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INTRODUCTION:
MARKETS AND PRICES
C H A P T E R S
1 Preliminaries 3 2 The Basics of Supply and Demand 19
1
1
PART 1 surveys the scope of microeconomics and introduces some basic
concepts and tools. Chapter 1 discusses the range of problems that micro- economics addresses, and the kinds of answers it can provide. It also explains what a market is, how we determine the boundaries of a market, and how we measure market price. Chapter 2 covers one of the most important tools of microeconomics: supply-demand analysis. We explain how a competitive market works and how supply and demand determine the prices and quantities of goods and services. We also show how supply-demand analysis can be used to deter- mine the effects of changing market conditions, including government intervention.
P A R T
4 Part 1 Introduction: Markets and Prices
microeconomics Branch of eco- nomics that deals with the behavior of individual eco- nomic units—consumers, firms, workers, and investors—as well as the mar- kets that these units comprise.
macroeconomics Branch of eco- nomics that deals with aggre- gate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation.
1.1 The Themes of Microeconomics
The Rolling Stones once said: “You can’t always get what you want.” This is true. For most people (even Mick Jagger), that there are limits to what you can have or do is a simple fact of life learned in early childhood. For economists, however, it can be an obsession. Much of microeconomics is about limits —the limited incomes that consumers can spend on goods and services, the limited budgets and technical know-how that firms can use to produce things, and the limited number of hours in a week that workers can allocate to labor or leisure. But microeconomics is also about ways to make the most of these limits. More precisely, it is about the allocation of scarce resources. For example, microeconomics explains how consumers can best allo- cate their limited incomes to the various goods and services available for pur- chase. It explains how workers can best allocate their time to labor instead of leisure, or to one job instead of another. And it explains how firms can best allo- cate limited financial resources to hiring additional workers versus buying new machinery, and to producing one set of products versus another. In a planned economy such as that of Cuba, North Korea, or the former Soviet Union, these allocation decisions are made mostly by the government. Firms are told what and how much to produce, and how to produce it; workers have little flexibility in choice of jobs, hours worked, or even where they live; and con- sumers typically have a very limited set of goods to choose from. As a result, many of the tools and concepts of microeconomics are of limited relevance in those countries.
Trade-Offs
In modern market economies, consumers, workers, and firms have much more flexibility and choice when it comes to allocating scarce resources. Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how these trade-offs are best made. The idea of making optimal trade-offs is an important theme in micro- economics—one that you will encounter throughout this book. Let’s look at it in more detail.
Consumers Consumers have limited incomes, which can be spent on a wide
variety of goods and services, or saved for the future. Consumer theory , the sub- ject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based on their preferences, maximize their well-being by trading off the purchase of more of some goods for the purchase of less of others. We will also see how con- sumers decide how much of their incomes to save, thereby trading off current consumption for future consumption.
Workers Workers also face constraints and make trade-offs. First, people must
decide whether and when to enter the workforce. Because the kinds of jobs—and corresponding pay scales—available to a worker depend in part on educational attainment and accumulated skills, one must trade off working now (and earn- ing an immediate income) for continued education (and the hope of earning a higher future income). Second, workers face trade-offs in their choice of employ- ment. For example, while some people choose to work for large corporations that offer job security but limited potential for advancement, others prefer to work
Chapter 1 Preliminaries 5
for small companies where there is more opportunity for advancement but less security. Finally, workers must sometimes decide how many hours per week they wish to work, thereby trading off labor for leisure.
Firms Firms also face limits in terms of the kinds of products that they can pro-
duce, and the resources available to produce them. The Ford Motor Company, for example, is very good at producing cars and trucks, but it does not have the ability to produce airplanes, computers, or pharmaceuticals. It is also con- strained in terms of financial resources and the current production capacity of its factories. Given these constraints, Ford must decide how many of each type of vehicle to produce. If it wants to produce a larger total number of cars and trucks next year or the year after, it must decide whether to hire more workers, build new factories, or do both. The theory of the firm , the subject matter of Chapters 6 and 7, describes how these trade-offs can best be made.
