Comments on

Microeconomic Theory and Applications by Browning and Zupan

as used in Intermediate Microeconomics (Econ 303) at Ohio University. This course is offered also as correspondence course / distance learning / independent study through the Independent and Distance Learning Program at Ohio U.

Dr. Christopher Barrington-Leigh May 2003

If you are using this text in your course, please read my comments below, written for the 5th Edition. Many of them concern the ideological and deceptive nature of the material in this text. Please send comments to me by email (easy to nd on the net). If your course uses this text, I believe your departments role in undergraduate education is to replace common sense with ideological (highly normative; not scientic) and dangerous absurdities. This document is a compilation of my homeworks, so bits of it may not be interesting. See, though, for some of the most blatant dishonesty, instances of outright mathematical deception in aggregating the supply curve (on page 39) and in aggregating the demand curve (on pages 19 and 20).

Contents
1 2 3 4 5 6 7 Assignment 1 / Chapter One Assignment 1 / Chapter Two Assignment 2 / Chapter Three Assignment 3 / Chapter Four Responses to comments Assignment 4 / Chapters Five and Eight Assignment 5 / Chapter Nine 1 2 5 8 14 20 22 31

Assignment 7 / Chapter Ten

36

Assignment 1 / Chapter One

1. Why is microeconomics frequently called price theory? Microeconomics considers proximal causes or effects of price. Adherents consider price to be a central piece of communication in society, and this choice is likely because price is most easily measurable rather than because it is especially important when compared with all the other institutional, social, psychological, and practical cues that help to communicate about what things to produce. 2. How do economists and others develop economic theories or principles? What are the limitations of economic principles? Theories in the sciences generally deal with isolable subsystems, and describe a fairly complete set of relevant causes and effects. In contrast, economics has an insurmountable selection problem: there are no isolable systems; any subsystem chosen is not a subset of the system, but rather a subset of causes and effects. Those causes which an economic theorist wishes to emphasize (ie, offer for policy change) are called causes, and the rest are called preconditions or etc. The choice of which causes are to be open to change and which are xed as preconditions is often a matter of policy and requires cognizance of ones values. Economic principles are limited by two problems that separate economics from basic sciences. First, the relationships involved in deciding what a society chooses to produce are so complex and historical that any economic principle needs much non-quantitative context to determine its applicability or use i.e., any useful (compact) theory must choose a tiny subset of causes and effects to take on, and cannot be expected to be relevant to a majority of well-posed questions. Second, economics is full of reexive ideas and theories: that is, beliefs about economic causes, effects, and predictions can have positive feedback (e.g., ination, recession, etc.) or negative feedback on what actually happens. Therefore, such predictions, though ostensibly falsiable propositions, can be intrinsically neither correct nor incorrect. Clearly, historical analysis and awareness of beliefs and values (thus debate) is crucial for the best available understanding of causality. A related problem is that, unlike lower sciences, and maybe even more so than history, the language of economics is non-neutral. It is full of loaded words such as perfect, efciency, etc; it is hard in such a socially important and contentious discipline to formulate concepts which are objective. As a result, I wonder whether microeconomics, for example, has been generally successful in predicting many real things beyond built-in relationships which were otherwise already known to any entrepreneur who is making choices regarding changing demand. Businesspeople are more likely to think in terms of causal principles of psychology and to focus on the formation of tastes and pref-

erences, rather than to consider price, wealth, and tastes as independent variables (i.e. theres the problem of selection of causes vs conditions). 3. Explain the difference between positive and normative analysis. I dont see any difference, except in rhetoric. Claiming that a question or theory regarding causality is devoid of subjective judgments is to be unaware of ones values which went into choosing the question, or choosing the causes identied as such in a theory. Facts are still facts some supercial things can be observed or measured to exist in a certain state but causality in complex systems (e.g., with feedback) is a matter of choosing which necessary conditions to identify as causes (ie., under consideration for change). Considering the minimum wage example given: if your theory (trains and) allows you to make calculations about aggregate employment numbers (rather than security or quality of jobs, distribution of employment amongst different industries, U.N. HDI, degree of frustrated demand, political participation, or etc.) then those are the kinds of qualitative effects that will be looked for and on which more normative judgments will be made. Since what the text calls expected, objective outcomes (p. 3) must be highly incomplete (system is too complex to offer a complete description), ie selective, they are not objective. This is the case for all history and cause/effect/prediction economics. In non-social sciences, the three-step process described on page 3 doesnt exist. There is no difference between determining whether the magnitude of an effect is considerable and determining whether it qualitatively occurs. The qualitative step described here is a sign of the normative nature of economic analysis. 4. In a conict between positive and normative analysis which should be more important? Explain. I cannot imagine a conict between positive and normative, which seem to exist as a continuum and usually in subtle measure. It is most important to make statements only of truth, even though the analysis is normative, and to understand how ones own and others values affect the form of analysis, i.e. to know what questions one has chosen to answer. Even better is to also be aware of, and to be able to do analysis on behalf of, others sets of questions / values. In science, no quantitative proposition is ever made without a detailed statement/analysis of uncertainty (e.g., in experiment, determining this from all relevant factors is always harder than calculating the value of the measurement itself). This seems also important to emulate in any economic analysis. 5. Analyze the three basic assumptions made by economists about buyers and sellers in markets. The rst assumption is that of self-interested behavior. This is described in the text as being entirely tautologous, since it is not falsiable all behavior is considered by followers of this ideology to be self-interested. Tautologous statements have no prediction or explanation value. This seems especially dangerous 3

since people who are not adherents of the ideology but are exposed to it are not likely to assume a tautologous meaning for self-interested. Indeed, the idea is supercially absurd to mammalian biologists, social psychologists, and most people, especially those from most cultures without a strong social/academic inuence from microeconomists. It appears to describe not a universal trait of behavior, but a rhetorical prescription for a particular hypothetical society. The second and third assumptions are those of rational behavior and limitless wants. These assumptions are things which could be related directly to observations i.e., assessed for legitimacy in the textbook. Are these statements thought to be true by experts who study human behaviour? To assume rational behavior as a fundamental cause and then consider nonrational behavior (I am guessing we must consider this later in microecon?) as a perturbation on the model is an example of normative selection of causes. One could just as well choose psychological, moral-driven behavior fundamental, and then consider other kinds deviations. The limitless desires assumption seems bizarre to me, and ies in the face of many contemporary cultures. Rather than an insight, it seems more to reect a western corporate marketing message, likely in light of massive frustrated demand (ie certain wants not available at any cost). 6. Much of economic analysis or theory is based on opportunity costs. Explain why. I need help here. The examples in the book (pp 5-6) always use future income as the individuals criterion for calculating opportunity cost. How can money be a central/necessary/underlying concept at this early stage? Surely, money is a very articial, non-neutral social tool whose implementation and power structure is of major consequence? If price is the language, how can we hope to evaluate most of the things we choose between (ie value) when they are not part of the market subsystem of society? Surely market decisions usually include non-market alternatives (choices), thus foiling the whole method? Opportunity cost is central because microeconomics assumes all good things are limited and must be earned with pain (undesirable things). 7. Explain why it is important to look at a goods relative price as opposed to its absolute or money cost. Important for what end? this is not clear to me until I see how the notation proves useful in applied cases. Using prices relative to some CPI may suggest that ination is more of an anomaly than, say, changes in distribution of spending power. For instance, scaling all prices by the minimum wage rather than an imposed set of consumer items might be a more useful practice for economists with different ideals. 8. By referring to gure 1.2 (p.11) explain why opportunity costs tend to be concave to the origin.

I am quite bafed by this example. It does not look like the total number of students is conserved. And it seems just as likely that the school will be able to change around the use of its infrastructure faster than it can radically change the professions of its students. Surely any university president will tell you that its very costly to start up a new program or sports team, or to expand it when it is small, but very easy/cheap to expand it when it is already big. From my experience, I (and most business owners considering a change/choice) would likely come up with a PPF convex to the origin most of the time. What does typical mean here? 9. Explain the difference between economic and accounting costs. Accounting costs are those transactions which have already been realised/expressed in terms of someones currency. Economic costs are whatever possibilities an economist can imagine to be expressed in terms of someones currency. Since most human values and transactions require extraordinary imagination to evaluate in terms of someones currency, they are simply excluded from both accounts. 10. Why should sunk costs be ignored when making economic decisions? They should not. Clearly, decisions concerning current and future choices concern only future effects, and therefore sunk costs cannot be in the set of possible future effects to promote or prevent (ie optimise). They therefore do not have an easy numerical role in any optimisation problem. Nevertheless, this does not mean they should be ignored in decision making, since economic decisions are never just about numbers. Rather, if a sunk cost becomes a mistake, a historical analysis should examine what beliefs and values went into it, and whether they could recur during ones current decision.

Assignment 1 / Chapter Two

1. Explain the two reasons why the demand curve is negatively sloped. I only know one. The negative dependence of price on quantity demanded is equivalent to the statement that the lower the price of a good, the larger the quantity consumers wish to purchase if all other relevant factors are held to be constant. The latter is offered a priori in the text. 2. Explain why the supply curve is positively sloped. Actually, I would expect supply curves to usually lie horizontal or slope downward, since in industrial situations, producers always operate at a volume such that they can respond to changes (positive or negative) in demand i.e., not at full capacity. This means that they can typically benet from economy of scale (lower price) if they make more. Certainly it seems absurd to consider a positive slope for low volumes of output. 3. Explain the meaning of an increase in demand and what accounts for increases.

