This is an electronic version of the print textbook

Licensed to: CengageBrain UserLicensed to: CengageBrain UserThis is an electronic version of the print textbook. Due to electronic rights restrictions,some third party content may be suppressed. Editorial review has deemed that any suppressedcontent does not materially affect the overall learning experience. The publisher reserves the rightto remove content from this title at any time if subsequent rights restrictions require it. Forvaluable information on pricing, previous editions, changes to current editions, and alternateformats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword formaterials in your areas of interest.Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain UserMicroeconomic Theory: Basic Principlesand Extensions, Eleventh EditionWalter Nicholson, Christopher SnyderVP/Editorial Director: Jack W. CalhounPublisher: Joe SabatinoSr. Acquisitions Editor: Steve ScobleSr. Developmental Editor: Susanna C. SmartMarketing Manager: Nathan AndersonSr. Content Project Manager: Cliff KallemeynMedia Editor: Sharon MorganSr. Frontlist Buyer: Kevin KluckSr. Marketing Communications Manager:Sarah Greberª 2012, 2008 South-Western, Cengage LearningALL RIGHTS RESERVED. No part of this work covered by the copyrightherein may be reproduced, transmitted, stored, or used in any form orby any means graphic, electronic, or mechanical, including but notlimited to photocopying, recording, scanning, digitizing, taping, webdistribution, information networks, or information storage and retrievalsystems, except as permitted under Section 107 or 108 of the 1976United States Copyright Act, without the prior written permission ofthe publisher.For product information and technology assistance, contact us atCengage Learning Customer & Sales Support, 1-800-354-9706For permission to use material from this text or product, submit allrequests online at www.cengage.com/permissionsFurther permissions questions can be emailed topermissionrequest@cengage.comSr. Rights Specialist: Deanna EttingerProduction Service: Cenveo Publisher ServicesSr. Art Director: Michelle KunklerInternal Designer: Juli Cook/Plan-It PublishingCover Designer: Red Hangar Design LLCLibrary of Congress Control Number: 2011928483ISBN-13: 978-111-1-52553-8ISBN-10: 1-111-52553-6Cover Image: ª Jason Reed/Getty ImagesSouth-Western5191 Natorp BoulevardMason, OH 45040USACengage Learning products are represented in Canada by NelsonEducation, Ltd.For your course and learning solutions, visit www.cengage.comPurchase any of our products at your local college store or at ourpreferred online store www.cengagebrain.comAll graphs and figures owned by Cengage Learning. ª 2010 CengageLearning.Printed in the United States of America1 2 3 4 5 6 7 15 14 13 12 11Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain UserIntroductionPARTONEChapter 1Economic ModelsChapter 2Mathematics for MicroeconomicsThis part contains two chapters. Chapter 1 examines the general philosophy of how economists build modelsof economic behavior. Chapter 2 then reviews some of the mathematical tools used in the construction ofthese models. The mathematical tools from Chapter 2 will be used throughout the remainder of this book.1Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain UserCopyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain UserCHAPTERONEEconomic ModelsThe main goal of this book is to introduce you to the most important models that economists use to explain the behavior of consumers, firms, and markets. These models arecentral to the study of all areas of economics. Therefore, it is essential to understand boththe need for such models and the basic framework used to develop them. The goal of thischapter is to begin this process by outlining some of the conceptual issues that determinethe ways in which economists study practically every question that interests them.Theoretical ModelsA modern economy is a complicated entity. Thousands of firms engage in producing millions of different goods. Many millions of people work in all sorts of occupations andmake decisions about which of these goods to buy. Let’s use peanuts as an example. Peanuts must be harvested at the right time and shipped to processors who turn them intopeanut butter, peanut oil, peanut brittle, and numerous other peanut delicacies. Theseprocessors, in turn, must make certain that their products arrive at thousands of retailoutlets in the proper quantities to meet demand.Because it would be impossible to describe the features of even these peanut marketsin complete detail, economists have chosen to abstract from the complexities of the realworld and develop rather simple models that capture the ‘‘essentials.’’ Just as a road mapis helpful even though it does not record every house or every store, economic models of,say, the market for peanuts are also useful even though they do not record every minutefeature of the peanut economy. In this book we will study the most widely used economicmodels. We will see that, even though these models often make heroic abstractions fromthe complexities of the real world, they nonetheless capture essential features that arecommon to all economic activities.The use of models is widespread in the physical and social sciences. In physics, thenotion of a ‘‘perfect’’ vacuum or an ‘‘ideal’’ gas is an abstraction that permits scientists tostudy real-world phenomena in simplified settings. In chemistry, the idea of an atom or amolecule is actually a simplified model of the structure of matter. Architects use mock-upmodels to plan buildings. Television repairers refer to wiring diagrams to locate problems. Economists’ models perform similar functions. They provide simplified portraits ofthe way individuals make decisions, the way firms behave, and the way in which thesetwo groups interact to establish markets.3Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain User4 Part 1: IntroductionVerification of Economic ModelsOf course, not all models prove to be ‘‘good.’’ For example, the earth-centered model ofplanetary motion devised by Ptolemy was eventually discarded because it proved incapable of accurately explaining how the planets move around the sun. An important purposeof scientific investigation is to sort out the ‘‘bad’’ models from the ‘‘good.’’ Two generalmethods have been used for verifying economic models: (1) a direct approach, whichseeks to establish the validity of the basic assumptions on which a model is based; and (2)an indirect approach, which attempts to confirm validity by showing that a simplifiedmodel correctly predicts real-world events. To illustrate the basic differences between thetwo approaches, let’s briefly examine a model that we will use extensively in later chaptersof this book—the model of a firm that seeks to maximize profits.The profit-maximization modelThe model of a firm seeking to maximize profits is obviously a simplification of reality. Itignores the personal motivations of the firm’s managers and does not consider conflictsamong them. It assumes that profits are the only relevant goal of the firm; other possiblegoals, such as obtaining power or prestige, are treated as unimportant. The model alsoassumes that the firm has sufficient information about its costs and the nature of themarket to which it sells to discover its profit-maximizing options. Most real-world firms,of course, do not have this information readily available. Yet such shortcomings in themodel are not necessarily serious. No model can exactly describe reality. The real question is whether this simple model has any claim to being a good one.Testing assumptionsOne test of the model of a profit-maximizing firm investigates its basic assumption: Dofirms really seek maximum profits? Some economists have examined this question bysending questionnaires to executives, asking them to specify the goals they pursue. Theresults of such studies have been varied. Businesspeople often mention goals other thanprofits or claim they only do ‘‘the best they can’’ to increase profits given their limited information. On the other hand, most respondents also mention a strong ‘‘interest’’ in profits and express the view that profit maximization is an appropriate goal. Therefore,testing the profit-maximizing model by testing its assumptions has provided inconclusiveresults.Testing predictionsSome economists, most notably Milton Friedman, deny that a model can be tested byinquiring into the ‘‘reality’’ of its assumptions.1 They argue that all theoretical models arebased on ‘‘unrealistic’’ assumptions; the very nature of theorizing demands that we makecertain abstractions. These economists conclude that the only way to determine the validity of a model is to see whether it is capable of predicting and explaining real-worldevents. The ultimate test of an economic model comes when it is confronted with datafrom the economy itself.Friedman provides an important illustration of that principle. He asks what kind oftheory one should use to explain the shots expert pool players will make. He argues thatthe laws of velocity, momentum, and angles from theoretical physics would be a suitable1See M. Friedman, Essays in Positive Economics (Chicago: University of Chicago Press, 1953), chap. 1. For an alternative viewstressing the importance of using ‘‘realistic’’ assumptions, see H. A. Simon, ‘‘Rational Decision Making in Business Organizations,’’ American Economic Review 69, no. 4 (September 1979): 493–513.Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain UserChapter 1: Economic Models5model. Pool players shoot shots as if they follow these laws. But most players askedwhether they precisely understand the physical principles behind the game of pool willundoubtedly answer that they do not. Nonetheless, Friedman argues, the physical lawsprovide accurate predictions and therefore should be accepted as appropriate theoreticalmodels of how experts play pool.Thus, a test of the profit-maximization model would be provided by predicting thebehavior of real-world firms by assuming that these firms behave as if they were maximizing profits. (See Example 1.1 later in this chapter.) If these predictions are reasonablyin accord with reality, we may accept the profit-maximization hypothesis. However, wewould reject the model if real-world data seem inconsistent with it. Hence the ultimatetest of any theory is its ability to predict