BrowningAndZupan

Comments on

Microeconomic Theory and Applicationsby Browning and Zupan

as used in Intermediate Microeconomics (Econ 303) at Ohio University. This course is offered

also as correspondence course / distance learning / independent study through the Independent

and Distance Learning Program at Ohio U.

Dr. Christopher Barrington-Leigh

May 2003

If you are using this text in your course, please read my comments below, writtenfor the 5th Edition. Many of them concern the ideological and deceptive nature of thematerial in this text. Please send comments to me by email (easy to find on the ’net). Ifyour course uses this text, I believe your department’s role in undergraduate educationis to replace common sense with ideological (highly normative; not scientific) anddangerous absurdities.

This document is a compilation of my homeworks, so bits of it may not be in-teresting. See, though, for some of the most blatant dishonesty, instances of outrightmathematical deception in aggregating the supply curve (on page 39) and in aggregat-ing the demand curve (on pages 19 and 20).

Contents

1 Assignment 1 / Chapter One 2

2 Assignment 1 / Chapter Two 5

3 Assignment 2 / Chapter Three 8

4 Assignment 3 / Chapter Four 14

5 Responses to comments 20

6 Assignment 4 / Chapters Five and Eight 22

7 Assignment 5 / Chapter Nine 31

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8 Assignment 7 / Chapter Ten 36

1 Assignment 1 / Chapter One

1. Why is microeconomics frequently called price theory?

Microeconomics considers proximal causes or effects of price. Adherents con-sider price to be a central piece of communication in society, and this choice islikely because price is most easily measurable rather than because it is especiallyimportant when compared with all the other institutional, social, psychological,and practical cues that help to communicate about what things to produce.

2. How do economists and others develop economic theories or principles? Whatare the limitations of economic principles?

Theories in the sciences generally deal with isolable subsystems, and describea fairly complete set of relevant causes and effects. In contrast, economics hasan insurmountable selection problem: there are no isolable systems; any “sub-system” chosen is not a subset of the system, but rather a subset of causes andeffects. Those causes which an economic theorist wishes to emphasize (ie, offerfor policy change) are called causes, and the rest are called “preconditions” oretc. The choice of which “causes” are to be open to change and which are fixedas “preconditions” is often a matter of policy and requires cognizance of one’svalues.

Economic principles are limited by two problems that separate economics frombasic sciences. First, the relationships involved in deciding what a society choosesto produce are so complex and historical that any economic principle needs muchnon-quantitative context to determine its applicability or use – i.e., any useful(compact) theory must choose a tiny subset of causes and effects to take on, andcannot be expected to be relevant to a majority of well-posed questions.

Second, economics is full of reflexive ideas and theories: that is, beliefs abouteconomic causes, effects, and predictions can have positive feedback (e.g.,infla-tion, recession,etc.) or negative feedback on what actually happens. Therefore,such predictions, though ostensibly falsifiable propositions, can be intrinsicallyneither correct nor incorrect. Clearly, historical analysis and awareness of beliefsand values (thus debate) is crucial for the best available understanding of causal-ity. A related problem is that, unlike lower sciences, and maybe even more sothan history, the language of economics is non-neutral. It is full of loaded wordssuch as “perfect,” “efficiency,” etc; it is hard in such a socially important andcontentious discipline to formulate concepts which are objective.

As a result, I wonder whether microeconomics, for example, has been generallysuccessful in predicting many real things beyond built-in relationships whichwere otherwise already known to any entrepreneur who is making choices re-garding changing demand. Businesspeople are more likely to think in terms ofcausal principles of psychology and to focus on the formation of tastes and pref-

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erences, rather than to consider price, wealth, and tastes as independent variables(i.e. there’s the problem of selection of “causes” vs “conditions”).

3. Explain the difference between positive and normative analysis.

I don’t see any difference, except in rhetoric. Claiming that a question or theoryregarding causality is devoid of subjective judgments is to be unaware of one’svalues which went into choosing the question, or choosing the causes identifiedas such in a theory. Facts are still facts — some superficial things can be observedor measured to exist in a certain state — but causality in complex systems (e.g.,with feedback) is a matter of choosing which necessary conditions to identify as“causes” (ie., under consideration for change). Considering the minimum wageexample given: if your theory (trains and) allows you to make calculations aboutaggregate employment numbers (rather than security or quality of jobs, distribu-tion of employment amongst different industries, U.N. HDI, degree of frustrateddemand, political participation, or etc.) then those are the kinds of qualitativeeffects that will be looked for and on which more normative judgments will bemade.

Since what the text calls “expected, objective outcomes” (p. 3) must be highlyincomplete (system is too complex to offer a complete description), ie selective,they are not objective. This is the case for all history and cause/effect/predictioneconomics.

In non-social sciences, the three-step process described on page 3 doesn’t exist.There is no difference between determining whether the magnitude of an effect isconsiderable and determining whether it qualitatively occurs. The “qualitative”step described here is a sign of the normative nature of economic analysis.

4. In a conflict between positive and normative analysis which should be more im-portant? Explain.

I cannot imagine a conflict between positive and normative, which seem to existas a continuum and usually in subtle measure. It is most important to makestatements only of truth, even though the analysis is normative, and to understandhow one’s own and others’ values affect the form of analysis, i.e. to know whatquestions one has chosen to answer. Even better is to also be aware of, and to beable to do analysis on behalf of, others’ sets of questions / values.

In science, no quantitative proposition is ever made without a detailed state-ment/analysis of uncertainty (e.g., in experiment, determining this from all rel-evant factors is always harder than calculating the value of the measurementitself). This seems also important to emulate in any economic analysis.

5. Analyze the three basic assumptions made by economists about buyers and sell-ers in markets.

The first assumption is that of “self-interested behavior.” This is described inthe text as being entirely tautologous, since it is not falsifiable — all behavior isconsidered by followers of this ideology to be self-interested. Tautologous state-ments have no prediction or explanation value. This seems especially dangerous

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since people who are not adherents of the ideology but are exposed to it are notlikely to assume a tautologous meaning for “self-interested.” Indeed, the ideais superficially absurd to mammalian biologists, social psychologists, and mostpeople, especially those from most cultures without a strong social/academicinfluence from microeconomists. It appears to describe not a universal trait ofbehavior, but a rhetorical prescription for a particular hypothetical society.

The second and third assumptions are those of rational behavior and limitlesswants. These “assumptions” are things which could be related directly to obser-vations — i.e., assessed for legitimacy — in the textbook. Are these statementsthought to be true by experts who study human behaviour?

To assume rational behavior as a fundamental cause and then consider non-rational behavior (I am guessing we must consider this later in microecon?) as aperturbation on the model is an example of normative selection of causes. Onecould just as well choose psychological, moral-driven behavior fundamental, andthen consider other kinds deviations.

The limitless desires assumption seems bizarre to me, and flies in the face ofmany contemporary cultures. Rather than an insight, it seems more to reflect awestern corporate marketing message, likely in light of massive frustrated de-mand (ie certain wants not available at any cost).

6. Much of economic analysis or theory is based on opportunity costs. Explainwhy.

I need help here. The examples in the book (pp 5-6) always use future income asthe individual’s criterion for calculating opportunity cost. How can money be acentral/necessary/underlying concept at this early stage? Surely, money is a veryartificial, non-neutral social tool whose implementation and power structure is ofmajor consequence? If price is the language, how can we hope to evaluate mostof the things we choose between (ie value) when they are not part of the mar-ket subsystem of society? Surely market decisions usually include non-marketalternatives (choices), thus foiling the whole method?

Opportunity cost is central because microeconomics assumes all good things arelimited and must be earned with pain (undesirable things).

7. Explain why it is important to look at a good’s relative price as opposed to itsabsolute or money cost.

Important for what end? — this is not clear to me until I see how the notationproves useful in applied cases. Using prices relative to some CPI may suggestthat inflation is more of an anomaly than, say, changes in distribution of spendingpower. For instance, scaling all prices by the minimum wage rather than animposed set of consumer items might be a more useful practice for economistswith different ideals.

8. By referring to figure 1.2 (p.11) explain why opportunity costs tend to be concaveto the origin.

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I am quite baffled by this example. It does not look like the total number ofstudents is conserved. And it seems just as likely that the school will be ableto change around the use of its infrastructure faster than it can radically changethe professions of its students. Surely any university president will tell you thatit’s very costly to start up a new program or sports team, or to expand it whenit is small, but very easy/cheap to expand it when it is already big. From myexperience, I (and most business owners considering a change/choice) wouldlikely come up with a PPF convex to the origin most of the time. What does“typical” mean here?

9. Explain the difference between economic and accounting costs.

Accounting costs are those transactions which have already been realised/expressedin terms of someone’s currency. Economic costs are whatever possibilities aneconomist can imagine to be expressed in terms of someone’s currency. Sincemost human values and transactions require extraordinary imagination to evalu-ate in terms of someone’s currency, they are simply excluded from both accounts.