An increase in demand is used to account for the dependence of quantity demanded on any factors other than the nominal price asked, whenever these effects tend to increase the quantity demanded at a given price. These factors include changes in distribution of wealth, changes in advertising, changes in the competition/alternatives, changes in values or education, and so on. 4. Explain the meaning of an increase in supply and what explains such increases. An increase in supply is used to account for the dependence of quantity produced on any factors other than the nominal price offered, whenever these effects tend to increase the quantity produced at a given price. These factors could include reduced prot demands, reduced corporate debt loads, new corporate tax loopholes, benets of publicly funded research spinning off into production, public stimuli in industries producing intermediate goods, new access to human capital whose production costs (education, health, raising, etc) are borne by someone else (e.g. another society), etc. 5. In a perfectly competitive market the market price is constantly changing. Explain why. In the competitive ideal, there is an assumed equilibrium of price, yet the many other determinants of supply and demand are acknowledged not to be in equilibrium; therefore the price varies continuously. Indeed, to say that the price is constantly changing is to contradict the premise that the market is in equilibrium. 6. By referring to gure 2.5, explain equilibrium and disequilibrium of market. Equilibrium of the market is used to mean that changes in adjustments to price occur much faster than ANY other of the factors affecting either the quantity supplied or demanded. Disequilibrium means the opposite. This language also biases analysis to focus on the (short, by construction) hypothetical timescale that is in between variations of price and those of everything else. Since other factors (supplies, preferences, etc) are likely to be varying as fast or faster than price, there is not likely to be an equilibrium in the sense meant here. All the argument in the text says is that for the D and S curves shown, market forces tend to push price towards an intersection point, which is vague but makes sense. I cannot think of many situations in Western market-oriented states where price varies in response to xed consumer demand, except maybe at farmers markets etc. Why are none listed? Disequilibrium is not modeled in science by perturbations on equilibrium, as any chemist or meteorologist or etc knows the dynamics are entirely different. 7. By referring to gure 2.7, explain how market outcomes can be predicted (price and quantity). A new assumption is now invoked: that the non-price factors affecting the supply and demand quantities affect one and not the other (unlike price, which is related to both). With this, and if price remains more uid than the change that is occurring in supply or demand, then if one knows the local dependence of S 6

and D on price, a calculable offset of one of S or D allows one to estimate a new set of values for the market price and quantity of sale. 8. What is point elasticity of demand and how is it measured? Point price elasticity of demand is QpD QD , just one of the many partials in the p total derivative of the demand quantity, QD . I would like help with knowing how it is measured i.e., how these hypothetical curves S and D are measured. Certainly one could never hope to measure more than one at once, since one presumably must watch a non-price-dependent change in one of S or D in order to learn anything about the form of the other. In science, great theoretical advances have come about when thinkers have been more explicit than before about how, operationally, to measure things. Scientism, on the other hand, thrives when there are poorly dened and unmeasurable (ie rhetorical) quantities which nevertheless sound measurable. 9. Explain the arc elasticity formula. Over some chosen range, the arc price elasticity of Q is conceptually similar to = p Q Q p

where denotes an average over price. (In fact, except for the value of Q , this is identical to the textbook denition). So it is a form of average useful for application with nite changes in the quantities involved. 10. Explain income elasticity, cross-price elasticity, and elasticity of supply. Income elasticity of demand is the analogous scaled (dimensionless) local dependence of quantity demanded on some kind of (mean? median? poverty-line? Average income is not a very insightful quantity to watch in the U.S.A.) income measurement: QID QD . I Cross-price elasticity of demand is the analogous dependence on the price p of p a related (competitive or complementary or etc) good, QD QD . p Price elasticity of the supply quantity QS is analogously
p QS QS p .

Questions
Dear Professor, How many goods are what the text calls normal? I would expect the majority of preferences of the majority of people in the world to be highly dependent on their wealth. It just doesnt seem like many people want more when they have more money; they primarily want different. Thank you!!

Assignment 2 / Chapter Three

1. What is the signicance of the height of demand and supply curves? According to the microeconomic premises of individual behaviour, the relationship qD (p) exists for an individual; this represents the quantity effectively demanded at a given price. If this relationship is monotonic (e.g, decreasing), then the inverse function p(qD ) also exists and is the maximum unit price the individual is willing to pay for quantity qD . This meaning for the height of the demand curve cannot be applied to the aggregate demand, since, unlike an individual rational demand, The aggregate demand function will in general possess no interesting properties... The neoclassical theory of the consumer places no restrictions on aggregate behaviour in general.1 Similarly, the relationship qS (p) may exist (i.e., the price could be the main determinant of quantity supplied) for an individual supplier; however, this relationship is less likely to be monotonic, since at low output volumes economy of scale will almost certainly apply, while in some cases on certain timescales, diminishing returns will apply for the very upper end of output volumes (i.e., resulting in a down-sloping/at-bottomed -shaped curve). Nevertheless, while qS (p) would thus not be a true function, its inverse, the height p(qS ) of the supply curve, may, and would correspond to the minimum unit payment p required for the supplier to produce a quantity qS . 2. Explain the concept of marginal benet and discuss its importance. Marginal benet to a consumer is the hypothetical difference between the price she pays and the maximum price she might be willing to pay for the purchase. It does not correspond to any change in price, nor any payment, nor anything tangible. The importance of this idea is not justied in the text. Evaluating the benet to someone in terms of a national currency, regardless of the way the currency is implemented or what its purposes are, is hard to interpret. It is hard to imagine the meaning of adding the marginal benet from one person with that of another; it is a premise of the neoclassical ideology outlined in the next chapter that one cannot compare utility between persons. (Economists with other values might say that you can compare, but not add that 1$ extra to a wealthy person usually offers less utility than does 1$ to a poor person.) Certainly the intended signicance of the aggregated marginal benet is not explained explicitly in the text. 3. If price is lowered, what is the impact on consumer surplus? Explain. Consumer surplus is S = 0QD (p(qD ) p) dqD where p is the market price, QD is the market quantity, and where the maximum price payable p(qD ) is thought (as usual) to be a function of the quantity qD . Thus the change in S due to a
1 Varian,

H., Microeconomic Analysis, Norton, New York, 1984, 1992.

change p in p has two terms, one due to p in the integrand, and one due to the dependence on p of QD in the limits: S =
QD 0

p dq +

QD +Q QD

(p(qD ) (p + p)) dqD

4. Discuss consumer surplus and free T.V. Determination by TV companies that many consumers would be willing to pay for their television reception if they received additional channels meant there was a market for cable television. Assessing by poll how much consumers would pay allowed business plans to weigh the expected income against the anticipated costs of producing, distributing, and marketing the product. 5. By reference to gure 3.5, explain equilibrium price in trade. Consider two sets of demand/supply curves, s1 , d1 , s2 , d2 which all slope monotonically as in the microeconomists hypothetical paradigm. Then when the two markets are brought together, the new intersection point is determined from s1 + s2 = d1 + d2 . In gure 3-5, the curve sT (this is NOT the true total supply s1 + s2 ) is given by sT = s1 + (d2 s2 ), and the intersection sT = d1 is thus equivalent to the form given above. 6. By reference to gure 3.6, explain the net gain from trade by United States and rest of world. This analysis does not offer any quantitative conclusions, since the demand and supply curves presumably cannot be measured in practice (danger of scientism rather than science), and maybe dont exist as such. Instead, the conclusion is the common-sense one that if one joins two markets in such a way that they communicate only in exchange of money and the good of interest, then the price will tend toward an intermediate value, and the country in which the price rises will get less of the resource/product, and vice versa. The rest of the claims are deeply awed as follows: (a) The measure of benet in this example is not money (e.g. GDP), but rather an intangible similar to utility but measured in money. The argument compares the utility when it is given to people of different wealth (or social class?). This is a no-no in neoclassical economics, which claims that individual utilities cannot be compared (nor can the utility of a given amount of currency when offered to different people). Therefore, what is here termed the benet to consumers in the U.S. cannot be compared with, or said to be offset by, the loss to the producers in the U.S. (b) The language surrounding the analysis of freer trade being good mentions multiple times the welfare of each country. This term is not dened, but the insinuation here is that one can measure this quantity in money terms regardless of where the money is (i.e., what it is doing). 9

(c) The argument mentions a net benet to the U.S. because it could in theory redistribute its gains and losses to please everyone. This is unrealistic (unprecedented). As a form of government intervention, it is absurd, given the context of the anti-tariff stance of the text. Unless there is a trade balance in effect and no foreign investment, or a perfect match in wealth between trading partners, this redistribution would not even be a consequence of opening trade in other industries at the same time. (d) This case shows that less sugar goes to the poorer/cheaper country. If sugar is a necessity, more people in the other country may be able to afford none at all, and while starving will get no representation in the market. The death of this human capital is not reversible. This is an example of benets which cannot be measured by the description given, nor in practice by any market mechanism. (e) The analysis makes the mistake of analysing benets only in instantaneous terms. Losing domestic control of certain industries has both strategic and economic effects for stability. The negative effects of susceptibility to shocks due to external control of prices could easily outweigh any benets as described in the time-ignorant model given. Similarly, by intuitive application of ideas concerning systems interaction, or from observation of diversity in nature, one can infer that global economic systems may become less stable, and therefore damaging to everyone, without the buffering afforded by a multiplicity of largely self-reliant interacting economic systems. (f) Maybe worst of all, the analysis neglects the possibility of foreign investment, which negates the argument of benets to both countries. It is possible for the producers in the poorer country, who gain from the trade, to be owned by residents of the rich country, thus concentrating the losses in the poorer country (imperialism). Clearly, there is no positive analysis whatsoever in this section of the text. There is highly selective exposition of causality, rhetorically-loaded language, and manipulation of poorly-founded concepts. 7. Explain the link between exports and imports. If Keynes suggestion for Bretton Woods had been heeded, then there would be incentives for countries to keep balanced trade accounts. Then, in currency terms, one might expect jobs lost overseas to be reliably replaced by jobs serving overseas consumers, though not necessarily by jobs equally good for the health and stability of the economy. As it is, countries are all ostensibly ghting trade wars to attain what are called trade surpluses for reasons to do with the mechanics of monetary systems (internal and external debt). Thus, there is no special relationship between exports and imports in general. Moreover, in modern times, international ows of currency are overwhelmingly to do with investment, not trade, so any claim of an equilibrium in job swapping is misleading. 10

