Price Theory and Appications

Price Theory and Applications
Ennio Emanuele Piano

December 2, 2015
Chapter 1
Introduction
1.1
The Task of Economics
Economics is the study of the allocation of scarce resources among competing

ends, when the object of the allocation is the maximization of such ends. The
allocation of scarce resources among competing end is often referred to as the
economic problem. The two fundamental notions, in identifying an economic
problem, are scarcity and competing ends. Scarcity is pervasive in human
affairs. It is the direct and unavoidable result of human nature and the insatiability of human wants. If resources were superabundant, and not scarce, than
all human wants could be satisfied and no problem of allocation, that is, no
competition for such resources, would emerge.
Scarcity in resources implies that there must be a process through which
these resources have to be allocated. In general, the two alternative when choosing how to allocate resources are cooperation and conflict. Throughout history,
mankind has experienced a variety of systems for the allocation of resources:
Involuntary transfer of goods: Goods are allocated through violent
means. Theft and some government policies have in common the fact that
they result in a transfer of rights that often differ from what would emerge
if only voluntary transfers were to happen.
Voluntary transfer of goods: Gifts and market exchanges are two
categories of voluntary transfer of goods and services.
Command: organizations often allocate resources through command instead of violence or exchange.
Economics, as a positive science, does not tell you which is the best method
for the allocation of resources. In the case of a boxing match, the allocation
of the winners prize is often, though not always, accomplished through the
use of violence, and when exchange between the parties involved is employed,
the purpose of the match itself is compromised. Families, on the other hand,
3
CHAPTER 1. INTRODUCTION
often use a mix of gifts and command for the allocation of resources, while
firms and other organization choose command to avoid to incur in the high
transaction costs associated with the use of the price mechanism. Finally, most
economies rely on voluntary transfer of goods for the allocation of resources
among producers as well as consumers.
It is important to understand that scarcity is not the same thing as a shortage. Scarcity is pervasive. Whenever we observe a price, we know that the
priced good is scarce. Sometimes, scarce goods are not priced because of a
variety of reasons, including government interventions and moral taboos. A
non-scarce resource has no price, since nobody would pay for something that
is freely available to him at any moment and everywhere. A shortage, on the
other hand, consists in the failure of the price system to bring demand to meet
supply. A shortage emerges when the price is wrong, and consumers would
like to consume a quantity of the good that is larger than the quantity that sellers are willing to give up for that price. Shortages are often due to government
intervention in setting the price below its equilibrium level, that is, imposing a
price ceiling, or alternatively by an error on the part of the seller. In the latter
case, though, we can expect the shortage to last far less than in the former one,
since the price mechanism will incentivize the seller to adjust the price in order
to increase profits.
1.2
The Scope of Economics
Economics as the study of the formation of prices in the market system focuses
on four forms of behavior:
1. Production: Production consists in all those processes that change the
characteristics of resources in order to enhance their capacity to satisfy individual wants. Physical and chemical transformations are therefore to be
considered as production processes, as well as changes in the geographical
characteristics of the resources.
2. Consumption: Consumption consists in the destruction of goods for the
purpose of satisfying the wants of the individual. Economists refer to this
process as utility maximization. Utility maximization is not limited to
materialistic wants, but include every and each good, service, etc. that
the individual sees the consumption of which as an improvement relative
to its current position, where the evaluation of such an improvement are
entirely subjective.
3. Exchange: An exchange is a transfer of property rights over the services
of particular goods. Exchanges can be voluntary or not. In the market,
though, all exchanges are always assumed to be voluntary. For an exchange to take place, the two parties must value the good offered by the
other party more than the good offered by himself.
1.3. THE METHODOLOGY OF ECONOMICS
4. Specialization: Specialization occurs whenever some individuals or group

produces more than he expect to consume, for the purpose of exchanging
it for a different goods. Specialization tend to increase the productivity
of all parties involved, as well as their ability to attain an higher level of
utility.
Another important notion in the study of markets, and especially in the
analysis of the behavior of consumers and firms, is that of cost. The cost of an
individuals choice is here defined as the best among all forsaken opportunities
that the agent faced at the moment of the choice itself. Thus, cost is always
opportunity cost. Unfortunately, the economic notion of cost is often confused
with the layman notion of cost as the price one has to pay for a good or service. This confusion is highly misleading. In evaluating courses of actions, it is
irrelevant what the absolute monetary cost of taking one action is. What are
relevant are the net benefits associated with all courses of action (independent
of the budget constraint of the individual, of course). An action that costs 10,
but gives a utility of 1000, will be preferred to one that costs 1, but gives only
a utility of 200.
1.3
The Methodology of Economics
Economics is a positive science, meaning that it only answers questions about

what is, what was, and what will be. It does not answers questions about what
should be. Economics tries to formulate general laws of causation (if A then
B), and in doing so it focuses only on few of the myriad of features of human
nature and of social life. Economics relies on a precise understanding of some
universal traits of human nature. Individuals are seen as rational utility
maximizers, meaning that their behavior must be interpreted as always directed
toward the satisfaction of some subjective end.
The unit of analysis of the study of markets is always the individual. The
individual in question is, as I said, assumed to be a utility maximizer, to have
subjective preferences, and to be able to rank different goods according to his
subjective preference. From these, it follows that the individual allocates his
own budget among services and goods according to a cost benefit analysis that
deals with marginal units. He will always spend the next dollar to the good
or services the next unit of which is going to give him the most satisfaction.
Since he has multiple wants to satisfy, all goods and services have a diminishing
marginal utility, meaning that as more units of the same goods are consumed,
the satisfaction that he is going to derive from the next unit is going to be lower
and lower, that is, he will shift to consume units of a different good as soon as
the first on it of the latter gives him more satisfaction then the next unit of the
former. The individual is also assumed to have not just one, but a multiplicity
of wants, and that he acts under circumstances of scarcity.
CHAPTER 1. INTRODUCTION
1.4
The Postulates of Consumer Theory
1. Each person desires many goods and has many goals.

2. For each person, some goods are scarce.
3. Each person is willing to forsake some of a good to get more of other
goods. All values are relative.
4. The more of a good one has, the larger the total personal use value, but
the lower the marginal personal value of a unit.
5. Tastes are subjective.
6. People are innovative but consistent in their choices.
Chapter 2
Equilibria and Optima

2.1
Introduction
Price theory analyses its subject matters by using the tween notions of equilibrium and optimum. Equilibrium theorizing asks questions about what would be
the final state of rest of individuals acting rationally and in their self interest.
To do so, it focuses on those points at which supply and demand intercept,
that is, on the equilibrium points. Optimization is the science of how to get to
the best possible outcome given the circumstances. Optimization focuses on the
comparison between marginal magnitudes, such as marginal costs and benefits.
2.2
Equilibrium Analysis
The supply and demand schedule constitutes the most basic use of the notion of
equilibrium in the study of market phenomena. Supply and demand analysis,
though simple, is based on a sophisticated understanding of the behavior of
consumers on the one hand, and of firms on the other. From the economic
theory of behavior there emerge some laws, which are the foundations of supply
and demand analysis. These are the two fundamental laws of demand and the
law of supply.
2.2.1
The First Law of Demand
The first law of demand says that, for any given good Xi , there always is a price
p1 > p such that the individual will buy a quantity q1 < q. Similarly, there is
always a price p2 < p such that the individual will buy a quantity q2 > q.
The law of demand tells us that all demand curves slope downward, meaning
that as the price of a unit of a particular good increases, consumers would only
by fewer and fewer units of that same good. The law of supply, on the other
hand, tells us that as the price of a unit of a good increases, more and more
7
CHAPTER 2. EQUILIBRIA AND OPTIMA
firms would like to enter the market and the total quantity of the good offered
will increase, thus making the supply curve slope upward.
With the potential exception of Giffen and Veblen goods, where the demand
curve might go up for a little bit at relatively high prices, the supply and demand
curves intersect at one point, referred to as the equilibrium point. Demand and
supply equilibrate when, at the price p , the sum of the quantities demanded
by all consumers at that price equals the sum of the quantity supplied. Price
theorists often uses the method of comparative statics to analyze how changes in
the data of the market affect the equilibrium price and quantity. These changes
can originate within or outside the model. Changes within the model include: i.
changes in prices or quantities of substitute goods, as well as in complementary
goods, which affect the demand curve; ii. changes in prices and quantities of
goods related in supply (as is the case with cattle beef and hides), which affect
the supply curve; iii. changes in income, which also affect the demand curve.
Changes outside the model include: changes in technology and resources, which
affect the supply curve, changes in tastes, that affect the demand curve, but
also changes in the legal and regulatory environment, which affect both supply
and demand.
In doing comparative statics, one must always distinguish between movements of the curve itself and movements along the curve, or in other words, the
difference between quantity demanded and quantity supplied on the one hand,
and demand and supply on the other. Quantity demanded is the particular
value assumed by qd at a given price. Demand is a function representing all
quantity demanded at all prices. Thus, qd might change without the demand
schedule changing, and it might (in some extreme cases) remain the same even
though the entire demand schedule has shifted. Thus, an increase in demand is
a movement of the demand curve itself, an outward curve in this case, while an
increase in quantity demanded is a movement along the demand curve. Movements of the curve affect p* and q* in the following ways:
an increase in demand, with supply staying constant, brings about p
greater than p* and q greater than q*
an increase in supply, with demand staying constant, brings about p
smaller than p* and q greater than q*
an increase in both supply and demand brings about an a new equilibrium
price which is either greater or smaller than the previous one, according
to which movements is the larger one, and a q greater than q*
2.2.2
Supply and Demand
Both supply and demand intercept the ordinate line P. The intersection of demand and P is called choke price of demand. The choke price of demand
indicates the situation in which the price is so high that no consumer in the
market would like to buy units of the good. The intersection between the supply
curve and P is called choke price of supply. At the choke price of supply,
2.2. EQUILIBRIUM ANALYSIS
the price is so low that, although many consumer would be willing to buy it, no
firm would like to supply even one unit of the good.
The most simple mathematical expression of supply and demand curves is
the linear one:
P =abQ
(2.1)
2.1 is the linear equation for the demand curve, where a is the value of the
choke price of demand and -b is the slope (the sign of which is, as I discuss
above, negative) of the curve.
P =c+dQ
(2.2)
2.2 is the linear equation for the supply curve, where c is the choke price of
supply and d is the slope (the sign of which is positive) of the curve. At
equilibrium, by definition, the quantity demanded and the quantity supplied
must be equal, and in the absence of intervention by a third party, also the
prices paid by consumers and those received by suppliers must also be equal.
Thus, combining the two we obtain the following system of equations:
P =abQ
(2.3)
P =c+dQ
(2.4)
which, once solved, gives the following solutions:

P = [(a d) + (b c)]/(b + d)
(2.5)
P = (a c)/(b + d)
(2.6)
In a national market, the total supply curve may be the result of the sum
of a domestic supply curve and of an import supply curve. To find the total
supply curve, we must express the two supply functions in terms of Q, and then
add them. The equilibrium price and quantity would then be found by the
intersection of the demand curve and the newly obtained total demand curve.
Third party interventions can influence the equilibrium of a market in a
variety of ways. The most simple case is that of state intervention though
taxation. States have two methods for taxing consumption: though unit taxes,
and through percentage taxes. A unit tax consists in a fixed amount T , which
can either be levied on suppliers or consumers. In the presence of a unit tax,
the price paid by consumers is equal to the price received by the suppliers plus
the value of T , or, that is the same, the price received by the suppliers is equal
to the price paid by the consumers minus the amount of the tax:
Pd = Ps + T
(2.7)
The effect of a unit tax can be interpreted as shifting the demand curve inward,
which reduces the equilibrium quantity from Q to Q0 , while at the same time
producing state revenues equal to the new equilibrium quantity times the value
of the unit tax:
R = Q0 T
(2.8)
10
The effect of a proportionate tax is slightly different. Under a proportional

system of taxation on consumption, the price received by seller is equal to that
paid by the consumer times the difference between one and the value of the
proportionate tax t:
P s = P d (1 t)
(2.9)
Unlike the unit tax, the proportionate tax dos not only shifts the demand curve
inward, but it also changes (i.e., increases) its slope.
Another way for governments to interfere with the dynamics of the market
is by imposing price floors and price ceilings. A price ceiling occurs when the
government imposes a maximum mandatory price to buyers and sellers. If this
price is above the equilibrium price, the effect of the policy is null. If, on
the other hand, the price is below the equilibrium price, the effect would be
to reduce the quantity supplied, and therefore, the quantity exchanged in the
market. In fact, for a price p0 less than p , buyers would be willing to buy more
units of the good, but at the same time sellers would only like to sell fewer
units. A price floor is the exact opposite of a price ceiling. The government
imposes a price floor when it considers the equilibrium price too low. The
new minimum price would therefore be above the equilibrium one, once agains
provoking a contraction of the quantity exchanged. In the presence of a price
floor, sellers would be willing to sell more units of the good, but their hopes
would be frustrated by the fact that buyers now want fewer units.
2.3
Optimization Analysis
Optimization consists in finding the action that leads to the best outcome.
Price theory focuses on two generalized types of optimization: i. Utility maximization (by consumers or households); ii. Profits maximization (by firms).
Price theory finds the solution to these optimization problems through marginal
analysis. Marginal analysis consists in the comparison at the margin between two
magnitudes. In the case of utility maximization, these magnitudes are benefits
on the one hand and costs on the other. In the case of profits maximization,
these magnitudes are revenues on the one hand and costs on the other.
Marginal analysis uses three types of magnitudes: Total magnitudes; Average Magnitudes; Marginal magnitudes. These magnitudes are reciprocally
related. Let us take for example the case of a firm. A firm is assumed to care
about profits, and would therefore do whatever is needed to maximize them.
Profits will be maximized when the production of the marginal unit of the good
is expected to costs as much as it is expected to generate in revenues. Since
there would be no profits in doing so, the firm will not produce that unit. For
the sake of argument, let us assume that the firm does in fact produce beyond
the quantity at which the marginal unit produced generates zero profits. The
next unit would then cost more than it is expected to spur in revenues, which
means that the firm would incur in a net loss compared to before it produced
this unit. Thus, a profit maximizing firm would not produce it. The same reasoning applies if a firm were to stop production before reaching the M R = M C
2.3. OPTIMIZATION ANALYSIS
11
condition. In this case, by producing the next unit, the firm would receive
from it revenues greater than costs. A profit maximizing firm would therefore
continue production.
The algebraic relation between Total, Average, and Marginal magnitudes is
as follows. An average is the ration between the total magnitude (i.e., Total
Revenue) and quantity. A marginal magnitude is the ratio between an increase
in the total magnitude (i.e. Total Costs) and the increase in quantity. Thus
Marginal Cost (MC) is equal to the increase in total costs (C) divided by the
increase in quantity (Q). For very small changes in quantity, the relationship
between marginal magnitudes can be expressed using calculus:
MC =
dC
dQ
(2.10)
When only discrete choices can be made, the optimal total magnitude is found
when the smallest upward movement brings about MR less than MC and the
smallest downward movement brings about MR greater than MC.
When, on the other hand, infinitesimally small units can be used, the relation
between T, A, and M has also algebraic and geometrical meanings. The marginal
magnitude is in fact the derivative of T in terms of Q, which means that it is
also the slope of the T curve. A, on the other hand, is the slope of a ray the
origin to the T curve. These relation gives us some more informations about the
behavior of the T, A, and M curves: i. When T rises, M is always positive; ii.
When T falls, M is always negative; iii. When T is at its maximum or minimum,
M is zero; iv. When M is lower than A, A always falls; v. When M is greater
than A, A always rise; vi. A and M intersect when A is at its minimum.
12
Chapter 3
Exchange, Transaction
Costs, and Money
3.1
Pure Exchange
The simplest model of a market economy is the two players two goods Edgeworth
box. The Edgeworth box is a rectangle the dimensions of which are determined
by the total quantity of each product that are in the market. In the pure exchange
version of this model (which excludes the possibility of production), the length
of the height of the rectangle (Y ) is determined by the sum of the sum of the
quantity of the good y owned by A (ya ) and that owned by B (yb ):
Y = ya + yb
(3.1)
The width of the rectangle, on the other hand, is determined by the total quantity of the good X in the economy. It is therefore the sum of the quantity of X
owned by A and that owned by B:
X = xa + xb
(3.2)
Both A and B are assumed to have well-behaved indifference curves, with their
indifference maps covering the entire surface of the Edgeworth box. Before
exchange takes place, the reciprocal distribution of good X and Y is identified
by the point E, which is also a point in which the indifference curves of A
and B intersect. The two indifference curves intersecting at point E delimit an
area called Region of Mutual Advantage. This name expresses the fact that each
individual would be better off if she could move to any point above the indifference
curve going through E, and that voluntary exchanges would only occur when bot
individuals were made better off, which means that no exchange can result at a
point outside the area delimited by the two curves. Thus, if allowed to exchange
quantities of the two goods, the two will end up at point T, which is also the
point at which two new indifference curves intersect. This process of exchange
13
14
CHAPTER 3. EXCHANGE, TRANSACTION COSTS, AND MONEY
continues until the two reach a point at which the indifference curves do not
intersect, but are tangent to each other (graphically, at the tangency point,
the Region of Mutual Advantage would disappear). Within the Edgeworth box,
there is an infinite number of tangency point between As and Bs indifference
curves. These points form a curve called Contract Curve. Algebraically the
point at which A and B will rest, that is, the final equilibrium point, can be
determined by solving the following system of equations:
Px Xa + Py Ya = Px xa + Py ya
(3.3)
Px Xb + Py Yb = Px xb + Py yb
(3.4)
M RSCa = Px /Py = M RSCb
(3.5)
Where 3.3 is As budget line, 3.4 is Bs budget line, and 3.5 is expresses the
identity solution for a utility maximization problem (the slope of the indifference
curve equals the slope of the budget line). Equation 3.5 also shows that there is
only one pair of relative prices such that the two indifference curves are tangent,
for any given initial allocation of X and Y .
3.2
Supply and Demand in Pure Exchange
To better understand the results of the analysis of the previous section, we