10. Why should “sunk” costs be ignored when making economic decisions?

They should not. Clearly, decisions concerning current and future choices con-cern only future effects, and therefore sunk costs cannot be in the set of possiblefuture effects to promote or prevent (ie optimise). They therefore do not havean easy numerical role in any optimisation problem. Nevertheless, this does notmean they should be ignored in decision making, since economic decisions arenever just about numbers. Rather, if a sunk cost becomes a mistake, a historicalanalysis should examine what beliefs and values went into it, and whether theycould recur during one’s current decision.

2 Assignment 1 / Chapter Two

1. Explain the two reasons why the demand curve is negatively sloped.

I only know one. The negative dependence of price on quantity demanded isequivalent to the statement that “the lower the price of a good, the larger thequantity consumers wish to purchase” if all other relevant factors are held to beconstant. The latter is offereda priori in the text.

2. Explain why the supply curve is positively sloped.

Actually, I would expect supply curves to usually lie horizontal or slope down-ward, since in industrial situations, producers always operate at a volume suchthat they can respond to changes (positive or negative) in demand – i.e., not atfull capacity. This means that they can typically benefit from economy of scale(lower price) if they make more. Certainly it seems absurd to consider a positiveslope for low volumes of output.

3. Explain the meaning of an increase in demand and what accounts for increases.

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An “increase in demand” is used to account for the dependence of quantity de-manded on any factors other than the nominal price asked, whenever these effectstend to increase the quantity demanded at a given price. These factors includechanges in distribution of wealth, changes in advertising, changes in the compe-tition/alternatives, changes in values or education, and so on.

4. Explain the meaning of an increase in supply and what explains such increases.

An “increase in supply” is used to account for the dependence of quantity pro-duced on any factors other than the nominal price offered, whenever these effectstend to increase the quantity produced at a given price. These factors could in-clude reduced profit demands, reduced corporate debt loads, new corporate taxloopholes, benefits of publicly funded research spinning off into production, pub-lic stimuli in industries producing intermediate goods, new access to human capi-tal whose production costs (education, health, raising, etc) are borne by someoneelse (e.g. another society), etc.

5. In a perfectly competitive market the market price is constantly changing. Ex-plain why.

In the competitive ideal, there is an assumed equilibrium of price, yet the manyother determinants of supply and demand are acknowledged not to be in equi-librium; therefore the price varies continuously. Indeed, to say that the price isconstantly changing is to contradict the premise that the market is in equilibrium.

6. By referring to figure 2.5, explain equilibrium and disequilibrium of market.

“Equilibrium of the market” is used to mean that changes in adjustments to priceoccur much faster than ANY other of the factors affecting either the quantitysupplied or demanded. Disequilibrium means the opposite. This language alsobiases analysis to focus on the (short, by construction) hypothetical timescalethat is in between variations of price and those of everything else.

Since other factors (supplies, preferences, etc) are likely to be varying as fastor faster than price, there is not likely to be an equilibrium in the sense meanthere. All the argument in the text says is that for the D and S curves shown,market forces tend to push pricetowardsan intersection point, which is vaguebut makes sense. I cannot think of many situations in Western “market-oriented”states where price varies in response to fixed consumer demand, except maybeat farmers markets etc. Why are none listed?

Disequilibrium is not modeled in science by perturbations on equilibrium, as anychemist or meteorologist or etc knows — the dynamics are entirely different.

7. By referring to figure 2.7, explain how market outcomes can be predicted (priceand quantity).

A new assumption is now invoked: that the non-price factors affecting the sup-ply and demand quantities affect one and not the other (unlike price, which isrelated to both). With this, and if price remains more fluid than the change thatis occurring in supply or demand, then if one knows the local dependence of S

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and D on price, a calculable offset of one of S or D allows one to estimate a newset of values for the market price and quantity of sale.

8. What is point elasticity of demand and how is it measured?

Point price elasticity of demand ispQD

∂QD∂p , just one of the many partials in the

total derivative of the demand quantity,QD. I would like help with knowinghow it is measured – i.e., how these hypothetical curves S and D are measured.Certainly one could never hope to measure more than one at once, since onepresumably must watch a non-price-dependent change in one of S or D in orderto learn anything about the form of the other.

In science, great theoretical advances have come about when thinkers have beenmore explicit than before about how, operationally, to measure things. Scientism,on the other hand, thrives when there are poorly defined and unmeasurable (ierhetorical) quantities which nevertheless sound measurable.

9. Explain the arc elasticity formula.

Over some chosen range, the arc price elasticity ofQ is conceptually similar to

η =〈p〉〈Q〉

⟨∂Q∂p

⟩where〈〉 denotes an average over price. (In fact, except for the value of〈Q〉,this is identical to the textbook definition). So it is a form of average useful forapplication with finite changes in the quantities involved.

10. Explain income elasticity, cross-price elasticity, and elasticity of supply.

Income elasticity of demand is the analogous scaled (dimensionless) local de-pendence of quantity demanded on some kind of (mean? median? poverty-line?Average income is not a very insightful quantity to watch in the U.S.A.) incomemeasurement:IQD

∂QD∂I .

Cross-price elasticity of demand is the analogous dependence on the pricep′ ofa related (competitive or complementary or etc) good,p′

QD

∂QD∂p′ .

Price elasticity of the supply quantityQS is analogouslypQS

∂QS∂p .

Questions

Dear Professor,How many goods are what the text calls “normal”? I would expect the majority

of preferences of the majority of people in the world to be highly dependent on theirwealth. It just doesn’t seem like many people want “more” when they have moremoney; they primarily want “different.”

Thank you!!

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3 Assignment 2 / Chapter Three

1. What is the significance of the height of demand and supply curves?

According to the microeconomic premises of individual behaviour, the relation-ship qD(p) exists for an individual; this represents the quantity effectively de-manded at a given price. If this relationship is monotonic (e.g,decreasing), thenthe inverse functionp(qD) also exists and is the maximum unit price the indi-vidual is willing to pay for quantityqD. This meaning for the “height” of thedemand curve cannot be applied to the aggregate demand, since, unlike an indi-vidual “rational” demand,

The aggregate demand function will in general possess no inter-esting properties... The neoclassical theory of the consumer places norestrictions on aggregate behaviour in general.1

Similarly, the relationshipqS(p) may exist (i.e., the price could be the main de-terminant of quantity supplied) for an individual supplier; however, this relation-ship is less likely to be monotonic, since at low output volumes economy of scalewill almost certainly apply, while in some cases on certain timescales, diminish-ing returns will apply for the very upper end of output volumes (i.e., resulting inadown-sloping/flat-bottomed∪-shaped curve). Nevertheless, whileqS(p) wouldthus not be a true function, its inverse, the heightp(qS) of the supply curve, may,and would correspond to the minimum unit paymentp required for the supplierto produce a quantityqS.

2. Explain the concept of marginal benefit and discuss its importance.

Marginal benefit to a consumer is the hypothetical difference between the priceshe pays and the maximum price she might be willing to pay for the purchase.It does not correspond to any change in price, nor any payment, nor anythingtangible. The importance of this idea is not justified in the text. Evaluating the“benefit” to someone in terms of a national currency, regardless of the way thecurrency is implemented or what its purposes are, is hard to interpret. It is hard toimagine the meaning of adding the marginal benefit from one person with that ofanother; it is a premise of the neoclassical ideology outlined in the next chapterthat one cannot compare utility between persons. (Economists with other valuesmight say that you can compare, but not add — that 1$ extra to a wealthy personusually offers less utility than does 1$ to a poor person.) Certainly the intendedsignificance of the aggregated marginal benefit is not explained explicitly in thetext.

3. If price is lowered, what is the impact on consumer surplus? Explain.

Consumer surplus isS=∫ QD

0 (p(qD)− p) dqD wherep is the market price,QD

is the market quantity, and where the maximum price payablep(qD) is thought(as usual) to be a function of the quantityqD. Thus the change inS due to a

1Varian, H.,Microeconomic Analysis, Norton, New York, 1984, 1992.

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change∆p in p has two terms, one due top in the integrand, and one due to thedependence onp of QD in the limits:

∆S=∫ QD

0−∆pdq+

∫ QD+∆Q

QD

(p(qD)− (p+∆p)) dqD

4. Discuss consumer surplus and free T.V.

Determination by TV companies that many consumers would be willing to payfor their television reception if they received additional channels meant there wasa market for cable television. Assessing by poll how much consumers wouldpay allowed business plans to weigh the expected income against the anticipatedcosts of producing, distributing, and marketing the product.