8. Explain why rent control produces a shortage of housing. If there are renters willing to pay more than the price cap, then they will be in the market with the cap in effect and might not have been without it. Therefore there will be more competition than normal for apartments. This does not tell how much longer it will take someone to nd/choose an apartment (this always takes time) just that there will be less choice (it will be harder). Similarly, if there are owners who would rent above the cap, they will not be in the market, but might have been with a higher price. This market seems like it might be relatively well approximated by the (given) independent supply and demand model with an increasing aggregate supply curve. This is because there is not much economy of scale in supply, and the buyers and sellers nd each other without much nancing, marketing, or distribution costs. 9. With rent control, discuss who loses and who gains. The fuzzy idea of net aggregate benet gives no conclusive policy here, so the test resorts to expository consideration of many non-price considerations to argue its point. The situation is complex (otherwise it would not be contentious in policy). If this market was isolated from the economy and subject to rent control, then (1) landlords would get less rental income while they had tenants (but have them more continuously), (2) tenants would probably be better off for some years and (3) tenants would have mixed benets on the longer term as housing quality deteriorated. However, rent control makes a sellers market, and this can result in peace of mind, as well as enjoyable and productive friendships (1st hand experience in Berkeley) since landlords can be very selective about who is living in their property. Rather than having high prices be the primary selection factor as in the less-regulated market, non-market interpersonal criteria become primary and price secondary. Small property owners especially may nd this peace and friendship equally or more valuable. More importantly, if housing were isolated from the rest of the economy, rent control would never have been conceived of in the rst place. Instead, rent control is intended to help businesses stay local by keeping their property and salary costs down, and to help workers by keeping their commute times down. In places where gentrication has evicted working class people, market fundamentalists tend not to evaluate all the suffering and wasted time, cost, and smog that is borne, silently, by the poorer parts of society who commute into town, nor by the (wealthier) residents who have to travel out of their central communities to frequent many of the businesses they need. 10. The greater the price elasticity of supply of rental housing services, the larger are the adverse effects of rent control on tenants. Explain this statement. On the contrary, if rents are pegged at current rates but then the demand goes up (shifts to the right on the canonical curve), then the LESS elastic the supply, the bigger the nancial incentive of a landlord to get rid of (i.e., induce suffering on) her tenant. 11

On the other hand, the MORE elastic the supply, the more landlords will want to stay or get out of the rental market. So variations in elasticity mean some tradeoff between the number of oppressed tenants and the degree of their oppression. 11. Restricting imports will save U.S. jobs. Evaluate this statement. This is a poor simplication whose meaning and validity both depend on the context. For instance: Does the statement refer to imports in the U.S. or in some other country? Will the given import restrictions be accompanied by other rules which cause the loss of other U.S. jobs? If so, which jobs are more desirable for the U.S. to keep control over? Are the industry factors involved exible and mobile so they could put their resources to even better use (and maintain jobs)? Will restricting imports increase the price much, or are the imported products higher quality/price anyway? These questions and more need to be considered to evaluate such a statement, which is premised on quantity of jobs, not (economic) quality, and considers only proximal, not profound or long-term, effects. 12. By reference to gure 3.8, discuss the impact on U.S. and rest of the world of a sugar import quota. Fig 3.8 does not tell us anything specic, since these curves are ctitious (not measurable except for local elasticities). The useful analysis here is primarily the (highly normative) prose. It says (page 59): ... much of the consumer cost simply covers the higher production cost of sugar in this country. In sum, contrary to the statements made by many political advocates of the quota, the U.S. is worse off on net because of the quota: domestic consumers are harmed more than domestic producers are helped. The higher production cost of sugar in this country is not measured in physical terms, but by money. This money cycles in the economy, i.e. is paid to workers in the economy it does not disappear into the soil somehow. Adding the consumer surplus to that of the producers does not tell us anything about the welfare of the country. It is not ironic that many of the countries that produce sugar are less-developed countries (p. 60), but rather not surprising if imperialist external powers wish to see the less-developed countries produce cheap sugar as a service to wealthy ones, rather than encouraging the less-developed countries to make economic decisions and resource allocations that encourage food security and thus development, coherent economic self-determination, and democracy. 13. Discuss demand elasticity and cable television pricing. Though they are not shown, this would be a poor example for upward-sloping supply curves, since the price elasticity of supply for a cable television company is surely negative (i.e., down-sloping supply curve). Nevertheless, local elasticities, though they may not be the sign selected by neoclassical economists, are conceptually sound since they can likely be assessed 12

through interviews with buyers and sellers and they do not rest on claims of the existence of a demand or supply curve, nor on the exclusion of other independent variables more important than price. Because elasticities are scaled partial derivatives, it works out that the net revenue goes up with price when the price elasticity of down-sloping demand is >-1 (inelastic) and vice versa. Statements concerning protability, however, depend on knowledge of marginal costs whenever the elasticity is <-1. This can be seen nicely from the fact that the change in revenue pq is d(pq) = p dq + q d p q dp +q dp = p p = q(1 + ) d p

where =

p dqD q dp .

14. Explain the split-basic-tier system for television. What were the results? When the U.S. reimposed rate regulation, the industry outsmarted the new law by shifting most consumers into a tier not subject to the law. Maybe the law, to have had its intended effect, needed to be stronger. Nevertheless, the regulation did have the effect of controlling prices on a medium which the government considered to have some non-market value as a public good namely, media in free democracies carry the crucial rles of disseminating information and of providing discussion of issues and critiques of the government. 15. The incidence of a tax depends on the relative elasticity of demand and supply. Explain. I am not sure what incidence means here. However, I have investigated how the revenue of a tax depends on the elasticities. I did this in two ways. One is to consider that the supply curve shifts up in price by amount t (tax included in price), as in the text, and the other is to consider that the demand curve shifts down by amount t (tax paid when purchasing) but that this amount is then added back on to the equilibrium price to reect the total price to a consumer. Both cases lead to the result that the change q in quantity sold q is q = qt S D , p S + D

where the S and D are the price elasticities of supply and demand. Thus the net tax revenue r = t(q + q) can be calculated and maximised. Taking dr/dt = 0, I nd that tax revenue is maximum for tax rate t S + D = p S D Of course, this expression is only appropriate when the maximum revenue happens to occur at a small tax rate, since local elasticities are used. 13

16. A price oor applied to a previously competitive agricultural market will increase the output of the good. Explain why. On the contrary, there is not demand for more product at the higher price, so the producers will not produce more. If the price oor is below the previous price, only subtle changes will occur. If the price oor is above the previous price, the producers may produce less, and certainly will do so if they are subject to economy of scale at current output levels. How much less will be determined by demand i.e., by the size of stockpiles / rate of sales, etc. This shows how supply is not a function of price, but is limited by the marketing and distribution used to affect demand quantity. Dear Professor, I have one (more) question. If price of something is pegged by the government below the market value, how much will be sold? The text assumes the answer to be the intersection of p and qS for housing, but the intersection of p and qD for T.V. How can one tell, if these quantities are each independently determined by price? Thank you very much for your comments and help. Chris

Assignment 3 / Chapter Four

1. Explain how the budget line is constructed. The budget line is, for a given total expenditure b, a surface satisfying

pi ni = b
i

where the sum is over each type of option i, and where p and n are the price and quantity of an option. This surface connects each pair of axes by a straight line b and has intercepts pi for axis i. 2. What is the importance of the slope of the budget line? With only two choices (i = 1 . . . 2), the slope is the ratio of their prices; this follows from the two properties mentioned above. 3. Explain what happens to the budget line when income changes. If income changes as a result of a consumers changing preferences (e.g. earning/working more to fund certain purchases, or working less because she has enough of everything) the budget line will move out or in. Any changes in slope will be due only to independent relative price changes. However, the changing preferences will be reected in a simultaneous change of indifference surfaces. If income changes as a result of economic shifts, the relative prices are also likely to change, and thus the budget curve will change unpredictably.