Prices and Markets
A second important theme of microeconomics is the role of prices. All of the trade-offs described above are based on the prices faced by consumers, workers, or firms. For example, a consumer trades off beef for chicken based partly on his or her preferences for each one, but also on their prices. Likewise, workers trade off labor for leisure based in part on the “price” that they can get for their labor— i.e., the wage. And firms decide whether to hire more workers or purchase more machines based in part on wage rates and machine prices. Microeconomics also describes how prices are determined. In a centrally planned economy, prices are set by the government. In a market economy, prices are determined by the interactions of consumers, workers, and firms. These interactions occur in markets —collections of buyers and sellers that together determine the price of a good. In the automobile market, for example, car prices are affected by competition among Ford, General Motors, Toyota, and other manufacturers, and also by the demands of consumers. The central role of mar- kets is the third important theme of microeconomics. We will say more about the nature and operation of markets shortly.
Theories and Models
Like any science, economics is concerned with the explanations of observed phe- nomena. Why, for example, do firms tend to hire or lay off workers when the prices of their raw materials change? How many workers are likely to be hired or laid off by a firm or an industry if the price of raw materials increases by, say, 10 percent? In economics, as in other sciences, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. The theory of the firm , for example, begins with a simple assumption—firms try to maximize their profits. The theory uses this assumption to explain how firms choose the amounts of labor, capital, and raw materials that they use for production and the amount of output they produce. It also explains how these choices depend on the prices of inputs, such as labor, cap- ital, and raw materials, and the prices that firms can receive for their outputs. Economic theories are also the basis for making predictions. Thus the theory of the firm tells us whether a firm’s output level will increase or decrease in
Chapter 1 Preliminaries 7
normative analysis Analysis examining questions of what ought to be.
Positive analysis is central to microeconomics. As we explained above, theories are developed to explain phenomena, tested against observations, and used to con- struct models from which predictions are made. The use of economic theory for prediction is important both for the managers of firms and for public policy. Suppose the federal government is considering raising the tax on gasoline. The change would affect the price of gasoline, consumers’ preferences for small or large cars, the amount of driving that people do, and so on. To plan sensibly, oil compa- nies, automobile companies, producers of automobile parts, and firms in the tourist industry would all need to estimate the impact of the change. Government policy- makers would also need quantitative estimates of the effects. They would want to determine the costs imposed on consumers (perhaps broken down by income cate- gories); the effects on profits and employment in the oil, automobile, and tourist industries; and the amount of tax revenue likely to be collected each year. Sometimes we want to go beyond explanation and prediction to ask such questions as “What is best?” This involves normative analysis , which is also important for both managers of firms and those making public policy. Again, consider a new tax on gasoline. Automobile companies would want to deter- mine the best (profit-maximizing) mix of large and small cars to produce once the tax is in place. Specifically, how much money should be invested to make cars more fuel-efficient? For policymakers, the primary issue is likely to be whether the tax is in the public interest. The same policy objectives (say, an increase in tax revenues and a decrease in dependence on imported oil) might be met more cheaply with a different kind of tax, such as a tariff on imported oil. Normative analysis is not only concerned with alternative policy options; it also involves the design of particular policy choices. For example, suppose it has been decided that a gasoline tax is desirable. Balancing costs and benefits, we then ask what is the optimal size of the tax. Normative analysis is often supplemented by value judgments. For example, a comparison between a gasoline tax and an oil import tariff might conclude that the gasoline tax will be easier to administer but will have a greater impact on lower- income consumers. At that point, society must make a value judgment, weighing equity against economic efficiency. When value judgments are involved, microeco- nomics cannot tell us what the best policy is. However, it can clarify the trade-offs and thereby help to illuminate the issues and sharpen the debate.
1.2 What Is a Market?
We can divide individual economic units into two broad groups according to function— buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use to produce goods and services. Sellers include firms, which sell their goods and services; workers, who sell their labor services; and resource owners, who rent land or sell mineral resources to firms. Clearly, most people and most firms act as both buyers and sellers, but we will find it helpful to think of them as sim- ply buyers when they are buying something and sellers when they are selling something. Together, buyers and sellers interact to form markets. A market is the collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. In the market for personal computers, for example, the buyers are business firms, households, and students; the sellers are Compaq, IBM, Dell, Gateway, and a number of other firms. Note that a market
market Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products.