5. By reference to figure 3.5, explain equilibrium price in trade.

Consider two sets of demand/supply curves,s1, d1, s2, d2 which all slope mono-tonically as in the microeconomist’s hypothetical paradigm. Then when the twomarkets are brought together, the new intersection point is determined from

s1 +s2 = d1 +d2.

In figure 3-5, the curvesT (this is NOT the true total supplys1 +s2) is given bysT = s1 +(d2− s2), and the intersectionsT = d1 is thus equivalent to the formgiven above.

6. By reference to figure 3.6, explain the net gain from trade by United States andrest of world.

This analysis does not offer any quantitative conclusions, since the demand andsupply curves presumably cannot be measured in practice (danger of scientismrather than science), and maybe don’t exist as such. Instead, the conclusion isthe common-sense one that if one joins two markets in such a way that theycommunicate only in exchange of money and the good of interest, then the pricewill tend toward an intermediate value, and the country in which the price riseswill get less of the resource/product, andvice versa. The rest of the claims aredeeply flawed as follows:

(a) The measure of benefit in this example is not money (e.g.GDP), but ratheran intangible similar to utility but measured in money. The argument com-pares the utility when it is given to people of different wealth (or socialclass?). This is a no-no in neoclassical economics, which claims that indi-vidual utilities cannot be compared (nor can the utility of a given amount ofcurrency when offered to different people). Therefore, what is here termedthe “benefit” to consumers in the U.S. cannot be compared with, or said tobe offset by, the “loss” to the producers in the U.S.

(b) The language surrounding the analysis of “freer trade being good” men-tions multiple times the “welfare” of each country. This term is not defined,but the insinuation here is that one can measure this quantity in moneyterms regardless of where the money is (i.e.,what it is doing).

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(c) The argument mentions a “net benefit” to the U.S. because it could in the-ory redistribute its “gains” and “losses” to please everyone. This is unreal-istic (unprecedented). As a form of government intervention, it is absurd,given the context of the anti-tariff stance of the text. Unless there is a tradebalance in effect and no foreign investment, or a perfect match in wealth be-tween trading partners, this redistribution would not even be a consequenceof opening trade in other industries at the same time.

(d) This case shows that less sugar goes to the poorer/cheaper country. If sugaris a necessity, more people in the other country may be able to affordnoneat all, and while starving will get no representation in the market. The deathof this human capital is not reversible. This is an example of “benefits”which cannot be measured by the description given, nor in practice by anymarket mechanism.

(e) The analysis makes the mistake of analysing benefits only in instantaneousterms. Losing domestic control of certain industries has both strategicand economic effects for stability. The negative effects of susceptibilityto shocks due to external control of prices could easily outweigh any ben-efits as described in the time-ignorant model given. Similarly, by intuitiveapplication of ideas concerning systems interaction, or from observationof diversity in nature, one can infer that global economic systems may be-come less stable, and therefore damaging to everyone, without the buffer-ing afforded by a multiplicity of largely self-reliant interacting economicsystems.

(f) Maybe worst of all, the analysis neglects the possibility of foreign invest-ment, which negates the argument of benefits to both countries. It is possi-ble for the producers in the poorer country, who “gain” from the trade, tobe owned by residents of the rich country, thus concentrating the “losses”in the poorer country (imperialism).

Clearly, there is nopositiveanalysis whatsoever in this section of the text. Thereis highly selective exposition of causality, rhetorically-loaded language, and ma-nipulation of poorly-founded concepts.

7. Explain the link between exports and imports.

If Keynes’ suggestion for Bretton Woods had been heeded, then there wouldbe incentives for countries to keep balanced trade accounts. Then, in currencyterms, one might expect jobs “lost overseas” to be reliably replaced by jobs serv-ing overseas consumers, though not necessarily by jobs equally good for thehealth and stability of the economy. As it is, countries are all ostensibly fightingtrade wars to attain what are called “trade surpluses” for reasons to do with themechanics of monetary systems (internal and external debt). Thus, there is nospecial relationship between exports and imports in general.

Moreover, in modern times, international flows of currency are overwhelminglyto do with investment, not trade, so any claim of an equilibrium in job swappingis misleading.

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8. Explain why rent control produces a shortage of housing.

If there are renters willing to pay more than the price cap, then they will be inthe market with the cap in effect and might not have been without it. Thereforethere will be more competition than normal for apartments. This does not tellhow much longer it will take someone to find/choose an apartment (this alwaystakes time) — just that there will be less choice (it will be harder).

Similarly, if there are owners who would rent above the cap, they will not be inthe market, but might have been with a higher price.

This market seems like it might be relatively well approximated by the (given) in-dependent supply and demand model with an increasing aggregate supply curve.This is because there is not much economy of scale in supply, and the buyers andsellers find each other without much financing, marketing, or distribution costs.

9. With rent control, discuss who loses and who gains.

The fuzzy idea of “net aggregate benefit” gives no conclusive policy here, sothe test resorts to expository consideration of many non-price considerations toargue its point.

The situation is complex (otherwise it would not be contentious in policy). Ifthis market was isolated from the economy and subject to rent control, then (1)landlords would get less rental income while they had tenants (but have themmore continuously), (2) tenants would probably be better off for some years and(3) tenants would have mixed benefits on the longer term as housing quality de-teriorated. However, rent control makes a seller’s market, and this can result inpeace of mind, as well as enjoyable and productive friendships (1st hand expe-rience in Berkeley) since landlords can be very selective about who is living intheir property. Rather than having high prices be the primary selection factor asin the less-regulated market, non-market interpersonal criteria become primaryand price secondary. Small property owners especially may find this peace andfriendship equally or more valuable.

More importantly, if housing were isolated from the rest of the economy, rentcontrol would never have been conceived of in the first place. Instead, rentcontrol is intended to help businesses stay local by keeping their property andsalary costs down, and to help workers by keeping their commute times down.In places where gentrification has evicted working class people, market funda-mentalists tend not to evaluate all the suffering and wasted time, cost, and smogthat is borne, silently, by the poorer parts of society who commute into town, norby the (wealthier) residents who have to travel out of their central communitiesto frequent many of the businesses they need.

10. “The greater the price elasticity of supply of rental housing services, the largerare the adverse effects of rent control on tenants.” Explain this statement.

On the contrary, if rents are pegged at current rates but then the demand goes up(shifts to the right on the canonical curve), then the LESS elastic the supply, thebigger the financial incentive of a landlord to get rid of (i.e., induce suffering on)her tenant.

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On the other hand, the MORE elastic the supply, the more landlords will want tostay or get out of the rental market. So variations in elasticity mean some trade-off between the number of oppressed tenants and the degree of their oppression.

11. “Restricting imports will save U.S. jobs.” Evaluate this statement.

This is a poor simplification whose meaning and validity both depend on thecontext. For instance: Does the statement refer to imports in the U.S. or in someother country? Will the given import restrictions be accompanied by other ruleswhich cause thelossof other U.S. jobs? If so, which jobs are more desirablefor the U.S. to keep control over? Are the industry factors involved flexible andmobile so they could put their resources to even better use (and maintain jobs)?Will restricting imports increase the price much, or are the imported productshigher quality/price anyway? These questions and more need to be considered toevaluate such a statement, which is premised on quantity of jobs, not (economic)quality, and considers only proximal, not profound or long-term, effects.

12. By reference to figure 3.8, discuss the impact on U.S. and rest of the world of asugar import quota.

Fig 3.8 does not tell us anything specific, since these curves are fictitious (notmeasurable except for local elasticities). The useful analysis here is primarilythe (highly normative) prose. It says (page 59):

... much of the consumer cost simply covers the higher productioncost of sugar in this country. In sum, contrary to the statements madeby many political advocates of the quota, the U.S. is worse off onnet because of the quota: domestic consumers are harmed more thandomestic producers are helped.

The “higher production cost of sugar in this country” is not measured in physicalterms, but by money. This money cycles in the economy,i.e. is paid to workersin the economy — it does not disappear into the soil somehow. Adding theconsumer surplus to that of the producers does not tell us anything about thewelfare of the country.

It is not ironic that “many of the countries that produce sugar are less-developedcountries” (p. 60), but rather not surprising if imperialist external powers wishto see the less-developed countries produce cheap sugar as a service to wealthyones, rather than encouraging the less-developed countries to make economicdecisions and resource allocations that encouragefood securityand thus devel-opment, coherent economic self-determination, and democracy.

13. Discuss demand elasticity and cable television pricing.

Though they are not shown, this would be a poor example for upward-slopingsupply curves, since the price elasticity of supply for a cable television companyis surely negative (i.e.,down-sloping supply curve).

Nevertheless, local elasticities, though they may not be the sign selected by neo-classical economists, are conceptually sound since they can likely be assessed

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through interviews with buyers and sellers and they do not rest on claims of theexistence of a demand or supply curve, nor on the exclusion of other “indepen-dent” variables more important than price.

