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Economics
Eighth Edition

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economics

Economics
Eighth Edition

David Begg
Stanley Fischer Rudiger Dornbusch

London Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogot Caracas Kuala Lumpur Lisbon Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

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Economics Eighth Edition David Begg, Stanley Fischer and Rudiger Dornbusch ISBN-13: 978-007710775-8 ISBN-10: 0-07-7107756

Published by McGraw-Hill Education Shoppenhangers Road Maidenhead Berkshire SL6 2QL Telephone: 44 (0) 1628 502 500 Fax: 44 (0) 1628 770 224 Website: www.mcgraw-hill.co.uk British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data The Library of Congress data for this book has been applied for from the Library of Congress Acquisitions Editor: Kirsty Reade Senior Development Editor: Caroline Howell Senior Production Editor: Eleanor Hayes Marketing Director: Petra Skytte Text design by Claire Brodmann Book Designs, Lichfield, Staffs. Cover design by Ego Creative Ltd Typeset by Northern Phototypesetting Co Ltd, Bolton Printed and bound in Spain by Mateu Cromo Artes Graficas SA, Madrid Published by McGraw-Hill Education (UK) Limited an imprint of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY 10020. Copyright 2005 by McGraw-Hill Education (UK) Limited. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. ISBN-13: 978-007710775-8 ISBN-10: 0-07-7107756 2005. Exclusive rights by The McGraw-Hill Companies, Inc. for manufacture and export. This book cannot be re-exported from the country to which it is sold by McGraw-Hill.

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Dedication
For Honora, Mary and Robin

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vii

Brief table of contents

Detailed table of contents Suggested outlines for a shortened course Getting the most out of this book Preface Acknowledgements for the eighth edition Guided tour Technology to enhance learning and teaching

ix xviii xx xxi xxiii xxiv xxvi

Part one
1. 2. 3.

Introduction
Economics and the economy Tools of economic analysis Demand, supply and the market

1
3 15 30

Part two
4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

Positive microeconomics
Elasticities of demand and supply Consumer choice and demand decisions Introducing supply decisions Costs and supply Perfect competition and pure monopoly Market structure and imperfect competition The labour market Different types of labour Factor markets and income distribution Risk and information The information economy

45
47 64 85 101 120 142 162 185 201 222 241

Part three
15. 16. 17. 18.

Welfare economics
Welfare economics Government spending and revenue Industrial policy and competition policy Natural monopoly: public or private?

257
259 279 298 315

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Brief table of contents

Part four
19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32.

Macroeconomics
Introduction to macroeconomics Output and aggregate demand Fiscal policy and foreign trade Money and banking Interest rates and monetary transmission Monetary and fiscal policy Aggregate supply, prices and adjustment to shocks Inflation, expectations and credibility Unemployment Exchange rates and the balance of payments Open economy macroeconomics Economic growth Business cycles Macroeconomics: taking stock

333
335 353 367 384 401 418 430 447 469 484 500 517 536 549

Part five
33. 34. 35. 36.

The world economy

International trade Exchange rate regimes European integration Less developed countries

565
567 589 605 622

Appendix: Answers to review questions Glossary Index

638 646 657

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Detailed table of contents

Suggested outlines for a shortened course Getting the most out of this book Preface Acknowledgements for the eighth edition Guided tour Technology to enhance learning and teaching

xviii xx xxi xxiii xxiv xxvi

Part one Introduction

Chapter 1 Economics and the economy
1.1 1.2 1.3 1.4 1.5 Economic issues Scarcity and the competing use of resources The role of the market Positive and normative Micro and macro Summary Review questions Economic data Index numbers Nominal and real variables Measuring changes in economic variables Economic models Models and data Diagrams, lines and equations Another look at other things equal Theories and evidence Some popular criticisms of economics and economists Summary Review questions The market Demand, supply and equilibrium Demand and supply curves Behind the demand curve Shifts in the demand curve Behind the supply curve Shifts in the supply curve Free markets and price controls What, how and for whom Summary Review questions

1
3
4 6 8 11 12 13 14

Chapter 2 Tools of economic analysis

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10

15
16 17 18 20 20 21 22 24 25 25 27 28

Chapter 3 Demand, supply and the market

3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9

30
30 31 32 33 35 36 37 38 40 42 44

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Part two Positive microeconomics

Chapter 4 Elasticities of demand and supply
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 The price responsiveness of demand Price, quantity demanded and total expenditure Further application of the price elasticity of demand Short run and long run The cross-price elasticity of demand The effect of income on demand Inflation and demand Elasticity of supply Who really pays the tax? Summary Review questions Demand by a single consumer Adjustment to income changes Adjustment to price changes The market demand curve Complements and substitutes Transfers in kind Summary Review questions Appendix: Consumer choice with measurable utility Business organization A firms accounts Firms and profit maximization Corporate finance and corporate control The firms supply decision Marginal cost and marginal revenue Marginal cost and marginal revenue curves Summary Review questions Input and output Costs and the choice of technique Long-run total, marginal and average costs Returns to scale Average cost and marginal cost The firms long-run output decision Short-run costs and diminishing marginal returns A firms output decision in the short run Short-run and long-run costs Summary Review questions

45
47
47 52 53 55 55 56 59 59 60 62 63

Chapter 5 Consumer choice and demand decisions

5.1 5.2 5.3 5.4 5.5 5.6

64
64 71 73 78 79 79 80 81 82

Chapter 6 Introducing supply decisions

6.1 6.2 6.3 6.4 6.5 6.6 6.7

85
85 86 90 91 92 94 97 99 99

Chapter 7 Costs and supply

7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9

101
101 102 104 105 109 110 110 115 117 117 118

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Chapter 8 Perfect competition and pure monopoly

8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 Perfect competition A perfectly competitive firms supply decision Industry supply curves Comparative statics for a competitive industry Global competition Pure monopoly: the opposite limiting case Profit-maximizing output for a monopolist Output and price under monopoly and competition A monopoly has no supply curve Monopoly and technical change Summary Review questions Why market structures differ Monopolistic competition Oligopoly and interdependence Game theory and interdependent decisions Reaction functions Entry and potential competition Strategic entry deterrence Summing up Summary Review questions The firms demand for factors in the long run The firms demand for labour in the short run The industry demand curve for labour The supply of labour Industry labour market equilibrium Transfer earnings and economic rents Do labour markets clear? UK wages and employment Summary Review questions Appendix: Isoquants and the choice of production technique Productivity differences Discrimination Trade unions Summary Review questions

