Introduction to Economic Analysis.pdf

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Introduction to Economic Analysis

R. Preston McAfee

J. Stanley Johnson Professor of

Business, Economics & Management

California Institute of Technology

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McAfee: Introduction to Economic Analysis, http://www.introecon.com , July 24, 2006

Dedication to this edition :

For Sophie. Perhaps by the time she goes to university, we’ll have won the war against

the publishers.

Disclaimer :

This is the third draft. Please point out typos, errors or poor exposition, preferably by

email to intro@mcafee.cc . Your assistance matters.

In preparing this manuscript, I have received assistance from many people, including

Michael Bernstein, Steve Bisset, Grant Chang-Chien, Lauren Feiler, Alex Fogel, Ben

Golub, George Hines, Richard Jones, Jorge Martínez, Joshua Moses, Dr. John Ryan,

and Wei Eileen Xie. I am especially indebted to Anthony B. Williams for a careful,

detailed reading of the manuscript yielding hundreds of improvements.

McAfee: Introduction to Economic Analysis, http://www.introecon.com , July 24, 2006

This work is licensed under the Creative Commons Attribution-

NonCommercial-ShareAlike License. To view a copy of this license, visit

http://creativecommons.org/licenses/by-nc-sa/2.0/

or send a letter to Creative Commons, 559 Nathan Abbott Way, Stanford, California

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Please email changes to intro@mcafee.cc.

Introduction to Economic Analysis

Version 2.0

R. Preston McAfee

J. Stanley Johnson Professor of

Business, Economics & Management

California Institute of Technology

Begun: June 24, 2004

This Draft: July 24, 2006

This book presents introductory economics (“principles”) material using standard

mathematical tools, including calculus. It is designed for a relatively sophisticated

undergraduate who has not taken a basic university course in economics. It also

contains the standard intermediate microeconomics material and some material that

ought to be standard but is not. The book can easily serve as an intermediate

microeconomics text. The focus of this book is on the conceptual tools and not on fluff.

Most microeconomics texts are mostly fluff and the fluff market is exceedingly over-

served by $100+ texts. In contrast, this book reflects the approach actually adopted by

the majority of economists for understanding economic activity. There are lots of

models and equations and no pictures of economists.

McAfee: Introduction to Economic Analysis, http://www.introecon.com , July 24, 2006