Because elasticities are scaled partial derivatives, it works out that the net rev-enue goes up with price when the price elasticity of down-sloping demand is >-1(inelastic) andvice versa. Statements concerning profitability, however, dependon knowledge of marginal costs whenever the elasticity is <-1. This can be seennicely from the fact that the change in revenuepq is

d(pq) = p dq+q dp

= p

(qp

ηdp

)+q dp

= q(1+η) dp

whereη = pq

dqDdp .

14. Explain the split-basic-tier system for television. What were the results?

When the U.S. reimposed rate regulation, the industry outsmarted the new lawby shifting most consumers into a tier not subject to the law. Maybe the law, tohave had its intended effect, needed to be stronger. Nevertheless, the regulationdid have the effect of controlling prices on a medium which the governmentconsidered to have some non-market value as a public good — namely, mediain free democracies carry the crucial rôles of disseminating information and ofproviding discussion of issues and critiques of the government.

15. The incidence of a tax depends on the relative elasticity of demand and supply.Explain.

I am not sure what “incidence” means here. However, I have investigated howthe revenue of a tax depends on the elasticities. I did this in two ways. One isto consider that the supply curve shifts up in price by amountt (tax included inprice), as in the text, and the other is to consider that the demand curve shiftsdown by amountt (tax paid when purchasing) but that this amount is then addedback on to the equilibrium price to reflect the total price to a consumer. Bothcases lead to the result that the change∆q in quantity soldq is

∆q = −qtp

ηSηD

ηS+ηD,

where theηS andηD are the price elasticities of supply and demand. Thus the nettax revenuer = t(q+∆q) can be calculated and maximised. Takingdr/dt = 0, Ifind that tax revenue is maximum for tax rate

tp

=ηS+ηD

ηSηD

Of course, this expression is only appropriate when the maximum revenue hap-pens to occur at a small tax rate, since local elasticities are used.

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16. A price floor applied to a previously competitive agricultural market will increasethe output of the good. Explain why.

On the contrary, there is not demand for more product at the higher price, so theproducers will not produce more. If the price floor is below the previous price,only subtle changes will occur. If the price floor is above the previous price,the producers may produce less, and certainly will do so if they are subject toeconomy of scale at current output levels. How much less will be determinedby demand — i.e., by the size of stockpiles / rate of sales, etc. This shows howsupply isnot a function of price, but is limited by the marketing and distributionused to affect demand quantity.

Dear Professor,I have one (more) question. If price of something is pegged by the government

below the market value, how much will be sold? The text assumes the answer to be theintersection ofp andqS for housing, but the intersection ofp andqD for T.V. How canone tell, if these quantities are each independently determined by price?

Thank you very much for your comments and help.Chris

4 Assignment 3 / Chapter Four

1. Explain how the budget line is constructed.

The budget line is, for a given total expenditureb, a surface satisfying

∑i

pini = b

where the sum is over each type of optioni, and wherep andn are the price andquantity of an option. This surface connects each pair of axes by a straight lineand has interceptsbpi

for axis i.

2. What is the importance of the slope of the budget line?

With only two choices (i = 1. . .2), the slope is the ratio of their prices; thisfollows from the two properties mentioned above.

3. Explain what happens to the budget line when income changes.

If income changes as a result of a consumer’s changing preferences (e.g. earn-ing/working more to fund certain purchases, or working less because she hasenough of everything) the budget line will move out or in. Any changes in slopewill be due only to independent relative price changes. However, the changingpreferences will be reflected in a simultaneous change of indifference surfaces.

If income changes as a result of economic shifts, the relative prices are also likelyto change, and thus the budget curve will change unpredictably.

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4. Explain what happens to the budget line when price changes.

In contrast to the claims of the text, significant changes in relative price typicallyreflect some change in the supply, and therefore in economic measures such asdistribution of wealth. As a result, the slope of the budget line will change, andthe totalb will increase for some consumers and decrease for others.

In a market in which the price changes due to a change in demand, the changein demand is typically due to a change in preferences (e.g. as a result of moreor less advertising, or due to a location being increasingly desirable,etc); thus,not only may the distribution of wealth change, and hence the distribution ofbvalues, but the relevant indifference maps will also change simultaneously.

5. Explain the three assumptions that economists assume [sic] about preferences oftypical consumers.

Completeness:This assumption rests on the assertions that choice-makers have(1) infinite knowledge not just about the details of any apparent options, butabout all (other) existing possibilities, and how much they would cost (in-cluding all implicit costs not reflected in the price), and (2) infinite knowl-edge about the set of factors which affect the personal satisfaction inherentin the option. This is thus subject to another selection problem: the to-tal utility of a given choice depends on how many tangible and intangiblefactors one takes into account. Does one want to know how a commoditywas made, who or what was destroyed by its production, or what the alter-natives might have been, given that such knowledge will likely affect theobject’s desirability (utility)? Since not buying something but rather wait-ing for a future alternative (which might radically change the attractivenessof existing options) is always one option, the current utility is not even the-oretically assessable. All these (thoroughly impossible) conditions wouldtogether mean that every pair of options has a unique ordering of utility.

Transitivity: Essentially, this says the pair ordering above extends to more thantwo options and is unique.

Non-satiation: This is the idea, expressed earlier in the course, that people al-ways want more — not of something, but ofeverythingand anything! Thishas elsewhere been called the philosophy of the cancer cell. Despite thedrumbeat message from corporate advertising, it is false, even within thespecific American cultural context of the course material.

Convexity: The marginal value a person gets from each commodity falls withthe number of units.

Non-mammalian behaviour: This seems separate from the other “rationality”criteria above. This is the assumption that a consumer not only can or-der preferences between options, but acts on such a utility-based rationalerather than, say, primarily out of habit or subject to an influence like “train-ing” (e.g. due to marketing). In other words, the relationship between“utility” and effective “preference” is quietly assumed, in contradiction to

15

what any psychologist or advertising agent knows. In reality, people mak-ing choices are well aware that they are not acting on the sum of theirknowledge, but rather on habit, bias, and impulse as well. Consumers donot make their purchase decisions all at once, and thus do not have a “bud-get line” for most decisions. This “irrationality” applies to mass behaviour(subject to “fashion”) even more than it does to individuals.

In addition, many choices and purchases are made by someone other thanthe person they are intended for, further diluting the influence of assessingutility.

Independence of budget and desires:It is assumed that consumers do not havecontrol over the amount of their income. In reality, many people are in aposition to earn extra income when they need to purchase something big,and to emphasize work which does not earn monetary compensation whenthey have enough.

Independence of purchase choices from non-monetary choices:More gener-ally, since the given formalism is used to represent money-transactions only— i.e. in the context of a market — there is an assumption that a consumer’sset of choices which concern monetary costs is entirely independent fromthe set of choices which do not have any cost involved. For instance, con-sider the indifference curve between units of “oil” bought and usedvs.unitsof “peace”. The cost of this peace is zero (e.g.,maybe a consumer couldchoose maximum peace of mind about not fueling oil-fed wars if she choseto buy no oil, but equivalent utility would result from a bit of oil and abit less peace, or from lots of oil and no peace, and so on), so trying tooptimise the choice with a budget line is impossible. Instead, humans aresocial beings and thus use heuristics such as morality and social influenceto make these decisions. If this is true, the rational choice theory cannot berepaired with any perturbation; it is simply inapplicable.

Independence of purchase choices from budget:Coming in the next chapterwhere the individual demand curve is aggregated to the group’s is the ma-jor assumption, in effect, that consumers all spend the same fraction oftheir wealth on each commodity, no matter whether they are a pauper ora billionaire. This underlies the microeconomist’s major ignorance of thedistribution of wealth in society.

6. By reference to figure 4.5, explain an indifference map.

An indifference map is a set of surfaces in “option space”, each of which repre-sents a uniform total utility. Given the first three of the set of assumptions above,the surfaces are non-intersecting, as shown in 2-space in the figure.

7. Explain the difference between ordinal and cardinal utility.

The concept of utility corresponds to measuring the cardinal value of a choice.By abstracting to the constant-utility contours of a utility function and dropping

16

the “height” but keeping the ordering of the contours, an ostensibly more general,ordinal veneer is given to the theory.

In fact, the theory may measure utility in units of any other good, since therequirements for each measure are simply ordinal —i.e., utility increases (butwith unknown amount) with higher measure both for “utils” and for “quantity”of any other good. Thus, measuring the absolute marginal utility in utils of goodA is fully equivalent to measuring the marginal utility of goodA in terms of goodB.

8. Why are indifference curves convex to the origin? Explain.

This is simply an assumption (called “satiation”), nearly asa priori as the as-sumption that everyone wants more (called, paradoxically, “non-satiation”!). Itis claimed that marginal utilities go down but stay positive for “goods.”