must focus on the behavior of each individual separately. Each individual can
be seen as having two kinds of demand and two kinds of supply. A persons
Full Demand is the quantity that she ends up with at the end of the exchange
process. A persons Transaction Demand is the quantity acquired during the
process, or, in other words, the difference between her Full Demand and her
Initial Endowment. A persons Full Supply corresponds, in the absence of
production, to her Initial Endowment. Her Transaction Supply, on the
other hand, is the quantity that she ends up selling in the exchange process, or,
in other words, the difference between her Full Supply and her Full Demand :
Full Demand: xi
Full Supply: xi
Transaction Demand: xti = xi xi
Transaction Supply: xti = xi xi
The price ratio at which xti and xti both equal zero is called Autarky
Price Ratio. As the name suggests, at this price at the individual prefer is
initial endowment to all the alternatives, and will therefore restrain from any
exchange whatsoever.
The sum of all individual Full Demands is called Market Full Demand, and
the same applies also to Market Full Supply, Market Transaction Demand, and
Market Transaction Supply:
3.3. EXCHANGE AND PRODUCTION
15
Market Full Demand: X

Market Full Supply: barX
Market Transaction Demand: Xt=X-barX
Market Transaction Supply: -Xt=barX-X
3.3
Exchange and Production
In a market economy, people do not just exchange goods from their initial
endowment, but also use their labor (and resources) to produce goods that
can then exchange for other goods in the marketplace. Each individual has a
Production Possibility Curve of the form:
Q(x, y) = axc + by d1
(3.6)
An example of P roductionP ossibilityF unction is:

Q(x, y) = x2 + y 2 16
(3.7)
In a Robinson Crusoe economy (that is, an economy in which exchange is ruled

out), the individual maximizes his utility by producing the bundle goods resulting from the tangency point between her Production Possibility Curve and her
Indifference Curve. In other words, her Production Optimum (R) is also her
Consumption Optimum (C). Algebraically, this Robinsons Optimum is found
by equating her Marginal Rate of Substitution in Consumption to her Marginal
Rate of Transformation:
M RT S = M RT
(3.8)
that is, by equating the first order derivative of the Production Possibility Function to the first order derivative of the Indifference Curve.
By creating the opportunity for trade, the market economy separates production from consumption. Each individual will produce such as to maximize
her budget line, given the prevailing prices in the market2 , by selling a positive
quantity of a good, and then use the profits from this sale to buy the optimal
quantity of the other good. Individual Full Supply and, thus, Market Full Supply
are a function of the prevailing price for the good in the market.
This discussion highlights the two main advantages of trade: i. Trade allows for a better allocation of existing goods; and ii. Trade allows
for specialization in production. Both these advantages guarantee a better
situation for everyone involved.
1 For
2I
simplicity, we are assuming an economy with only two goods

am assuming a perfectly competitive market.
16
3.4
The Costs of Exchange
Real markets are seldom perfect. Among the many sources of market imperfection are:
1. Imperfect Communication (Ignorance)
2. Nonunique Prices
3. Transaction Costs
Transaction Costs do not include the costs of physical transfer of commodities.
Indeed, the former only exists in a market economy, while the latter will always
also exist in a command economy, that is, in a context where exchange is ruled
out. Transaction costs are, as the name suggests, the costs associated with carrying out a transaction: the costs of communicating and disclosing information;
the costs of negotiating and enforcing a contract; and so forth. Transaction
costs can either be proportional or lump-sum. Proportional transaction costs
have the same effect of a per unit tax in that the price paid by the buyer exceeds
the price received by the seller by the amount of the cost:
p+
x = px + g
(3.9)
where g is the value of the Per-unit Trading Fee. In the presence of proportional
transaction costs the quantity exchanged [...] is necessarily smaller than the
ideal equilibrium amount (Hirshleifer et al., 2005: 434). Transaction costs
affect the behavior of individuals in production and exchange by creating a gap
between sellers price and buyers price. As this gap increases, each individual
finds herself closer and closer to the autarky price. Indeed, for the market as
3.5. THE TRANSACTION COSTS THEORY OF MONEY
17
a whole, for large enough transaction costs, the market can disappear entirely,
which geometrically means that the demand and supply curves intersect in the
negative quadrant.
Lump-sum transaction costs are the reason why buyers and sellers hold inventories. In the presence of a lump-sum transaction cost, consumer may find
preferable to incur in some inventory costs, and, instead of buying the good
just before consumption, store it and allocate consumption throughout the time
interval T . As T ends, each consumer will buy some quantity of the good once
again and consume it throughout T2 , and so forth. So, given a lump-sum cost F ,
an individual full consumption flow x, and a production flow x
lower than x, the
individual will maintain her consumption flow constant by making a purchase
of size L at any T :
x=x
+ (L/T )
(3.10)
The value of lump-sum transaction costs is given by the sum of the entry fee
(the lump-sum payment proper) and the cost of keeping an inventory:
V = F/T + hT L/2
(3.11)
Where F/T is the transaction fee per unit of time and hT L/2 is the average cost
of the inventory. Equation 3.11 shows that as T increases, the average lumpsum cost per unit consumed decreases, while the inventory costs increase. A
consequence of lump-sum transaction costs is that they transform the autarky
price of the transaction costs-free world in an interval. Unlike proportional
transaction costs, though, lump-sum transaction costs do not generate a price
gap between what is paid by consumers and what is received by sellers.
3.5
The Transaction Costs Theory of Money
Money is an institutions that reduces the costs of transacting. It does so by

performing two functions: i. Medium of exchange; and ii. Temporary store of
value. Money emerged of exchange in order to reduce the search costs associated
with finding a counterpart who does not only sells a good for which we have
a positive transaction demand, but also has a positive transaction demand for
the good for which we have a positive transaction supply. As a store of value,
on the other hand, money solved the problem of inter temporal consumption:
a seller may store the money received for a payment in order to allow himself
to consume it in the future. In order to become the prevalent money in an
economy, a commodity should therefore be relatively cheap to produce and to
store, must have a relatively stable value, and be difficult to counterfeit.
3.6
Auctions
Every market economy is characterized by a variety of exchange mechanisms: i.

bilateral exchange; ii. broker markets (which can take the form of geographical
and chronological arbitrage); and iii. Auctions. Auctions emerge to overcome
18
the problem of asymmetrical information between buyers and sellers. Unlike in

monopoly markets, in an auction the seller does not know the buyers reservation
price (or willingness to pay). There are four types of auctions:
1. English or Ascending P rice
2. Dutch or Descending P rice
3. F irst P rice
4. Second P rice
English and Dutch auctions are done according to the public outcry method, in
which each bidder publicly announce her bid. First- and Second-Price auctions
are follow the Sealed-Bid method. In the English auction, each bidders best
strategy is to bid until her own reservation price is reached. The winner will
therefore pay only one unit more than the second bidders reservation price.
Although they follow a different method, Second-Price auctions are analytically
similar, with the winner paying the bid made by the second highest bidder,
which exactly corresponds with the latters reservation price.s In a sealed-bid,
First-Price reservation price, on the other hand, the best strategy is always
to bid half your reservation price. Once agains, the Dutch auction, although
following a different method, arrives has the same optimal strategy: bidding
only half your reservation price.
Chapter 4
The Theory of Consumer

Behavior I: Utility and
Preference
4.1
Introduction
The theory of consumer behavior deals with the problem of optimization in consumption, and is therefore an application of optimization theory, which means
that, in its analysis, it makes use of marginal magnitudes such as Marginal Utility and Marginal Cost. The two fundamental concepts of Consumer Theory are
Instrumental Rationality and Utility Maximization.
4.2
The Laws of Preference
The theory of consumer behavior builds on some fundamental axioms:

1. The Axiom of Comparison: Consumers are able to compare any two baskets of goods. For any pair of such bundles A and B, a consumer must
either prefer A to B, prefer B to A, or be indifferent between the two.
2. The Axiom of Transitivity: Transitivity requires that, if a consumer prefers
A to B, and B to C, then it must be that she prefers A to C.
3. The Axion of Completeness: Any possible baskets within the consumption
set is either more preferred to another or is less preferred.
The complete ordering of all possible bundles in the reach of the consumer
can be expressed by a preference function.The bundles that are ordered by the
preference function can contain three types of commodities:
Goods: A commodity is called a good whenever more of it is preferred
to less, that is, whenever the marginal utility derived from it is positive.
19
20CHAPTER 4. THE THEORY OF CONSUMER BEHAVIOR I: UTILITY AND PREFERENCE

Neuter Commodities: A commodity is called neuter whenever the consumers utility is not influenced by either an increase nor a decrease in its
quantity, that is, the marginal utility derived from it is zero.
Bads: A commodity is called a bad whenever less of it is preferred to
more, that is, whenever the marginal utility derived from it is negative.
This categorization is not intrinsic in the commodity itself, but rather depends
on consumer preferences. Indeed, the same commodity can be a good, a neuter
commodity, and a bad not for different consumers, but it can also be so for a
single consumer. I can prefer more of a commodity (which is thus a good), but
only up to a point, beyond which I am indifferent to an increase in its quantity,
but as it increases even more, I would actually like to have less of it, which
means that it has become a bad to me.
4.3
Utility and Preference
Price theory assumes that consumers, in the market place, direct their behavior
toward the maximization of their own utility, where utility can be interpreted
as a cardinal magnitude having an exact, measurable value, or as an ordinal
magnitude, where we can compare the utility drawn from a good and compare
it to that of another good, but never say exactly what is the difference between
the two utilities. The latter is called cardinal utility theory, while the latter (the
more popular among price theorists) is called ordinal utility theory. In the latter
case Utility is the variable whose relative magnitude indicates the direction of
preference (Hirshleifer and Hirshleifer, 2005: 73).
When economists say that individuals maximize their utility, they mean that,
given the alternatives they face, they will choose the one that will give them
more utility, not that there is a maximum total utility that can be achieved.
Cardinal utility theory, on the other hand, assumes that utility can indeed be
measured (in utils, for example). Geometrically, utility maximization can be
expressed thorough a total utility function and a marginal utility function. The
total utility function is positively sloped, which means that utility in consumption is an increasing function of quantity consumed, and that marginal utility is
always positive. The marginal utility function, on the other hand, is a decreasing
function of quantity consumed, meaning that its slope is always negative, a characteristic which is referred to as diminishing marginal utility. Algebraically,
MU is the slope of the rate of change of total utility:
dU/dC > 0
(4.1)
d2 U/dC 2 > 0
(4.2)
Equation 4.1 tells us that the slope of the Utility function is increasing in C, and
that MU of a good is always positive. Equation 4.2 tells us that the slope of the
Marginal Utility function (the second derivative of the total utility function) is
negative, meaning that MU diminishes as the quantity consumed increases.
4.4. CHARACTERISTICS OF INDIFFERENCE CURVE
21
The utility maximization problem, in its cardinal interpretation, can be represented graphically by three-dimensional Utility Hill. Each point on the surface
of the hill is associated with a total utility the value of which is determined by
the height of the hill at that point. All points of the hill at the same distance
from the Cartesian plane are all associated with the same utility. These points
form the so called curves of total utility, or indifference curves. By maintaining
the indifference curves, but getting rid of the tridimensional hill, economists arrive at a graphical representation of the ordinal theory of consumer preferences.
4.4
Characteristics of Indifference Curve
Let us build the utility map for an individual, where each point of the map
represent a bundle with varying quantities of two goods, X and Y . Then, the
indifference curves for this individual will have the following characteristics:
1. Indifference Curves are negatively sloped (otherwise, they would violate
the more is better assumption)
2. Indifference Curves never intersect (otherwise they would violate the transitivity axiom)
3. There are an infinite number of Indifference Curves (an indifference curve
can, in theory, always be draw in between two indifference curves)
4. Indifference Curves are convex to the origin.1
4.5
Goods and Bads
An indifference map needs not represent the relative preference between bundles
of goods, but also between bundles containing a good and a bad. For example,
portfolio preference theory tells us that as the riskiness of an investment increases, an individual must be compensated with an increase in mean return in
order to be kept along the same indifference curve. This means that as the quantity of the bad (riskiness) increases, the good (mean return) must also increase,
and the indifference curves assume a positive slope.
4.5.1
Charity as an application of consumer theory
A charitable person is one who has a positive marginal utility for another persons income (empirically, is fair to say that it will be so only as long as the
latters income is lower than her own). An uncharitable person is one whose
indifference curves are straight lines parallel to ordinate. Finally, a malevolent
person will have a positive slope, as the income of the other person is a bad
1 According to Hirshleifer et al (2005: 81), this can only be demonstrated if we adopt the
cardinals interpretation of utility theory. In fact, I think this conclusion can be drawn by the
assumption of diminishing marginal utility.
22CHAPTER 4. THE THEORY OF CONSUMER BEHAVIOR I: UTILITY AND PREFERENCE

from the point of view of the individual, and its increase must be compensate
by an increase in the latters income to keep it on the same utility function.
Chapter 5