120
121 122 125 128 130 131 132 134 136 138 139 140

Chapter 9 Market structure and imperfect competition

9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8

142
143 146 147 150 152 156 157 159 160 161

Chapter 10 The labour market

10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8

162
163 164 168 169 174 175 176 179 180 181 182

Chapter 11 Different types of labour

11.1 11.2 11.3

185
186 191 194 199 199

Chapter 12 Factor markets and income distribution

12.1 12.2 Physical capital Rentals, interest rates and asset prices

201
202 203

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12.3 12.4 12.5 12.6 12.7 12.8 12.9 12.10 12.11

Saving, investment and the real interest rate The demand for capital services The supply of capital services Equilibrium and adjustment in the market for capital services The price of capital assets Land and rents Allocating a fixed land supply between competing uses The facts again Income distribution in the UK Summary Review questions Appendix: The simple algebra of present values and discounting Individual attitudes to risk Insurance and risk Uncertainty and asset returns Portfolio selection Efficient asset markets More on risk Summary Review questions E-products Consuming information Distributors of information Setting standards Recap Boom and bust of the dot.com companies Summary Review questions

207 208 209 212 213 214 215 216 217 219 220 221

Chapter 13 Risk and information

13.1 13.2 13.3 13.4 13.5 13.6

222
222 224 227 229 233 236 239 240

Chapter 14 The information economy

14.1 14.2 14.3 14.4 14.5 14.6

241
241 242 246 250 251 251 254 255

Part three Welfare economics

Chapter 15 Welfare economics
15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 Equity and efficiency Perfect competition and Pareto efficiency Distortions and the second best Market failure Externalities Environmental issues Other missing markets: time and risk Quality, health and safety Summary Review questions

257
259
259 261 264 266 267 270 274 274 276 278

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Chapter 16 Government spending and revenue

16.1 16.2 16.3 16.4 16.5 16.6 16.7 Taxation and government spending The government in the market economy The principles of taxation Taxation and supply-side economics Local government Economic sovereignty Political economy: how governments decide Summary Review questions Industrial policy Economic geography The social cost of monopoly power Competition policy Mergers Summary Review questions Natural monopoly Nationalized industries Public versus private Privatization in practice Regulating private monopolies The private finance initiative Summary Review questions

279
281 281 285 289 290 291 293 295 296

Chapter 17 Industrial policy and competition policy

17.1 17.2 17.3 17.4 17.5

298
299 302 303 308 310 313 314

Chapter 18 Natural monopoly: public or private?

18.1 18.2 18.3 18.4 18.5 18.6

315
316 317 321 324 325 327 330 330

Part four Macroeconomics

Chapter 19 Introduction to macroeconomics
19.1 19.2 19.3 19.4 19.5 The big issues The facts An overview National income accounting What GNP measures Summary Review questions Components of aggregate demand Aggregate demand Equilibrium output Another approach: planned saving equals planned investment A fall in aggregate demand The multiplier The paradox of thrift

333
335
336 336 337 339 347 350 351

Chapter 20 Output and aggregate demand

20.1 20.2 20.3 20.4 20.5 20.6 20.7

353
355 357 357 359 360 362 363

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Summary Review questions 365 366

Chapter 21 Fiscal policy and foreign trade

21.1 21.2 21.3 21.4 21.5 21.6 21.7 Government and the circular flow The government and aggregate demand The government budget Deficits and the fiscal stance Automatic stabilizers and discretionary fiscal policy The national debt and the deficit Foreign trade and income determination Summary Review questions Money and its functions Modern banking How banks create money The monetary base and the money multiplier Measures of money Competition between banks The demand for money Summary Review questions The Bank of England The Bank and the money supply Lender of last resort Equilibrium in financial markets Monetary control Targets and instruments of monetary policy The transmission mechanism Summary Review questions Monetary policy rules The ISLM model The ISLM model in action Shocks to money demand The policy mix The effect of future taxes Demand management revisited Summary Review questions Inflation and aggregate demand Aggregate supply Equilibrium inflation

367
368 368 372 374 375 377 378 381 383

Chapter 22 Money and banking

22.1 22.2 22.3 22.4 22.5 22.6 22.7

384
384 386 388 390 392 393 394 398 399

Chapter 23 Interest rates and monetary transmission

23.1 23.2 23.3 23.4 23.5 23.6 23.7

401
401 402 404 404 407 409 409 415 416

Chapter 24 Monetary and fiscal policy

24.1 24.2 24.3 24.4 24.5 24.6 24.7

418
418 420 422 423 424 426 428 428 429

Chapter 25 Aggregate supply, prices and adjustment to shocks

25.1 25.2 25.3

430
431 433 434

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Detailed table of contents

25.4 25.5 25.6 25.7 25.8 The labour market and wage behaviour Short-run aggregate supply The adjustment process Sluggish adjustment to shocks Tradeoffs in monetary objectives Summary Review questions Money and inflation Inflation and interest rates Inflation, money and deficits Inflation, unemployment and output The costs of inflation Defeating inflation The Monetary Policy Committee Summary Review questions The labour market Analysing unemployment Explaining changes in unemployment Cyclical fluctuations in unemployment The cost of unemployment Summary Review questions The foreign exchange market Exchange rate regimes The balance of payments The real exchange rate Determinants of the current account The financial account Internal and external balance The long-run equilibrium real exchange rate Summary Review questions Fixed exchange rates Macroeconomic policy under fixed exchange rates Devaluation Floating exchange rates Monetary and fiscal policy under floating exchange rates The pound since 1980 Summary Review questions 437 438 439 441 444 445 446

xv

Chapter 26 Inflation, expectations and credibility

26.1 26.2 26.3 26.4 26.5 26.6 26.7

447
448 450 452 453 459 462 464 466 467

Chapter 27 Unemployment
27.1 27.2 27.3 27.4 27.5

469
470 471 475 479 480 482 483

Chapter 28 Exchange rates and the balance of payments

28.1 28.2 28.3 28.4 28.5 28.6 28.7 28.8

484
484 487 488 490 491 492 494 495 498 499

Chapter 29 Open economy macroeconomics

29.1 29.2 29.3 29.4 29.5 29.6

500
500 503 504 507 511 512 514 515

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Chapter 30 Economic growth

30.1 30.2 30.3 30.4 30.5 30.6 30.7 30.8 Economic growth Growth: an overview Technical knowledge Growth and accumulation Growth through technical progress Growth in the OECD Endogenous growth The costs of growth Summary Review questions Trend and cycle: statistics or economics? Theories of the business cycle Real business cycles An international business cycle? UK recovery after 1992 The odyssey after 2001 Summary Review questions Areas of disagreement New Classical macroeconomics Gradualist monetarists Moderate Keynesians Extreme Keynesians A summing up Summary Review questions