9. Explain the relationship between the marginal rate of substitution and the slopeof the consumer’s indifference curve.

See question 7 on the preceding page. As explained above, the idea of “marginalrate of substitution” is just more language for that of “marginal utility,” given thearray of assumptions made. The slope of a curve ofq(A) vs. utility in utils hasslope of marginal utility; if we measure the utility in terms ofq(B) instead, thecurve still has slope of marginal utility but now in terms ofB — that is, the slopeis the marginal rate of substitution ofB for A.

To relate this marginal utility (MRS) to the indifference surface in a more generalway, consider the utilityU(q1,q2,q3,...)obtained from several kinds of goods. Invector notation, the gradient of this utility function in option space is

∇U(q1,q2,q3,...) =∂U∂q1

q1 +∂U∂q2

q2 +∂U∂q3

q3 + ...

Contours of constant valueU will locally look like vectorsc perpendicular tothis gradient;i.e., the dot product between the two will be zero:

0 = c·∇U

= c1∂U∂q1

+c2∂U∂q2

+c3∂U∂q3

+ ...

This is the relationship between the two surfaces in general. In the simple two-dimensional case treated in the text, this reduces to:

c2

c1= −

(∂U∂q1

)/

(∂U∂q2

)= −∂q2

∂q1

wherec2c1

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

17

10. Explain the reason for the diminishing marginal rate of substitution.

This assumption recognizes that people are satiable. The claim of diminishingmarginal rate of substitution (MRS) has no more content than the statement thatmarginal utility (MU) decreases with quantityq. In fact, it is a weaker statement,since even if goodA has constant MU, but its value is plotted against goodB,which has decreasing MU, thenA would be said to have diminishing MRS. Thisis because, at smaller quantities ofB, a given change inq(B) represents a largervalues in utils.

11. By referring to figure 4.9, explain “bad” and “neuter” goods.

Figure 9 now measures value in $ (rather than utils, goodB, or “all other goods”).Bad and neuter things are things with 0 or negative marginal utilities. It is impliedthat things always have absolutely-negative or absolutely-positive or constant-zero marginal utilities.

These ideas are peculiar to microeconomists’ ideology. For instance, to life/biologicalsystems, most things terrestrial are goods in low quantities and bads at high quan-tities (for some glaring examples: CO2 or O2 while breathing, sun light, water,vitamins,etc.).

12. By referring to figure 4.10, explain perfect substitutes and perfect complements.

If the utility of A is measured in terms of a goodB whose own absolute utilityscales in direct proportion toA’s, then the curve will appear as a straight line,and the goods are “substitutes.” Goods which have zero utility by themselvesbut finite utility in groupings form “complements.” The utility of a set of themis completely determined by the quantity of the limiting “reagent,” as shown infigure 4.10.

13. By referring to figure 4.11, explain why point W is the consumer’s optimumconsumption choice.

This corresponds to a maximisation with a constraint. Based on all the assump-tions, there is only one solution (intersection), and both curves have positiveslope. This can only be if the curves are tangent, and that only happens at pointW in figure 4.11.

14. By referring to figure 4.11, explain why basket R is inferior to basket W.

Point R is allowed by the constraint, but is on a lower equi-utility curve than W.This can be ascertained by increasing one of the two quantities while holding theother constant, until the W curve is reached. “More is always better...”

15. By referring to figure 4.14, explain how changes in income alters [sic] the opti-mal consumption choice.

As discussed in question 3 on page 14, budget changes can be expected to ac-company price or preference changes, so the effect on the point of maximumavailable utility is not predictable.

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However, even if one could hold the preferences and prices constant, not muchcould be said from the theory. One could be sure that the utility-maximisingchoice would change, since the new budget curve must be tangent to a differ-ent utility curve. Nevertheless, one can say nothing about the market basket’slocal dependence (partial derivative) on the budget since, even with all the as-sumptions, the theory places almost no constraints on the shape of the income-consumption (“Engels”) curve. For example, even if the budget rises, any subset(except for all) of the chosen quantities could godown.

16. Discuss the utility approach to consumer’s choice.

See questions 7 on page 16 and 9 on page 17. This is essentially an equivalentformulation, since utility as constructed in the theory is not really cardinal: it isexplicitly not measurable or comparable in a cardinal sense between people oreven between choices made by an individual. Thus the utility approach trans-forms to the utility-free approach through the trivial change in units from utils tosome other (composite) good.

Dear Professor Adie,I have one large question. It seems we are finished constructing the demand curve in

this course, and the next chapter fuzzes the concept between individual and aggregatedemand curves.

What does the aggregated demand curve mean? For the individual, this curve repre-sented solutions optimising individual utility. Does the aggregated demand curve showhow to optimise the total utility of society? Or does it show how to optimise somethingelse?

It cannot optimise total utility of society, since:

1. Each person’s individual total utility gleaned from purchases depends on the sizeof her budget, but the distribution of wealth (and thus her budget) is a separate(free) variable in the aggregation. In other words, changing the distribution ofwealth (such as giving needy people more resources) will produce a differenttotal for society’s utility.

2. Each person’s demand curve is a function of her budget, so that if the distributionof wealth changes (by changing the distribution of prices and thus salaries, andso on), all of the individual demand curves change. The aggregate effect ofsuch a change is not simple unless all the consumers have wealth-independentconsumption patterns — that is, unless the pauper and the billionaire spend thesamefractionof their budgets on each item.

It has been known since at least 19532 and 19823 that no reasonable assumptions cancircumvent these problems. The method of this aggregation is not discussed in the text,but its impossibility entirely invalidates the rest of the book and all of microeconomic

2Gorman, W.M., “Community Preference Fields”, Econometrica, 21: 63-803Shafer, W. and Sonnenschein, H., “Market demand and excess demand functions,” in K. J. Arrow and

M. D. Intriligator (eds),Handbook of Mathematical Economics (Vol. II), North-Holland, Amsterdam.

19

market theory. It tells us that a separate means must be used to choose policy forthe distribution of wealth; the market “equilibrium” does not optimise anything if thedistribution of wealth is allowed to vary.

How do microeconomists like the authors of this book deal with this problem, andgo about their business pretending that the distribution of wealth either does not matterwithin and between economies, or that it is somehow optimised by the market system?The book does not say what the authors wish to optimise with the market policy. I amalso interested why, after going into some detail through the esoterica of indifferencetheory to justify individual demand curves, the massive leap to the aggregated curve ishidden from the student.

Thank you very much for your help and comments!Chris

5 Responses to comments

Dear Professor,Thank you for all your comments. I have the following questions to follow up:

• Please do not begrudge my not including figures so far. It was not obvious that“refer to a figure in the book” should mean “copy the figure from the book.” Ihave not been ignoring your advice; rather, I had finished my third assignmentby the time I received your response to my first. It is taking three weeks to getthe work back by mail!

Also, there may be some figures that I cannot honestly copy from the book.I believe in the existence of elasticities, but sometimes I find the claim of theexistence of demand curves to be used not as a theoretical aid but rather as aplatform for supplanting common sense with highly normative political ideol-ogy. Such stuff should not be prominent in this course, so please forgive me ifI occasionallyfind other, easier ways to explain what’s asked. I prefer “entianon sunt multiplicanda praeter necessitatem” to endless “ceteris paribus.” AsNewton put it inPrincipia,

Rule 1. We are to admit no more causes of natural things than suchas are both true and sufficient to explain their appearances.

I will still learn the methods of the text for possible application in more advancedmaterial to come (the ubiquitous claim), but I will notrecitearguments which Iconsider dishonestuntil I learn enough to consider them honest. I believe thiswill not be a frequent issue.

• Aggregation of demand curves. As I understand it, you agree that there is no so-cial/aggregate utility curve (thus the Benthamite aim to show logically that socialgood is maximised through selfish action has been proved a failure). I am askingwhether there is even such a thing as an aggregate demand curve/relationship. Ihad heard that this was a well-known fallacy, and so have been stuck on the miss-ing discussion in the text. The fallacy is similar to “divideX by a large number

20

N, approximate the small valueX/N as zero, multiplyX/N ≈ 0 back byN, andconclude thatX is zero.” It goes like this:

1. We wish to describe the demand in society for a given commodity. Weknow that in a market economy the distribution of wealth is determined bythe distribution of prices (and thus income). To determine the aggregatedemand, we look at each individual.

2. Assume that an individual’s budget is independent of prices (this will be agood approximation for most people and commodities, but very wrong forsome, whose income disappears when a price goes down and they are laidoff, etc). Derive an individual demand vs price curve for each commodity,based on the individual’s choices between all commodities, with the caveatthat the effect of prices on wealth must be negligible.

3. Forgetting the caveat, add all those individual demand curves back up, andall those negligible effects back up. Consider the summed demand to bethe aggregate demand curve, but consider the summed “small effects” tobe zero, thus concluding that incomes are NOT determined by distributionof prices in a market economy (contradiction).