14

4. Explain what happens to the budget line when price changes. In contrast to the claims of the text, signicant changes in relative price typically reect some change in the supply, and therefore in economic measures such as distribution of wealth. As a result, the slope of the budget line will change, and the total b will increase for some consumers and decrease for others. In a market in which the price changes due to a change in demand, the change in demand is typically due to a change in preferences (e.g. as a result of more or less advertising, or due to a location being increasingly desirable, etc); thus, not only may the distribution of wealth change, and hence the distribution of b values, but the relevant indifference maps will also change simultaneously. 5. Explain the three assumptions that economists assume [sic] about preferences of typical consumers. Completeness: This assumption rests on the assertions that choice-makers have (1) innite knowledge not just about the details of any apparent options, but about all (other) existing possibilities, and how much they would cost (including all implicit costs not reected in the price), and (2) innite knowledge about the set of factors which affect the personal satisfaction inherent in the option. This is thus subject to another selection problem: the total utility of a given choice depends on how many tangible and intangible factors one takes into account. Does one want to know how a commodity was made, who or what was destroyed by its production, or what the alternatives might have been, given that such knowledge will likely affect the objects desirability (utility)? Since not buying something but rather waiting for a future alternative (which might radically change the attractiveness of existing options) is always one option, the current utility is not even theoretically assessable. All these (thoroughly impossible) conditions would together mean that every pair of options has a unique ordering of utility. Transitivity: Essentially, this says the pair ordering above extends to more than two options and is unique. Non-satiation: This is the idea, expressed earlier in the course, that people always want more not of something, but of everything and anything! This has elsewhere been called the philosophy of the cancer cell. Despite the drumbeat message from corporate advertising, it is false, even within the specic American cultural context of the course material. Convexity: The marginal value a person gets from each commodity falls with the number of units. Non-mammalian behaviour: This seems separate from the other rationality criteria above. This is the assumption that a consumer not only can order preferences between options, but acts on such a utility-based rationale rather than, say, primarily out of habit or subject to an inuence like training (e.g. due to marketing). In other words, the relationship between utility and effective preference is quietly assumed, in contradiction to 15

what any psychologist or advertising agent knows. In reality, people making choices are well aware that they are not acting on the sum of their knowledge, but rather on habit, bias, and impulse as well. Consumers do not make their purchase decisions all at once, and thus do not have a budget line for most decisions. This irrationality applies to mass behaviour (subject to fashion) even more than it does to individuals. In addition, many choices and purchases are made by someone other than the person they are intended for, further diluting the inuence of assessing utility. Independence of budget and desires: It is assumed that consumers do not have control over the amount of their income. In reality, many people are in a position to earn extra income when they need to purchase something big, and to emphasize work which does not earn monetary compensation when they have enough. Independence of purchase choices from non-monetary choices: More generally, since the given formalism is used to represent money-transactions only i.e. in the context of a market there is an assumption that a consumers set of choices which concern monetary costs is entirely independent from the set of choices which do not have any cost involved. For instance, consider the indifference curve between units of oil bought and used vs. units of peace. The cost of this peace is zero (e.g., maybe a consumer could choose maximum peace of mind about not fueling oil-fed wars if she chose to buy no oil, but equivalent utility would result from a bit of oil and a bit less peace, or from lots of oil and no peace, and so on), so trying to optimise the choice with a budget line is impossible. Instead, humans are social beings and thus use heuristics such as morality and social inuence to make these decisions. If this is true, the rational choice theory cannot be repaired with any perturbation; it is simply inapplicable. Independence of purchase choices from budget: Coming in the next chapter where the individual demand curve is aggregated to the groups is the major assumption, in effect, that consumers all spend the same fraction of their wealth on each commodity, no matter whether they are a pauper or a billionaire. This underlies the microeconomists major ignorance of the distribution of wealth in society. 6. By reference to gure 4.5, explain an indifference map. An indifference map is a set of surfaces in option space, each of which represents a uniform total utility. Given the rst three of the set of assumptions above, the surfaces are non-intersecting, as shown in 2-space in the gure. 7. Explain the difference between ordinal and cardinal utility. The concept of utility corresponds to measuring the cardinal value of a choice. By abstracting to the constant-utility contours of a utility function and dropping

16

the height but keeping the ordering of the contours, an ostensibly more general, ordinal veneer is given to the theory. In fact, the theory may measure utility in units of any other good, since the requirements for each measure are simply ordinal i.e., utility increases (but with unknown amount) with higher measure both for utils and for quantity of any other good. Thus, measuring the absolute marginal utility in utils of good A is fully equivalent to measuring the marginal utility of good A in terms of good B. 8. Why are indifference curves convex to the origin? Explain. This is simply an assumption (called satiation), nearly as a priori as the assumption that everyone wants more (called, paradoxically, non-satiation!). It is claimed that marginal utilities go down but stay positive for goods. 9. Explain the relationship between the marginal rate of substitution and the slope of the consumers indifference curve. See question 7 on the preceding page. As explained above, the idea of marginal rate of substitution is just more language for that of marginal utility, given the array of assumptions made. The slope of a curve of q(A) vs. utility in utils has slope of marginal utility; if we measure the utility in terms of q(B) instead, the curve still has slope of marginal utility but now in terms of B that is, the slope is the marginal rate of substitution of B for A. To relate this marginal utility (MRS) to the indifference surface in a more general way, consider the utility U(q1 ,q2 ,q3 ,...) obtained from several kinds of goods. In vector notation, the gradient of this utility function in option space is U(q1 ,q2 ,q3 ,...) = U U U q1 + q2 + q3 + ... q1 q2 q3

Contours of constant value U will locally look like vectors c perpendicular to this gradient; i.e., the dot product between the two will be zero: 0 = c U U U U + c2 + c3 + ... = c1 q1 q2 q3 This is the relationship between the two surfaces in general. In the simple twodimensional case treated in the text, this reduces to: c2 U = c1 q1 / U q2 = q2 q1

where c2 is the slope of the indifference curve. Thus, with only two commodities, c1 the slope of the indifference curve is the negative ratio of the marginal utilities; this is precisely the marginal rate of substitution.

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10. Explain the reason for the diminishing marginal rate of substitution. This assumption recognizes that people are satiable. The claim of diminishing marginal rate of substitution (MRS) has no more content than the statement that marginal utility (MU) decreases with quantity q. In fact, it is a weaker statement, since even if good A has constant MU, but its value is plotted against good B, which has decreasing MU, then A would be said to have diminishing MRS. This is because, at smaller quantities of B, a given change in q(B) represents a larger values in utils. 11. By referring to gure 4.9, explain bad and neuter goods. Figure 9 now measures value in $ (rather than utils, good B, or all other goods). Bad and neuter things are things with 0 or negative marginal utilities. It is implied that things always have absolutely-negative or absolutely-positive or constantzero marginal utilities. These ideas are peculiar to microeconomists ideology. For instance, to life/biological systems, most things terrestrial are goods in low quantities and bads at high quantities (for some glaring examples: CO2 or O2 while breathing, sun light, water, vitamins, etc.). 12. By referring to gure 4.10, explain perfect substitutes and perfect complements. If the utility of A is measured in terms of a good B whose own absolute utility scales in direct proportion to As, then the curve will appear as a straight line, and the goods are substitutes. Goods which have zero utility by themselves but nite utility in groupings form complements. The utility of a set of them is completely determined by the quantity of the limiting reagent, as shown in gure 4.10. 13. By referring to gure 4.11, explain why point W is the consumers optimum consumption choice. This corresponds to a maximisation with a constraint. Based on all the assumptions, there is only one solution (intersection), and both curves have positive slope. This can only be if the curves are tangent, and that only happens at point W in gure 4.11. 14. By referring to gure 4.11, explain why basket R is inferior to basket W. Point R is allowed by the constraint, but is on a lower equi-utility curve than W. This can be ascertained by increasing one of the two quantities while holding the other constant, until the W curve is reached. More is always better... 15. By referring to gure 4.14, explain how changes in income alters [sic] the optimal consumption choice. As discussed in question 3 on page 14, budget changes can be expected to accompany price or preference changes, so the effect on the point of maximum available utility is not predictable.

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However, even if one could hold the preferences and prices constant, not much could be said from the theory. One could be sure that the utility-maximising choice would change, since the new budget curve must be tangent to a different utility curve. Nevertheless, one can say nothing about the market baskets local dependence (partial derivative) on the budget since, even with all the assumptions, the theory places almost no constraints on the shape of the incomeconsumption (Engels) curve. For example, even if the budget rises, any subset (except for all) of the chosen quantities could go down. 16. Discuss the utility approach to consumers choice. See questions 7 on page 16 and 9 on page 17. This is essentially an equivalent formulation, since utility as constructed in the theory is not really cardinal: it is explicitly not measurable or comparable in a cardinal sense between people or even between choices made by an individual. Thus the utility approach transforms to the utility-free approach through the trivial change in units from utils to some other (composite) good. Dear Professor Adie, I have one large question. It seems we are nished constructing the demand curve in this course, and the next chapter fuzzes the concept between individual and aggregate demand curves. What does the aggregated demand curve mean? For the individual, this curve represented solutions optimising individual utility. Does the aggregated demand curve show how to optimise the total utility of society? Or does it show how to optimise something else? It cannot optimise total utility of society, since: 1. Each persons individual total utility gleaned from purchases depends on the size of her budget, but the distribution of wealth (and thus her budget) is a separate (free) variable in the aggregation. In other words, changing the distribution of wealth (such as giving needy people more resources) will produce a different total for societys utility. 2. Each persons demand curve is a function of her budget, so that if the distribution of wealth changes (by changing the distribution of prices and thus salaries, and so on), all of the individual demand curves change. The aggregate effect of such a change is not simple unless all the consumers have wealth-independent consumption patterns that is, unless the pauper and the billionaire spend the same fraction of their budgets on each item. It has been known since at least 19532 and 19823 that no reasonable assumptions can circumvent these problems. The method of this aggregation is not discussed in the text, but its impossibility entirely invalidates the rest of the book and all of microeconomic
W.M., Community Preference Fields, Econometrica, 21: 63-80 W. and Sonnenschein, H., Market demand and excess demand functions, in K. J. Arrow and M. D. Intriligator (eds), Handbook of Mathematical Economics (Vol. II), North-Holland, Amsterdam.
3 Shafer, 2 Gorman,