8 Part 1 Introduction: Markets and Prices
market definition Determination of the buyers, sellers, and range of products that should be included in a particular market.
arbitrage Practice of buying at a low price at one location and selling at a higher price in another.
perfectly competitive market Market with many buyers and sellers, so that no single buyer or seller has a significant impact on price.
market price Price prevailing in a competitive market.
includes more than an industry. An industry is a collection of firms that sell the same or closely related products. In effect, an industry is the supply side of the market. Economists are often concerned with market definition —with determining which buyers and sellers should be included in a particular market. When defin- ing a market, potential interactions of buyers and sellers can be just as important as actual ones. An example of this is the market for gold. A New Yorker who wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold in New York will interact only with sellers in New York. But because the cost of transporting gold is small relative to its value, buyers of gold in New York could purchase their gold in Zurich if the prices there were significantly lower. Significant differences in the price of a commodity create a potential for arbitrage : buying at a low price in one location and selling at a higher price somewhere else. The possibility of arbitrage prevents the prices of gold in New York and Zurich from differing significantly and creates a world market for gold. Markets are at the center of economic activity, and many of the most interest- ing issues in economics concern the functioning of markets. For example, why do only a few firms compete with one another in some markets, while in others a great many firms compete? Are consumers necessarily better off if there are many firms? If so, should the government intervene in markets with only a few firms? Why have prices in some markets risen or fallen rapidly, while in other markets prices have hardly changed at all? And which markets offer the best opportunities for an entrepreneur thinking of going into business?
Competitive versus Noncompetitive Markets
In this book, we study the behavior of both competitive and noncompetitive markets. A perfectly competitive market has many buyers and sellers, so that no single buyer or seller has a significant impact on price. Most agricultural markets are close to being perfectly competitive. For example, thousands of farmers pro- duce wheat, which thousands of buyers purchase to produce flour and other products. As a result, no single farmer and no single buyer can significantly affect the price of wheat. Many other markets are competitive enough to be treated as if they were per- fectly competitive. The world market for copper, for example, contains a few dozen major producers. That number is enough for the impact on price to be negligible if any one producer goes out of business. The same is true for many other natural resource markets, such as those for coal, iron, tin, or lumber. Other markets containing a small number of producers may still be treated as competitive for purposes of analysis. For example, the U.S. airline industry contains several dozen firms, but most routes are served by only a few firms. Nonetheless, because competition among those firms is often fierce, for some purposes airline markets can be treated as competitive. Finally, some markets contain many produc- ers but are noncompetitive ; that is, individual firms can jointly affect the price. The world oil market is one example. Since the early 1970s, that market has been domi- nated by the OPEC cartel. (A cartel is a group of producers that acts collectively.)
Market Price
Markets make possible transactions between buyers and sellers. Quantities of a good are sold at specific prices. In a perfectly competitive market, a single price—the market price —will usually prevail. The price of wheat in Kansas City
10 Part 1 Introduction: Markets and Prices
consumers can use either. Diesel fuel, however, is not part of this market because cars that use regular gasoline cannot use diesel fuel, and vice versa.^3 Market definition is important for two reasons: A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future. It must also know the product boundaries and geographical boundaries of its market in order to set price, determine advertising budgets, and make capital investment decisions. Market definition can be important for public policy decisions. Should the government allow a merger or acquisition involving companies that produce similar products, or should it challenge it? The answer depends on the impact of that merger or acquisition on future competition and prices; often this can be evaluated only by defining a market.
E X A M P L E 1. 1 Markets for Prescription Drugs
The development of a new drug by a pharma- ceutical company is an expensive venture. It begins with large expenditures on research and development, then requires various stages of laboratory and clinical testing, and, if the new drug is finally approved, market- ing, production, and sales. At that point, the firm faces the important problem of deter- mining the price of the new drug. Pricing depends on the preferences and medical needs of the consumers who will be buying the drug, the characteristics of the drug, and the number and characteris- tics of competing drugs. Pricing a new drug, therefore, requires a good under- standing of the market in which it will be sold. In the pharmaceutical industry, market boundaries are sometimes easy to deter- mine, and sometimes not so easy to determine. Markets are usually defined in terms of therapeutic classes of drugs. For example, there is a market for antiulcer drugs that is very clearly defined. For some time, there were four competitors in the mar- ket: Tagamet, Zantac, Axid, and Pepcid. All four drugs work in roughly the same way: They cause the stomach to produce less hydrochloric acid. They differ slightly in terms of their side effects and their interactions with other drugs that a patient might be taking, but in most cases they could be readily substituted for each other.^4 Another example of a clearly defined pharmaceutical market is the market for anticholesterol drugs. There are five major products in the U.S. market: the leading brand is Merck’s Mevacor, followed by Pravachol (Bristol-Myers Squibb), Zocor (also Merck), Lescol (Novartis), and Lipitor (Pfizer). These drugs all do pretty much the same thing (reduce blood cholesterol levels) and work in pretty much the
(^3) How can we determine the extent of a market? Since the market is where the price of a good is estab- lished, one approach focuses on market prices. We ask whether product prices in different geo- graphic regions (or for different product types) are approximately the same, or whether they tend to move together. If either is the case, we place them in the same market. For a more detailed discussion, see George J. Stigler and Robert A. Sherwin, “The Extent of the Market,” Journal of Law and Economics 27 (October 1985): 555–85. (^4) As we will see in Example 10.1, more recently Prilosec and then Prevacid entered the market, and by 1997 Prilosec became the largest selling drug in the world. These are also antiulcer drugs, but work on a different biochemical mechanism.