This is no small blunder. If there is a disparity in the distribution of wealth, anincrease in the price of a commodity can have apositive or negativeeffect onthe aggregate demand, even if individual demand curves (because they neglectprice effect on budgets) are downward sloping! Since on average poor and richmay have (predictably) different budget-demand (Engel’s) curves for the givencommodity, one needs to know about correlations between wealth and the de-pendence of budget on price in order to say how the aggregate demand respondsto price change. One way to get around this problem would be to split soci-ety up into different groups based on wealth and preference patterns (call them“social classes”) and approximate different aggregate demand curves for eachgroup. But this approach would recognize that there is no true price equilib-rium, since changes in price and wealth can have positive feedback on the socialclass distinctions. (For instance, if the commodity is produced by a poor peoplewho can hardly buy it, then the aggregate demand curve for the rich consumersmight exist independent of price, but that of the poor producers would be entirelynonsensical;i.e., budgets highly dependent on price.)

The point is that the real dependence of demand on price does not look like anindividual’s (down-sloping, monotonic, convex to origin,etc.). According tothe (?) authoritative text on the subject, “The aggregate demand function willin general possess no interesting properties... The neoclassical theory of theconsumer places no restrictions on aggregate behaviour in general.”4

The interest in hiding this dependence at an early stage of microeconomics byharping on the properties of individual demand curves and then fuzzing the con-cepts between individual and aggregate in order to make believe that aggregate

4Varian, H.,Microeconomic Analysis, Norton, New York, 1984, 1992.

21

demand curves should follow the premises of “rational” behaviour could be mo-tivated by the (obviously normative) value of wanting to be able to increase thedisparity of wealth in society, and thus to ignore the distribution of wealth.

Have I made a mistake?

• Methodology: Regarding your comment that “assumptions of a model DO NOTNEED to mimic reality,” I am confused. As Newton’s claims in his quote above,causes in science should betrue and sufficient. Making a model with blatantlyfalse assumptions is not progress unless you are willing to accept the assump-tions should your model prove successful. Is not the way science works that ifsuch a model were to be successful, its component assumptions would start tobe considered as truth? I agree with you that models should focus on a small setof causes/details, ignoring others, but only when the models are self-cognizantof their applicable context (i.e. what those ignorances are). The methodology ofconstructing a model which has strong limits on its applicability, or has no directverification at all, and then claiming that extra adjustments to it can be used to de-scribe everything (or anything), is one that is doomed to be used as a vehicle forideology, not science, since it has given up its responsibility to verification earlyon. That is, if the perturbations are going to outweigh the approximation (un-derlying “theory”), then the approximation should suffer Occam’s razor. Morespecifically, the study of Perturbation Theory (e.g. in physics) is the study ofhow approximate solutions can be used to model small variations from a givensolution, and how models which are NOT a realistic APPROXIMATE solutioncannot be used to model anything, regardless of the number of perturbations. Asa result, I am trying to keep myself honest in my understanding of the applica-bility of the ideas the book is putting forward, especially since they are anythingbut an objective choice of causes.

On the topic of predictive value, a theory must, as part of its self-cognizance,provide criteria offalsifiability which arespecific to it, as compared with other(e.g., simpler) explanations, and then find many examples when the falsifiabilitytest fails.

I am still trying to follow the text, the homework, and the directions you provide, and Iam fully committed to this course.

6 Assignment 4 / Chapters Five and Eight

1. Explain the derivation of the consumer’s price consumption curve (figure 5.1).

22

The dots in my drawing show an individual’s optimum choice (basket of goods)on each of two budget lines, which reflect a change in the price of commodityx.Connecting such dots forms the price-consumption curve between commodityxand the other commodities (plotted on ordinate).

2. What is the significance of the marginal benefit to the consumer?

In the text the marginal benefit, measured in $, sounds now to be a measure ofthe personal utility of an item. This is a sleight of hand, since all the measuresof utility so far do not have cardinal properties. That is, one can claim from theassumptions given that 6$ of benefit is more than 3$, but by an unknown factor.Also, the text now confuses the price a consumer pays (p. 105) with the “relativeimportance of it to them.” The price is set by the seller or market, whereas it isthe (hypothetical) maximum willing price of the buyer, not the price paid, thathas the relation claimed. This again confounds an abstract (max willing price)with a measurable (price paid). The rhetorical end appears to be a tautologicalassociation between whatever happens in a free market and the best interest ofeveryone. Again, this is not a theory, but an ideology.

3. Explain why raising the price of alcohol is more effective in reducing teenagedrinking than imposing age restrictions.

This is very biased and deceptive language for describing the observation. Theclaim in the article is sensible only if alcohol prices were raised by a whopping67% (beer) to 330% (liqueur), and if the drinking age were 21 years in all states.From this weak statement, it does NOT follow that price measures are more ef-fective. In addition, the analysis and the question both leave out the obviousissue of the effect on non-teen consumers, which law but not market can miti-gate. This highly normative (value-loaded) analysis presents, like many of the

23

“applications” in this text, a thinly-veiled rhetorical attack on the value of demo-cratic law. The motivation may be a wish to indoctrinate with an ideology ratherthan to teach general skills of analysis. The consistent values behind this anti-government ideology may be the wish to increase disparities in the distributionof wealth.

4. How does the producer determine what price to charge?

This depends a lot on the strength of the many factors involved, but typically theproducer looks at costs of production, debt repayment schedules and dividendsand profit expectations, and then considers different levels of advertising andrange of shipping and the anticipated sales resulting from each. These “fixed”costs, plus the variable cost of different amounts of advertising and distribution,are added to determine the final cost possibilities, and thus the level of advertis-ing which will maximise profits. This business common sense flies in the faceof micreconomic theory. As any mathematician or physicist knows, corrections(perturbations) to a model cannot be made if they are large as compared with theapproximations / assumptions made when developing the model; the case wheredemand ishighlyproducer-driven cannot be described by adding on caveats andadjustments to a model that has made conclusions assuming complete indepen-dence of demand and supply.

5. Explain the income effect of a price change.

The income effect refers to the change in individual demand for a commodity asa result of a change in overall budget, when preferences and the relative pricesof different commodities are constant.

This term neglects what one might well also call the income effect of a pricechange. The demand curves for individuals which are shown in texts alwayscorrespond to those of individuals whose livelihood is not affected directly orindirectly by the price of the commodity of interest. In reality, incomes aredetermined by prices in the market, and so for people involved in the production(through rent, profit, or wage) there will be a large effect on their income whenthe price of something changes.

For aggregate curves, the concept of income effect, in the text’s sense, is evenmore fallacious because changes in income will not have any predictable effecton the aggregate demand unless every consumer has the same Engel’s curve,i.e.,the pauper and the billionnaire spend the same fraction of their income on eachkind of commodity, a preposterous claim. Implicit use of the income effect con-cept in the aggregate case could be motivated by the wish to ignore distributionof wealth in economic theory.

6. Explain the substitution effect of a price change.

The substitution effect refers to the change in the ratio of different commoditiesdemanded by an individual as a result of a change in the ratio of the commodities’prices, and assuming that the preferences of the individual are constant. Thiseffect is usually measured in terms of the quantity of a single commodity (the

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one whose price is changed) with the additional restriction that the utility tothe individual is constant. The calculation of this rather abstract quantity relieson knowledge of the indifference curve. Indeed, so does the calculation of theincome effect, which is simply the actual change in quantity demanded minusthe quantity of the substitution effect.

In the case of aggregate demand, there is certainly no quantity of the substitutioneffect of a price change, since there is no such thing as a social (aggregate)indifference curve.

7. Explain income and substitution effects of inferior goods with a price change.(figure 5.4)

price p(x) decrease price p(x) increaseThe substitution effect is always negative (q goes up whenp goes down) if theindifference curve is convex to the origin. By definition, the income effect isnegative (more income, less good) for inferior goods and positive for superiorgoods. A change in demand resulting from a change in price can be considereda sum of the two effects. Because for inferior goods they have opposite sign,the overal sign of the change in demand depends on the relative size of the twoeffects. My drawing points out that there is no simple relation between the sizesof substitution or income effects during an increase in pricevs. a decrease inprice of the same amount (though their sum is of course equal and opposite).

8. When will people buy more if price rises? Explain.

• Whenever the price rise and the increase in demand have the common cause

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of increased expenditure on advertising and distribution (producer control-ling demand). This is extremely common.

• When there is snob appeal. This is portrayed as exotic in the text, but thesnob effect is typically due to “brand name recognition” which is developedthrough producer control of demand, as above. This is very common inclothing and other commodities.