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market theory. It tells us that a separate means must be used to choose policy for the distribution of wealth; the market equilibrium does not optimise anything if the distribution of wealth is allowed to vary. How do microeconomists like the authors of this book deal with this problem, and go about their business pretending that the distribution of wealth either does not matter within and between economies, or that it is somehow optimised by the market system? The book does not say what the authors wish to optimise with the market policy. I am also interested why, after going into some detail through the esoterica of indifference theory to justify individual demand curves, the massive leap to the aggregated curve is hidden from the student. Thank you very much for your help and comments! Chris

Responses to comments

Dear Professor, Thank you for all your comments. I have the following questions to follow up: Please do not begrudge my not including gures so far. It was not obvious that refer to a gure in the book should mean copy the gure from the book. I have not been ignoring your advice; rather, I had nished my third assignment by the time I received your response to my rst. It is taking three weeks to get the work back by mail! Also, there may be some gures that I cannot honestly copy from the book. I believe in the existence of elasticities, but sometimes I nd the claim of the existence of demand curves to be used not as a theoretical aid but rather as a platform for supplanting common sense with highly normative political ideology. Such stuff should not be prominent in this course, so please forgive me if I occasionally nd other, easier ways to explain whats asked. I prefer entia non sunt multiplicanda praeter necessitatem to endless ceteris paribus. As Newton put it in Principia, Rule 1. We are to admit no more causes of natural things than such as are both true and sufcient to explain their appearances. I will still learn the methods of the text for possible application in more advanced material to come (the ubiquitous claim), but I will not recite arguments which I consider dishonest until I learn enough to consider them honest. I believe this will not be a frequent issue. Aggregation of demand curves. As I understand it, you agree that there is no social/aggregate utility curve (thus the Benthamite aim to show logically that social good is maximised through selsh action has been proved a failure). I am asking whether there is even such a thing as an aggregate demand curve/relationship. I had heard that this was a well-known fallacy, and so have been stuck on the missing discussion in the text. The fallacy is similar to divide X by a large number 20

N, approximate the small value X/N as zero, multiply X/N 0 back by N, and conclude that X is zero. It goes like this: 1. We wish to describe the demand in society for a given commodity. We know that in a market economy the distribution of wealth is determined by the distribution of prices (and thus income). To determine the aggregate demand, we look at each individual. 2. Assume that an individuals budget is independent of prices (this will be a good approximation for most people and commodities, but very wrong for some, whose income disappears when a price goes down and they are laid off, etc). Derive an individual demand vs price curve for each commodity, based on the individuals choices between all commodities, with the caveat that the effect of prices on wealth must be negligible. 3. Forgetting the caveat, add all those individual demand curves back up, and all those negligible effects back up. Consider the summed demand to be the aggregate demand curve, but consider the summed small effects to be zero, thus concluding that incomes are NOT determined by distribution of prices in a market economy (contradiction). This is no small blunder. If there is a disparity in the distribution of wealth, an increase in the price of a commodity can have a positive or negative effect on the aggregate demand, even if individual demand curves (because they neglect price effect on budgets) are downward sloping! Since on average poor and rich may have (predictably) different budget-demand (Engels) curves for the given commodity, one needs to know about correlations between wealth and the dependence of budget on price in order to say how the aggregate demand responds to price change. One way to get around this problem would be to split society up into different groups based on wealth and preference patterns (call them social classes) and approximate different aggregate demand curves for each group. But this approach would recognize that there is no true price equilibrium, since changes in price and wealth can have positive feedback on the social class distinctions. (For instance, if the commodity is produced by a poor people who can hardly buy it, then the aggregate demand curve for the rich consumers might exist independent of price, but that of the poor producers would be entirely nonsensical; i.e., budgets highly dependent on price.) The point is that the real dependence of demand on price does not look like an individuals (down-sloping, monotonic, convex to origin, etc.). According to the (?) authoritative text on the subject, The aggregate demand function will in general possess no interesting properties... The neoclassical theory of the consumer places no restrictions on aggregate behaviour in general.4 The interest in hiding this dependence at an early stage of microeconomics by harping on the properties of individual demand curves and then fuzzing the concepts between individual and aggregate in order to make believe that aggregate
4 Varian,

H., Microeconomic Analysis, Norton, New York, 1984, 1992.

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demand curves should follow the premises of rational behaviour could be motivated by the (obviously normative) value of wanting to be able to increase the disparity of wealth in society, and thus to ignore the distribution of wealth. Have I made a mistake? Methodology: Regarding your comment that assumptions of a model DO NOT NEED to mimic reality, I am confused. As Newtons claims in his quote above, causes in science should be true and sufcient. Making a model with blatantly false assumptions is not progress unless you are willing to accept the assumptions should your model prove successful. Is not the way science works that if such a model were to be successful, its component assumptions would start to be considered as truth? I agree with you that models should focus on a small set of causes/details, ignoring others, but only when the models are self-cognizant of their applicable context (i.e. what those ignorances are). The methodology of constructing a model which has strong limits on its applicability, or has no direct verication at all, and then claiming that extra adjustments to it can be used to describe everything (or anything), is one that is doomed to be used as a vehicle for ideology, not science, since it has given up its responsibility to verication early on. That is, if the perturbations are going to outweigh the approximation (underlying theory), then the approximation should suffer Occams razor. More specically, the study of Perturbation Theory (e.g. in physics) is the study of how approximate solutions can be used to model small variations from a given solution, and how models which are NOT a realistic APPROXIMATE solution cannot be used to model anything, regardless of the number of perturbations. As a result, I am trying to keep myself honest in my understanding of the applicability of the ideas the book is putting forward, especially since they are anything but an objective choice of causes. On the topic of predictive value, a theory must, as part of its self-cognizance, provide criteria of falsiability which are specic to it, as compared with other (e.g., simpler) explanations, and then nd many examples when the falsiability test fails. I am still trying to follow the text, the homework, and the directions you provide, and I am fully committed to this course.

Assignment 4 / Chapters Five and Eight

1. Explain the derivation of the consumers price consumption curve (gure 5.1).

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The dots in my drawing show an individuals optimum choice (basket of goods) on each of two budget lines, which reect a change in the price of commodity x. Connecting such dots forms the price-consumption curve between commodity x and the other commodities (plotted on ordinate). 2. What is the signicance of the marginal benet to the consumer? In the text the marginal benet, measured in $, sounds now to be a measure of the personal utility of an item. This is a sleight of hand, since all the measures of utility so far do not have cardinal properties. That is, one can claim from the assumptions given that 6$ of benet is more than 3$, but by an unknown factor. Also, the text now confuses the price a consumer pays (p. 105) with the relative importance of it to them. The price is set by the seller or market, whereas it is the (hypothetical) maximum willing price of the buyer, not the price paid, that has the relation claimed. This again confounds an abstract (max willing price) with a measurable (price paid). The rhetorical end appears to be a tautological association between whatever happens in a free market and the best interest of everyone. Again, this is not a theory, but an ideology. 3. Explain why raising the price of alcohol is more effective in reducing teenage drinking than imposing age restrictions. This is very biased and deceptive language for describing the observation. The claim in the article is sensible only if alcohol prices were raised by a whopping 67% (beer) to 330% (liqueur), and if the drinking age were 21 years in all states. From this weak statement, it does NOT follow that price measures are more effective. In addition, the analysis and the question both leave out the obvious issue of the effect on non-teen consumers, which law but not market can mitigate. This highly normative (value-loaded) analysis presents, like many of the 23

applications in this text, a thinly-veiled rhetorical attack on the value of democratic law. The motivation may be a wish to indoctrinate with an ideology rather than to teach general skills of analysis. The consistent values behind this antigovernment ideology may be the wish to increase disparities in the distribution of wealth. 4. How does the producer determine what price to charge? This depends a lot on the strength of the many factors involved, but typically the producer looks at costs of production, debt repayment schedules and dividends and prot expectations, and then considers different levels of advertising and range of shipping and the anticipated sales resulting from each. These xed costs, plus the variable cost of different amounts of advertising and distribution, are added to determine the nal cost possibilities, and thus the level of advertising which will maximise prots. This business common sense ies in the face of micreconomic theory. As any mathematician or physicist knows, corrections (perturbations) to a model cannot be made if they are large as compared with the approximations / assumptions made when developing the model; the case where demand is highly producer-driven cannot be described by adding on caveats and adjustments to a model that has made conclusions assuming complete independence of demand and supply. 5. Explain the income effect of a price change. The income effect refers to the change in individual demand for a commodity as a result of a change in overall budget, when preferences and the relative prices of different commodities are constant. This term neglects what one might well also call the income effect of a price change. The demand curves for individuals which are shown in texts always correspond to those of individuals whose livelihood is not affected directly or indirectly by the price of the commodity of interest. In reality, incomes are determined by prices in the market, and so for people involved in the production (through rent, prot, or wage) there will be a large effect on their income when the price of something changes. For aggregate curves, the concept of income effect, in the texts sense, is even more fallacious because changes in income will not have any predictable effect on the aggregate demand unless every consumer has the same Engels curve, i.e., the pauper and the billionnaire spend the same fraction of their income on each kind of commodity, a preposterous claim. Implicit use of the income effect concept in the aggregate case could be motivated by the wish to ignore distribution of wealth in economic theory. 6. Explain the substitution effect of a price change. The substitution effect refers to the change in the ratio of different commodities demanded by an individual as a result of a change in the ratio of the commodities prices, and assuming that the preferences of the individual are constant. This effect is usually measured in terms of the quantity of a single commodity (the 24

