price Discrimination”
Customer A Customer B
Price QA Total Revenue from A Marginal Revenue QB Total Revenue from B Marginal Revenue
$12 1 12 $12 0 0 0
11 2 22 10 0 0 0
10 3 30 8 0 0 0
9 4 36 6 0 0 0
8 5 40 4 1 8 8
7 6 42 2 2 14 6
6 7 42 0 3 18 4
5 8 40 -2 4 20 2
4 9 36 -4 5 20 0
3 10 30 -6 6 18 -2
2 11 22 -8 7 14 -4
1 12 12 -10 8 8 -6

If the price to customer A were raised to $8, at which only 5 units would be bought, the revenue from A would change from $42 (= $7 × 6) to $40 (= $8 × 5), a reduction of $2. That unit could instead be sold to B by lowering B’s price from $7 to $6, at which B would buy 3 units. The revenue from B will rise from $14 (= $7 × 2) to $18 (= $6 × 3), a marginal revenue of $4. The $4 marginal revenue for B more than offsets the loss of the $2 marginal revenue from A, and the two marginal revenues are equated. The total revenue is now $58 (= $40 + $18), a gain of $2 (= $58 − $56). To maximize total revenue from a given number of available units to sell, the prices have to be such that the marginal revenues are equal.

This marginal revenue equalization, in order to maximize revenue, is called price discrimination because the prices are different. If it’s to be successful, the lower-priced buyers must not be able to resell to the higher-priced customers by undercutting the higher price.


Moving beyond a predetermined number of units to be sold, what determines the amount produced? Suppose marginal cost is a constant $2 per unit. Equating MC and MR for each customer, data in table 20.1 show that output will be 10 units, with 6 sold to A at $7 and 4 to B at $5.

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At a price of $7 to A, marginal revenue is $2, and total revenue from this customer is $42. That’s the profit-maximizing price for A. At a price of $5 to B, marginal revenue would be $2, and total revenue is $20.

Two conditions are satisfied: the marginal revenues are (a) equalized for both customers and (b) equal to marginal cost. Total profit is maximized at 10 units. Producing more units would incur marginal costs exceeding the possible marginal revenue.


This kind of differential pricing is price discrimination because the prices are not the same to all customers. Discrimination suggests something bad, so we’ll call it marginal revenue equalization. The applicability of this principle of equalizing marginal revenues is easily illustrated. In figure 20.1, an equal price, P0, charged to both buyers A and B would result in amounts sold of Qa

and Qb. However, by raising the price to A to PA, and lowering the price to B to PB, more will be sold to B at greater revenue over cost, and less will be sold to A.

Figure 20.1

Equating Price with Marginal Revenue of Each Customer

Any seller whose prices to different buyers result in unequal marginal revenues among buyers would increase his profits by changing prices so as to equate marginal revenues. This is shown in the diagram with the gains to seller (or avoidance of losses) being shaded. This price differentiation is called price discrimination. If it is to be successful, lower-priced buyers must not be able to resell to higher-priced buyers.

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The data in table 20.1 could represent custo