Chapter 1 Preliminaries 11
(^5) This example is based on F. M. Scherer, “Archer-Daniels-Midland and Clinton Corn Processing,” Case C16-92-1126, John F. Kennedy School of Government, Harvard University, 1992.
same way. While their side effects and interactions differ somewhat, they are all close substitutes. Thus when Merck sets the price of Mevacor, it must be concerned not only with the willingness of patients (and their insurance companies) to pay, but also with the prices and characteristics of the four competing drugs. Likewise, a drug company that is considering whether to develop a new anticholesterol drug knows that if it commits itself to the investment and succeeds, it will have to com- pete with the four existing drugs. The company can use this information to project its potential revenues from the new drug, and thereby evaluate the investment. Sometimes, however, pharmaceutical market boundaries are more ambigu- ous. Consider painkillers , a category that includes aspirin, acetaminophen (sold under the brand name Tylenol but also sold generically), ibuprofen (sold under such brand names as Motrin and Advil but also sold generically), naproxen (sold by prescription but also sold over the counter by the brand name Aleve), and Voltaren (a more powerful prescription drug produced by Novartis). There are many types of painkillers, and some work better than others for certain types of pain (e.g., headaches, arthritis, muscle aches, etc.). Side effects likewise differ. While some types of painkillers are used more frequently for certain symptoms or conditions, there is considerable spillover. For example, depend- ing on the severity of the pain and the pain tolerance of the patient, a toothache might be treated with any of the painkillers listed above. This substitutability makes the boundaries of the painkiller market difficult to define.
E X A M P L E 1. 2 The Market for Sweeteners
In 1990, the Archer-Daniels-Midland Company (ADM) acquired the Clinton Corn Processing Company (CCP). 5 ADM was a large company that produced many agricultural products, one of which was high-fructose corn syrup (HFCS). CCP was another major U.S. corn syrup producer. The U.S. Department of Justice (DOJ) challenged the acquisition on the grounds that it would lead to a dominant producer of corn syrup with the power to push prices above competitive levels. ADM fought the DOJ decision, and the case went to court. The basic issue was whether corn syrup represented a distinct market. If it did, the combined market share of ADM and CCP would have been about 40 percent, and the DOJ’s con- cern might have been warranted. ADM, however, argued that the correct market definition was much broader—a market for sweeteners which included sugar as well as corn syrup. Because the ADM–CCP combined share of a sweetener mar- ket would have been quite small, there would be no concern about the com- pany’s power to raise prices. ADM argued that sugar and corn syrup should be considered part of the same market because they are used interchangeably to sweeten a vast array of food products, such as soft drinks, spaghetti sauce, and pancake syrup. ADM also showed that as the level of prices for corn syrup and sugar fluctuated, industrial food producers would change the proportions of each sweetener that they used in their products. In October 1990, a federal judge agreed with ADM’s argument that sugar and corn syrup were both part of a broad market for sweeteners. The acquisition was allowed to go through.
Chapter 1 Preliminaries 13
TABLE 1.1 The Real Prices of Eggs and of a College Education
1970 1975 1980 1985 1990 1995 2002 Consumer Price Index 38.8 53.8 82.4 107.6 130.7 152.4 181. Nominal Prices Grade A Large Eggs $0.61 $0.77 $0.84 $0.80 $1.01 $0.93 $1. College Education $2530 $3403 $4912 $8202 $12,018 $16,207 $18, Real Prices ($1970) Grade A Large Eggs $0.61 $0.56 $0.40 $0.29 $0.30 $0.24 $0. College Education $2530 $2454 $2313 $2958 $3568 $4126 $
(^8) You can get data on the cost of a college education at http://www.collegeboard.com/ , or visit the National Center for Education Statistics and download the Digest of Education Statistics at http://nces.ed.gov/. Historical and current data on the average retail price of eggs can be obtained from the Bureau of Labor Statistics (BLS) at http://www.bls.gov/ , by selecting CPI—Average Price Data.