517
518 519 521 523 526 527 530 532 533 534

Chapter 31 Business cycles

31.1 31.2 31.3 31.4 31.5 31.6

536
537 538 541 544 545 546 547 548

Chapter 32 Macroeconomics: taking stock

32.1 32.2 32.3 32.4 32.5 32.6

549
550 554 556 557 559 560 561 562

Part five The world economy

Chapter 33 International trade
33.1 33.2 33.3 33.4 33.5 33.6 33.7 33.8 Trade patterns Comparative advantage Intra-industry trade Gainers and losers The economics of tariffs Good and bad arguments for tariffs Tariff levels: not so bad? Other trade policies Summary Review questions The gold standard An adjustable peg Floating exchange rates

565
567
568 570 575 577 578 580 585 585 587 588

Chapter 34 Exchange rate regimes

34.1 34.2 34.3

589
590 591 593

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Detailed table of contents

34.4 34.5 34.6 34.7 Speculative attacks on pegged exchange rates Fixed versus floating International policy co-ordination The European Monetary System Summary Review questions The Single Market Benefits of the Single Market From EMS to EMU The economics of EMU Central and Eastern Europe Summary Review questions World income distribution Obstacles to development Development through trade in primary products Industrialization Borrowing to grow Development through structural adjustment Aid Summary Review questions 594 596 598 599 602 603

xvii

Chapter 35 European integration

35.1 35.2 35.3 35.4 35.5

605
605 606 607 610 614 619 620

Chapter 36 Less developed countries

36.1 36.2 36.3 36.4 36.5 36.6 36.7

622
622 623 625 629 631 633 634 635 636

Appendix: Answers to review questions Glossary Index

638 646 657

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Suggested outlines for a shortened course

As a lecturer using this textbook to deliver an economics module, you may not be able to use the complete text. Below are some suggestions on how it may be used on a short economics course, or as a text for a microeconomics or macroeconomics module.

First option A short introduction to economics

1 2 3 4 6 7 8 9 10 12 15 19 20 21 22 23 24 32 33 Economics and the economy Tools of economic analysis Demand, supply and the market Elasticities of demand and supply Introducing supply decisions Costs and supply Perfect competition and pure monopoly Market structure and imperfect competition The labour market Factor markets and income distribution Welfare economics Introduction to macroeconomics Output and aggregate demand Fiscal policy and foreign trade Money and banking Interest rates and monetary transmission Monetary and fiscal policy Macroeconomics: taking stock International trade

Second option An introduction to microeconomics

1 2 3 4 5 6 7 8 9 10 12 15 16 17 Economics and the economy Tools of economic analysis Demand, supply and the market Elasticities of demand and supply Consumer choice and demand decisions Introducing supply decisions Costs and supply Perfect competition and pure monopoly Market structure and imperfect competition The labour market Factor markets and income distribution Welfare economics Government spending and revenue Industrial policy and competition policy

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Suggested outlines for a shortened course

18 33 Natural monopoly: public or private? International trade

xix

Third option An introduction to macroeconomics

1 2 3 19 20 21 22 23 24 25 26 27 28 29 30 31 32 34 Economics and the economy Tools of economic analysis Demand, supply and the market Introduction to macroeconomics Output and aggregate demand Fiscal policy and foreign trade Money and banking Interest rates and monetary transmission Monetary and fiscal policy Aggregate supply, prices and adjustment to shocks Inflation, expectations and credibility Unemployment Exchange rates and the balance of payments Open economy macroeconomics Economic growth Business cycles Macroeconomics: taking stock Exchange rate regimes

Also available from McGraw-Hill:

Begg, Fischer and Dornbusch, Foundations of Economics, 3rd edition Tailored to suit a 1012 week foundation module in economics, for use with economics specialist or non-specialist students. Begg and Ward, Economics for Business A new text for students of economics on business and management programmes that focuses on economics problems faced by businesses.

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Getting the most out of this book

NO

Studied economics before?

YES

Want a refresher?
YES

NO

Read Chapters 13

NO

Just the technical tools?

YES

Try Chapter 2

Prove you understand! Do problems and check the answers

Normal order? Begin with microeconomics

YES NO

Chapters 414 on positive microeconomics

Chapters 1932 on macroeconomics

Finding indifference curves hard?

YES NO

Chapters 3435 have more open economy analysis

Try appendix to Chapter 5

Want remaining global issues?

YES

Chapters 3336 Read Chapters 1518 on welfare economics

NO

Did you skip Chapters 418?

YES

Macroeconomics next?
NO

YES

Want to do microeconomics? Global economy microeconomics

NO YES NO

YES

YOU'VE FINISHED!

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Preface
Economics is much too interesting to be left to professional economists. It affects almost everything we do, not merely at work or at the shops but also in the home and the voting booth. It inuences how well we look after our planet, the future we leave for our children, the extent to which we can care for the poor and the disadvantaged, and the resources we have for enjoying ourselves. These issues are discussed daily, in bars and buses as well as cabinet meetings and boardrooms. The formal study of economics is exciting because it introduces a toolkit that allows a better understanding of the problems we face. Everyone knows a smoky engine is a bad sign, but sometimes only a trained mechanic can give the right advice on how to x it. This book is designed to teach you the toolkit and give you practice in using it. Nobody carries an enormous toolbox very far. Useful toolkits are small enough to be portable but contain enough proven tools to deal both with routine problems and unforeseen circumstances. With practice, you will be surprised at how much light this analysis can shed on daily living. This book is designed to make economics seem as useful as it really is.

How much do economists disagree?

There is an old complaint that economists never agree about anything. This is simply wrong. The media, taxi drivers, and politicians love to talk about topics on which there is disagreement; it would be boring TV if all participants in a panel discussion held identical views. But economics is not a subject in which there is always an argument for everything. There are answers to many questions. We aim to show where economists agree on what and for what reason and why they sometimes disagree.