Behavior II: Consumption
and Demand
5.1
The Geometry of Consumer Choice
The geometrical representation of the optimal consumer choice consists of two

elements: the consumers indifference map, and her budge constraint. The
budget constraint represents the upward limit on the combinations of X and Y
the consumer can achieve for a given income I:
Px x + Py y = I
(5.1)
Equation 5.1 is called budget function. By zeroing one of the two variables, it is
possible to identify the intercepts of the function with the horizontal and vertical
axes, which represent the maximum quantity of either good if the consumer were
to spend her entire income on it.
Geometrically, the optimum choice of the consumer is represented by the tangency point between the budget constraint and the higher attainable indifference
curve. In fact, all the other point on the budget constraint would be points of
intersection between it and another, inferior, indifference curve, while none of
the superior indifference curve ever touch the budget constraint, meaning that,
although they could bring about a higher utility, they are not attainable.
23
24CHAPTER 5. THE THEORY OF CONSUMER BEHAVIOR II: CONSUMPTION AND DEMAND
The slope of the budget is found as follows:

Px x + Py y = I > Py y = I Px x > y = I/Py (Px /Py ) x (5.2)
where the first element of the right-hand side of the equation is the vertical
intercept and the second element is the slope of the line.
The geometry of the optimal bundle offers also a justification for the assumption of convexity for the indifference curves. If indifference curves were
concave, in fact, for any possible budget line, the higher tangency point will
always be a corner solution, meaning that no individual will ever choose to diversify consumption, no matter her income nor the characteristics of the goods
involved. Convex indifference curves, on the other hand, allow both for interior
and corner solutions.
5.2. COMPLEMENTS AND SUBSTITUTES
25
The algebraic understanding of the optimal choice of the consumer varies

according to whether one choose the cardinal or the ordinal approach to utility
theory. If one chooses the cardinal theory of individual utility, than an interior
solution must be consistent with the Consumption Balance Equality:
M Ux /Px = M Uy /Py
(5.3)
Equation 5.3 tells us that, according to cardinal utility theory, the optima bundle
would be such only when the marginal utility derived by the last dollar spent in
buying the good X is equal to the marginal utility derived from the last dollar
spent in Y . A corner solution, on the other hand, must be consistent with the
Consumption Balance Inequality:
M Ux (whenx = 0)/Px < M Uy (wheny > 0)/Py
(5.4)
If one, on the other hand, chooses the ordinal approach to utility theory, then he
cannot use marginal utility as a meaningful notion, since in ordinal utility theory,
there is no way to compare two utilities against each other. Marginal utility
is therefore substitutes by the notion of Marginal Rate of Substitution in
Consumption, that is, the ratio at which a person is just willing to substitute a
small amount of X for a small amount of Y by keeping the consumer indifferent:
M RSc = dy/dx|u
(5.5)
An interior solution must therefore be consistent with the Substitution Balance

Equation:
M RSc = Px /Py
(5.6)
Equation 5.6 tells us that the indifference curve would be tangent to the budget
line when the MRSc equals the absolute value of the slope of the budget line,
that is, the ratio between the price of X and the price of Y . For a corner
solution, on the other hand, the choice must be consistent with the Substitution
Balance Inequality:
M RSc < Px /Py
(5.7)
When the entire market is in equilibrium, the price ratio P x/P y is an objective
fact that emerges out of the subjective preferences of all agents, and this price
ratio will also be equal to the MRSc of all those who buy a positive quantity of
all goods. The MRSc can also be expressed for one good by using the notion
of Marginal Value (MV) or Marginal Willingness to Pay. M V x is obtained by
expressing the MRSc taking Y as the numberer and Py as the price numberer:
M Vx = dY /dX = Px /1
5.2
(5.8)
Complements and Substitutes
The consumption choice of the individual depends on three factors: i. Her

preferences; ii. her Income; and, finally, iii. relative prices. The particular characteristics of a good may also affect the consumers preference for the optima

quantity of the other good. It is easy to imagine, for example, two goods from
which an individual can derive a greater utility when consumed in conjunction
(i.e., a right and a left shoes). An opposite case will be that of two goods that
will never be consumed in conjunction, for example, because they satisfy exactly
the same need (i.e., two right shoes). The former are called Complementary
Goods: Two goods are said to be complementary when a large change in the
price ratio causes only a very small change in the consumption choice. Strict
complementarity requires that the two goods are consumed always and exclusively in fixed proportions. Geometrically, the indifference curve picturing two
perfect complementary goods will be right-angled. The opposite case is that
of Substitute Goods: Two goods are said to be substitute when a very small
change in the price ratio brings about a large change in the preferred bundle.
Perfect substitutes are depicted through a negatively sloped, straight indifference curve.
5.3
The Consumer Response to Changing Opportunities
If individual preferences were to remain constant, then only external factors,

that is, only changes in opportunities, could account for a change in consumer
choices. Two changes in opportunities can be imagined: i. A change in income;
and ii. A change in relative prices. The effect of changes in income is expressed
graphically by the Income Expansion Path (IEP). The IEP represents all
the preferred bundles for a consumer when her income changes and the relative
prices remain the same (different price ratios will produce different IEPs). The
function for the income expansion path is given by the Substitution Balance
Equality:
M RSc = Px /Py
(5.9)
5.3. THE CONSUMER RESPONSE TO CHANGING OPPORTUNITIES 27
The behavior of the IEP can tell us something about the particular goods
depicted by the indifference curves. If, for example, the IEP is positively sloped,
meaning that as income increases, the consumption of both goods also increases,
then both goods are Superior Goods. If, on the other hand, the IEP is negatively sloped, meaning that as income increases the consumption of at least one
good decreases, then the good for which consumption has decreased is called
Inferior Good, while the good for which consumption has increased more than
the increase in income is called Ultrasuperior.
The relationship between income and consumption can also be represented

for each good taken separately by the Engel Curve. An Engel Curve has income
on the horizontal axis and the quantity of the good of interest on the vertical
axis. For superior good, the Engle Curve will always have a positive slope, while
for inferior goods, the slope will be positive up to a threshold after which it will
start declining, that is, have a negative slope.
The Price Expansion Path does what the IEP did for the relationship between
income and quantity for that between price and quantity. The PEP takes income
as fixed (indeed, there are as many PEPs as there are levels of income) and varies
the price ratio (that is, not the nominal values of the two prices, but the ratio
between the varying price of X taking that of Y constant). The function for
the PEP is given by the combination of the Substitution Balance Equation and
the Budget Function:
M V x = Px
(5.10)
I = Px x + Py y
(5.11)
dY /dX = Px
(5.12)
y = I/Py (dY /dX)/Py x
(5.13)
5.3. THE CONSUMER RESPONSE TO CHANGING OPPORTUNITIES 29

The Price Expansion Path has four properties:
1. Utility increases as Px decreases.
2. A negatively sloped PEP indicates that, as Px decreases, the consumer

chooses to consumer more of X and less of Y ; a positively sloped PEP
indicates that, as Px decreases, the consumer chooses more of both X and
Y.
3. The PEP can never go above the straight line Y=I/Py, since the consumer
cannot buy more of Y when Px is declining than when Px is zero.
4. The Pep always goes rightwards, but in the case of a Giffen good, in which
case the PEP will curl leftward for some values of Px.
A Giffen good is an expectation to the Law of Demand. A commodity is

identified as a Giffen good when an increase in its price brings about an increase
in the quantity consumed. For this to be possible, though, the good must be an
inferior one, and it must occupy a large share of the budget of the consumers.
The same data used to draw the PEP can also be used to build a demand
curve. The individual demand curve will have Px on the vertical axis and Q/t
on the horizontal one, and the same is true for the market demand curve, which
is the horizontal (that is, in terms of Q) sum of all individual demand curves.
5.4
Income and Substitution Effects of a Price

Change
When the relative prices of two or more goods change, while nominal income is
kept constant, this has an effect on the consumption behavior of the individual.
This effect can be separated into two components:
1. Pure Substitution Effect: Measures the effect of the change in the price
ratio by not considering the effect on real income of the price change. This
is done by observing what the consumer would have chosen if, after the
price had change, she would have been forced to choose the new bundle
along the same indifference curve of the original one.
2. Income Effect: the residual effect once the pure substitution effect has
been identified. It is the effect provoked by the change in real income due
to the change in relative prices.
5.5. FROM INDIVIDUAL TO MARKET DEMAND
31
The pure substitution effect is characterized by the fact that it has always
the opposite direction of the price change: when Px increases, X* decreases,
when Px decreases, X* increases. Geometrically, since the indifference curve
is negatively sloped, when Px decreases, the budget line takes a flatter slope,
which means that the tangency point will be to the right of the original one. On
the other hand, the income effect can have the same and the opposite direction
of the change in price. When the change is in the opposite direction, than X
is a normal good, but when it follows the same direction then the good is an
inferior one, and if the effect is so large that the new optimal quantity of X is
lower than the original one, the good in a Giffen good.
5.5
From Individual to Market Demand
Market demand is the horizontal sum of all individual demands in the market,
expressed as a function of price:
X=
n
X
xi
(5.14)
i=1
5.6
An Application: Subsidy Versus Voucher
A subsidy corresponds to a change in the relative prices faced by the recipients,

while the voucher represents a change in income that can be spent in one of
the two goods. Geometrically, thus, a subsidy is exactly the same of a relative
price change, while the voucher is more similar to an increase in income, where
the new income line is parallel to the previous one, but keeps the same vertical
intercept, which is connected to the new budget line through a horizontal segment. Voucher and subsidies vary in their effect especially for goods that were

not consumed before the introduction of the new policy. In such cases, in fact,
subsidies tend to have little if any effect (since the original solution was a corner
one), while a voucher does at least increases the quantity purchased of the good
of interest.
Chapter 6

Behavior III: Applications
and Extensions
6.1
The Engel Curve and Income Elasticity of

Demand
The Engle Curve shows the relationship between income and the consumption
of a good. The slope of the Engle Curve is dX/dI can be used to measure
consumers responsiveness to changes in income. One problem with this measurement is that it is very sensitive to the unit of measurement. To avoid these
shortcomings, the Engle Curve can be substituted by the notion of Elasticity.
Elasticity eliminates the problem of sensitivity to the unit of measurement by
measuring changes in percentage terms:
x =
X/X
X/I
=
= X/I I/X
I/I
X/I
Any nonlinear Engle curve will have a unitary income elasticity in the neighbor
of the tangency point with a straight line from the origin. Income elasticity
can have values equal, greater than, or smaller than one. We can distinguish
between: i. Point elasticity (the income elasticity at one point of the Engle
Curve); ii. Arc Elasticity (the average of all point elasticities along an arc of
the Curve).
A persons income elasticities over all commodities consumed are connected
by an important condition: The Weighted average of an individuals income
elasticities equals one, where the weights are the proportions of the budget
33
34CHAPTER 6. THE THEORY OF CONSUMER BEHAVIOR III: APPLICATIONS AND EXTENSION

spent on each commodity (Hirshleifer and Hirshleifer, 2005: 131):
kx = Px x/I
(6.1)
ky = Py y/I
(6.2)
The weighted average of all income elasticities cannot exceed unity (nor can, in
the unhampered market and for utility maximizing individuals, be lower than
one), since one cannot increase it expenses for the purchase of X and Y by more
than the increase in her income:
1 = kx x + ky y
(6.3)
1 = (dX/dI) (I/X) (Px X/I) + (dY /dI) (I/Y ) (Py Y /I)
(6.4)
1 = (dX/dI) Px + (dY /dI) Py
(6.5)
1 = 1/dI (dX Px + dY Py )
(6.6)
dI = (dX Px + dY Py )
(6.7)
6.2
The Demand Curve and the Price Elasticity

of Demand
The Demand Curve depicts the responsiveness of consumption to changes in

prices. From the point of view of the seller, the demand schedule does not
represent a good indicator of his total revenues. This is because increases in
the price of the good sold need not, and often do not, result in increases in the
revenue of the seller. This sis because as price increases, buyers can respond by
buying less of the good. If the increase in revenues due to the increase in price is
offset by the decrease in quantity demanded, the net result will be a decrease in
the revenues of the seller. When the net effect is negative, the demand schedule
is said to be elastic at the original combination of Q and P. When the net
effect is zero (total revenue remains universe) the demand is said to be unit
elastic. When the net effect is an increase in total revenues, the demand is
said to be inelastic. As in the case of the Engel curve, though, the Demand
Curve also has a measurement problem due to the unit of measurement. To
overcome these measurement issues, economists use the notion of price elasticity
of demand, which measures the responsiveness of consumption to change in
prices in percentage terms:
x = (X/X)/(Px /Px ) = X/Px Px /X
(6.8)
Since the relationship between price and quantities, as expressed by the demand
function, is usually inverse, dX/dPx is usually negative, is also negative. The
demand for X is:
Elastic, when x < 1
Unit Elastics, when x = 1
6.2. THE DEMAND CURVE AND THE PRICE ELASTICITY OF DEMAND35

Inelastic, when x > 1
Different price elasticities have different effect on the total spending on a particular good, Ex :
E x = Px x
(6.9)
For x < 1, that is, when demand is elastic, a decrease in the relative price
Px brings about an increase in total spending on X. Correspondingly, when
x >1 , when demand is inelastic, a decrease in Px provokes a decrease in total
expenditure on X. To better identify the relationship between price change
and expenditure on X, it is possible to use the notion of Marginal Expenditure,
M Ex :
dT R
dX
d(Px X)
MR =
dX
dPx X + dX Px
MR =
dX
dPx X
dX Px
MR =
+
dX
dX
dPx
MR =
X + Px
dX
dPx dX
M R = Px (
+ 1)
dX dPx
dX Px
x =
dPx X
1
M R = Px ( + 1)
x
Px
x =
M R Px
MR =
(6.10)
(6.11)
(6.12)
(6.13)
(6.14)
(6.15)
(6.16)
(6.17)
(6.18)
MR will be positive for elastic demand, zero for unit elastic demand, and
negative for inelastic demand.
6.2.1
The Second Law of Demand
According to the second law of demand, a demand schedule is always more

elastic in the long run than in the short run: The longer the time allowed
to adjust amount demanded in response to a price change, the greater is the
change in amount demanded, that is, the greater the elasticity (Alchian and
Allen: 28). This greater elasticity in the long run is caused by a process put
in motion by any price change. Buyers and sellers alike will respond to a price
change by trying to find ways to adjust and, for example, buying (or producing,
in the case of the sellers) substitute to the good the price of which increased.
6.3
The Cross-Elasticity of Demand
The Cross-Elasticity of Demand is the measure of how a change in the price of

Y affects the quantity consumed of the good X:
x y =
dx/x
= dx/dPy Py /x
dPy /Py
(6.19)
When two goods are complements in consumption, an increase in the price of

either of the two causes a decrease in the consumption of the other. Since the
two changes have opposite signs, the cross-elasticity will be negative: x y < 0
When two goods are substitute in consumption, an increase in the price of Y
provokes an increase in the consumption of X. Since the two changes have the
same sign, the cross-elasticity will be positive: x y > 0
6.4
Fitting the Demand Curve
The notion of price elasticity can be used to fit econometric data into a statistical
demand curve for the market as a whole. The elasticity of market demand thus
becomes:
x =
Px /X
dX/X
=
dPx /Px
dPx /dX
(6.20)
Where X is the total quantity of X consumed in the market.