real-world events.Importance of empirical analysisThe primary concern of this book is the construction of theoretical models. But the goal ofsuch models is always to learn something about the real world. Although the inclusion of alengthy set of applied examples would needlessly expand an already bulky book,2the Extensions included at the end of many chapters are intended to provide a transitionbetween the theory presented here and the ways that theory is applied in empirical studies.General Features of EconomicModelsThe number of economic models in current use is, of course, large. Specific assumptionsused and the degree of detail provided vary greatly depending on the problem beingaddressed. The models used to explain the overall level of economic activity in theUnited States, for example, must be considerably more aggregated and complex thanthose that seek to interpret the pricing of Arizona strawberries. Despite this variety,practically all economic models incorporate three common elements: (1) the ceteris paribus (other things the same) assumption; (2) the supposition that economic decisionmakers seek to optimize something; and (3) a careful distinction between ‘‘positive’’ and‘‘normative’’ questions. Because we will encounter these elements throughout this book,it may be helpful at the outset to describe the philosophy behind each of them.The ceteris paribus assumptionAs in most sciences, models used in economics attempt to portray relatively simple relationships. A model of the market for wheat, for example, might seek to explain wheatprices with a small number of quantifiable variables, such as wages of farmworkers, rainfall, and consumer incomes. This parsimony in model specification permits the study ofwheat pricing in a simplified setting in which it is possible to understand how the specificforces operate. Although any researcher will recognize that many ‘‘outside’’ forces (e.g.,presence of wheat diseases, changes in the prices of fertilizers or of tractors, or shifts inconsumer attitudes about eating bread) affect the price of wheat, these other forces areheld constant in the construction of the model. It is important to recognize that economists are not assuming that other factors do not affect wheat prices; rather, such othervariables are assumed to be unchanged during the period of study. In this way, the effect2For an intermediate-level text containing an extensive set of real-world applications, see W. Nicholson and C. Snyder, Intermediate Microeconomics and Its Application, 11th ed. (Mason, OH: Thomson/Southwestern, 2010).Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain User6 Part 1: Introductionof only a few forces can be studied in a simplified setting. Such ceteris paribus (otherthings equal) assumptions are used in all economic modeling.Use of the ceteris paribus assumption does pose some difficulties for the verification ofeconomic models from real-world data. In other sciences, the problems may not be sosevere because of the ability to conduct controlled experiments. For example, a physicistwho wishes to test a model of the force of gravity probably would not do so by droppingobjects from the Empire State Building. Experiments conducted in that way would besubject to too many extraneous forces (e.g., wind currents, particles in the air, variationsin temperature) to permit a precise test of the theory. Rather, the physicist would conductexperiments in a laboratory, using a partial vacuum in which most other forces could becontrolled or eliminated. In this way, the theory could be verified in a simple setting,without considering all the other forces that affect falling bodies in the real world.With a few notable exceptions, economists have not been able to conduct controlledexperiments to test their models. Instead, they have been forced to rely on various statistical methods to control for other forces when testing their theories. Although these statistical methods are as valid in principle as the controlled experiment methods used byother scientists, in practice they raise a number of thorny issues. For that reason, the limitations and precise meaning of the ceteris paribus assumption in economics are subject togreater controversy than in the laboratory sciences.Structure of Economic ModelsMost of the economic models you will encounter in this book will have a mathematicalstructure. They will highlight the relationships between factors that affect the decisions ofhouseholds and firms and the results of those decisions. Economists tend to use differentnames for these two types of factors (or, in mathematical terms, variables). Variables thatare outside of a decision-maker’s control are called exogenous variables. Such variablesare inputs into economic models. For example, in consumer theory we will usually treatindividuals as price-takers. The prices of goods are determined outside of our models ofconsumer behavior, and we wish to study how consumers adjust to them. The results ofsuch decisions (e.g., the quantities of each good that a consumer buys) are endogenousvariables. These variables are determined within our models. This distinction is picturedschematically in Figure 1.1. Although the actual models