Economics in the 21st century

Our aim is to allow students to understand todays economic environment. This requires mastering the theory and practising its application. Just as the theory of genetics or information technology is slowly progressing, so the theory of economics continues to make progress, sometimes in dramatic and exciting ways. We believe in introducing students immediately to the latest ideas in economics. If these can be conveyed simply, why force students to use older approaches that work less well? Two recent developments in economics underlie much of what we do. One is the role of information, the other is globalization. How information is transmitted and manipulated is central to many issues in incentives and competition, including the recent boom in e-commerce. Ease of information, coupled with lower transport costs, also explains trends towards globalization, and associated reductions in national sovereignty, especially in smaller countries. Modern economics helps us make sense of our changing world, think about where it may go next, and evaluate choices that we currently face.

Learning by doing
Few people practise for a driving test just by reading a book. Even when you think you understand how to do a hill start, it takes a lot of practice to master the ner points. In the same way, we give you lots of examples and real-world applications not just to emphasize the relevance of economics but also to help you master it for yourself. We start at square one and take you slowly

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Preface
through the tools of theoretical reasoning and how to apply them. We do not use algebra and there are very few equations in the book. The best ideas are simple and robust, and can usually be explained quite easily.

How to study
Dont just read about economics, try to do it! It is easy, but mistaken, to read on cruise control, highlighting the odd sentence and gliding through paragraphs we have worked hard to simplify. Active learning needs to be interactive. When the text says clearly, ask yourself why is it clear? See if you can construct the diagram before you look at it. As soon as you dont follow something, go back and read it again. Try to think of other examples to which the theory could be applied. The only way to check you really understand things is to try the review questions and see if you got the right answer. The eighth edition has comprehensive answers, which you will nd on pages 63845. You can also explore the on-line resources centre that accompanies this book for extra learning resources, and may also wish to consider using the student workbook that accompanies this text. To assist you in working through this text, we have developed a number of distinctive study and design features. To familiarize yourself with these features, please turn to the Guided Tour on pages xxivxxv, overleaf.

Changes to the eighth edition

The eighth edition has been thoroughly revised, even though we have kept to the familiar and proven structure, to ensure that it keeps up with the latest thinking about our evolving world and the way in which economics can make sense of it. Specic changes to the new edition include:
G

A complete revision of the discussion of UK competition policy, reflecting changes in legislation and regulatory practice, themselves a response to evolving market conditions that we explain. A realistic discussion of modern monetary policy using ination targeting. Traditional analyses that rely on IS/LM with fixed money supply are more obsolete than ever, and the core of Part 4 integrates the new monetary policy into traditional discussions of aggregate supply and the Phillips curve. The eighth edition streamlines the pioneering discussion of the new monetary policy, first introduced in the seventh edition, stripping it down to its bare essentials to make it fully accessible to students learning economics for the first time. Fully updated throughout to include 2003/2004 data in graphs and tables, and many new contemporary boxes to illustrate key ideas with relevance to students. Revised design that places key terms in the margin for easy reference, and that aims to make the text easier to navigate and use. More resources provided for lecturers.

Supplementary resources
Economics eighth edition offers a comprehensive package of resources for the teaching and learning of economics. The resources offered with the new edition have been developed in response to feedback from current users in order to provide lecturers with a variety of teaching resources for class teaching, lectures and assessment. Students are also offered a range of extra materials to assist them in learning, revising and applying the principles of economics.

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Acknowledgements for the eighth edition

We thank the team at McGraw-Hill for their support, advice and enthusiasm, and the many readers of previous editions who took the trouble to write with suggestions for improvements and ideas for the new edition. We would like to thank the following reviewers who provided helpful suggestions and comments on the book as it progressed through its revisions: Steve Cook, University of Swansea Tom Craven, University of Ulster at Jordanstown Richard Godfrey, University of Wales Institute, Cardiff David Gray, University of Lincoln Anthony Heyes, Royal Holloway, University of London Pietie Horn, University of Stellenbosch, South Africa Geoffrey Killick, University of Westminster Jan Peter Madsen, Copenhagen Business School, Denmark Mahmood Messkoub, University of Leeds Liezl Nieuwoudt, University of Stellenbosch, South Africa Nicholas Perdikis, University of Wales Aberystwyth Robert Simmons, University of Lancaster Thea Sinclair, University of Nottingham Gerard Turley, National University of Ireland, Galway Nalini Vittal, Royal Holloway, University of London Michael Wood, London South Bank University

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Guided tour
Part openings

part two

Positive micro-economics

There are five Part Openers, which introduce the topics and themes covered throughout the five parts of the text.

ositive economics looks at how the economy functions. Microeconomics takes a detailed look at particular decisions without worrying about all the induced effects elsewhere. Part 2 studies in detail the demand behaviour of consumers and the supply behaviour of producers, showing how markets work and why different markets exhibit different forms of behaviour. By applying similar tools to the analysis of input markets, we can also understand why some people earn so much more than others. Chapter 4 examines the responsiveness of demand and supply behaviour. Chapter 5 develops a theory of demand based on self-interested choice by consumers. Chapter 6 introduces different types of firm and considers motives behind production decisions. Chapter 7 analyses how costs of production influence the output that firms choose to supply. Chapters 8 and 9 explore how differences in market structure affect competition and the output decision of firms. Chapters 10 to 12 analyse input markets for labour, capital and land, which determine the distribution of income. Chapter 13 explains why people dislike risk, how institutions develop to shift risk on to those who can bear it more cheaply, and why informational problems can inhibit the development of markets for some commodities. Chapter 14 uses the microeconomic analysis of Part 2 to examine recent developments in the information economy.

Contents
4 G Elasticities of demand and supply 00 5 G Consumer choice and decisions demand 6 G Introducing supply decisions 00 7 G Costs and supply 00 8 G Perfect competition and pure monopoly

00

Important key concepts

00

44

45

These are highlighted throughout each chapter and provide key points for ease of reference. A glossary at the end of the book compiles the key terms for handy reference.