In fitting the historical data into statistical demand curves, econometricians
usually face an alternative between choosing a Constant Slope demand curve
or a Constant Elasticity demand curve. A Constant Slope Demand Curve is
a straight line with negative slope. Straight lines have, by definition, constant
slope. Price elasticity along a constant slope demand curve varies at each point.
At high level of prices, for example, elasticity is larger than at low prices. This
is because elasticity is measured in percentage terms and a price change is likely
to affect consumption more at high prices that at low prices. At any point of
a constant slope demand curve, price elasticity is equal to the ratio between
the slope of a ray from the origin passing through the point of interest, and
the slope of the curve. At all points in the upper interval of the demand curve,
the slope of the ray will be greater, in absolute value, than the slope of the
curve. Since, though, the slope of the curve is negative, x < 1, meaning that
demand is elastic. At the lower arc of the demand curve, on the other hand, the
slope of the curve is steeper than that of the ray from the origin, meaning that
the ratio will be, in absolute value, less than one, and, since the slope of the
demand curve is negative, x > 1, meaning that demand is inelastic. Demand
will be unit elastic when the slope of the demand curve is exactly the reverse
fraction of the slope of the ray, that is, at the midpoint of the linear demand
curve. For a non-linear demand curve, the same reasoning applies, with the
only modification that, what matters is not the slope of the demand curve, but
rather the slope of the tangent of the demand curve at the point of interest.
6.4. FITTING THE DEMAND CURVE
37
The general function for a linear demand curve, that is, a constant slope
demand curve, is as follows:
X = A + BPx
(6.21)
Where A is a constant representing the horizontal intercept, and B is the slope

of the curve, which in normal cases assumes a negative value. The function can
be generalized even more by taking other variables that affect demand for X
such as income, price elasticity, the price of substitutes and that of complements,
and so forth:
X = A + BPx + CI + DPy + EPz ...
(6.22)
Where C is the slope of the Income Expansion Path, which is positive when
X is a superior good and negative when is an inferior one, D is the influence
the quantity purchased of a complementary good, which is always positive, and
E is the effect of the quantity purchased of a substitute good, which is always
negative.
The general function of a Constant Elasticity Demand Curve is as follows:
X = aPxb
(6.23)
Where a is the (varying) slope of the demand curve, and b is the constant
elasticity:
x =
dX Px
dX/X
=
dPx /Px
dPx X
(6.24)
X = aPxb
(6.25)
Pxb
(6.26)
Pxb
Px
Px
dX Px
= abPx( b 1)
= ab
= ab
Px
x
x
Px
x
x
b
aP
x = b xb = b
aPx
(6.27)
Equation 6.21 can also be written in logarithmic form (which can be represented graphically as a straight line):
log X = log a + b log Px
(6.28)
The general function can be extended to take other factors into consideration:
x = aPxb I c Pyd Pze
(6.29)
Which, once again, can be expressed in logarithmic terms as:

log x = log a + b log Px + c log I + d log Py + e log Pz
(6.30)
6.5
Determinants of Responsiveness of Demand

to Price
There are three main determinants of price responsiveness, or price elasticity,

on the part of the consumer:
1. Availability of substitutes: the closer the substitute, the greater the elasticity, since the consumer can shift to the substitute good as the price
increases. When there are not close substitutes to a good, on the other
hand, the consumer cannot easily shift to another good when the price of
the former increases (substitution effect)
2. Luxuries vs Necessities: The demand for luxuries tend to be more elastic
then that for necessities (income effect)
3. High priced vs Low priced goods: low priced goods tend to be less elastic
than high priced goods, especially when we assumed constant slope for
the demand curve
These determinants can help us understand the flaw in the importance fallacy,
according to which the less important a good is, in terms of its weight on the
total expenditure of the consumer, the less the latter will respond to change in
prices. This argument is often used to explain the little elasticity of demand
for goods such as salt, the expenditure on which is very small across the entire
spectrum of income distribution. But this phenomenon can be explained more
rigorously by appealing to the three determinants of demand responsiveness to
price: i. Salt has no close substitutes; ii. salt is a necessity; 3. salt is low priced.
Indeed, it is easy to show that two goods, one accounting for the vast majority
of consumers income, and the other for only a small fraction of it, can both
have the same (unitary) elasticity.
6.5.1
The effects of a price increase
An increase in prices has three effects on the behavior of individuals:

1. Endowment effect: If the individual owns units of the good, his endowment is now more valuable and his budget constraint moves upward, thus
increasing his own demand for the good.
2. Substitution effect: The price change increases the price of x relative to y,
thus making the individual substitute (at the margine) y for x.
3. Income effect: the increase in price reduces the purchasing power of the
individual, and can force him to buy less of both x and y.
6.6. MULTIPLE CONSTRAINTS: RATIONING
6.6
39
Multiple Constraints: Rationing
Rationing constitutes an artificial limitation on the consumption of one or more

goods. It is a popular policy in times of war and is often adopted by socialistic
inspired government around the world. There are two types of rationing:
1. Coupon Rationing
2. Point Rationing
A coupon rationing works by limiting the maximum amount of X that an
individual, or an household, can purchase during a given period of time. A
coupon rationing is binding only when the rationed quantity, Rx , is lower than
the quantity that would have been purchased in the absence of the rationing.
When the rationing is binding, the consumer will choose to consume as much as
is allowed of the rationed good and spend the rest of her income on the non rationed good. In the case in which both goods (assuming a two goods economy)
are rationed, and both rationing are binding, than the consumer will consume
the maximum allowed quantity of both. The rationale of point rationing is to
modify the relative prices of the rationed goods and, at the same time, restrict
the ability of wealthy individuals to consume more than everyone else. Point
rationing works by introducing a parallel, artificial price ratio in terms of points.
Each good is now priced both in money and in points, and each household is
given a fixed amount of such points N . Now, the choice of the consumer is
constrained by two functions:
the budget function: I = Px x + Py y
the point function: N = px x + py y
Under these constraints, three scenarios are possible. In the first scenario, the
point constraint is not binding, while the budget constraint is, thus allowing

the individual to consume the same bundle as before. In the second scenario,
the point constraint is binding (the function lies entirely below the budget function), meaning that the consumption choice will be entirely determine by the
artificial price ratio. Finally, in the third scenario, both functions are binding.
Chapter 7
The Firm
7.1
The Firm: Entrepreneurship, Ownership, and

Management
Firms are economic organizations the purpose of which is the production of

goods and services. In general, firms emerge out of a decentralized market
because of the following frictions: i. Transaction Costs; ii. Coordination in
production.
Transaction costs, that is, the costs associated with transacting, increase the
cost of producing a good in a decentralized manner. In order to produce the
consumer good, each producer of the intermediate goods will have to contract
with everyone else. This kind of multilateral contracting is very costly, since
each contact must be negotiated and enforced. The firm create the possibility of
bilateral contracting in which the responsible for the firm negotiate with every
contributor to the final product, including workers, suppliers, and so forth.
Furthermore, the firm are created to take advantage of coordination in production: there simply are some production processes that can only be carried
out by teams of people, and not by the cooperation of independently working
individuals.
The firm has three fundamental features:
1. Management: The manager is somebody who speaks and acts in the name
of the firm, which gives him or her some discretion over the direction of
the productive process.
2. Ownership: The owners are those who have invested their money in controlling a certain share of the firm. Owners are the residual claimants of
the firms revenues after all costs have been paid. Ownership and management need not, and often do not, coincide,
3. Entrepreneurship: The entrepreneur is the decision maker, the individual
responsible for deciding what actions to take under conditions of uncertainty.
41
42
CHAPTER 7. THE FIRM
Firms often take the form of corporations, which allow them to act in a
regime of limited liability. Limited liability means that the owner of a share of
the firm is only liable for his or her share of the firm. Corporations are also
subject to transferable shares, meaning that the owner of a share can sell it to
someone else.
All firms have to overcome two problems likely to obstruct their pursuit
of profits: i. The Need for Monitoring Management; ii. Distribution of Risk.
Sometimes, the owner of the firm cannot perfectly monitor the behavior of the
manager. In industries were the monitoring costs are relatively high, we will
tend to observe a coincidence of ownership and management. The easier it is
to monitor the quality of an input, the more likely it is for management and
ownership of the asset to be separated, the more difficult it is to monitor these
qualities, the more likely it is that those inputs are going to be owned by the
managers.
Many corporations diversify risk by producing two types of instruments for
corporate capitalization: i. Corporate bonds, ii. Corporate shares. Corporate
bonds are for risk-averse individuals, those who do not want to be involved in
the ownership of the firm. Corporate share are for those who are more riskprone, and are willing to expose themselves to the hazards of doing business.
These instruments allow for the specialization in risk-taking.
7.1.1
The Profit-Maximizing Firm
Economists assume that firms are profit maximizers. The economic notion of
profits, though, is different from the one used in accounting. In price theory,
profits are the difference between the firms revenue and costs, where costs are
really opportunity costs, and not accounting costs. Economists define opportunity costs as the best among the forgone uses of the resources employed by
the firms. Thus, to calculate the costs of doing business, an economist would
take into account the foregone opportunity of earning a salary by working as an
employee for a different firms.
Many have criticized the profit maximizing assumption for firms in which
management and ownership do not coincide. The critics claim that, when this
is the case, monitoring by owners is difficult, which allows managers to pursue
their own self-interest, rather than that of the firm. This would in turn lead
the firm to fail t maximize profits. For example, a manger may be interested
in making a name by increasing the performance of the firm in the short run,
but depleting the long run profits, thus endangering the position of the owners.
This is particularly likely when ownership is diffused, with small shareholders
left without power.
There are, though, mechanism through which owners, even small ones, can
monitor, although not perfectly, the behavior of managers. For example, they
might decide to sell their share, which lowers the value of those owned by the
larger ones and affects the public perception of the management of the firm. The
discretionary power of managers is thus limited by the possibility of changes in
the ownership structure. If a firm fails to maximize profits because of bad man-
7.1. THE FIRM: ENTREPRENEURSHIP, OWNERSHIP, AND MANAGEMENT43

agerial decisions, someone could buy enough shares and put himself (or someone
more capable) in the role of manager and gain the previously unexploited profit
opportunity. The more a manager acts against the interest of the firm, then, the
more profits are left on the sidewalk, and the more likely it is that people from
outside the firm will be willing to invest in it by buying shares and changing
the management of the firm.
7.1.2
Production with two or more factors
Within the theory of the market process, firms function is the production of
goods. Production is a process of transformation of inputs (the factors of production) into outputs (the products). Inputs can be raw materials like wood
and iron, or produced factors of production like machinery and human capital.
Similarly, a firm can produce consumption goods (like sliced bread) or factors
of production (like machinery) that are going to be used by other firms.
Classical economists used to distinguish between three general categories of
factors of production: 1. Labor; 2. Capital; 3. Land. Modern economists add
to this list Entrepreneurship and Capital Goods. The services of these factors
are a flow concept.
Land is often defined as the original and indestructible power of the soil.
Thus, any service that the land is capable of providing that is the result of
some human effort cannot be accounted for as services of the land, but rather
as capital goods. It must be noted that, unlike some classical economists like
Malthus thought, land is not fixed in supply.
Capital is the stored-up provision for the production of future goods derived
from past efforts or abstinence.
7.1.3
The Law of Diminishing Returns
Keeping one factor of production fixed, and given that such a factor is limiting (that is, it is an important factor in the production process of the firm),
then eventually the increase in the quantities of all other factors will lead to
diminishing returns in production. This means that, all but the fixed factors
increase, the firm will be able to produce fewer and fewer units of the good.
For example, let us assume that we have a firm using only two factors of
production, Land and Labor, in order to produce some output X. Lets assume
that the quantity of Land that the firm can use os fixed form some reason. The
firm then adds labor to the fixed land. Initially, the total product ofof labor
increases at an increasing rate, but after a while, adding more labor, though
increasing productivity, does so at a diminishing rate. Eventually, the firm will
arrive at a point such that adding more labor does not increase the quantity
of good produced, and even affects it negatively. In terms of output per unit
of labor, the marginal product of labor is first increasing, then decreasing, and
finally zero and even negative. The average product of labor is increasing as long
as output is increasing (that is, as long as MPAP) and then is decreasing. The
44
CHAPTER 7. THE FIRM
firm will always choose to produce output in the region where average product
is diminishing, but the marginal product is not negative.
The law of diminishing marginal returns is much misunderstood (Vickrey,
153) tells us that the prerequisite for the existence of a competitive equilibrium
will always be satisfied, somewhere. I
7.2
The Optimum of the Firm Under Pure competition
Under pure competition, each firm contributes to market supply only by a negligible amount, and has therefore no influence over the market price. Pure competition is the combination of pliopoly, that is, the possibility for firms outside
the market to enter it as soon as they think they can make economic profits, and
polyploy, that is, that many firms operate in the market at any given moment.
As I discuss above, firms are assumed to maximize profits:
=RC
(7.1)
R=P Q
(7.2)
C = AC Q
(7.3)
where is economic profits, R is total revenue, and C is total cost.

Each firms contribution to market supply is determined by the behavior of
their cost curves, which varies according to whether the firm is acting in the
short run or the long run. In the short run, total costs can be distinguished
between fixed costs and variable costs (or direct costs). In the short run, the
firm is assumed to have some inputs, a for example the size of the plant, fixed,
meaning that the costs it incurred in paying for it do not affect the choice of how
much to produce. Total costs curves, in the short run, have two characteristics:
1. At low levels of output, costs rise at a declining rate as quantity increases,
thanks to economies of scale.
2. At high levels of output, costs rise at an increasing rate, according tot he
law of demising returns.
The optimal strategy for a competitive firm is to produce until the point at
which the revenue from selling the next unit equals the cost of producing it:
MR = MC
(7.4)
To a competitive firm, though, marginal revenue is equal to price, since the