iii

Table of Contents

1 WHAT IS ECONOMICS? ..............................1-1

1.1.1 Normative and Positive Theories ..................1-2

1.1.2 Opportunity Cost ..........................................1-3

1.1.3 Economic Reasoning and Analysis ................1-5

2 SUPPLY AND DEMAND ...............................2-8

2.1 Supply and Demand .................................2-8

2.1.1 Demand and Consumer Surplus ...................2-8

2.1.2 Supply .........................................................2-13

2.2 The Market ...............................................2-18

2.2.1 Market Demand and Supply .......................2-18

2.2.2 Equilibrium .................................................2-20

2.2.3 Efficiency of Equilibrium ............................2-22

2.3 Changes in Supply and Demand ..........2-22

2.3.1 Changes in Demand ....................................2-22

2.3.2 Changes in Supply .......................................2-23

2.4 Elasticities ................................................2-27

2.4.1 Elasticity of Demand ...................................2-27

2.4.2 Elasticity of Supply .....................................2-30

2.5 Comparative Statics ...............................2-30

2.5.1 Supply and Demand Changes .....................2-30

2.6 Trade .........................................................2-32

2.6.1 Production Possibilities Frontier ................2-32

2.6.2 Comparative and Absolute Advantage ........2-36

2.6.3 Factors and Production ...............................2-38

2.6.4 International Trade .....................................2-39

3 THE US ECONOMY .....................................3-41

3.1.1 Basic Demographics ....................................3-41

3.1.2 Education ....................................................3-47

3.1.3 Households and Consumption ....................3-49

3.1.4 Production ..................................................3-56

3.1.5 Government ................................................3-65

3.1.6 Trade ...........................................................3-73

3.1.7 Fluctuations ................................................3-76

4 PRODUCER THEORY .................................4-79

4.1 The Competitive Firm ............................4-79

4.1.1 Types of Firms ............................................4-79

4.1.2 Production Functions ..................................4-81

4.1.3 Profit Maximization ....................................4-85

4.1.4 The Shadow Value .......................................4-91

4.1.5 Input Demand .............................................4-92

4.1.6 Myriad Costs ...............................................4-95

4.1.7 Dynamic Firm Behavior ..............................4-97

4.1.8 Economies of Scale and Scope ..................4-100

4.2 Perfect Competition Dynamics ..........4-104

4.2.1 Long-run Equilibrium ...............................4-104

4.2.2 Dynamics with Constant Costs ..................4-105

4.2.3 General Long-run Dynamics .....................4-109

4.3 Investment .............................................4-114

4.3.1 Present value .............................................4-114

4.3.2 Investment ................................................4-118

4.3.3 Investment Under Uncertainty .................4-120

4.3.4 Resource Extraction ..................................4-125

4.3.5 A Time to Harvest .....................................4-127

4.3.6 Collectibles ................................................4-130

4.3.7 Summer Wheat .........................................4-135

5 CONSUMER THEORY ............................. 5-139

5.1 Utility Maximization ........................... 5-139

5.1.1 Budget or Feasible Set .............................. 5-140

5.1.2 Isoquants ................................................. 5-143

5.1.3 Examples .................................................. 5-148

5.1.4 Substitution Effects .................................. 5-151

5.1.5 Income Effects .......................................... 5-155

5.2 Additional Considerations ................. 5-158

5.2.1 Corner Solutions ...................................... 5-158

5.2.2 Labor Supply ............................................ 5-160

5.2.3 Compensating Differentials ...................... 5-164

5.2.4 Urban Real Estate Prices .......................... 5-165

5.2.5 Dynamic Choice ....................................... 5-169

5.2.6 Risk .......................................................... 5-174

5.2.7 Search ...................................................... 5-178

5.2.8 Edgeworth Box ......................................... 5-181

5.2.9 General Equilibrium ................................. 5-188

6 MARKET IMPERFECTIONS ................... 6-195

6.1 Taxes ....................................................... 6-195

6.1.1 Effects of Taxes ........................................ 6-195

6.1.2 Incidence of Taxes .................................... 6-199

6.1.3 Excess Burden of Taxation ....................... 6-200

6.2 Price Floors and Ceilings ................... 6-202

6.2.1 Basic Theory ............................................. 6-203

6.2.2 Long- and Short-run Effects ..................... 6-207

6.2.3 Political Motivations ................................ 6-209

6.2.4 Price Supports .......................................... 6-210

6.2.5 Quantity Restrictions and Quotas ............ 6-211

6.3 Externalities ......................................... 6-213

6.3.1 Private and Social Value, Cost .................. 6-214

6.3.2 Pigouvian Taxes ....................................... 6-217

6.3.3 Quotas ...................................................... 6-218

6.3.4 Tradable Permits and Auctions ................ 6-219

6.3.5 Coasian Bargaining .................................. 6-220

6.3.6 Fishing and Extinction ............................. 6-221

6.4 Public Goods ......................................... 6-226

6.4.1 Examples .................................................. 6-226

6.4.2 Free-Riders .............................................. 6-227

6.4.3 Provision with Taxation ........................... 6-229

6.4.4 Local Public Goods ................................... 6-230

6.5 Monopoly ............................................... 6-232

6.5.1 Sources of Monopoly ................................ 6-232

6.5.2 Basic Analysis ........................................... 6-233

6.5.3 Effect of Taxes .......................................... 6-236

6.5.4 Price Discrimination ................................ 6-237

6.5.5 Welfare Effects ......................................... 6-240

6.5.6 Two-Part Pricing ...................................... 6-240

6.5.7 Natural Monopoly .................................... 6-241

6.5.8 Peak Load Pricing ..................................... 6-242

6.6 Information .......................................... 6-245

6.6.1 Market for Lemons ................................... 6-245

6.6.2 Myerson-Satterthwaite Theorem .............. 6-246

6.6.3 Signaling .................................................. 6-248

7 STRATEGIC BEHAVIOR ......................... 7-251

7.1 Games ..................................................... 7-251

7.1.1 Matrix Games ........................................... 7-251

7.1.2 Nash Equilibrium ..................................... 7-255

7.1.3 Mixed Strategies ....................................... 7-257

7.1.4 Examples .................................................. 7-262

7.1.5 Two Period Games ................................... 7-265

McAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006

7.1.6 Subgame Perfection .................................. 7-266

7.1.7 Supergames .............................................. 7-268

7.1.8 The Folk Theorem .................................... 7-269

7.2 Cournot Oligopoly ................................ 7-270

7.2.1 Equilibrium .............................................. 7-271

7.2.2 Industry Performance ............................... 7-272

7.3 Search and Price Dispersion ............. 7-274

7.3.1 Simplest Theory ........................................ 7-275

7.3.2 Industry Performance ............................... 7-277

7.4 Hotelling Model .................................... 7-279

7.4.1 Types of Differentiation ............................ 7-279

7.4.2 The Standard Model ................................. 7-280

7.4.3 The Circle Model ....................................... 7-280

7.5 Agency Theory ...................................... 7-283

7.5.1 Simple Model ............................................ 7-284

7.5.2 Cost of Providing Incentives ..................... 7-286

7.5.3 Selection of Agent ..................................... 7-287

7.5.4 Multi-tasking ............................................ 7-288

7.5.5 Multi-tasking without Homogeneity ......... 7-292

7.6 Auctions ..................................................7-295

7.6.1 English Auction .........................................7-295

7.6.2 Sealed-bid Auction ....................................7-296

7.6.3 Dutch Auction ...........................................7-298

7.6.4 Vickrey Auction .........................................7-299

7.6.5 Winner’s Curse ..........................................7-301

7.6.6 Linkage .....................................................7-303

7.6.7 Auction Design ..........................................7-304

7.7 Antitrust .................................................7-306

7.7.1 Sherman Act .............................................7-306

7.7.2 Clayton Act ................................................7-308

7.7.3 Price-Fixing ..............................................7-309

7.7.4 Mergers .....................................................7-311

8 INDEX ..........................................................8-315

8.1

List of Figures .......................................8-315

8.2

Index .......................................................8-317

McAfee: Introduction to Economic Analysis, http://www.introecon.com, July 24, 2006

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