Learning outcomes
Each chapter opens with a set of learning outcomes that introduce the issues that will be addressed in the chapter and offer a guide to the students for their revision and learning.
142 Part 2 : Positive microeconomics

chapter

Market structure and imperfect competition

Learning outcomes
By the end of this chapter, you should understand:

9
Table 9.1 Competition Perfect Imperfect:

Chapter 9: Market structure and imperfect competition

Is Eurostar a monopoly in cross-channel trains or an oligopolist in cross-channel travel? Similarly, when a country trades in a competitive world market, even the sole domestic producer may have little influence on market price. We can never fully remove these ambiguities but Table 9.1 shows some things to bear in mind as we proceed through this chapter. The table includes the ease with which new firms can enter the industry, which affects the ability of existing firms to maintain high prices and supernormal profits in the long run.
Market structure Number of firms Lots Monopolistic Oligopoly Monopoly Many Few One Ability to affect price Nil Little Medium Large Entry barriers None Small Bigger Huge Example Fruit stall Corner shop Cars Post Office

143

G 2 G 3 G 4 G 5 G 6 G 7 G 8 G 9 G 10 G 11 G 12 G
1

imperfect competition, oligopoly and monopolistic competition how cost and demand affect market structure how globalization changes domestic market structure equilibrium in monopolistic competition the tension between collusion and competition in a cartel game theory and strategic behaviour the concepts of commitment and credibility reaction functions and Nash equilibrium Cournot and Bertrand competition Stackelberg leadership why there is no market power in a contestable market innocent and strategic entry barriers 9.1 5.1

Why market structures differ

Figures and tables

Each chapter provides a number of figures and tables to help you to visualize the various economic models, and to illustrate and summarize important concepts. Captions offer thorough explanations of important figures.

erfect competition and pure monopoly are useful benchmarks of the extremes of market structure. Most markets are between the extremes. What determines the structure of a particular market? Why are there 10 000 florists but only a few chemical producers? How does the structure of an industry affect the behaviour of its constituent firms? An imperfectly competitive firm faces a down-sloping A perfectly competitive firm faces a horizontal demand curve at the market demand curve. Its output price price. It is a price-taker. Any other type of firm faces a downward-sloping demand reflects the quantity of goods it curve for its product and is imperfectly competitive. makes and sells. For a pure monopoly, the demand curve for the firm and the industry coincide. We now distinguish two intermediate cases of an imperfectly competitive An oligopoly is an industry market structure. with few producers, each The car industry is an oligopoly. The price of Rover cars depends not only on recognizing their its own output and sales but also the output of Ford and Toyota. The corner grointerdependence. An industry cers shop is a monopolistic competitor. Its output is a subtle package of physical with monopolistic goods, personal service and convenience for local customers. It can charge a competition has many sellers of products that are close slightly higher price than an out-of-town supermarket. But, if its prices are too substitutes for one another. high, even local shoppers travel to the supermarket. Each firm has only a limited As with most definitions, the lines between different market structures can ability to affect its output price. get blurred. One reason is ambiguity about the relevant definition of the market.

Some industries are legal monopolies, the sole licensed producers. Patent laws may confer temporary monopoly on producers of a new process. Ownership of a raw material may confer monopoly status on a single firm. We now develop a general theory of how demand and cost interact to determine the likely structure of each industry. The car industry is not an oligopoly one day but perfectly competitive the next. Long-run influences determine market structures. Eventually, one firm can hire anothers workers and learn its technical secrets. Figure 9.1 shows the demand curve DD for the output of an industry in the long run. Suppose all firms and potential entrants face the average cost curve LAC1. At the price P1, free entry and exit means that each firm produces q1. With the demand curve DD, industry output is Q1. The number of firms in the industry is N1 (= Q1/q1). If q1, the minimum average cost output on LAC1, is small relative to DD, N1 will be large. Each firm has a tiny effect on industry supply and market price. We have found a perfectly competitive industry. Next, suppose that each firm has the cost curve LAC3. Scale economies are vast relative to the market size. At the lowest point on LAC3, output is big relative to the demand curve DD. Suppose initially two firms each make q2. Industry output is Q2. The market clears at P2 and both firms break even. If one firm expands a bit, its average costs fall. Its higher output also bids the price down. With lower average costs, that firm survives but the other firm loses money. The f irm that expands undercuts its competitor and drives it out of business. This industry is a natural monopoly. Suppose Q3 is the output at which its marginal cost and marginal revenue coincide. The price is P3 and the natural A natural monopoly enjoys monopoly makes supernormal profits. There is no room in the industry for other such scale economies that it firms with access to the same LAC3 curve. has no fear of entry by others. A new entrant needs a big output to get average costs down. Extra output on this scale so depresses the price that both firms make losses. The potential entrant cannot break in. Finally, we show the LAC2 curve with more economies of scale than a competitive industry but fewer than a natural monopoly. This industry supports at least two firms enjoying scale

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Figure 9.1 Demand, costs, and market structure
The N-firm concentration ratio is the market share of the largest N firms in the industry.

Chapter 9: Market structure and imperfect competition

Even industries with only a few key players have some small firms on the fringe. The total number of firms can be a misleading indicator of the structure of the industry. Economists use the N-firm concentration ratio to measure the number of key firms in an industry. Thus, the 3-firm concentration ratio tells us the market share of the largest three firms. If there are three key firms, they will supply most of the market. If the industry is perfectly competitive, the largest three firms will only have a tiny share of industry output and sales. It would be nice to look at cross-country evidence to see if market structures always obey our theory. If this is to be an independent check, we really need national data before globalization and European integration became important. Table 9.3 examines evidence for the UK, France and Germany for the mid-1970s. CR is the 3-firm concentration ratio, the market share of the top three firms. NP is the number of plants at minimum efficient scale that the market size allows. If our theory of market structure is correct, industries with big scale economies relative to market size, and thus few plants NP, should have a large concentration ratio CR. Such industries should have few key firms. Conversely, where NP is very high, economies of scale are relatively unimportant and the largest three firms should have a much smaller market share. CR should be low. Table 9.3 confirms that this theory of market structure fits these facts. Industries such as refrigerator and cigarette manufacture had room for few plants operating at minimum efficient scale: these industries had high degrees of concentration. The largest three firms controlled almost the whole market. Scale economies still mattered in industries such as brewing and petroleum refining: the top three firms had about half the market. Industries such as shoemaking quickly met rising average cost curves, had room for many factories operating at minimum efficient scale and thus were much closer to competitive industries. The top three firms in shoemaking had under one-fifth of the market.
Table 9.3 Industry Refrigerators Cigarettes Refineries Brewing Fabrics Shoes Concentration and scale economies UK CR 65 94 79 47 28 17 NP 1 3 8 11 57 165 France CR 100 100 60 63 23 13 NP 2 2 7 5 57 128 Germany CR 72 94 47 17 16 20 NP 3 3 9 16 52 197