demand it faces is irresponsive to increases in quantity:
MR = P = MC
R
dR
and AR = Q
. On the cost side, M C =
Where M R = dQ
can now rewrite the profit equality as:
(7.5)
dC
Q
and AC =
= R C = (AR Q) (AC Q) = (AR AC) Q
C
Q.
We
(7.6)
7.3. COST FUNCTIONS
45
A firm will therefore produce the quantity at which P=MC. This only apply
when the intersection between the MC curve and the AVC curves intersect at
or above the P curve. In fact, if it were otherwise, it would mean that the firm
is losing money for each unit it produces. Note that the firm will still produce
even if it is making negative profits, since the revenues are less than the total
costs when fixed costs are taken into account. In the long run, thus, the firm
would simply not enter in the market when the price is lower than the average
total cost. But in the short run, since fixed costs are bygone, production will
occur as long as the average variable cost is not below the price.
7.2.1
Division of Output among Plants
Let us assume that a firm owns two plants, A and B, with different cost curves.
Then , the firm will produce in each plant such that the MC in plant A equals
the market price and the MC in plant B also equals the market price. The total
quantity supplied by the firm will be the sum of the quantities produced in each
plant.
7.3
Cost Functions
Short-run and long-run differ in that, the longer the run, the more inputs are
variable rather than fixed. There is therefore a continuum of short-runs between
the condition in which nothing is variable, and the extreme condition in which
everything is variable. In price theory, the short-run is usually assumed to be
46
CHAPTER 7. THE FIRM
such that some inputs, usually capital, is fixed, while labor is variable. The
long-run is seen as the condition in which both capital (the plant) and labor are
both variable. In the long run, thus, the total costs curve passes through the
origin, since the firm can always decide to produce zero at zero cost. Thanks
to the law of diminishing returns, the TC curve will increase at a decreasing
rate at low levels of output, and increase at an increasing rate for high levels of
output. The LRTC curve is the lower envelope of all the SRTC curves for any
fixed level of output. The LRTC curve represents e points at which, for each
level of fixed costs, it is least costly to produce.
The Long Run Average Cost Curve is the lower envelope of all Short Run
Average Cost Curves. It is tangent to them to the left of their minima when
increasing returns are in place (that is, when total costs increase at a diminishing
rate) and to the right when the law of diminishing returns enters into action, that
is, when costs increase at an increasing rate. The LRAC curve has its minimum
at the tangency point with the SRAC curve for which the combination of fixed
and variable costs produce the global minimum value of unit cost.
Note that the LRAC curve is tangent to all SRAC curves and always lies
below them. If this was not so, the LRAC will be greater, for the same quantity,
than the SRAC, which is impossible, since in the LR the firm can always shift
to the same combination of fixed and variable costs of the SRAC curve.
Similarly, the Long Run Marginal Cost Curve represents the points of interception between all the SRMC curves and the vertical lines that connect the
tangency point between LRAC and all the SRAC curves. The LRMC curve cuts
the LRAC curve at the latters minimum, which is also the point at which the
firm will produce in the long run. The particular characteristics of this point is
that, at it, LRMC, SRMC, LRAC, and SRAC all touch:
SRM C = LRM C = SRAC = LRAC
(7.7)
In real markets, the notion of long run is often different from the one used here.
Firms cannot always exit a market as easily as the theory would suggest. Firms
usually encore in fixed costs even while not producing, simply because it is less
costly than the alternative of selling its plan and machinery every time it has to
stop production. This is because transaction costs are positive and because firms
use specialized resources in their productive process, resources that are therefore
of little value for other firms, even those operating in the same market. Thus,
although it would be possible to sell or rent these resources when production is
stopped, the cost of doing so is greater than the opportunity cost, which means
that the firm is better off by keeping them for itself. If transaction costs were
zero and all resources were perfectly homogeneous (meaning that they could be
used in any production process without any costly modification), then the very
notion of short run will be meaningless, since firms will be able to modify all
their inputs at any moment in time.
7.3. COST FUNCTIONS
7.3.1
47
Rising Costs and Diminishing Returns
In the model of a pure competitive market in production, the usual assumption

is that Marginal and Average Costs both eventually increase as the quantity
produced increases. Modifications to these assumptions lead to different results. For example, let us assume that MC were falling throughout the carets
graph. Then, the MC curve will never intersect the MR=P curve from below,
meaning that a competitive optimum cannot be found. If, on the other hand,
AC falls throughout then a competitive market is also infeasible, since a firm
will in the long run expand its plant indefinitely cutting out all competitors
from the market. Thus, falling ACs are said to give life to natural monopolies.
48
CHAPTER 7. THE FIRM
In reality, AC and MC do eventually start to increase, thanks to the Law of Diminishing Returns. This law tells us that, keeping one input fixed, there is
an optimum level of the other input such that the quantity produced
is maximized. If this were not the case, it would be possible to increase the
level of one output to produce an indefinitely large level of output. The Law
would not apply if all inputs were really variable, since one firm could always
avoid an increase in MC and AC by modifying the combination of inputs. The
result would be flat MC and AC curves and equal to each other. But since not
all inputs can be varied together, the law does apply in most circumstances.
7.4
An Application: Peak Versus Off-Peak Operations
Let us assume a firm operating in a competitive market in which there are two
possible situations: Peak Demand and Off-Peak demand. The Peak demand is
greater than the Off-Peak one which requires an increase in variable and fixed
inputs, and, therefore, in variable and fixed costs. The firm has therefore two
new types of costs:
Common Costs: Common costs are the costs that the firm must paid in
order to maximize profits both at peak and off-peak.
Separable Costs: The costs incurred to serve only one market and not the
other.
For conveniency, let us assume that in the short run Marginal Common Costs
(MCC) and Average Common Costs (ACC) are constant at the value M, meaning that geometrically the two curves are horizontal lines. The Marginal Separable Cost and the Average Separable Cost are assumed to behave in the usual
manner. Then, there are two optimal strategy in the long run:
1. Stable Peak Solution: The MCC must be assumed to have been incurred
to meet the larger peak demand, meaning that the only relevant marginal
magnitude is MSC. Thus, Off-Peak, the optimal quantity to produce is
found by equating MSC to the off-peak price Po . On Peak, on the other
hand, MCC matter, thus the optimal strategy is to equal the sum of MCC
and MSC to the peak price Pp . Thus, the firm will produce two different
outputs, qo and qp .
M Co = M SC = Po
(7.8)
M Cp = M CC + M SC = Pp qo < qp
(7.9)
2. Shifting-Peak Solution: The Stable Peak solution only holds when Pp

Po > M CC. When M CC > Pp Po , another strategy is optimal. Since
the increase in price cannot pay for the increase in cost due to the Peak
7.4. AN APPLICATION: PEAK VERSUS OFF-PEAK OPERATIONS
49
Demand, the firm must produce the same output in both circumstances.
This optimal output is found by equating the sum of the MSC on peak,
the MSC off peak, and the MCC to the sum of the prices off and on peak:
M C = M CC + M SCp + M SCo = Po + Pp qp = qo
(7.10)
50
CHAPTER 7. THE FIRM
Chapter 8
Market Equilibrium in a
Competitive Industry
8.1
The Supply Function
In a competitive market, in the short run, the optimal strategy for a firm is
to produce output until the marginal cost equals the marginal revenue, which,
because demand is perfectly elastic, is in this case equal to the market price.
The firm, in the short run, will continue producing as long as the market price
is above the average variable cost. On the other hand, in the long run, it will
only stay in the market for a price above the average total cost.
The industry supply curve is the horizontal summation (that is, expressed
in terms of Q(p)) of all individual firm supplies. The problem is that this is
true only in a world in which a change in production does not affect the input
markets. When we allow for such changes, which are indeed likely to happen
in real world markets, than the actual market supply curve must take them
into account. Let assume for example that a change in tastes drive the market
demand upwards, that is, consumers are willing to pay more at each quantity
of the good. The new equilibrium price will not be found by moving along
the old supply curve. This is because the increase in demand has provoked
all firms to produce more of the good, which has in turn increased the price
of the factors of production and, therefore, the cost associated with it. The
new supply curve will thus be above the old one, and the new equilibrium will
be at the intersection between this and the new demand. The market supply
curve is therefore steeper than those of the individual firms but also of all those
associated with different demand curves.
The effect of a change in demand on the supply curve is called Input-Price
Effect. The I-PE tells us that the response of the industry as a whole to an
increase in price is likely to be smaller than it would have been if no such effect
existed. This effect influences the elasticity of supply, that is, the measure of
51
52CHAPTER 8. MARKET EQUILIBRIUM IN A COMPETITIVE INDUSTRY

how much a change in price affects the change in quantity supplied:
Q/Q
Q P
.
P/P
P Q
(8.1)
Unlike the price elasticity of demand, the price elasticity of supply tend to be
positive. Because of the IPE, the industry supply elasticity is less elastic than
the individual supply curve. The individual supply curve corresponds to the
firms MC curve above the shut-down decision point (that is, the intersection
between MC and AVC in the short run, and between MC and AC in the long
run), and the segment 0PC (where PC is the price level below which the firm
will shutdown) on the vertical axis.
In the long run, the elasticity of supply is greater than in the short run. This
is because of a combination of factors:
1. The the LRMC is flatter than the SRMC.
2. The Entry Exit Ef f ect: In the long run, firms are free to enter and exit
the market, which means that an increase in price will lead new firms to
start production. The quantity produced will be therefore greater because
of the response of firms already in the market and of the new ones.
Within an industry, it is possible for producers to incur in externalities

provoked by each firms reaction to a price change. These externalities are
called External Economies, and can be of two types:
8.2. FIRM SURVIVAL AND THE ZERO-PROFITS THEOREM
53
1. Pecuniary External Economies: The Input-Price Effect is an example

of pecuniary externalities, as is the long run effect of a change in demand
on the equilibrium price, since new firms, by entering the market, lower the
equilibrium price thus cutting economic profits for everyone. Pecuniary
external economies tend to be negative.
2. Technological External Economies: Ideas, and their application to
production, are an example of Technological External Economies. In the
computer industry, for example, technological economies have the effect of
reducing the cost of production even though demand has increased, thus
counterbalancing the Input-Price Effect. Technological economies can,
potentially, be positive or negative.
When external economies are positive, the industry supply curve will be flatter than any individual firms supply. For very large positive economies, like
a strong technological external economy, the curve might also be negatively
sloped, meaning that, a change in the demand curve causes quantity and price
to decrease at the same time (an example: the computer industry).
8.2
Firm Survival and the Zero-Profits Theorem
Survival in the long run requires the firm to have non-negative economic profits.
In a competitive industry, though, the long run profits in the industry will be zero.
If the industry is open to new firms to enter, as soon as price is above AC, new
firms will enter the market to take advantage of the opportunity, rising the price
of input factors and re-establishing the zero-profit condition.
8.3
The Benefits of Exchange: Consumer and

Producer Surplus
The Fundamental Theorem of Exchange tells us that voluntary trade is always

mutually beneficial. The benefits of exchange cannot be measured directly in
terms of the utility of consumers and producers, but we can measure their
willingness to pay and their reservation price, and, through these measures,
have an indication of the benefits of trade.
The Producers surplus is the shaded area contained by, on the left, the Y
axis, to the right and below by the supply curve, and above by a horizontal line
from the intersection of supply and demand to the Y axis. The Consumers
surplus is contained by the Y axis on the left, the demand curve on the right
and above, and the line between the intersection and the Y axis below.The most
valued a good and the smaller the price, the larger the surplus. The least valued
a good, and the higher the price, the smaller the consumer surplus.
These measures can help us assess the effects of, for example, changes in
technology which reduce the cost of production or increase the quality of a
good. Under both circumstances, the change shifts one of the two curves (supply

downward the former and demand upward the latter), which means that the area
contained by them (the sum of consumers and producers surpluses) is larger
after the introduction of the new technology.
8.4
Transaction Taxes and other Hindrances to

Trade
It follows from the fundamental theorem of exchange that, the more people
enter into trade, the larger the benefits. All hindrances to trade will, therefore,
reduce these benefits. Taxes are one example of such hindrances. A geometrical
as well as algebraic analysis will show that taxes do in fact reduce consumers
and producers surplus. Some of this surplus will enter the state treasury and
may finance public goods which also produce some benefits to consumers, but
taxes also always generate a deadweight loss, that is, some surplus is not be
transferred but simply disappears. The larger the transaction tax, the larger the
deadweight loss.
Supply quotas are another example. Unlike taxes, though, quotas do not
generate tax revenues. Quotas simply redistribute some consumer surplus to
producers, and produce a deadweight loss. Consumers are always made worse
off by quotas, while producers, although they lose some surplus as a result of
the deadweight loss, gain even more thanks to the redistributed surplus from the
consumers to themselves. Many countries have import quotas on some imported
goods, which are a way to redistribute surplus from domestic consumers to
domestic and foreign producers.
A third example of wealth destructing hindrances to trade are price ceilings.
A price ceiling is a maximum price introduced, at least in theory, in the interest
of consumers. In fact, price ceilings have a destructive effect in that they prevent the price mechanism to fulfill its function of allocating resources to their
most valued by spreading informations about profit opportunities. Price ceilings
prevent adjustments of supply to changes in demand, technology, and resources.
Let us assume, for example, that a city council decides to introduce a price
ceiling on housing by fixing P to its level at the moment of the adoption of
the measure. Then, after a little time, an external shock causes the supply
of houses to fall. If the absence of the price ceiling, the price of housing will
rise sharply in the immediate run, then decline in the short run thanks to an
increase in quantity supplied by existing providers of housing, and decline even
more, maybe even to its initial level, in the long run. In the presence of the
ceiling, though, no price adjustment is possible in the short run, meaning that
only those sellers the preservation price of which is lower than the mandated
price will sell their houses.
Furthermore, in the immediate run, some of the houses may end up in the
hands of people who do not value them the most, since buyers are prevented
from bid for the scarce resource. In the long run, though, the effect of a price
ceiling is to create a shortage: quantity demanded, at the mandated price,
8.4. TRANSACTION TAXES AND OTHER HINDRANCES TO TRADE 55

will be far larger than the quantity that suppliers are willing to supply at the
same price, which means that some people who would be willing to pay the
market price are prevented from doing so. No shortage is possible when
supply and demand are allowed to adjust to market conditions. Finally,
price ceilings have also the feature of generating wasteful practices which are
a deadweight loss for society. Absent the price system as a mechanism for
allocation of resource, other mechanisms, such as waiting lines, will emerge.
Unlike a direct payment at the equilibrium price, the loss for the waiting buyer
is not being transferred to the seller, and is therefore a net loss for the economy
as a whole.
.
Chapter 9
Monopolies, Cartels, and

Networks
Economists refer to a market as being monopolistic when only one firm (the
monopolist) operates in it. A monopoly can emerge in only two ways:
1. Natural Monopoly: A natural monopoly emerges when one or more firms
operating in the same market experience declining Average Costs throughout the relevant section of the schedule. Since the firm could always produce more at lower AC, only one firm can be in the market at equilibrium.
2. Artificial Monopoly: An artificial monopoly is the result of government
intervention in securing that only one firm operates in the market.
A third possibility is that of monopolistic competition, that is, competition
between many firms that, although they operate in the same market for the
same good, they all have some market power and can therefore influence price
at the margin. To avoid confusion, we can call legally protected monopolistic
markets as closed monopolies and those that emerge because of underlying
economic reasons open monopolists.
9.1
The Monopolists Profit-Maximizing Optimum
A firm operating under pure competition will do its best by producing the quantity of output such that the marginal cost equals the price. In the competitive
market, the single firm has no way of influencing the price, and therefore the
MR is always equal to the price, no matter how much it produces. But in the
non perfectly competitive market, the monopolist does have the power to influence the price, since if faces a downward sloping demand curve, which means
57
58
CHAPTER 9. MONOPOLIES, CARTELS, AND NETWORKS
that marginal revenues declines as quantity produced increases.