developed by economists may becomplicated, they all have this basic structure. A good way to start studying a particularmodel is to identify precisely how it fits into this framework.This distinction between exogenous and endogenous variables will become clearer as weexplore a variety of economic models. Keeping straight which variables are determinedoutside a particular model and which variables are determined within a model can be confusing; therefore, we will try to remind you about this as we go along. The distinctionbetween exogenous and endogenous variables is also helpful in understanding the way inwhich the ceteris paribus assumption is incorporated into economic models. In most caseswe will want to study how the results of our models change when one of the exogenousvariables changes. It is possible, even likely, that the change in such a single variable willchange all the results calculated from the model. For example, as we will see, it is likely thatthe change in the price of a single good will cause an individual to change the quantities ofpractically every good he or she buys. Examining all such responses is precisely why economists build models. The ceteris paribus assumption is enforced by changing only one exogenous variable, holding all others constant. If we wish to study the effects of a change in theprice of gasoline on a household’s purchases, we change that price in our model, but we donot change the prices of other goods (and in some cases we do not change the individual’sincome either). Holding the other prices constant is what is meant by studying the ceterisparibus effect of an increase in the price of gasoline.Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain UserChapter 1: Economic ModelsFIGURE 1.17Values for exogenous variables are inputs into most economic models. Model outputs (results) are valuesfor the endogenous variables.Structure of a TypicalMicroeconomic ModelEXOGENOUS VARIABLESHouseholds: Prices of goodsFirms: Prices of inputs and outputECONOMIC MODELHouseholds: Utility maximizationFirms: Profit maximizationENDOGENOUS VARIABLESHouseholds: Quantities boughtFirms: Output produced, inputs hiredOptimization assumptionsMany economic models start from the assumption that the economic actors being studiedare rationally pursuing some goal. We briefly discussed such an assumption when investigating the notion of firms maximizing profits. Example 1.1 shows how that model can beused to make testable predictions. Other examples we will encounter in this book includeconsumers maximizing their own well-being (utility), firms minimizing costs, and government regulators attempting to maximize public welfare. Although, as we will show, allthese assumptions are unrealistic, and all have won widespread acceptance as good starting places for developing economic models. There seem to be two reasons for this acceptance. First, the optimization assumptions are useful for generating precise, solvablemodels, primarily because such models can draw on a variety of mathematical techniquessuitable for optimization problems. Many of these techniques, together with the logicbehind them, are reviewed in Chapter 2. A second reason for the popularity of optimization models concerns their apparent empirical validity. As some of our Extensions show,such models seem to be fairly good at explaining reality. In all, then, optimization modelshave come to occupy a prominent position in modern economic theory.EXAMPLE 1.1 Profit MaximizationThe profit-maximization hypothesis provides a good illustration of how optimization assumptionscan be used to generate empirically testable propositions about economic behavior. Suppose that afirm can sell all the output that it wishes at a price of p per unit and that the total costs ofproduction, C, depend on the amount produced, q. Then profits are given byprofits ¼ p ¼ pq À CðqÞ:(1:1)Copyright 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.Licensed to: CengageBrain User8 Part 1: IntroductionMaximization of profits consists of finding that value of q which maximizes the profit expressionin Equation 1.1. This is a simple problem in calculus. Differentiation of Equation 1.1 and settingthat derivative equal to 0 give the following first-order condition for a maximum:dp¼ p À C 0 ðqÞ ¼ 0 ordqp ¼ C 0 ðqÞ:(1:2)In words, the profit-maximizing output level (qÃ) is found by selecting that output level for whichprice is equal to marginal cost, C 0 ðqÞ. This result should be familiar to you from your introductoryeconomics course. Notice that in this derivation the price for the firm’s output is treated as aconstant because the firm is a price-taker. That is, price is an exogenous variable in this model.Equation 1.2 is only the first-order condition for a maximum. Taking account of the secondorder condition can help us to derive a testable implication of this model. The second-ordercondition for a maximum is that at qà it must be the case thatd 2p¼ ÀC 00 ðqÞ < 0dq 2orC 00 ðqÃ Þ > 0:(1:3)That is, marginal cost must be increasing at qà for this to be a true point of maximum profits.Our model can now be used to ‘‘predict’’ how a firm will react to…

 

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