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D P3 Price, average costs LAC 2 LAC 3 P2 LAC 1 P1 D 0 q1 q2 q4 Q3 Q2 Q1 Output q of a firm and output Q of the industry
DD is the industry demand curve. In a competitive industry, minimum efficient scale occurs at an output level q1, when firms have average cost curves LAC1. The industry can support a very large number of firms whose total output is Q1 at the price P1. When LAC3 describes average costs, the industry will be a natural monopoly. When a single firm produces the entire industry output, no other firm can break into the market and make a profit. For intermediate positions such as LAC2 the industry can support a few firms in the long run, and no single firm can profitably meet the entire demand. The industry will be an oligopoly.

economies near the bottom of their LAC2 curves. It is an oligopoly. Attempts to expand either firms output beyond q4 quickly meet decreasing returns to scale and prevent a firm driving competitors out of business. The crucial determinant of market structure is minimum efficient scale relative to the size of the total market as shown by the demand curve. Table 9.2 summarizes our analysis of the interaction of market size and minimum efficient scale. When the demand curve shifts to the left, an industry previously with many firms may have room for only a few. Similarly, a rise in fixed costs, raising the minimum efficient scale, reduces the number of firms. In the 1950s there were Table 9.2 Demand, cost and market structure many European aircraft makers. Today, Minimum efficient scale relative to market size the research and development costs of a Tiny Intermediate Large major commercial airliner are huge. Apart Perfect competition Oligopoly Natural monopoly from the co-operative European venture Airbus Industrie, only the American giant The Boeing Company survives. Monopolistic competition lies between oligopoly and perfect competition. Monopolistic competitors supply different versions of the same product, such as the particular location of a newsagent.
Minimum efficient scale is the lowest output at which a firms LAC curve stops falling.

Note: Concentration ratio CR is % market share of 3 largest firms; number of plants NP is market size divided by minimum efficient scale. Sources: F. M. Scherer et al., The Economics of Multiplant Operation, Harvard University Press, 1975; and F. M. Scherer, Industrial Market Structure and Economic Performance, Rand McNally, 1980.

Evidence on market structure

The larger the minimum efficient scale relative to the market size, the fewer the number of plants and probably the number of firms in the industry. What number of plants (NP) operating at minimum efficient scale does a market size allow? Chapter 7 discussed estimates of minimum efficient scale in different industries. By looking at the total purchases of a product we can estimate market size. Hence we can estimate NP for each industry.

Globalization is the closer integration of markets across countries. Multinationals are firms operating in many countries simultaneously.

Globalization and multinationals

Table 9.3 showed data before the rise of globalization and multinationals. Globalization reflects cheaper transport costs, better information technology and a deliberate policy of reducing cross-country barriers in order to get efficiency gains from large scale and specialization. Multinationals sell in many countries at the same time. They may, or may not, also produce in many countries.

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272 Part 3 : Welfare economics Chapter 15: Welfare economics
disaster is avoided. Indirect control, through taxes or charges, runs the risk that the government does its sums wrong and set the tax too low. Pollution is then higher than intended and may be disastrous. Regulating the total quantity of pollution, with spot checks on compliance by individual producers, is a simple policy that avoids the worst outcomes. However, by ignoring differences in the marginal cost of reducing pollution across different polluters, it does not reduce pollution in the way that is cost-minimizing to society.

273

Prices versus quantities

If free markets tend to overpollute, society can cut pollution either by regulating the quantity of pollution or by using the price system to discourage such activities by taxing them. Is it more sensible to intervene through the tax system than to regulate quantities directly? Many economists prefer taxes to quantity restrictions. If each firm is charged the same price or tax for a marginal unit of pollution, each firm equates the marginal cost of reducing pollution to the price of pollution. Any allocation in which different firms have different marginal costs of reducing pollution is inefficient. If firms with low marginal reduction costs contract further and firms with high marginal reduction costs contract less, lower pollution is achieved at less cost. The main problem with using taxes rather than quantity restrictions is uncertainty about outcome. Suppose pollution beyond a critical level has disastrous consequences, for example irreversibly damaging the ozone layer. By regulating the quantity directly, society can ensure a

Examples throughout the chapters bring economics to life and demonstrate the application of theories and concepts to contemporary issues.

Lessons from the United States

The US has gone furthest in trying to use property rights and the price mechanism to cut back pollution efficiently. The US Clean Air Acts established an environmental policy that includes an emissions trading programme and bubble policy. The Acts lay down a minimum standard for air quality and impose pollution emission controls to particular polluters. Any polluter emitting less than their specified amount gets an emission reduction credit (ERC), which can be sold to another polluter wanting to exceed its allocated pollution limit. Thus, the total quantity of pollution is regulated but firms that can reduce pollution cheaply have an incentive to do so, and sell off the ERC to firms for which pollution reduction is more expensive. We get closer to the efficient solution in which the marginal cost of pollution reduction is equalized across firms. When a firm has many factories, the bubble policy applies pollution controls to the firm as a whole. The firm can cut back most in the plants in which pollution reduction is cheapest. Thus, the US policy combines control over quantities for aggregate pollution, where the risks and uncertainties are greatest, with control through the price system for allocating efficiently the way these overall targets are achieved.

BOX 15-2

Atmosphere of pollution
timetres. As with acid rain, organizing collective international cutbacks has been difficult. In 1997 the Kyoto Protocol agreed national targets for lower emissions of greenhouse gases. Becoming binding in 200812, the Kyoto deal would have cut emissions by 5 per cent relative to the 1990 level, but by much more relative to the growth that a do-nothing policy would have allowed. The table shows 1990 levels, actual behaviour in the 1990s and the target for 2012. BOX 15-3
1990 emissions (million tonnes) Japan USA Germany UK Italy France Spain 1190 5713 1204 715 532 498 301 2012 target (% change from 1990 level) 6 7 21 12 6 0 +15

Chlorofluorocarbons (CFCs), gases used in things like aerosols, are destroying the ozone layer that protects the earth from solar rays. Without this sunscreen, more people develop skin cancer. Organizing international cutbacks in atmospheric pollution is difficult: each country wants to free-ride, enjoying the benefits of other countries cutbacks but making no contribution of its own. The Montreal Protocol on substances that deplete the ozone layer was signed by nearly 50 countries in 1987. Before the Protocol, projected ozone depletion was 5 per cent by 2025 and 50 per cent by 2075. In the Protocol, countries agreed to take steps to reduce ozone depletion to 2 per cent by 2025 with no further deterioration thereafter. Such optimistic aims are hard to achieve. A second type of atmospheric pollution is even more important. The greenhouse effect arises from emissions of CFCs, methane, nitrous oxide and, especially, carbon dioxide. Greenhouse gases are the direct result of pollution and the indirect result of the atmospheres reduced ability to absorb them. Plants convert carbon dioxide into oxygen. Chopping down forests to clear land for cattle, as global demand for hamburgers rises, has accelerated the greenhouse effect. The consequence is global warming. People in London and Stockholm get better suntans, people in Africa face drought and famine. As icecaps melt, the sea rises, flooding low-lying areas. By 2070 the temperature will have risen by 4 C, and the sea by 45 cen-