MR = MC
d(P Q)
dQ
dP
P
MR
(P
) + (Q
)P +Q
dQ
dQ
dQ
Q
P
MC = P + Q
Q
(9.1)
(9.2)
(9.3)
The profit-maximizing strategy for a monopolist can also be expressed in terms

of price elasticity of demand, :
Q P
Q
Q/Q
P
P/P
P Q
P Q
1
M R P + Q dP/dQ P (1 + Q/P dP/dQ) P (1 + )
(9.4)
(9.5)
The monopolist firm will never produce in territory where > 1, since
where demand is inelastic a change in price leads to a decrease in total revenues. On the other hand, in the territory of elastic demand, the monopolist
can produce more, thus indirectly reducing price, but at the same time increase
revenue.
The differences in market conditions between competitive and monopolistic

industry leads to different equilibria. The monopolistic equilibrium will always
have lower output and higher price than under pure competition.
A monopoly is restrained in its strategy by two factors: i. the price elasticity
of demand; ii. the potential competition of firms from outside the industry.
9.2. MONOPOLY AND ECONOMIC EFFICIENCY
59
Competition, in particular, can constrain the strategy of monopolist even more

than elasticity of demand since the monopolist cannot maintain its position if it
were to produce at a quantity at a price that is larger than the AC of the least
costly potential competitor.
9.1.1
Two-level optimization under monopoly
The publishing industry is a case of monopolistic market in which there emerges

a two-level optimization problem. Each publisher is the sole seller of a particular
title, over which it has market power. The author, on his part, will want to
maximize her royalties. But the two would choose two different quantities at
which they maximize profits. The publisher would like to have a higher prize,
which means fewer books sold, while authors would like a combination in which
price is smaller and quantity is larger. If the author could pick her own preferred
royalty rate, knowing that it would be taken into account by the publisher, it will
choose it such that maximizes her profits. But the publisher could offer a lump
sum payment larger than the royalties and then set the price that maximize its
own profits, making both parties better off.
9.1.2
Monopolist with Competitive Fringe
Some markets are characterized by a particular internal organization in which

one of the firm operating in it has market power, while other smaller firms operate in it but are price takers. The monopolist and the fringe firms have different
strategies. The monopolist first have to subtract the horizontal summation of
the fringe firms from market demand and then produces the quantity such that
the marginal revenue of the remaining demand equals its marginal cost. The
fringe firms each produce the output such that its own MC equals the price
resolution from the monopolists choice.
9.2
Monopoly and Economic Efficiency
Let us assume we are observing a competitive market with an indefinite number

of small firms. Each of these firms will produce until MC=P, and the final result
will be an equilibrium that maximizes consumers and producers benefits. Now
assume that the firms merge creating a giant monopolist, which can now choose
the output such that MC=MRP. This will have two effects on consumers and
total surplus. First, the monopolist will be able to transfer to itself some consumer surplus. Second, a share of total surplus will be lost on a deadweight loss.
As long as its loss is counterbalanced by the share of consumer surplus transferred to itself, the monopolist will be better off, but consumer are definitely
worse off. The loss in total surplus is not the only efficiency loss of monopoly.
In the case of government mandated monopoly, in fact, multiple firms compete
for the privilege, which generates a competition between rent seekers, the effect
of which is a waste of resources.
60
9.3
Regulation of Monopoly
As a matter of principle, the regulation of monopoly is aimed at forcing monopolists to the zero long-run economic profits condition. The problem with
regulation is that it can be wrong, in the sense that it can choose a price that
is not optimal and generates an even larger efficiency loss. Indeed, if the chosen
combination of P and Q is such that the AC curve is raising at the intersection point, the MC will be larger than the price fixed, meaning that the firm is
losing money for each unit produced beyond the intersection between MC and
P, which also means that the firms will not be able to stay in the market in
the long run. Thus, the possibility of such an efficiency loss must be compared
to the efficiency loss associated with an unregulated monopoly, before deciding
which of the two is the preferable alternative.
Another possibility os the government regulating a natural monopoly, which
has declining AC over the relevant section of the schedule. Under such conditions, the government is likely to choose a too high price, which means that the
monopolist would be able to produce even more at a lower unit cost.
As I mentioned above, government regulation is not the only force that counterbalance the arbitrary power of the monopolist. Consumers price elasticity
of demand as well as potential competitors from outside the market limit the
range of price that the monopolist can choose autonomously. The influence of
competitions from outside the market, which is referred to as Competition for
the Field, is particularly important since, for small differences in the AC curve
between the monopolist and outside firms, the monopolist will choose a price
that is close to the one that would emerge under pure competition.
9.4
Monopolistic Price Discrimination
The monopolist can, just by adjusting the output produced, reallocate to itself
a share of consumers surplus. But there are ways for it to appropriate an even
larger share, though a strategy called price-discrimination.
Economists have identifies three types of price-discrimination:
1. Market Segmentation (Third Degree Price Discrimination): The monopolist sells the same good at different prices to different markets, or segments
of markets. Market segmentation is only possible when customers in the
high elasticity market cannot resell to those in the low price elasticity
market, that is, arbitrate between low-price and high-price markets. The
optimal strategy for a monopolist facing a fragmented market is to set
MC equal to the marginal revenue function of each market, meaning that
the marginal revenues of each market must be equal to each other:
M C = M R1 = M R2
1
1
M C = P1 (1 + ) = P2 (1 + )
1
2
(9.6)
(9.7)
9.5. CARTELS
61
Thus, the monopolist will choose a higher price for the least elastic market,
and a lower price for the most elastic one. Market segmentation need not
be geographical. Firms use other strategies, like fragmenting the market
according to age, willingness to pay, and so forth.
2. Block Pricing (Second Degree Price Discrimination): Block pricing consists in asking to the same customer declining prices for the further units
of the same good. Block pricing has a fundamental shortcoming: it is very
bad at discriminate between different buyers with different willingness to
pay.
3. Perfect Discrimination (First Degree Price Discrimination): Under perfect
discrimination, the monopolist asks different prices for each unit of the
good to the same buyer, according to the latters declining marginal utility.
The monopolist is therefore able to transfer to itself the entire consumer
surplus. Perfect price discrimination is different from the other two forms
in that it is efficient from the point of view of society, since every buyer that
wants to buy a unit of the good above its marginal cost is accommodated.
There is not, in this case, any monopolistic distortion.
9.5
Cartels
A cartel is an alliance between firms operating in the same market the aim of
which is to operate as a monopolist, thus making economic profits and allocating
them among the members of the cartel. The cartel assigns to each firm a quota
of total output that, if respected by every one firm, will maximize the profits of
the members.
The problem with cartels is that they are very unstable. For one thing, cartels only work if they are able to co-opt a very large share of all firms operating
in the industry, and at the same time restrain entry into the market. Furthermore, even firms that are part of the cartel have a strong incentive to chisel,
that is to start producing more of the good, since it can increase its profits by
doing so. If all firms were to behave in the same way, the cartel will soon break
down and competitions is restored.
9.6
Network Externalities
Sometimes, a particular technology will monopolize the market because of what

economists call network effect. A good is said to have network effects when the
utility that consumers can expect to derive from it increases as the number of
its consumers increase. Thus, the demand for such goods behave differently
from the demand for other goods. To build the demand curve for a network
good, we first need to draw demand curves for any possible number of people
that can be expected to also buy the good. There will be a demand curve for
x expected buyers, one for x + 1 expected buyers and so forth. The market
62
demand corresponds to the conjunction of all those points of the individual

demands curve in which the number of buyers is exactly its expected value.
Chapter 10
Competition Among the

Few: Oligopoly and
Strategic Behavior
The notion of oligopoly indicates a situation in which the industry is not dominated by a single firm (monopoly) nor are there an indefinitely large number
of firms (polypody and pliopoly). A market is said to be an oligopoly when the
number of firms is so small that they can behave in a strategic way.
10.1
Strategic Behavior: The Theory of Games
Game Theory is the mathematical study of strategic behavior. A game is an

interaction between one or two players the actions of which have repercussions
on those of all others. Through the application of the rationality and self-interest
assumption, economists can predict the result of the game based on the patterns
of the individual payoffs and the protocol (the rules of the game). Individual
payoffs matter because they are what determine the preferred strategy of selfinterested players. Games of strategy can have harmony of interests between
the players (coordination games) or divergence of interests, as is the case in the
popular prisonerss dilemma.
Public goods are an example of game in which individual interests diverge.
A public good is characterized by non-excludability, meaning that consumption
is open to anyone, and non-rivalry, meaning that ones consumption does not
affect the consumption of others. The problem with public goods is that it pays
for any individual to contribute only when her contribution is essential for the
provision of the good. When everyone contributes, the individual knows that
she would be able to consume it no matter if she does or not, and is therefore
tempted to free-ride. If everyone behaves in the same way, though, the public
good would not be provided in the first place.
63
64CHAPTER 10. COMPETITION AMONG THE FEW: OLIGOPOLY AND STRATEGIC BEHAVIOR
In game theory, a solution is a prediction about which state will emerge as an
equilibrium. The solution is often a function of the payoffs and the protocol of
the game. For example, it often matter whether the game is plaid simultaneously
or in sequence, where simultaneity is not intended in its chronological meaning,
but simply means that none of the player knows what the other players are
going to play. In a sequential play, whenever the first player chooses based on
its prediction of what the other players rational response will be, the result s
called subgame perfect equilibrium.
For simplicity, games are often depicted as if the players where behaving
within a symmetrical situation, meaning that they have the same information
and face the same payoffs. In real world situations, though, it is often the
case that the interacting individuals are in fact behaving under conditions of
asymmetry. For example, they might face different payoff schedules, or possess
different informations, and so forth. In sequential games, the second player
for example posses the information about the first players behavior, while the
latter did not know what the second player would have plaid.
In a simultaneous game, players choose their preferred strategy without
knowing what others are playing, based only on their knowledge about the
payoff schedule. When a player has a preferred strategy regardless of what
other players do, this is called a dominant strategy. The intersection between
the dominant strategies among all players is called dominant equilibrium. When
not all players have dominant strategies, there could still be an equilibrium. An
equilibrium will emerge when non e of the players can increase her own position
by changing strategy keeping other players strategy constant. Such an equilibrium is called Nash equilibrium. Although not all Nash equilibria are dominant
equilibria, all dominant equilibria are also Nash equilibria.
Sometimes, when players are only allowed to play pure strategies, a game
may not have any Nash Equilibrium. But when mixed strategies are allowed,
than all games have a Nash equilibrium. The aim of mixed strategies is to make
other players expected payoffs equally preferred.
10.2
Duopoly: Identical Products
A duopoly is the simplest form of oligopoly, in which only two firms operate in
the same market. Duopoly has only four solutions:
1. Collusive solution: the duopolists form a cartel and operate as a monopolist in order to maximize their combined profits.
2. Competitive solution: the duopolist behave as price takers, thus producing
the level of output such that MC=P.
3. Cournot Solution: the Cournot solution consists in a competition over
quantity produced. The Cournot solution is the result of a simultaneous
game in which each firm operate as if it was the monopolist of the residual demand once the supply of the other producer is taken into account.
10.3. DUOPOLY: DIFFERENTIATE PRODUCTS
65
The solution of the game if found by solving simultaneously the Reaction

F unction of the two firms:
D :P =abQ
(10.1)
Q = q1 + q2
(10.2)
M C1 = M C 2 = 0
(10.3)
M ax1 = P q1 = a q1 b
q12
q22
q1 q2
(10.4)
q1 q2
(10.5)
a b 2 q1 q2 = 0
(10.6)
a b 2 q2 q1 = 0
a q2
q1 =
2b
a q1
q2 =
2b
(10.7)
M ax2 = P q2 = a q2 b
(10.8)
(10.9)
Where 10.8 and 10.9 are respectively the Response Function of firm 1
and firm 2. The solution to the Cournot game is found simply by solving
simultaneously the two functions.
4. Bertnrand Solution: in the Bertrand solution, the two firms compete over
price instead of quantity, which drives prices toward the competitive solution.
10.3
Duopoly: Differentiate Products
So far I have depicted the situation of two duopolists competing for the market
of the same, identical product. Here we analyze a market in which the two
firms sell two different goods, the difference between them being measured by
an index of similarity, s, the value of which can go from 0, meaning that the two
goods are entirely different and thus hat the two firms are each the monopolist
over their own markets, to 1, at which value the two firms sell two identical
goods, that is the scenario I addressed above. The new demand functions faced
by the two firm will therefore be as follow:
D1 : P1 = a bq1 sq2
(10.10)
D2 : P2 = c d q2 s q1
(10.11)
M R1 = a 2 b q1 s q2
(10.12)
M R2 = c 2 d q1 s q1
(10.13)
M C1 = M C2 = 0
a s q2
q1 =
2b
c s q1
q2 =
2d
(10.14)
(10.15)
(10.16)
66CHAPTER 10. COMPETITION AMONG THE FEW: OLIGOPOLY AND STRATEGIC BEHAVIOR
The final equilibrium will thus depend on the index of similarity: the closer
s is to zero, the closer the solution will be similar to that of two monopolists
operating in different markets, the closer it is to one, the closers the solution
will be to that of a simple Cournot game.
10.4
Oligopoly, Collusion, and Numbers
The historical evidence suggests that, although it is an inferior solution to the

Cournot one, price competition between the oligopolistic firms. Indeed, prices
in oligopolistic markets tend to be remarkably stable. This has led economists
to believe that oligopolists have come up with a strategy that forces each one of
them to keep the same price and quantity constant. This strategy is known as
Kinked Demand Curve. The kinked demand curve is the result of the following
strategy: as soon a sone firm decides to sell at a lower price than expected, all
other firms do the same, thus reducing the slope of the demand faced beyond
the previous price. The demand curve being kinked, the MC curve intersect the
MR curve, which is the one that determines the optimal quantity and price of
the oligopolist, in a vertical jump, that is, a vertical segment, meaning that the
firm cannot increase its revenue by decreasing price at that point.
10.4.1
The Generalized Response Function
The analytics developed for a duopolist can be generalized for an oligopoly of

any number of firms. Given the market demand function P = a bQ, where
Q = qi , then the equilibrium qi , Q, and P are found as follows:
Q q1 + q2 + q3 + ... + qn
(10.17)
Q q1 + Q( n 1) q1 + (n1 )qo
(10.18)
P = a b(q1 + (n 1)qo )
(10.19)
M R1 = a 2bq1 b(n 1)qo
(10.20)
F or
(10.21)
M C1 = M Co = 0
(10.22)
a 2bq1 b(n 1)qo = 0
(10.23)
since
(10.24)
q1 = qo
(10.25)
a 2bq1 b(n 1)q1 = 0
(10.26)
a = (2b + bn b)q1
a
q1 =
bn + b
an
Q nq1
bn + b
an
an
an + a an
a
P = a b(
)=a
=
=
b(n + 1)
n+1
n+1
n+1
(10.27)
(10.28)
(10.29)
(10.30)
Chapter 11
The Demand for Factor

Services
11.1
Production and Factor Employment with

a Single Variable Input
A firms production possibility frontier is determined by its production function,

the technological relationship between the quantity and ratio of the input factors
and the quantity of output: q = (a, b, c, ...) For simplicity, we can assume
that output is a function of the quantity just one of the many inputs, those of
remaining ones being kept fixed. Then, the production function for one input
factor becomes q = q(a).
The Law of Diminishing Returns applies exactly to this scenario. Let us
assume that a firm that needs two factors, a and b, to produce output q, and
that the quantity of b is fixed. The firms total returns, marginal returns, and
average returns can now all be expressed in terms of input a. According to
the Law of Diminishing Returns, keeping all other factors fixed, the increase in
input a will first cause an increase in the quantity of output, this increase will
first have increasing rate, reach a maximum, and eventually decline. Similarly,
when marginal product is lower than average product, the latter will also start
declining. Total product will also arrive at its apex, after marginal product and
average product, after which the increase in factor a produces a decrease in the
quantity of output produced.
A firm has only two ways to produce a resource. It can own the factors that
are needed, or it can hire them on the factor market. For simplicity of analysis,
lets assume that the firm always hire all factors in the factor market. The firms
total cost function will thus depend on the quantity of each factor as well as
their hire prices:
C ha a + hb b + hc c + ...
67
(11.1)
68
CHAPTER 11. THE DEMAND FOR FACTOR SERVICES
Since, by assumption, we are keeping all input factors but a as fixed, equation
11.1 can be rewritten as:
C F + V F + ha a
(11.2)
Thanks to the production function, we can express total cost as a function of

output produced :
C = F + ha a F + ha a(q)
(11.3)
F or
(11.4)
(11.5)
q = a
(
q 1/)
(11.6)
Thus, the total cost function becomes a function of the hire-price and of the
inverse of the production function (that is, input as a function of output).
From the total cost function, it is now possible to derive the Marginal Cost
function and the Average Cost function expressed in term of of quantity of
output:
a=
q
ha a
ha
q
q/a
ha
MC
mpa
MC
(11.7)
(11.8)
(11.9)
where mpa is the Marginal Product of the input factor a. As equation 11.9
suggests, than, Marginal Cost is an function of the marginal product of the
input factor. MC increases as the marginal product decreases, and decreases as
the marginal product increases.
V
ha a
q
q
ha
ha
q/a
apa
ha
AV C
apa
AV C
(11.10)
(11.11)
(11.12)
Where apa is the average product of the input factor a. AVC increases as apa
decreases, and vice versa.
F +V
C
q
q
F + ha a
F
ha a
F
ha
+
q
q
q
q
apa
F
ha
AC
+
q
apa
AC
(11.13)
(11.14)
(11.15)
11.1. PRODUCTION AND FACTOR EMPLOYMENT WITH A SINGLE VARIABLE INPUT69