• Whenever someone is poor and dependent on something as a necessity. Thetext here goes out of its way to portray the Giffen good as a bizarre idea.This is ironic, since the ideology which the text advances has helped to pushmuch of the world’s population into dependence on Giffen goods. Themotivation behind ignoring theoretically the existence of upward-slopingindividual demand curves, or of likening to rats those people who sufferacutely from unmet necessities, might be the wish to train-out of buddingeconomists the common sense knowledge that one can indeed compare util-ity between people, and that some goods are not just demanded butrequiredfor life.

The text describes the conditions for a Giffen good to exist as “a stronglyinferior good, with most of the budget devoted to purchases of that good.”This is precisely the situation, not just of a family vacationing in exoticHawai’i (p. 111), but of any poor person dependent on inadequate healthcare, food, water, or education. The condition for a Giffen good is betterdescribed as the case when a class of goods is a necessity and is a significantpart of one’s budget. Consider a poor African family with three children,able to afford to send only two of them to a very poor school (no desks, nopaper, no chalk). If the school fees which were imposed by the IMF aredecreased, the bad school becomes cheaper, and the family may be able tosend one child to a better (more expensive) school, and subject only onechild to the very poor school.

9. By referring to figure 5.8, explain price — consumption curves and elasticity ofdemand.

26

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

amount to be spent on q(x), in terms of price of q(y)

If prices are expressed in terms of the commodity on the ordinate, then the re-gions shown in the sketch correspond to measures of the expenditure demandedon each commodity. Since a demand is elastic (inelastic) if price multiplied byquantityincreases (decreases) when pricedecreases, the price-consumption re-lationship shown provides an easy way to see the sign of the price elasticity ofdemand. For example, if the price-consumption curve slopes downward, an in-crease in expenditure demanded is associated with a decrease of the price (asshown), and thus the demand is called elastic.

10. Explain one of the three methods used to estimate demand.

Elasticity of demand can be estimated by asking consumers how their buyinghabits might change if a small change was made in a commodity’s price.

11. Explain total product, average product, and marginal product when only oneinput is variable.

For total productP( f ), when the amounts of all factors are fixed except for one,

f , the average product isP( f )/ f and the marginal product isdP( f )d f . The follow-

ing is an example:

27

12. By referring to figure 8.1, explain total, average, and marginal product curveswith one fixed and one variable input.

The number of fixed inputs is irrelevant. The totalP peaks where adding moreof factor f is literally counterproductive. The peaks of the average and marginalproducts are not especially intersting by themselves.

13. Explain the relationship between average and marginal product curves.

The “average product” curve is the average height of the “marginal product”curve between 0 andf , as shown in my sketch.

14. If marginal product is rising, what happens to total product? Why?

It is increasing at an increasing rate (e.g., the first two segments of my drawing,above), or is decreasing at a decreasing rate.i.e. if M = dP

d f is the marginalproduct, then

ifdMd f

> 0, then∂2P( f )

∂ f> 0, i.e.,P concave upwards.

15. Explain diminishing marginal returns.

The text has confused the meaning of this term, which was originally coinedto refer to the truly fixed resource of land in the context of biological produc-tion. Agriculture occurs first on the most productive land; with time, that whichremains unclaimed is likely to be less and less productive for a farmer (poorersoil, etc). The application of this term in the context of general production isnot reasonable. The text is setting me up to believe that producers work at a“technologically efficient rate,” or the equivalent once costs are included. This isa profound mistake. Producers never aim to produce at their maximum capacityagainst fixed inputs. If they did, they could not adjust to demand, and would

28

inevitably not be able to sell all their product (at times, and not provide enoughat others). Where are the axioms of the “rational producer”? Microeconomicsseems to have the producer optimise instantaneousrateof profit makingdp

dt . Butpeople don’t optimise something for immediaterate of gain; one optimises fornet gain over the long run, or whatever timescale one cares about (financing, etc).That is, people are interested in the future as well, and optimise something morelike

∫ dpdt dt over some time period — total profit, not rate of profit. As soon as

future rate of profit is included in an optimisation, the idea of producers all push-ing up against diminishing returns becomes clearly contrived. Businesspeopleactually typically produce where the returns are fairly flat or increasing and theycan remain agile (in other words, they plan ahead). The volume they produceis more likely determined by diminishing returns in controlling demand through(a) advertisement and (b) distribution. Piero Sraffa outlined thismajor flaw withmicroeconomic’s static analysis in the 1960’s.

16. Isoquants are used to explain production when all inputs are variable. Explainisoquants by referring to figure 5.3. [see below]

17. Explain the four characteristics of isoquants.

region where there are negative marginal productivies

normal view

Isoquants are the solution toP( f1, f2,...) = constant. The four characteristics ofisoquants in the text are:

downward-sloping: According to the total product curves discussion, the iso-quants are NOT downsloping everwhere, since adding too much of one

29

factor results in a decrease of output. If the “balance” of production factorsbecomes highly skewed, as in the “fixed proportions production function,”extra unneeded inputs are also likely to get in the way of production, so theisoquants, rather than than being square as in the text, will become roundedand up-sloping, as in the drawing above. Thus the down-sloping character-istic is a choice of which part of the isoquant curves do draw.

Increasing outputs with scale: This also is NOT true, according to the text. Ifthere can be altogether too much input for the technology or enterprise todeal with, total production will go down with the addition of any of thefactors, and the contours (isoquants) will be closed, as in the drawing. Ingeneral, though, there will usually be a limiting factor, so that adding somemore of it will increase production.

Non-intersecting: If any functionP( fi) exists, non-intersection is a mathemat-ical property of its contours.

Convexity to origin: This means that the MRTSxy = −dydx decreases as factory

is decreased. This is also clearly not true in general for isoquants, but is achoice of which region to show in a plot.

18. The marginal rate of technical substitution is defined as the amount by whichcapital can be reduced without changing output when there is a small (unit) in-crease in the amount of labour. Explain.

When only two factors are considered and they areK andL, thenL is plotted onthe abscissa by convention. Then a small movement along an isoquant consistsof a change∆L in labour and a change of∆K = ∆L

(dKdL

)isoquant=−(MRTS)∆L

in capital.

19. Explain increasing, constant, and decreasing returns to scale.

If all factors are increased, the production amount will lie on a new isoquant.Typically (outside the shaded region in my drawing) the output will increase.The terms increasing, constant, and decreasing returns to scale refer to the ratioof increase of output and the ratio of increase of factors. If the former is largerthan the latter, there is an increasing return to scale, and so on.

20. What is a Cobb-Douglas production function?

A Cobb-Douglas production function is of the form

P( f1, f2,...) = ∏i

f bii

where the productionP is dependent on variable inputs (factors of production)f , and the exponentsbi are typically determined empirically. Economists liketo model production using such a function. One reason is that we can imposeconstant returns to scale (for all ratios of factor inputs at once) by enforcing∑i bi = 1. Because a given set of fit constantsbi has a constant sum, a Cobb-Douglas function cannot represent theonsetof diminishing returns at high valuesof fi .

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Thank you!Chris

7 Assignment 5 / Chapter Nine

1. Explain the concept of cost.

Production cost is the rent and wages of physical and human capital used forproduction, plus interest (or dividends) on any money capital borrowed for pro-duction, plus the cost of materials bought and used for production. Rents maybe replaced by capital depreciation/maintenance costs if the producer owns thecapital (private property, slave labour, etc).

The rhetoric of hiding profit as a cost in the description of businesses, andthen speaking of zero-sum profits in markets, rather than speaking of a nor-mal/expected/optimum rate of profit on financial capital, is problematic. It putsthe microeconomic market analysis at the mercy of a macroeconomic equilib-rium to explain the appropriate rate of profit (10% per year is proposed severaltimes in the text!). It also helps to promote the false assertion that the moneysystem (financial capital) has as natural / neutral a rôle as physical and humancapital, when in fact the chosen implementation of debt and money has a hugeeffect on the issues at hand (e.g., growth and expected rate of profit). It alsodiscriminates against the farmer and small family-owned business (i.e., the oneswhich come closest to the perfect market), for which the ideas of easy reinvest-ment and a fixed rate of profit are most absurd (for example, owners live on thebusiness property).

2. Explain the difference between long run and short run.

In reality, any given factor of production can be varied a little on a short timescale or more on a longer time scale. These time scale distributions are differentfor each factor. In the model language, the short-run is a period which neatlyseparates factors of production into one quickly-variable and several which arenot quickly-variable. The long run is the other extreme, a period much longerthan all the timescales to do with varying factor of production (yet improbablyshort as compared with input costs). No reason has been given to think that theexistence of a short-run is likely, nor which factor might be the quick one. Also,other factors like costs and technology are assumed (but not justified) to varymore slowly thananyfactor.