one whose price is changed) with the additional restriction that the utility to the individual is constant. The calculation of this rather abstract quantity relies on knowledge of the indifference curve. Indeed, so does the calculation of the income effect, which is simply the actual change in quantity demanded minus the quantity of the substitution effect. In the case of aggregate demand, there is certainly no quantity of the substitution effect of a price change, since there is no such thing as a social (aggregate) indifference curve. 7. Explain income and substitution effects of inferior goods with a price change. (gure 5.4)

price p(x) decrease

price p(x) increase

The substitution effect is always negative (q goes up when p goes down) if the indifference curve is convex to the origin. By denition, the income effect is negative (more income, less good) for inferior goods and positive for superior goods. A change in demand resulting from a change in price can be considered a sum of the two effects. Because for inferior goods they have opposite sign, the overal sign of the change in demand depends on the relative size of the two effects. My drawing points out that there is no simple relation between the sizes of substitution or income effects during an increase in price vs. a decrease in price of the same amount (though their sum is of course equal and opposite). 8. When will people buy more if price rises? Explain. Whenever the price rise and the increase in demand have the common cause

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of increased expenditure on advertising and distribution (producer controlling demand). This is extremely common. When there is snob appeal. This is portrayed as exotic in the text, but the snob effect is typically due to brand name recognition which is developed through producer control of demand, as above. This is very common in clothing and other commodities. Whenever someone is poor and dependent on something as a necessity. The text here goes out of its way to portray the Giffen good as a bizarre idea. This is ironic, since the ideology which the text advances has helped to push much of the worlds population into dependence on Giffen goods. The motivation behind ignoring theoretically the existence of upward-sloping individual demand curves, or of likening to rats those people who suffer acutely from unmet necessities, might be the wish to train-out of budding economists the common sense knowledge that one can indeed compare utility between people, and that some goods are not just demanded but required for life. The text describes the conditions for a Giffen good to exist as a strongly inferior good, with most of the budget devoted to purchases of that good. This is precisely the situation, not just of a family vacationing in exotic Hawaii (p. 111), but of any poor person dependent on inadequate health care, food, water, or education. The condition for a Giffen good is better described as the case when a class of goods is a necessity and is a signicant part of ones budget. Consider a poor African family with three children, able to afford to send only two of them to a very poor school (no desks, no paper, no chalk). If the school fees which were imposed by the IMF are decreased, the bad school becomes cheaper, and the family may be able to send one child to a better (more expensive) school, and subject only one child to the very poor school. 9. By referring to gure 5.8, explain price consumption curves and elasticity of demand.

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amount to be spent on q(x), in terms of price of q(y) amount to be spent on q(y), in terms of price of q(y) (i.e., the quantity of q(y))

If prices are expressed in terms of the commodity on the ordinate, then the regions shown in the sketch correspond to measures of the expenditure demanded on each commodity. Since a demand is elastic (inelastic) if price multiplied by quantity increases (decreases) when price decreases, the price-consumption relationship shown provides an easy way to see the sign of the price elasticity of demand. For example, if the price-consumption curve slopes downward, an increase in expenditure demanded is associated with a decrease of the price (as shown), and thus the demand is called elastic. 10. Explain one of the three methods used to estimate demand. Elasticity of demand can be estimated by asking consumers how their buying habits might change if a small change was made in a commoditys price. 11. Explain total product, average product, and marginal product when only one input is variable. For total product P( f ), when the amounts of all factors are xed except for one, f , the average product is P( f )/ f and the marginal product is dP(ff ) . The followd ing is an example:

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12. By referring to gure 8.1, explain total, average, and marginal product curves with one xed and one variable input. The number of xed inputs is irrelevant. The total P peaks where adding more of factor f is literally counterproductive. The peaks of the average and marginal products are not especially intersting by themselves. 13. Explain the relationship between average and marginal product curves. The average product curve is the average height of the marginal product curve between 0 and f , as shown in my sketch. 14. If marginal product is rising, what happens to total product? Why? It is increasing at an increasing rate (e.g., the rst two segments of my drawing, above), or is decreasing at a decreasing rate. i.e. if M = dP is the marginal df product, then if dM 2 P( f ) > 0, then > 0, i.e., P concave upwards. df f

15. Explain diminishing marginal returns. The text has confused the meaning of this term, which was originally coined to refer to the truly xed resource of land in the context of biological production. Agriculture occurs rst on the most productive land; with time, that which remains unclaimed is likely to be less and less productive for a farmer (poorer soil, etc). The application of this term in the context of general production is not reasonable. The text is setting me up to believe that producers work at a technologically efcient rate, or the equivalent once costs are included. This is a profound mistake. Producers never aim to produce at their maximum capacity against xed inputs. If they did, they could not adjust to demand, and would 28

inevitably not be able to sell all their product (at times, and not provide enough at others). Where are the axioms of the rational producer? Microeconomics seems to have the producer optimise instantaneous rate of prot making d p . But dt people dont optimise something for immediate rate of gain; one optimises for net gain over the long run, or whatever timescale one cares about (nancing, etc). That is, people are interested in the future as well, and optimise something more like d p dt over some time period total prot, not rate of prot. As soon as dt future rate of prot is included in an optimisation, the idea of producers all pushing up against diminishing returns becomes clearly contrived. Businesspeople actually typically produce where the returns are fairly at or increasing and they can remain agile (in other words, they plan ahead). The volume they produce is more likely determined by diminishing returns in controlling demand through (a) advertisement and (b) distribution. Piero Sraffa outlined this major aw with microeconomics static analysis in the 1960s. 16. Isoquants are used to explain production when all inputs are variable. Explain isoquants by referring to gure 5.3. [see below] 17. Explain the four characteristics of isoquants.

region where there are negative marginal productivies

normal view

Isoquants are the solution to P( f1 , f2 ,...) = constant. The four characteristics of isoquants in the text are: downward-sloping: According to the total product curves discussion, the isoquants are NOT downsloping everwhere, since adding too much of one 29

factor results in a decrease of output. If the balance of production factors becomes highly skewed, as in the xed proportions production function, extra unneeded inputs are also likely to get in the way of production, so the isoquants, rather than than being square as in the text, will become rounded and up-sloping, as in the drawing above. Thus the down-sloping characteristic is a choice of which part of the isoquant curves do draw. Increasing outputs with scale: This also is NOT true, according to the text. If there can be altogether too much input for the technology or enterprise to deal with, total production will go down with the addition of any of the factors, and the contours (isoquants) will be closed, as in the drawing. In general, though, there will usually be a limiting factor, so that adding some more of it will increase production. Non-intersecting: If any function P( fi ) exists, non-intersection is a mathematical property of its contours.
dy Convexity to origin: This means that the MRTSxy = dx decreases as factor y is decreased. This is also clearly not true in general for isoquants, but is a choice of which region to show in a plot.

18. The marginal rate of technical substitution is dened as the amount by which capital can be reduced without changing output when there is a small (unit) increase in the amount of labour. Explain. When only two factors are considered and they are K and L, then L is plotted on the abscissa by convention. Then a small movement along an isoquant consists of a change L in labour and a change of K = L dK isoquant = (MRTS)L dL in capital. 19. Explain increasing, constant, and decreasing returns to scale. If all factors are increased, the production amount will lie on a new isoquant. Typically (outside the shaded region in my drawing) the output will increase. The terms increasing, constant, and decreasing returns to scale refer to the ratio of increase of output and the ratio of increase of factors. If the former is larger than the latter, there is an increasing return to scale, and so on. 20. What is a Cobb-Douglas production function? A Cobb-Douglas production function is of the form P( f1 , f2 ,...) = fibi
i

where the production P is dependent on variable inputs (factors of production) f , and the exponents bi are typically determined empirically. Economists like to model production using such a function. One reason is that we can impose constant returns to scale (for all ratios of factor inputs at once) by enforcing i bi = 1. Because a given set of t constants bi has a constant sum, a CobbDouglas function cannot represent the onset of diminishing returns at high values of fi . 30

Thank you! Chris

Assignment 5 / Chapter Nine

1. Explain the concept of cost. Production cost is the rent and wages of physical and human capital used for production, plus interest (or dividends) on any money capital borrowed for production, plus the cost of materials bought and used for production. Rents may be replaced by capital depreciation/maintenance costs if the producer owns the capital (private property, slave labour, etc). The rhetoric of hiding prot as a cost in the description of businesses, and then speaking of zero-sum prots in markets, rather than speaking of a normal/expected/optimum rate of prot on nancial capital, is problematic. It puts the microeconomic market analysis at the mercy of a macroeconomic equilibrium to explain the appropriate rate of prot (10% per year is proposed several times in the text!). It also helps to promote the false assertion that the money system (nancial capital) has as natural / neutral a rle as physical and human capital, when in fact the chosen implementation of debt and money has a huge effect on the issues at hand (e.g., growth and expected rate of prot). It also discriminates against the farmer and small family-owned business (i.e., the ones which come closest to the perfect market), for which the ideas of easy reinvestment and a xed rate of prot are most absurd (for example, owners live on the business property). 2. Explain the difference between long run and short run. In reality, any given factor of production can be varied a little on a short time scale or more on a longer time scale. These time scale distributions are different for each factor. In the model language, the short-run is a period which neatly separates factors of production into one quickly-variable and several which are not quickly-variable. The long run is the other extreme, a period much longer than all the timescales to do with varying factor of production (yet improbably short as compared with input costs). No reason has been given to think that the existence of a short-run is likely, nor which factor might be the quick one. Also, other factors like costs and technology are assumed (but not justied) to vary more slowly than any factor. 3. How does the production function affect AVC, ATC, and MC? Given a monotonic production function Q( fi ) describing the highest possible output as a function of a factor of production fi , and a xed price pi for the factor fi , one can express the function in terms of cost as Q(pi fi ) = Q(C). The inverse function C(Q) is the cost to produce a given level of output. From this, the marginal cost MC = dC(Q)/dQ, the average total cost ATC = C(Q)/Q, and the average variable cost (C(Q) C(0))/Q are dened. 31