After having expressed the cost functions in term of output, we can now
derive the demand for the single input factor. Geometrically, the demand for
the input factor a corresponds to the downward sloping section of the vmpa
curve, that is, the Value of the Marginal Product (or Marginal Value Product):
vmpa P mpa , that is, the Marginal Value Product of s is the product of the
marginal product and the price of output.
The optimal choice for the firm is to hire a up to the point at which the
mvpa just equals the mf ca (the Marginal Factor Cost of a), which, if the factor
market is a competitive one on the buyers side, will be equal to af ca (Average
Factor Cost) and to the hire-price of a ha :
mvpa = mf ca = af ca = ha
(11.16)
Equation 11.16 represents the Factor Employment Condition for a Competitive

Firm. The firm will continue hire the input fact until the cost of hiring it just
equal the marginal revenue of employing it in production. If that was not the
case, the firm will not being maximizing its profits, since it could hire some
more of the input factor and make a profit from the next unit of output.
If the firm is a monopolist in the product market (that is, it faces a downward
sloping demand curve), the Factor Employment Condition must be generalized
as:
mrpa = ha
(11.17)
Where mrpa is the Marginal Revenue Product, that is, the Revenue that the
firm can make by using the next unit of input factor a1 :
mrpa = M R mpa
(11.18)
The logical relationship between the firms input and output decision can be
algebraically demonstrated:
MC
ha
mpa
(11.19)
dividing both sides by MR

ha
MC
MR
mpa M R
since
mpa M R mrpa
MC
ha
MR
mrpa
(11.20)
(11.21)
(11.22)
(11.23)
Since the firms equality condition for profit maximization in the product market
is M R = M C it must also be that, at the same output quantity, ha = mrpa .
1 The Marginal Value Product and the Marginal Revenue Product differ because the monopolist faces a downward sloping, and not perfectly horizontal, demand curve
70
11.2
Production and Factor Employment with

Several Variable Inputs
When referring to the choice of a firm regarding factor employment with more
than one inputs, it is easier to think in terms of two input factors, usually
labor and capital. Geometrically, the choice of the firm in the factor market
resembles that of the utility-maximizing consumer. As consumers choice can
be seen as a utility hill, the firms choice can be seen as a output hill. In two
dimensions, the choice is represented by a family of curves called isoquants,
each representing the infinite combinations of inputs a and b that can be used
to produce the same quantity of output q 0 , each iso quant being associated with
a different level of output.
The Output Hill can be used to illustrate geometrically two properties of

the production process: i. the Law of Diminishing Returns; and ii. Returns
to Scale. The law of diminishing marginal returns tells us that, keeping one
input fact fixed, any further increase in the employment of the variable factor
will increase output at a diminishing rate. Returns to scale, on the other hand,
refer to the effect of a combined increase in both input factors (in a two-input
factor world), and the effect of such an increase on output. If the increase in
output is greater than the increase in the increase in the quantity employed of
the two factors, the firms is said to have increasing returns to scale. When the
increase in output is smaller than the increase in inputs, the firm is said to have
decreasing returns to scale. When the two changes are of the same magnitude,
the firm is said to have constant returns to scale.
11.2. PRODUCTION AND FACTOR EMPLOYMENT WITH SEVERAL VARIABLE INPUTS71
Algebraically, economists often use a function of the form q = a b to

express a production function, where is expresses the general technological
process of the industry. This function is called Cobb-Douglas, and has the
72
property of making it easier to see whether a firm has increasing, decreasing, or

constant returns to scale:
q = a b
(11.24)
(a) (b) + a b
(11.25)
(a b )
(11.26)
For + > 1, + > , meaning that the increase in total output is greater
than the increase in input. Under constant returns to scale, if a factors hireprice equals its Marginal Product, then each exponent also equals the fractional
share of total output going to that factor (Hirshleifer and Hirshleifer, 2005:
354).
The optimal ratio between the two inputs of a firm is given by the tangency condition between the budget line of the firm and its isoquants. Unlike
a consumer, though, a firm has (given perfectly working capital markets) the
possibility of expanding its own budget line, meaning that it will have not one,
but an entire family of budget lines. The tangency points between a firms budget lines and its isoquants produces a Scale Expansion Path (SEP), the best
combination of inputs at any level of cost. Algebraically, the points of the Scale
Expansion Path are given by the Factor Balance Equation:
M RSq =
ha
hb
(11.27)
Where M RSq is the Marginal Rate of Substitution in Production (also known

as Marginal Rate of Technical Substitution), that is, the amount of input B
that the firm needs to hire in order to just compensate a small an infinitesimal
quantity of input A, or the slope of the isoquants; and hhab is the slope of the
q
budget lines, or isocosts. Since mpa = a
and mpb = q
b :
b
a
mpa
q/a
mpb
q/b
q b
b
a q
a
mpa
M RSq
mpb
M RSq
(11.28)
(11.29)
(11.30)
(11.31)
11.2. PRODUCTION AND FACTOR EMPLOYMENT WITH SEVERAL VARIABLE INPUTS73

We can now rearrange the Factor Balance Equation as follows:
ha
hb
b
mpa
M RSq
a
mpb
mpa
ha
=
mpb
hb
mpa
mpb
=
ha
hb
M RSq =
(11.32)
(11.33)
(11.34)
(11.35)
Thus rearranged, the Factor Balance Equation simply tells us that the marginal
products per dollar of all inputs,at the optimal solution, must be equal to each
other. If that was not the case, the firm could produce even more at the same
cost by shifting from employing the more costly input to the least costly one.
hb
ha
= mp
. From
The Factor Balance Equation can as well be expressed as mp
a
b
ha
equation 11.19, we know that mpa = M C. Thus:
MC =
ha
hb
=
mpa
mpb
(11.36)
At the optimal solution, then:

MC
ha
hb
ha
hb
=
=
=
MR
M R mpa
M R mpb
mrpa
mrpb
(11.37)
Since the optimal strategy is to set MR=MC, it must be also that ha = mrpa
and hb = mrpb , which is the Factor Employment Condition for an optimal
choice in the factor market.
As in consumption, in production as well facots are usually not independent
to each other. It is often the case that two facts are complementary in production, meaning that an increase in the quantity employed of one of them increase
the marginal product of the other. Two factors can also be anticomplementary,
when the increase in the use of one of them decreases the marginal productivity of the other. When they have no effect on the marginal productivity of
each other, they are said to be independent. Algebraically, complementarity
or anticomplementarity are found by taking the second cross derivative of the
production function:
q = q(a, b)
(11.38)
q
ab
(11.39)
When equation 11.39 is greater than zero, the two input factors are complementary. When it is less than zero, the two are anti-complementary.
With more than one inputs, the firms demand for an input is not simply
the downward sloping section of the vmp curve, or, more correctly, it is only so
74
when the two inputs are independent to each other. When the two are complementaries or anticomplementaries, the matter is slightly more complicated.
This is because when the hire-price of a factor falls, the firm will buy more of
it, but since the two are complements, the firm will also like to buy more of the
other good the mp of which has in the meantime being increased. This process
is called reverberation, and can go back and forth between the two input factors
for a while, put to a limit such that, again, the mrpa = ha and the mrpb = hb .
This means that, the firms demand curve for an input factor is flatter than
it would have been if it and all other factors had been independent. Since the
demand for a factor must be downward sloping throughout, no Giffen effect is
possible for input factors,
11.3
The Industrys Demand for Inputs
The industry demand for a factor is usually not simply the horizontal summation
of all firms individual demand curves. This is so because of two complications.
1. The first complication is the product-price effect. When the hire-price of
an input factor decrease, all firms will like to expand production, which
means that the new equilibrium prize in the product market will be lower
than it would have been if only one firm had adjusted to the change. The
change in the product market affects the equilibrium in the factor market
through the output price. Since the output price determines the vmp of the
factor of interest, a change in the hire price of the fact indirectly lowers the
vmp of the factor by lowering the equilibrium price. The industry demand
is therefore steeper, that is, less responsive to a change in the hire-price,
than the demand of each firm.
2. The second complication is the entry-exit effect. An increase in the hiringprice of an input factor might cause some firm to go out of business,
shifting the demand in the factor market to the left. Likewise, when the
hiring price decreases, more firms will enter in the market, thus shifting
the demand curve in the factor market to the right. Thus, the industry
demand curve is flatter than each individual demand curve.
11.4
Monopsony in the Factor Market
A monopsonist firm is the sole buyer of an input factor. This implies that the
quantity it buys actually affects the factor hire price. Geometrically, the firm
faces an upward sloping supply curve. The optimal choice for a monopsonist firm
is therefore not to buy the quantity if input such that mrpa = ha , but rather the
quantity such that the marginal factor cost curve intersect the marginal revenue
product curve. Like a monopolist in the product market, the monopsonist
chooses the quantity to purchase, but the price is determined by the supply
11.5. MINIMUM-WAGE LAWS
75
curve, which corresponds to the average factor cost function af ca :
mf ca =
Ca
ha a aha
ha
+
ha + a
a
a
a
a
(11.40)
An the Factor Employment Condition for a Monopsonist is:
mrpa = mf ca
11.5
(11.41)
Minimum-Wage Laws
When assessing the effect of minimum-wage legislation, economists face a choice

between two models, the responses of which can be very different. If the competitive model is employed, all minimum wage laws are deemed to generate both
a disemployment effect (that is, at the mandated wage, the equilibrium quantity
of labor exchanged is lower than at the market price equilibrium) and a unemployment effect (meaning that at the mandated price, more people would like to
work than employers are willing to hire). When the monopsony model is used,
the effect of minimum wage laws is mixed, with some people gaining from it
and others being net losers. Low skilled workers are the ones who are the most
negatively affected, while medium skilled workers might end up with greater employment and higher wage, but is also likely to produce some unemployment.
High skill workers are seldom affected by minimum wage laws.
76
Chapter 12
Resource Supply and the

Factor Market Equilibrium
12.1
The Optimum of the Resource Owner
In equilibrium, all income must ultimately come from resources that have been
offered for hire in the factor market. Resource owners have only two ways to
emply their resources: i. Retain them for reservation uses; and ii. offer them
in the factor market. Ones labor, or more accurately, ones labor services ant
time are among such resources. Each individual has an initial endowment of
time of 24 hours per day. This time can be employed in its reservation use as
leisure time or it can be offered to firms as labor:
Rt ot = L + Rl eisure
(12.1)
(12.2)
The optimal choice of the individual concern the amount of time to allocate
to each of these uses. This choice is a function of the resource owners own
preferences and of her income. The latter, in fact, determines the opportunity
set of the resource owner, that is, all the attainable combinations of leisure
and disposable income. The budget function will thus have the form It ot =
Ie ndowment + hL L, where the individual disposes of an initial endowment and
the remaining income is determined by the wage offered in the labor market
and the hours of labor she offers:
Rt ot = L + Rl eisure
(12.3)
lt ot = Ie ndowment + hL L
(12.4)
substituting
(12.5)
It ot = Ie ndowment + hL (Rt ot Rl eisure)
(12.6)
(12.7)
77
78CHAPTER 12. RESOURCE SUPPLY AND THE FACTOR MARKET EQUILIBRIUM

Geometrically, therefore, the budget line is a negatively sloped straight line,
which intersects the vertical axis at the point in which income is maximized,
that is, when the individual chooses to employ all its time as labor, and a
vertical line that goes through R = 24, at a point that corresponds to the initial
endowment, that is, when she offers none of her time as labor. The slope of the
budget line corresponds to the negative of the hire-price for the resource, that
is, wage.
The optimal choice of the consumer will thus be at the tangency point between its indifference curves (an indifference curves which is function of income
and leisure) and the budget line. Algebraically, therefore, the optimal choice
requires the Marginal Rate os Substitution in Resource Supply to be equal to
the absolute value of the hire-price of the resource:
I
|u
R
M RSR = hl
M UR
= hl
M UI
M UR = hL M UI
M RSR =
(12.8)
(12.9)
(12.10)
(12.11)
As the initial endowment Ie ndowment increases, the optimal choice of the

individual will vary. Geometrically, this relationship between income endowment and labor supplied can be expressed through the Income Expansion Path
(IEP). For the usual well-behaved indifference curves, the individual will choose
to supply less and less labor as her initial endowment increases.
Similarly, as the hire-price for the resource, wage, in this case, varies, the
optimal choice of the individual also varies. Geometrically, the choice of the
individuals can be shown by the Wage Expansion Path (WEP). This curve
has the particular feature of being backward bending. Initially, for low values
of hL , the response of the individual will be that of expanding her supply of
labor. After a threshold, though, an increase in wage provokes a decrease in
the quantity of labor supplied in the market. This is because changes in the
market wage generate both a substitution and an income effect. The substitution
effect is that of making the resource owner wanting to provide more labor. This
effect can though be counterbalanced by an income effect: when wage rises, the
resource owner now has more income for any level of labor supplied, and is
therefore tempted to forgo some income in order to use the increased income in
order to enjoy more leisure.
The backward bending of the WAP is reflected in the individual labor supply
curve. Unlike most supply curves, the supply curve for labor slopes negatively
beyond some value of W.
This model can be used to predict the effect of the introduction of welfare
guarantees. Welfare guarantees are payments to all those individuals who cannot
reach a certain level of income. The problem with such guarantees is that they
tend to push individuals toward a corner solution in which they supply zero
hours of labor.
12.2. PERSONNEL ECONOMICS: MANAGERIAL APPLICATIONS OF EMPLOYMENT THEORY79
12.2
Personnel Economics: Managerial Applications of Employment Theory
Quantity, expressed in terms of hours of work, is not the only relevant feature of
labor. Effort is equally, if not more, important. The problem, with effort, is that
it is very costly to observe, meaning that employers will find it costly to monitor
their employees and pay them the right wage to incentivize effort. The relative
cost of monitoring effort and the quality of the product are the main causes of
firms choice between two payment methods: i. Payment by the Hour; and ii.
Payment by the Piece. Payment by the hour is the most common method, and
makes no distinction among workers based on effort, with the result that effort
is relatively disincentivised. Payment by the piece is, on the other hand, more
effort sensitive. The least effort averse employees will like to produce more units
of output, thus increasing their hour wages. The problem with piece payments
is that they incentivize workers to produce more but often at the expense of
quality. When quality is easily observed, though, by the piece payment is often
relatively more efficient. Thus, we will observe more by the piece payment when
quality monitoring is cheaper.
A third dimension of labor is quality. Usually, the more human capital an
individual has accumulated, the more productive would one unit of her labor be.
Employers must therefore find a way to pay differential wages to high quality
and low quality workers. When mechanisms of this sort are too costly, the result
is a Pooling Equilibrium, in which high quality and low quality workers are paid
the same wage. If, on the other hand, the firm is able to find a mechanism to sort
the one type from the other, the result is a Sorting or Separating Equilibrium.
A sorting equilibrium can be the result of: i. signaling, when the potential
employees are the ones sorting themselves out (e.g, getting a degree at a good
college); or of ii. screening, when the employer comes up with a way to sort
them out (for example, by requiring candidates to do a test for assessing their
abilities).
The application of the signaling model to biology has produced the theory
of the handicap principle, according to which an animal which is able to survive
notwithstanding an evolutionary handicap (as is the case with a peacocks tail)
indirectly signals that it is stronger or more intelligent than others, thus making
its genes more preferable by its potential partners.
12.3
Factor Market Equilibrium
The factor market equilibrium is determined by the intersection between market

demand and market supply. Unlike the individual supply curve, the market
supply curve (which is the horizontal summation of all individual supply curves)
needs not be backward bending. Since individual preferences vary a lot, and
since some individual will likely supply more resource as the hire-price increase
at any given level in the relevant section of the demand-supply schedule, the
market supply curve will actually have the usual positive slope.