$1.03 a dozen, and the average cost of a college education was $18,273. In real terms, were eggs more expensive in 2002 than in 1970? Had a college education become more expensive? Table 1.1 shows the nominal price of eggs, the nominal cost of a college educa- tion, and the CPI for 1970–2002. (The CPI is based on 1983 = 100.) Also shown are the real prices of eggs and a college education in 1970 dollars, calculated as follows:
and so forth.
Real price of eggs in 1975
CPI CPI
nominal price in 1975
Real price of eggs in 1980
CPI CPI
nominal price in 1980
1970 1975 1970 1980
= ×
= ×
The table shows clearly that the real cost of a college education rose (by 55 per- cent) during this period, while the real cost of eggs fell (by 74 percent). It is these relative changes in prices that are important for the choices that consumers make, not the fact that both eggs and college cost more in nominal dollars today than they did in 1970. In the table, we calculated real prices in terms of 1970 dollars, but we could have just as easily calculated them in terms of dollars of some other base year. For example, suppose we want to calculate the real price of eggs in 1980 dollars. Then:
and so forth. By going through the calculations, you can check to see that in terms of 1980 dollars, the real price of eggs was $1.30 in 1970, $1.18 in 1975, 84 cents in 1980, 61 cents in 1985, 64 cents in 1990, and 47 cents in 2002. You will also see that the per- centage declines in real price are the same no matter which base year we use.^8
Real price of eggs in 1975 CPI CPI
nominal price in 1975
Real price of eggs in 1985
CPI CPI
nominal price in 1985
1980 1975 1980 1985
= ×
= ×
14 Part 1 Introduction: Markets and Prices
1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
0
Dollars per hour
2
4
6
8
Real Wage ($1996)
Nominal Wage
FIGURE 1.1 The Minimum Wage In nominal terms, the minimum wage has increased steadily over the past 60 years. However, in real terms its 2003 level is below that of the 1970s.
(^9) Some states also have minimum wages that are higher than the federal minimum wage. You can learn more about the minimum wage at this Web site: http://www.dol.gov/.
Nonetheless, the 1996 decision to increase the minimum wage was a difficult one. Although the higher minimum wage would provide a better standard of liv- ing for those workers who had been paid below the minimum, some analysts feared that it would also lead to increased unemployment among young and unskilled workers. The decision to increase the minimum wage, therefore, raises
E X A M P L E 1. 4 The Minimum Wage
The federal minimum wage—first instituted in 1938 at a level of 25 cents per hour—has been increased periodically over the years. From 1981 through 1989, for example, it was $3.35 an hour and was raised to $4.25 an hour in 1990. In 1996, after much deliberation and debate, Congress voted to raise the minimum wage to $4.70 in 1996 and then to $5.15 in 1997. 9 Figure 1.1 shows the minimum wage from 1938 through 2003, both in nominal terms and in 1996 constant dollars. Note that although the legislated minimum wage has steadily increased, in real terms the minimum wage today is not much different from what it was in the 1950s.
16 Part 1 Introduction: Markets and Prices
of steel and other raw materials affect costs? How much and how fast would costs decline as managers and workers gained experience with the production process? And to maximize profits, how many of these cars should Ford plan to produce each year? (We discuss production and cost in Chapters 6 and 7 and the profit-maximizing choice of output in Chapter 8.) Ford also had to design a pricing strategy and consider how competitors would react to it. For example, should Ford charge a low price for the basic stripped-down version of the Explorer but high prices for individual op- tions, such as leather seats? Or would it be more profitable to make these options “standard” items and charge a higher price for the whole package? Whatever strategy Ford chose, how were competitors likely to react? Would DaimlerChrysler try to undercut Ford by lowering the price of its Jeep Grand Cherokee? Might Ford be able to deter DaimlerChrysler or GM from lowering prices by threatening to respond with its own price cuts? (We discuss pricing in Chapters 10 and 11 and competitive strategy in Chapters 12 and 13.) Because its SUV product line required large investments in new capital equip- ment, Ford had to consider both the risks and possible outcomes of its decisions. Some of this risk was due to uncertainty over the future price of gasoline (higher gasoline prices would reduce the demand for heavy vehicles). Some was due to uncertainty over the wages that Ford would have to pay its workers. What would happen if world oil prices doubled or tripled, or if the U.S. government imposed a heavy tax on gasoline? How much bargaining power would unions have, and how might union demands affect wage rates? How should Ford take these uncer- tainties into account when making investment decisions? (Commodity markets and the effects of taxes are discussed in Chapters 2 and 9. Labor markets and union power are discussed in Chapter 14. Investment decisions and the role of uncertainty are discussed in Chapters 5 and 15.) Ford also had to worry about organizational problems. Ford is an inte- grated firm in which separate divisions produce engines and parts and then assemble finished cars. How should managers of different divisions be rewarded? What price should the assembly division be charged for engines that it receives from another division? Should all parts be obtained from the upstream divisions, or should some be purchased from outside firms? (We dis- cuss internal pricing and organizational incentives for the integrated firm in Chapters 11 and 17.) Finally, Ford had to think about its relationship to the government and the effects of regulatory policies. For example, all of Ford’s cars must meet federal emissions standards, and production-line operations must comply with health and safety regulations. How might these regulations and standards change over time? How might they affect costs and profits? (We discuss the role of govern- ment in limiting pollution and promoting health and safety in Chapter 18.)