EU climate targets in trouble?

are 111 per cent of total CO2 emissions in 2000. As a result the forward market in permits fell from m12 per tonne of CO2 to m6 per tonne. However, there are other considerations. The UK government has suggested that it will restrict the supply of permits to the extent that the UK more than meets its obligations under the Kyoto agreement. However, business is concerned that the resulting higher price of emission permits will place UK business at a significant costs disadvantage to its EU rivals.
Country UK France Germany Italy Netherlands Czech Republic
Source: OECD

In 2001 US President George W Bush announced that the United States would not ratify the Kyoto Protocol because it did not oblige poorer countries such as India and China to do their share of pollution reduction. In July 2001, after a meeting in Bonn, 178 countries decided to proceed with a weaker version of the Kyoto Protocol, despite the refusal of the United States to participate.

Experts in the emerging market for climate-friendly investment fear a key scheme to cut the amount of carbon dioxide (CO 2 ) reaching the atmosphere could fail. The controversy centres on the EU Emissions Trading Scheme which comes into force next year and forms a central plank of the policy to meet the targets set by the Kyoto climate change agreement. Most countries are still well adrift of those targets which require EU emissions to be 8 per cent below 1990 levels over the period 2008 12. Adapted from BBC News Online, 30 April 2004.

Review questions
These questions encourage you to review and apply the knowledge you have acquired from each chapter and can be undertaken to test your understanding or as a focus for discussion in class. Students can check progress by reviewing the answers at the back of the book.

A market in emission permits should create a financial incentive to invest in cleaner technology. But such a system will only work if the price of permits is higher than the cost of investing in lower emission production technologies. The concern at present is that governments within the EU are oversupplying permits to business, leading to an excess supply and a fall in the price of permits. For 2004 Italy has provided permits which

CO2 emissions (tonnes per capita) 9.3 6.3 10.5 7.3 11.0 12.0

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End of chapter summary

This briefly reviews and reinforces the main topics covered in each chapter, offering a useful revision too and a means of testing that a solid understanding of the key topics has developed.
180 Part 2 : Positive microeconomics
Technical progress and capital investment in the basic utilities energy and water supply meant that jobs continued to contract in the sector. Table 10.1 confirms that, with so much capital per worker, workers are very productive and are highly paid. However, privatization and greater competition within this sector have eroded the bargaining power of workers, who have not secured substantial wage increases over the last decade.

Chapter 10: The labour market G The industry supply curve of labour depends on the wage paid relative to wages in other
industries using similar skills. Equilibrium wage differentials are the monetary compensation for differences in non-monetary characteristics of jobs in different industries undertaken by workers with the same skill. Taking monetary and non-monetary rewards together, there is then no incentive to move between industries.

181

G When the labour supply curve to an industry is less than perfectly elastic, the industry pays

S U M M A RY
G In the long run, a firm chooses a production technique to minimize the cost of a particular
output. By considering each output, it constructs a total cost curve.

higher wages to expand employment. For the marginal worker, the wage is a pure transfer earning, required to induce that worker into the industry. For workers prepared to work in the industry at a lower wage, there is an element of economic rent (the difference between income received and transfer earnings for that individual).

G In the long run, a rise in the price of labour (capital) has a substitution effect and an
output effect. The substitution effect reduces the quantity of labour (capital) demanded as the capitallabour ratio rises (falls) at each output. But total costs and marginal costs of output increase. The more elastic the firms demand curve and marginal revenue curve, the more the higher marginal cost curve reduces output, reducing demand for both factors. For a higher price of a factor, the substitution and output effects both reduce the quantity demanded.

G In free market equilibrium, some workers choose not to work at the equilibrium wage rate.
They are voluntarily unemployed. Involuntary unemployment is the difference between desired supply and desired demand at a disequilibrium wage rate. Workers would like to work but cannot find a job.

G There is considerable disagreement about how quickly labour markets can get back to
equilibrium if initially in disequilibrium. Possible causes of involuntary unemployment are minimum wage agreements, trade unions, scale economies, insideroutsider distinctions and efficiency wages.

G In the short run, the firm has fixed factors, and probably a fixed production technique.
The firm can vary short-run output by varying its variable input, labour, which is subject to diminishing returns when other factors are fixed. The marginal physical product of labour falls as more labour is hired.

REVIEW QUESTIONS
1 G 2 G (a) Explain why the marginal product of labour eventually declines. (b) Show in a diagram the effect of an increase in the firms capital stock on its demand curve for labour. Over the last 100 years the real wage has risen but the length of the working week has fallen. (a) Explain this result using income and substitution effects. (b) Explain how an increase in the real wage could cause everyone in employment to work fewer hours but still increase the total amount of work done in the economy. Why should the labour supply curve to an industry slope upwards even if the aggregate labour supply to the economy is fixed? Answer the questions with which we began the chapter. (a) Why can a top golfer earn more in a weekend than a university professor earns in a year? (b) Why can students studying economics expect to earn more than equally smart students studying philosophy? Common fallacies Why are the following statements wrong? (a) There is no economic reason why a sketch that took Picasso one minute to draw should fetch 100 000. (b) Higher wages must raise incentives to work.

G A profit-maximizing firm produces the output at which marginal output cost equals marginal
output revenue. Equivalently, it hires labour until the marginal cost of labour equals its marginal revenue product. One implies the other. If the firm is a price-taker in its output market, the MRPL is its marginal value product, the output price times its marginal physical product. If the firm is a price-taker in the labour market, the marginal cost of labour is the wage rate. A perfectly competitive firm equates the real wage to the marginal physical product of labour.

G The downward-sloping marginal physical product of labour schedule is the short-run

demand curve for labour (in terms of the real wage) for a competitive firm. Equivalently, the marginal value product of labour schedule is the demand curve in terms of the nominal wage. The MVPL schedule for a firm shifts up if the output price increases, the capital stock increases or if technical progress makes labour more productive.