Demand and supply are each influenced by a combination of factors. Concerning demand, these are:
Technology (which determines the marginal product and complementarity
of factors)
Demand for the final product (which influences the equilibrium price in
the product market and therefore the mrp of the resource)
Supply of complementary resources
The factors influencing the supply side are:
Preferences of the resource owners
Initial endowment of the resource owners
Demography quantity of resource owners and concentration of resource
ownership
Social Forces and Legislation
12.3.1
Sources of Growing Wage Inequality
The historical evidence seems to suggest that, since the 1980s, the US population has seen an increase in wage inequality between the top 10 percent and
the bottom 10 percent. Economists have suggested a variety of causes as the
responsible for this process:
1. International competition (competition from low skilled workers has driven
down remuneration for the bottom of the income distribution)
2. Technological change (low skilled workers have been substituted by machinery, while high skill ones have seen their mrp increase)
3. Immigration
4. Weakened unionization
5. Winner-take-all markets
6. Increasing Opportunity Paradox
12.4
The Functional Distribution of Income
Classical economists used to divide resources into Land, Capital, and Labor.
According to them, economics consisted in the study of the forces that determine
the distribution of income toward each of these resources, where their returns
were called respectively Rent, Interest, and Wage. Modern economists refute
the analytical element of this distinction, since the laws for the remuneration
12.5. ECONOMIC RENT
81
of resources is the same regardless of their physical characteristics. Moreover,

modern economics has questioned the very distinction between such resources,
especially when this is based on physical differences. For example, if capital is
indeed defined as the produced factor of production, then much of what makes
ones labor productive (such as education) is itself capital (human capital). At
the same time, land, which included all natural productive powers of the soil,
and is assumed to be inelastic in supply, cannot be used to define actual land,
the supply of which is at least in part a function of its hire-price.
Capital in particular has been the subject of much discussion in modern
economics. Capital is often used to refer to two different notions: Real Capital,
that is the capital goods in their physical features, and Capital value, that is the
market evaluation of capital goods. According to the law of equal returns, all
resources must ultimately receive an equal return, otherwise more firms might
demand more of the more remunerative one, thus rising its relative price until
the rates of returns are equilibrated. The rate of return (ROR) is the ratio
between annual net earnings and capital value:
RORa
Za + oPa
Pa
(12.12)
Where Za is the annual net earnings, to which it must be added the anticipated
change in value of the resource Pa , and Pa is the capital value.
12.5
Economic Rent
Economists define economic rent as the differential between the reservation price
of the resource and the actual market price that emerges in the factor market.
Economic rent thus corresponds to the producers surplus in the product market.
Chapter 13
The Economics of Time

13.1
Present Versus Future
People dont only exchange present goods for other present goods, but often
exchange present goods against future ones. The rate of interest 1 + r is the
premium on the value of current goods relative to future goods. Geometrically,
the rate of interest is the slope of the intertemporal budget line of the consumer
choice, and algebraically its the ratio between the price of present consumption
and that of the future consumption:
P0
1+r
P1
(13.1)
Mathematically, r can be any positive number, but it can also be negative

as long as it is greater than minus one. Indeed, if that was the case, 1 + r would
be negative, meaning that one of the prices of the goods involved must also
be negative, contradicting the assumption that both items are in fact economic
goods.
13.2
Consumption Choices Over Time: Pure Exchange
Time allows the individual to perform three different but interconnected actions:
1. Borrowing
2. Lending
3. Investing
In a pure exchange economy, no net investment can take place, since there is
no production. The consumption choice of the individual is therefore determined in the same way as in the atemporal choice. The optimum combination
83
84
CHAPTER 13. THE ECONOMICS OF TIME
of present and future consumption is found at the tangency point between the
inter temporal budget line and the individuals indifference curve. Lets assume
the individual in question has an initial endowment of q0 in T0 and of q1 in
P0
1
= 1+r
. The budget line
T1 , and that P0 is the numeraire, so that P1 = 1+r
limits the combinations of present and future consumption attainable. At one
extreme, the individual can choose to consume her entire inter temporal budget
in present consumption meaning that she would consume all her endowment of
present goods and will also exchange all her future endowment for some quantity of present goods, the value of which is determined by the rate of interest.
Algebraically, the maximum of present consumption would therefore be equal
q1
. At the other extreme, if the consumer were to consume only future
to q0 + 1+r
goods, the maximum she could achieve would be given by the sum of the future
endowment and the future value of the present endowment: q1 + (1 + r) q0 ,
which means that the intercept between the vertical axis and the budget line is
greater than that between the horizontal axis and the budget line.
When the tangency line between the budget line and the indifference curve
is such that the optimal quantity of future good is larger than the future endowment q1 , and the optimal quantity consumed of present goods is smaller
than the initial endowment q0 , than the individual is choosing to forego present
consumption against future consumption, that is, she is a net lender. In the
opposite case, when consumption of present good is larger than its initial endowment and the consumption of future good is smaller than it, the individual
is scarifying future consumption for present one, meaning that she is a net borrower. When the tangency point exactly coincides with the initial endowment,
the consumer funds herself at Polonius Point (Varian, Ch. 9), the point at
which she is neither a lender nor a borrower.
The optimal choice of the individual is determined by three factors:
1. His Initial Endowment
2. The Markets Rate of Interest
3. Individual Preferences
Changes in the rate of interest affect the individual choice as follows. Keeping
everything else equal, an increase in the rate of interest corresponds to a double
price change, that is, an increase in todays price of consumption and a decrease
in the price of future consumption. Geometrically, as the interest rate increases,
the budget line becomes steeper. similarly, as the rate of interest decreases,
the opportunity cost of present consumption is diminished, which geometrically
means that the budget line becomes flatter.
13.3
Production and Consumption over Time:

Saving and Investment
For simplicity, so far I have assumed that no investment were possible, meaning
that todays foregone consumption could only increase tomorrows consumption
13.4. INVESTMENT DECISIONS AND PROJECT ANALYSIS
85
through appreciation at the markets rate of interest. Production, though, allows

for an even greater increase in future consumption, since present endowment can
be used to increase the future one (although not indefinitely, thanks to the law of
diminishing returns). When production is introduced, the individual will have
a production optimum and a consumption optimum. First, the individual will
choose the production optimum that maximizes her budget given the prevailing
rate of interest. Then, she will find the optimal consumption bundle at the
tangency point between the new budget line and the highest indifference curve.
At equilibrium, the supply of saving equals the demand for investment, and
similarly borrowing equals lending.
13.4
Investment Decisions and Project Analysis
According to the Separation T heorem a persons production optimum position

Q is entirely independent of his or her personal preferences. The separation
theorem tells us that a maximizing individual will produce such that her budget
is maximized, and that the decision of how much to produce will be determined
entirely by external forces (the relative prices of the goods produced) and not
by her preferences about such goods.
The assessment of a project in two periods is based on the present value of
z1
. According
the flows z0 and z1 , which is given by the identity V0 z0 + 1+r
1
to the present value rule, the individual should always choose to pursue projects
with positive present value, and forego projects with negative present values.
This is only true when all projects are independent. When the available projects
are mutually exclusive, the present value rule tells us that we should choose the
project with the greater present value, given that this is positive. More generally,
the individual should choose the combination of projects that maximize present
value.
Algebraically, the present value of a flow zt in time t is given by the following
equation:
V0
zt
(1 + r)t
(13.2)
Where r is the prevailing rate of interest throughout all periods. The present
value of n cashflows zi is given by the following identity:
V0 z0 +
z1
z2
z3
zn
+
+
+ ... +
2
3
1 + r (1 + r)
(1 + r)
(1 + r)n
(13.3)
A particular case is that of the so called Consul, that is, a form of bond that
pays a certain sum of money forever. The present value of a Consul is found as
86
follows:
z
z
z
z
+
+ ... +
+
1 + r (1 + r)2
(1 + r)3
(1 + r)n
z
z
1
z
z
+
+ ... +
)
V0
(z +
+
1+r
1 + r (1 + r)2
(1 + r)3
(1 + r)n
1
V0
(z + V0 )
1+r
V0
z
+
V0
1+r 1+r
(1 + r) V0 z + V0
V0
V0 r z
z
V0
r
(13.4)
(13.5)
(13.6)
(13.7)
(13.8)
(13.9)
(13.10)
An alternative to the present value rule is the Rate or Return (ROR) Rule.
According to this rule, a firm should always adopt a project when the ROR is
positive > 0. The rate of return is the discount rate such that the present
value of any project is equal to zero:
V0 = 0
z1
z2
zn
0 z0 +
+
+ ... +
1 + (1 + )2
(1 + )n
(13.11)
(13.12)
When > r, the project should be adopted. The problem with the ROR rule is
that it is not a reliable guide for investment decisions, especially when multiple,
incompatible alternatives are presented to the firm. It might in fact be the case
that the project with the highest rate of return is not also the one with the larger
present value. When this is the case, the firm should always choose the one with
the largest present value, regardless of the ROR.
13.5
Real Interest Rate and Monetary Interest:

Allowing for Inflation
In real world economies, there is not just one interest rate, but rather a multitude
of them. Distinguishing between them is very important, especially in the case of
real and nominal (or monetary) rates of interest. The monetary rate of interest
0
is the premium on current money over future money, that is, r is the extra
amount of future money that must be offered in exchange for current money:
1 + r0
m1
m0
(13.13)
The nominal and the real rate of interest determine the price level, P . The price
level is equal to the ratio between the quantity of money and the quantity of
13.6. THE MULTIPLICITY OF INTEREST RATES
87
tradable goods and services:

m0
c0
m1
P1 =
c1
P0 =
(13.14)
(13.15)
(13.16)
The monetary or nominal rate of interest is equal to the sum of the real rate of
interest, the rate of inflation a1 , and the cross product of the two:
r10 = r1 + a1 + a1 r1
(13.17)
The effect of an increase in the monetary base is not univocal, but depends
on the expectation of the consumers. If consumers expect the increase in the
monetary base to be only temporary, they would be relatively more willing to
trade present money for future money, thus decreasing the equilibrium rate of
interest. But if they interpret the expansion as a signal of even larger ones in
the future, they might rather exchange future money for present money, thus
increasing the equilibrium rate of interest.
13.6
The Multiplicity of Interest Rates
There are three main causes of the presence of multiple interest rates in the
economy:
1. Risk: Different plans have different levels of risk, which means that the
more risky plans must offer a compensation.
2. Transaction Costs: Transaction Costs also generate higher rates of interest
3. Terms: The longer the term of a plan, the higher the interest rate ceteris
paribus. This is due to two factors: the first is that the future is riskier
than the present, and risk must be compensated for; the second concerns
flexibility. Plans that take longer to produce returns are less flexible, and
people have a positive preference for flexibility. This lack of flexibility is
therefore compensated by higher interest rates.
13.7
The Fundamental of Investment, Saving,

and Interest
The equilibrium interest rat between the supply of saving and the demand for
borrowing is determined by a variety of factors, which accounted for the fact
that, through time and across places, this has varied hugely. Among these
factors, the most important are:
88

1. Time-Preference: Individuals end to prefer todays consumption to tomorrows consumption, ceteris paribus
2. Time-Endowment: The allocation of ones endowment across the different
periods influence her choice between being a net borrower and a net lender
3. Time Productivity: The more time productive a plan, the more investment
we will observe, and the lower present consumption will be.
4. Degree of Isolation: Insulated areas with little access to broad financial
markets have interest rates far from the global average
5. Risk

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Price Theory and Applications

Ennio Emanuele Piano

The Task of Economics

Economics is the study of the allocation of scarce resources among competing

The Scope of Economics

1.3. THE METHODOLOGY OF ECONOMICS

4. Specialization: Specialization occurs whenever some individuals or group

The Methodology of Economics

Economics is a positive science, meaning that it only answers questions about

The Postulates of Consumer Theory

1. Each person desires many goods and has many goals.

Equilibria and Optima

The First Law of Demand

CHAPTER 2. EQUILIBRIA AND OPTIMA

Supply and Demand

2.2. EQUILIBRIUM ANALYSIS

which, once solved, gives the following solutions:

CHAPTER 2. EQUILIBRIA AND OPTIMA

The effect of a proportionate tax is slightly different. Under a proportional

2.3. OPTIMIZATION ANALYSIS

CHAPTER 2. EQUILIBRIA AND OPTIMA

CHAPTER 3. EXCHANGE, TRANSACTION COSTS, AND MONEY

M RSCa = Px /Py = M RSCb

Supply and Demand in Pure Exchange

To better understand the results of the analysis of the previous section, we

3.3. EXCHANGE AND PRODUCTION

Market Full Demand: X

Exchange and Production

An example of P roductionP ossibilityF unction is:

In a Robinson Crusoe economy (that is, an economy in which exchange is ruled

simplicity, we are assuming an economy with only two goods

CHAPTER 3. EXCHANGE, TRANSACTION COSTS, AND MONEY

The Costs of Exchange

3.5. THE TRANSACTION COSTS THEORY OF MONEY

The Transaction Costs Theory of Money

Money is an institutions that reduces the costs of transacting. It does so by

Every market economy is characterized by a variety of exchange mechanisms: i.

CHAPTER 3. EXCHANGE, TRANSACTION COSTS, AND MONEY

the problem of asymmetrical information between buyers and sellers. Unlike in

The Theory of Consumer

The Laws of Preference

The theory of consumer behavior builds on some fundamental axioms:

20CHAPTER 4. THE THEORY OF CONSUMER BEHAVIOR I: UTILITY AND PREFERENCE

Utility and Preference

4.4. CHARACTERISTICS OF INDIFFERENCE CURVE

Characteristics of Indifference Curve

Goods and Bads

Charity as an application of consumer theory

22CHAPTER 4. THE THEORY OF CONSUMER BEHAVIOR I: UTILITY AND PREFERENCE

The Theory of Consumer

The Geometry of Consumer Choice

The geometrical representation of the optimal consumer choice consists of two

24CHAPTER 5. THE THEORY OF CONSUMER BEHAVIOR II: CONSUMPTION AND DEMAND

The slope of the budget is found as follows:

5.2. COMPLEMENTS AND SUBSTITUTES

The algebraic understanding of the optimal choice of the consumer varies

An interior solution must therefore be consistent with the Substitution Balance

Complements and Substitutes

The consumption choice of the individual depends on three factors: i. Her

26CHAPTER 5. THE THEORY OF CONSUMER BEHAVIOR II: CONSUMPTION AND DEMAND

The Consumer Response to Changing Opportunities

If individual preferences were to remain constant, then only external factors,

5.3. THE CONSUMER RESPONSE TO CHANGING OPPORTUNITIES 27

The relationship between income and consumption can also be represented