4. What is the relation between production function and AFC? If C(Q) is the inverse production function, then C(0) is the xed cost and the average xed cost is AFC = C(0)/Q. 5. Why is the MC U-shaped? We tend to draw the MC -shaped, or the production function sigmoid-shaped, to reect the two extremes of increasing and diminishing marginal returns, which are expected at low and very high values, respectively, of the limiting factor. No reason is given yet to expect that production volumes are ever near one extreme or another. This claim comes only from the perfect market assumption that quantity demanded appears innite to any producer (and thus as much is produced as can be produced cheaply). Since this is rarely true in practice, assuming it at this stage is a mistake. The theory ought to be broad enough to describe the case where locality is an advantage in the market, thus the demand is limited for individual producers, thus distribution and marketing (which create demand) are usually the short-run limiting factors. Thus the chimera of diminishing returns for factors of production never applies not even approximately. 6. Where does MC intersect ATC and AVC? Explain fully.

40 TC Total cost 30 20 10 Unit costs 0.6 0.4 0.2 0 10 20 30 40 50 60 Quantity 70 80 90 100 MC ATC AVC

Figure 1: Production function (TC) and derived quantities (showing a more realistic cost curve than those of the text) As demonstrated in Figure 1, the MC intersects each of these averages at their respective minima. Any cumulative average will not change if a new value equal 32

to the average is included in the calculation. Therefore any point where an average cost is equal to the marginal cost will be a stationary point for the average. According to the suggested shape of production functions, the average costs will have only one stationary point, and it is a minimum. For example, for cost C(Q) and quantity produced Q, ATC = C/Q and MC = dC/dQ, so the curves cross (MC = ATC) where dC/dQ = C/Q. But this is also the solution to the stationary equation for ATC: 0= d(ATC) dC C = dQ dQ Q

7. By reference to gure 9.3, explain 9.3a and 9.3b.

Total variable cost

50 40 30 20 10 0 1 MC AVC TC-FC Inflection point

Unit costs

0.8 0.6 0.4 0.2 0 20 40 60

Quantity

80

100

Figure 2: Total variable cost (TC FC) and derived quantities Figure 2 shows the relationship between the total variable cost (TVC = TC FC) and the marginal (MC) and average variable costs (AVC). The TVC is a vertically-shifted version of the production function. Because MC is the derivative of TVC, the minimum of MC occurs at an inection point of TVC, as shown in the gure. Since AVC = TVC/Q, its stationary points occur at values of Q where a line tangent to TVC also goes through the origin. 8. The shape of LAC depends on changing returns to scale. Explain. 33

Returns to scale deal with production possibilities in the long run. In particular, the returns to scale are the ratio of possible production output to production cost, i.e. the reciprocal of the cost per unit output, or the LAC. Thus an increasing slope of LAC reects decreasing returns to scale and vice versa. 9. The slope of TAC curve depends on marginal cost. Explain. I cannot nd TAC dened. 10. Explain the derivation of the isocost line. Unit prices of factors of production are assumed to be constant. For a given expenditure on all the factors, an isocost line shows all the possible combinations of factors. This is entirely analogous to the individual consumers budget line. 11. What is the meaning of the expansion path? Explain what it identies. When an increase in total expenditure on factors of production is allowed, adjustments up or down in the amount of each factor of production may be needed to achieve the highest technologically possible output (in the long run) at the new level of expenditure. The expansion path is the sequence of adjustments in amounts of factors of production required to maximise output during a change in total expenditure. Making such a sequence of adjustments will keep the output and expenditure values on the long run total cost curve. 12. If constant returns to scale apply to the entire range of production, explain the shape of the long run total cost curve. I am confused about this. Constant returns to scale exist when, given rapidly-variable factors of production, the quantity of output is linearly proportional to the cost of production if the ratios of the quantities of factors of production are held constant. In the long run cost curve, however, these ratios need not be held constant, so without this constraint the production output may be more than proportional to the inputs; i.e. there is an economy of scale. On the other hand, if the economy of scale description holds (??) for any given set of quantities of factors of production, then the optimum choice at any production level will be due to the same ratios of factors of production. Then the long run total cost curve will be a straight line. 13. By referring to gure 9.6, explain short- and long-run average cost curves. For any level of total cost or of output, the most efcient combination of factors of production occurs when the marginal productivity divided by the marginal cost is the same for all factors. Thus if quantity of each input is measured in terms of money, then the marginal productivity (slope of cost vs output) is the same for each factor, and indeed the same for the overall cost curve. This means that this slope of total cost vs. output is, at any level of output, the same for the long term curve as for the short term curve corresponding to variation of any single factor of production. This equivalence of slopes is also true for the average cost curves, as shown in Figure 3. Because optimally varying 34

average costs varying only one factor long run average cost, varying all factors

Figure 3: Long run and short run cost curves a single factor cannot be better than optimising over all the factors, the singlefactor cost curves (i.e., short run curves) curve upward from the all-factors (long run) curves. 14. Interpret and explain gures 9.8a and 9.8b. The expansion path can be conceived as (1) the series of steps to take to continually maximise output while increasing total expenditure on production, or as (2) the series of steps to take to continuously minimise expenditure while increasing output volume. Realistically, growth in rms is likely to be limited by (1) raising capital (loans) and (2) marketing to increase demand for their product. The two views of expansion paths can thus correspond to these mindsets of available expenditure or output volume as independent variables in the growth. Figure 9.8a in the text is relevant to the case when the output volume is somewhat predetermined (even though this is not justied in the text and implies that demand might be a determining factor i.e., the market is not nearly perfect). In this gure, one considers total expenditure to be variable but total output xed, so a change in the relative prices of the factors of production means a substitution effect along the isoquant. Figure 9.8b just shows that cost curves rise when costs increase. 15. Explain economies of scope. An economy of scope is the obvious situation in which a rms infrastructure can relatively cheaply be used for more than one product at a time. This very vague language is only used as rhetoric to give an efciency reason for multiproduct conglomerates.5 No examples of diseconomies of scope are given, of course.
5 The

textbook, p. 240.

35

Economies of scope apply most of all to governments, which can be extremely efcient at providing a wide variety of goods for the least possible price. Dear Professor, Thank you! I have one new question. Why do we assume that consumers are limited to a budget, but rms are not? Both use loans. I have one repeat question. At the end of assigment 2, I asked you the following: If price of something is pegged by the government below the market value, how much will be sold? The text assumes the answer to be the intersection of p and qS for housing, but the intersection of p and qD for T.V. How can one tell, if these quantities are each independently determined by price? The answer you gave me was the following:

regulated price

Qs = quantity supplied. Thats how much will be sold and that therefore there will be a shortage of Qs QD . I still dont understand. Your answer describes the situation for housing (p. 54). But for the same situation with regulated television prices (p. 61), the amount sold is QD , NOT QS , so my original confusion still stands: How can one tell which (or what) amount will be sold, if these quantities (supply and demand) are each independently determined by price?? Many thanks for your help, once again! Chris

8 Assignment 7 / Chapter Ten

I have taken competitive in the following questions to mean in the hypothetical perfectly competitive limit. 1. Explain how the market price is determined in a competitive industry. It appears that microeconomics does not attempt to answer this question even for its model perfect market, since it leaves the amount of prot hidden in costs up 36

to the details of the money system, or at least to all the other industries. For there to be a sensible xed rate of prot (cost), all the industries would need to be competitive. If this were to happen, the rate of prot would likely, it seems to me, shrink to only just cover the average investment risk of forfeit in the economy; this rate would also be the opportunity cost of money capital the bankers interest rate. Moreover, even with the assumption of some xed prot rate in the long run, and even with the assumption of some aggregate demand curve in the industry (debunked in a previous chapter), the texts account of how price is determined for a competitive industry in the short run is entirely incorrect, since it confuses the industry supply curve with the industry-aggregated marginal cost curve; see Question 9 on page 39. 2. Describe the survivor principle of management operation. The survivor principle states that rms which dont maximise prot above all else will be run out of business and disappear in competitive markets. There are two major problems with this language which make it tautologous, i.e., purely retrodictive. This use may be motivated by a market ideology which is not justied by the theory of perfect markets. One fallacy is that the survivor principle assumes that any organisation will fall apart if its stakeholders fail to optimise prot above all, because they will be able to get higher prots elsewhere and thus will withdraw their capital. But real organisations can choose to take lower prots (or no prots) and continue to survive if they choose to be content with the lower prots, even if they are operating in a competitive market for goods or services and even if they do not minimise costs quite as much as some competition. Thus the statement in the text concerning survivorship is not an explanatory principle, but follows a normative ideology that all organisations and capital holders should be solely prot-motivated. This NEED NOT BE SO, even in competitive markets. A second problem is that this language perpetuates the confusion between the rate of prot income (which is not by itself of interest to a rm) and the total prot (money!), which is the product (or time integral) of the rate with some time period of interest. The typical time-blind view of the analysis in this text amounts to ignoring half of the two terms in the optimisation of total prot. In varying any factor of production q, the optimum total prot t is maximised where 0= d( t) d dt = t + dq dq dq