Public Policy Design: Automobile Emission
Standards for the Twenty-first Century
In 1970, the Federal Clean Air Act imposed strict tailpipe emission standards on new automobiles. These standards have become increasingly stringent—the 1970 levels of nitrogen oxides, hydrocarbons, and carbon monoxide emitted by automobiles had been reduced by about 90 percent by 1999. Now, as the number of cars on the roads keeps increasing, the government must consider how strin- gent these standards should be in the coming years.
Chapter 1 Preliminaries 17
The design of a program like the Clean Air Act involves a careful analysis of the ecological and health effects of auto emissions. But it also involves a good deal of eco- nomics. First, the government must evaluate the monetary impact of the program on consumers. Emission standards affect the cost both of purchasing a car (catalytic con- verters would be necessary, which would raise the cost of cars) and of operating it (gas mileage would be lower, and converters would have to be repaired and main- tained). Because consumers ultimately bear much of this added cost, it is important to know how it affects their standards of living. This means analyzing consumer preferences and demand. For example, would consumers drive less and spend more of their income on other goods? If so, would they be nearly as well off? (Consumer preferences and demand are discussed in Chapters 3 and 4.) To answer these questions, the government must determine how new stan- dards will affect the cost of producing cars. Might automobile producers mini- mize cost increases by using new lightweight materials? (Production and cost are discussed in Chapters 6 and 7.) Then the government needs to know how changes in production costs will affect the production levels and prices of new automobiles. Are the additional costs absorbed by manufacturers or passed on to consumers in the form of higher prices? (Output determination is discussed in Chapter 8 and pricing in Chapters 10 through 13.) Finally, the government must ask why the problems related to air pollution are not solved by our market-oriented economy. The answer is that much of the cost of air pollution is external to the firm. If firms do not find it in their self-interest to deal ade- quately with auto emissions, what is the best way to alter their incentives? Should standards be set, or is it more economical to impose air pollution fees? How do we decide what people will pay to clean up the environment when there is no explicit market for clean air? Is the political process likely to solve these problems? The ulti- mate question is whether the auto emissions control program makes sense on a cost- benefit basis. Are the aesthetic, health, and other benefits of clean air worth the higher cost of automobiles? (These problems are discussed in Chapter 18.) These are just two examples of how microeconomics can be applied in the are- nas of private and public-policy decision making. You will discover many more applications as you read this book.
S U M M A R Y
1. Microeconomics is concerned with the decisions made by individual economic units—consumers, workers, investors, owners of resources, and business firms. It is also concerned with the interaction of consumers and firms to form markets and industries. 2. Microeconomics relies heavily on the use of theory, which can (by simplification) help to explain how eco- nomic units behave and to predict what behavior will occur in the future. Models are mathematical represen- tations of theories that can help in this explanation and prediction process. 3. Microeconomics is concerned with positive questions that have to do with the explanation and prediction of phenomena. But microeconomics is also important for normative analysis, in which we ask what choices are best—for a firm or for society as a whole. Normative
analyses must often be combined with individual value judgments because issues of equity and fairness as well as of economic efficiency may be involved.
4. A market refers to a collection of buyers and sellers who interact, and to the possibility for sales and purchases that results from that interaction. Microeconomics involves the study of both perfectly competitive mar- kets, in which no single buyer or seller has an impact on price, and noncompetitive markets, in which indi- vidual entities can affect price. 5. The market price is established by the interaction of buyers and sellers. In a perfectly competitive market, a single price will usually prevail. In markets that are not perfectly competitive, different sellers might charge different prices. In this case, the market price refers to the average prevailing price.