3 G 4 G

G The industrys labour demand curve is not merely the horizontal sum of firms MVPL
curves. Higher industry output in response to a wage reduction also reduces the output price. The industry labour demand curve is steeper (less elastic) than that of each firm, and more inelastic the more inelastic is the demand curve for the industrys output.

5 G

G Labour demand curves are derived demands. A shift in the output demand curve for the
industry will shift the derived factor demand curve in the same direction.

G For someone already in the labour force, a rise in the hourly real wage has a substitution
effect tending to increase the supply of hours worked, but an income effect tending to reduce the supply of hours worked. For men, the two effects cancel out almost exactly in practice but the empirical evidence suggests that the substitution effect dominates for women. Thus women have a rising labour supply curve; for men it is almost vertical.

To check your answers to these questions, go to pages 000000.

G Individuals with non-labour income may prefer not to work. Four things raise the
participation rate in the labour force: higher real wage rates, lower fixed costs of working, lower non-labour income and changes in tastes in favour of working. These explain the trend for increasing labour force participation by married women over the last few decades.

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Chapter appendices
182 Part 2 : Positive microeconomics To help you grasp the key concepts of this chapter check out the
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Chapter 10: The labour market

Figure 10.A2 L I"' L1 I' Labour Labour L0 I C B A I" I' L2 C K1 K Capital
At the old factor prices the firms output level corresponds to the isoquant I. All isocost lines have the same slope as L1K1 and the firm produces its given output most cheaply by choosing the point B where the isoquant is tangent to the lowest possible isocost line L1K1. A wage increase makes all isocost lines flatter, parallel to L 2 K 1 . Each unit of capital sacrificed now allows the purchase of less additional labour. The wage increase has a pure substitution effect from B to B where the original isoquant I has the same slope as the new isocost lines. Firms substitute capital for labour. But with higher marginal costs at each output level, the firms profit-maximizing output is reduced, say to the level corresponding to the isoquant I. On this isoquant, costs are minimized by producing at C to reach the lowest possible isocost line L2K1 at the new factor prices. The move from B to C is the pure effect induced by the shift in the firms marginal cost curve for its output.

183

Cost minimization

Figure 10.A3 L L1

The effect of a wage increase

I"

I"

I' B B' I" I' K1 K

I"'

Appendix Isoquants and the choice of production technique

The choice of technique can be examined with techniques similar to the indifference curvebudget line approach used to study consumer choice in Chapter 5. Figure 10.A1 plots input quantities of capital K and labour L. Points A, B, C, and D An isoquant shows minimum show the minimum input quantities needed to make 1 unit of output using each combinations of inputs to make of four different techniques. Technique A is the most labour-intensive, requiring a given output. Different points on an isoquant reflect different LA units of labour and KA units of capital to make 1 unit of output. Technique D production techniques. is the most capital intensive. Connecting A, B, C, and D yields an isoquant (iso = the same, quant = quantity). Figure 10.A1 shows 4 techniques but we can Figure 10.A1 An isoquant imagine that there are other techniques. Figure 10.A2 shows smooth isoquants. Isoquant I corresponds to a particular output. Each point on isoA quant I reflects a different technique, from very LA capital intensive to very labour intensive. Higher isoquants, such as I, show higher output levels since more inputs are required. Each isoB quant shows different input combinations to make a given output. The isoquants constitute an isoquant C map. D Three properties of isoquants are important. First, they cannot cross. Each isoquant refers to a different output. Second, each isoquant slopes down. To make a given output, a technique can use 0 KA K more capital only if it uses less labour and vice versa. Capital Hence isoquants must slope down. Third, Figure Points A, B, C, and D show different input combinations required 10.A2 each isoquant becomes flatter as we move to produce 1 unit of output. By connecting them we obtain an isoquant that shows the different input combinations which can along it to the right, as Figure 10.A2 shows. Moving produce a particular level of output. down a given isoquant, it takes more and more extra capital input to make equal successive reductions in the labour input required to produce a given output. In Figure 10.A2 the line L0K0 is an isocost line. It shows different input combinations with the same total cost. For a given cost, the firm can use more units of capital only if it uses fewer units of labour. Facing given prices at which different inputs may be hired, we can say two things about isocost lines. First, the slope of the isocost line reflects the relative price of the two factors of production. Beginning at K0, where all the firms money is spent on capital, the firm can trade off 1 unit of
Labour D 0 Capital K0 I

Each isoquant such as I shows a particular output level. Higher isoquants such as I show higher output levels. Straight lines such as L0K0 are isocost lines showing different input combinations having the same total cost. The slope of an isocost line depends only on relative factor prices. A higher isocost line such as L1K1 implies a larger total cost. To produce a given output, such as that corresponding to the isoquant I , the firm chooses the point of tangency of that isoquant to the lowest possible isocost line. Thus poiint A is the cost minimizing way to produce the output level on I and point B the cost minimizing way to produce the output level on I.

These sections at the end of the chapters provide further explanations of economic models for those who wish to use them. They are not necessary to understand the economics of the text but rather for those who are interested in expanding their knowledge further.

capital for more units of labour the cheaper the wage rate relative to the rental cost of capital. Second, facing given factor prices, by raising spending a firm can have more capital and more labour. A higher isocost line parallel to L0K0 shows a higher spending on inputs. Along the isocost line L1K1 the firm spends more on inputs than along the isocost line L0K0. To minimize the cost of making a given output, a firm chooses the point of tangency of that isoquant to the lowest possible isocost line. At this point, the (negative) slope of the isocost line equals the (negative) slope of the isoquant. If w is the wage rate and r the rental cost of a unit of capital, the slope of the isocost line is r/w. What about the slope of the isoquant? With an extra unit of capital, the firm gains MPK units of output, where MPK is the marginal physical product of capital. But along an isoquant output is constant. By shedding a unit of labour the firm gives up MPL units of output. Lowering labour input by [MPK/MPL] keeps output constant when capital input is 1 unit higher. The isoquants slope [MPK/MPL] tells us by how much labour is changed to keep output constant when capital is 1 unit higher. Hence the tangency condition in Figure 10.A2 implies: Slope of isocost line = r/w = MPK/MPL = slope of isoquant

(A1)

Point A in Figure 10.A2 is the least-cost way to make the output shown by isoquant I. We can repeat this analysis for every other isoquant showing different outputs. That is how we derive the total cost curve discussed in the text.

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