The analysis in the text considers mathematically only the rst term. The second represents extending the life of the rm for a long time, without maximising the rate of prot. The academic emphasis on short-term optimisations in rm management may be motivated by the capital holders value of seeking ever-shorter timescales in money capital mobility. 37

3. How is marginal revenue related to a rms ideal output?

50 40 Total cost 30 20 10 0 0.8 Unit costs 0.6 0.4 0.2 0 0 AVC MC 20 40 60 Quantity 80 90 95 100 ATC TR TC TC-FC

P=AR

MR

Quantity

Figure 4: Short run output selection. The panels on the right are closeups of the panels on the left. In the limit of an innitesimal rm size, MR and P=AR are coincident and horizontal. Figure~4 shows an example of marginal revenue (MR) and marginal cost (MC) and associated relationships. The prot is positive for quantities where total revenue (TR) is greater than total cost (TC) and the prot is maximum where MR is equal to MC. 4. In gure 10.3, explain why producers would not choose output Q0 or Q2 . This claim is only applicable to the perfect competition model. The producer is assumed to be able on short timescales to vary the output level across the entire range shown in Figure~4 with endless demand. If the marginal revenue is less than the marginal cost, the rate of prot can be increased by decreasing production. If the marginal revenue is more than marginal cost, an increase in production will lead to an increase in rate of prot. 5. Compare gure 10.2 with 10.3 relating to short-run proft. The TC and TR curves in gure 10.2 are the integrals of the MC (with MC(0)=FC) and price=MR=demand curves. The curve is the area of the blue region in gure 10.3, which is a rectangle formed between the ordinate and a line showing the difference between MR and ATC. The intersection of MC and MR in gure 10.3 corresponds to an equality between the slopes of TC and TR in gure 10.2. 38

6. Analyze gure 10.4 explaining operating at a loss in short run.

price or cost per unit

marginal cost price marginal revenue

fixed costs

quantity produced
Figure 5: Short run break-even thresholds. In the limit of an innitesimal rm (perfect competition), the price and marginal revenue curves are horizontal. Figure 5 shows the operating thresholds in a different way (per unit costs) from the text. Here area corresponds to money. The coloured areas are the xed costs (FC), the positive prot (+ ) and the negative prot ( ). For a rm to turn a prot, + > + FC. For any production to happen, + > . If this condition is not met, the rm is better off producing nothing. 7. By using gure 10.5, explain the competitive rms short-run supply curve. See Figures 4 and 5. The short-run supply curve is the curve whose intersection with demand (price) yields the amount produced. If the demand curve is very close to the marginal revenue curve (identical in the case of innitesimal rms), the marginal cost curve behaves like a supply curve, since its intersection with demand determines the rms output. 8. If a rm cant cover its costs it will go out of business. Explain. See Figure 5. There are two possible meanings of cant cover its costs. In the short-run model, the rm will stop producing immediately if no amount of production will help its nances. However, even if no amount of production can recover the xed costs, but they can help to defray them ( < + < + FC), the rm may choose to continue production at a loss until it is able to shut down its xed costs, or improve its protability. 9. By using gure 10.7, explain the short-run competitive industry supply curve. Once again, the text shows an aggregation in sketchy terms but does not provide the mathematical treatment in the appendix, and attempts a bold-faced TRICK 39

to confuse the nave student. I will explain how I understand this gure 10.7 below, but personally I cannot believe that someone can write this section in the text (or section 12.5 in the text) without realising the fallacy and knowing they are being dishonest. I can imagine this ideology could be motivated by the value of wanting to promote more (outside) competition in others domestic markets and wanting to advocate for replacement of government provision of public goods by private industry at all costs. In the ideal of short run production exibility, each rm will always be able to produce at an output level where the marginal cost (MC) is rising, unless the price (demand) is so low that it is below even the lowest average variable cost (AVC). Thus, for a (nearly) horizontal MC, (almost) only upward-sloping portions (thus assumed to be monotonic) of MC will apply for rms with non-zero production; see Figure 4. In the ideal/limit of free entry and exit, all the MCs of different rms are independent. Based on these assumptions, the monotonic quantities produced can be added as a function of MC (i.e. the inverse functions of MC(q)) to produce the total industry production as a function of each rms marginal cost. If rms are interested in maximising the rate of prot, they will choose production outputs for which MC=MR. Is, therefore, this aggregated MC curve equal to the industry supply curve? NO! The price (i.e. demand pD ) curve seen by a rm is not the same as the marginal revenue MR (see Figure 4)6 . For an innitely small rm, the difference pD MR is vanishing, but when adding up over many rms, the difference is nite even within the model of perfect competition and indeed this difference pD MR is, after aggregation, IDENTICAL TO THE CASE OF THE MONOPOLY. This mistake or trick is a second major instance of the divide X by a large number N, approximate the small value X/N as zero, multiply X/N 0 back by N, and conclude that X is zero method used previously in aggregating individual demand. To summarize, if individual rms maximise their prot, they will not individually produce at the intersection of the price and the marginal cost (though very nearly) and they will not (even nearly), as an industry, produce at the intersection of demand and the horizontally-summed marginal cost curve. The aggregated marginal cost curve is NOT the industry supply curve. This situation is identical to that of a monopoly. This well-known aw in the teaching of introductory microeconomics is presumably admitted and treated (?!?) in higher level courses(?), but I can only see it as a blatant deception if hidden amongst dogmatic teaching at lower levels. Have I got something wrong?
6 Revenue

R = pD q, so marginal revenue dR/dq is MR = pD + d pD q dq

Here, d pD /dq is negative for a downward-sloping demand, and becomes zero for a single rm only in the limit of innitesimal rm size (i.e. small as compared with the size of the market). Thus the difference pD MR is only small in a model of perfect competition if the caveat is given that the difference is not being aggregated together over many rms!

40

10. By reference to gure 10.9, explain long-run prot maximization of a competitive rm. I think this long-run picture is identical to the short-run picture in Figure 4 on page 38. The confusion remains between the concepts of price (demand presented) and marginal revenue (even though these two have the same value in the limit of zero-sized rm). 11. Does the rm in gure 10.9 earn any prots in the long-run? Explain. In the long run, if prots are specied by society or by the larger economy (this is an ADDITIONAL assumption over those of a perfect competition!) and thus counted as xed costs, then in a perfectly competitive industry, the rm will nd that average cost per item of production is equal to average revenue: AC = AR. Average revenue is the price (not the marginal revenue, in general!) given by the competitive demand. In this sense, the prot in the long term is always zero. 12. With reference to gure 10.11, explain long-run supply in a constant-cost industry. If factor costs for the rms in an industry do not vary with the size of the industry and do not vary for any other reason either, then in the long run it is reasonable to expect that the industry supply curve will also be horizontal (innite long-run price elasticity of supply). In other words, the price will not depend on demand. Absolutely no justication is offered for the possibility that the cost of inputs is at. Since the text seems to think this is a likely scenario even while preaching that production always happens against long-run rising costs, it is no less likely for the input costs to decrease as the industry grows (demand increases). Indeed, many raw materials and intermediate products are cheaper to produce if the (producer) market for them is large. 13. With reference to gure 10.12, explain long-run supply in an increasing-cost industry. Similarly, if the cost of inputs increases with quantity of production, then the long-run industry supply curve will rise with quantity, just as the text has assumed is the case for the nal goods and services in the short run. 14. Since economic prots are zero for a competitive industrys long-run supply curve, does anyone gain? Explain. This question is asked three or four times in two assignments, so it must be important! The meaning of gain is political, but those who receive interest, a wage, rent, or dividends all gain money, and those whose ownership of physical capital in the rm grows gain physical capital. 15. In a constant-cost industry each rms MC curve is upward sloping, yet all the rst together the industry have a horizontal supply curve. Explain why there is no contradiction. Firms can go in and out of business; the number of rms forming the aggregate supply is not constant as a function of price. Thus a horizontal supply curve 41

means that the rate at which rms join the market is perfectly balanced by the rate at which each rms marginal cost curve increases. 16. Discuss the meaning of zero prots for rms in an industry. The rhetoric of hiding prot as a cost in the description of businesses, and then speaking of zero prots in markets, rather than speaking of a normal/expected/optimum rate of prot on nancial capital, is problematic. It puts the microeconomic market analysis at the mercy of a macroeconomic equilibrium to explain the appropriate rate of prot (10% per year is proposed several times in the text!). It also helps to promote the false assertion that the money system (nancial capital) has as natural / neutral a rle as physical and human capital, when in fact the chosen implementation of debt and money has a huge effect on the issues at hand (e.g., growth and expected rate of prot). It also discriminates against the farmer and small family-owned business (i.e., the ones which come closest to the perfect market), for which the ideas of easy reinvestment and a xed rate of prot are most absurd (for example, owners live on the business property). Thank you! Chris

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