3. How does the production function affect AVC, ATC, and MC?

Given a monotonic production functionQ( fi) describing the highest possibleoutput as a function of a factor of productionfi , and afixed price pi for thefactor fi , one can express the function in terms of cost asQ(pi fi) = Q(C). Theinverse functionC(Q) is the cost to produce a given level of output. From this,the marginal costMC = dC(Q)/dQ, the average total costATC= C(Q)/Q, andthe average variable cost(C(Q)−C(0))/Q are defined.

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4. What is the relation between production function and AFC?

If C(Q) is the inverse production function, thenC(0) is the fixed cost and theaverage fixed cost isAFC= C(0)/Q.

5. Why is the MC U-shaped?

We tend to draw the MC∪-shaped, or the production function sigmoid-shaped,to reflect the two extremes of increasing and diminishing marginal returns, whichare expected at low and very high values, respectively, of the limiting factor.

No reason is given yet to expect that production volumes are ever near one ex-treme or another. This claim comes only from the perfect market assumptionthat quantity demanded appears infinite to any producer (and thus as much isproduced as can be produced cheaply). Since this is rarely true in practice, as-suming it at this stage is a mistake. The theory ought to be broad enough todescribe the case where locality is an advantage in the market, thus the demandis limited for individual producers, thusdistribution and marketing(which createdemand) are usually the short-run limiting factors. Thus the chimera of dimin-ishing returns for factors of production never applies — not even approximately.

6. Where does MC intersect ATC and AVC? Explain fully.

10

20

30

40

Tota

l cos

t

TC

10 20 30 40 50 60 70 80 90 100 0

0.2

0.4

0.6

Quantity

Uni

t cos

ts

MC ATC AVC

Figure 1: Production function (TC) and derived quantities (showing a more realisticcost curve than those of the text)

As demonstrated in Figure 1, the MC intersects each of these averages at theirrespective minima. Any cumulative average will not change if a new value equal

32

to the average is included in the calculation. Therefore any point where an aver-age cost is equal to the marginal cost will be a stationary point for the average.According to the suggested shape of production functions, the average costs willhave only one stationary point, and it is a minimum.

For example, for costC(Q) and quantity producedQ, ATC= C/Q andMC =dC/dQ, so the curves cross(MC = ATC) wheredC/dQ= C/Q. But this is alsothe solution to the stationary equation forATC:

0 =d(ATC)

dQ=

dCdQ

− CQ

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

0

10

20

30

40

50

Tota

l var

iabl

e co

st

TC-FC

0 20 40 60 80 100 0.2

0.4

0.6

0.8

1

Quantity

Uni

t cos

ts

MC

AVC

Inflection point

Figure 2: Total variable cost(TC−FC) and derived quantities

Figure 2 shows the relationship between the total variable cost(TVC= TC−FC) and the marginal(MC) and average variable costs(AVC). TheTVC is avertically-shifted version of the production function. BecauseMC is the deriva-tive of TVC, the minimum ofMC occurs at an inflection point ofTVC, as shownin the figure. SinceAVC= TVC/Q, its stationary points occur at values ofQwhere a line tangent toTVCalso goes through the origin.

8. The shape of LAC depends on changing returns to scale. Explain.

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Returns to scale deal with production possibilities in the long run. In particular,the returns to scale are the ratio of possible production output to production cost,i.e. the reciprocal of the cost per unit output, or theLAC. Thus an increasingslope ofLAC reflects decreasing returns to scale andvice versa.

9. The slope of TAC curve depends on marginal cost. Explain.

I cannot findTACdefined.

10. Explain the derivation of the isocost line.

Unit prices of factors of production are assumed to be constant. For a givenexpenditure on all the factors, an isocost line shows all the possible combinationsof factors. This is entirely analogous to the individual consumer’s budget line.

11. What is the meaning of the expansion path? Explain what it identifies.

When an increase in total expenditure on factors of production is allowed, ad-justments up or down in the amount of each factor of production may be neededto achieve the highest technologically possible output (in the long run) at thenew level of expenditure. The expansion path is the sequence of adjustments inamounts of factors of production required to maximise output during a change intotal expenditure. Making such a sequence of adjustments will keep the outputand expenditure values on the long run total cost curve.

12. If constant returns to scale apply to the entire range of production, explain theshape of the long run total cost curve.

I am confused about this.

Constant returns to scale exist when, given rapidly-variable factors of production,the quantity of output is linearly proportional to the cost of productionif theratios of the quantities of factors of production are held constant.In the longrun cost curve, however, these ratios need not be held constant, so without thisconstraint the production output may be more than proportional to the inputs;i.e. there is an economy of scale. On the other hand, if the “economy of scale”description holds (??) for any given set of quantities of factors of production,then the optimum choice at any production level will be due to the same ratios offactors of production. Then the long run total cost curve will be a straight line.

13. By referring to figure 9.6, explain short- and long-run average cost curves.

For any level of total cost or of output, the most efficient combination of factorsof production occurs when the marginal productivity divided by the marginalcost is the same for all factors. Thus if quantity of each input is measured interms of money, then the marginal productivity (slope of cost vs output) is thesame for each factor, and indeed the same for the overall cost curve.

This means that this slope of total costvs. output is, at any level of output,the same for the long term curve as for the short term curve corresponding tovariation of anysingle factor of production. This equivalence of slopes is alsotrue for theaveragecost curves, as shown in Figure 3. Because optimally varying

34

average costs varying only one factor

long run average cost, varying all factors

Figure 3: Long run and short run cost curves

a single factor cannot be better than optimising over all the factors, the single-factor cost curves (i.e.,short run curves) curve upward from the all-factors (longrun) curves.

14. Interpret and explain figures 9.8a and 9.8b.

The expansion path can be conceived as (1) the series of steps to take to continu-ally maximise output while increasing total expenditure on production, or as (2)the series of steps to take to continuously minimise expenditure while increasingoutput volume. Realistically, growth in firms is likely to be limited by (1) rais-ing capital (loans) and (2) marketing to increase demand for their product. Thetwo views of expansion paths can thus correspond to these mindsets of availableexpenditure or output volume as independent variables in the growth.

Figure 9.8a in the text is relevant to the case when the output volume is some-what predetermined (even though this is not justified in the text and implies thatdemand might be a determining factor —i.e., the market is not nearly perfect).In this figure, one considers total expenditure to be variable but total output fixed,so a change in the relative prices of the factors of production means a substitutioneffect along the isoquant. Figure 9.8b just shows that cost curves rise when costsincrease.

15. Explain economies of scope.

An economy of scope is the obvious situation in which a firm’s infrastructure canrelatively cheaply be used for more than one “product” at a time. This very vaguelanguage is only used as rhetoric to “give an efficiency reason for multiproductconglomerates.”5 No examples of diseconomies of scope are given, of course.

5The textbook, p. 240.

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Economies of scope apply most of all to governments, which can be extremelyefficient at providing a wide variety of goods for the least possible price.

Dear Professor,Thank you!I have one new question. Why do we assume that consumers are limited to a budget,

but firms are not? Both use loans.I have one repeat question. At the end of assigment 2, I asked you the following:

If price of something is pegged by the government below the market value, how muchwill be sold? The text assumes the answer to be the intersection ofp andqS for housing,but the intersection ofp andqD for T.V. How can one tell, if these quantities are eachindependently determined by price?

The answer you gave me was the following:

regulated price

“Qs= quantity supplied. That’s how much will be sold” and that therefore there willbe a shortage ofQs−QD.

I still don’t understand. Your answer describes the situation for housing (p. 54).But for the same situation with regulated television prices (p. 61), the amount sold isQD, NOT QS, so my original confusion still stands: How can one tell which (or what)amount will be sold, if these quantities (supply and demand) are each independentlydetermined by price??

Many thanks for your help, once again!Chris

8 Assignment 7 / Chapter Ten

I have taken “competitive” in the following questions to mean “in the hypotheticalperfectlycompetitive limit.”

1. Explain how the market price is determined in a competitive industry.

It appears that microeconomics does not attempt to answer this question even forits model perfect market, since it leaves the amount of profit hidden in “costs” up

36

to the details of the money system, or at least to all the other industries. For thereto be a sensible fixed rate of profit (“cost”),all the industries would need to becompetitive. If this were to happen, the rate of profit would likely, it seems to me,shrink to only just cover the average investmentrisk of forfeit in the economy;this rate would also be the opportunity cost of money capital — the bankers’interest rate.

Moreover, even with the assumption of some fixed profit rate in the long run,and even with the assumption of some aggregate demand curve in the industry(debunked in a previous chapter), the text’s account of how price is determinedfor a competitive industry in the short run is entirely incorrect, since it confusesthe industry supply curve with the industry-aggregated marginal cost curve; seeQuestion 9 on page 39.

2. Describe the survivor principle of management operation.

The survivor principle states that firms which don’t maximise profit above all elsewill be run out of business and disappear “in competitive markets.” There are twomajor problems with this language which make it tautologous,i.e.,purely retro-dictive. This use may be motivated by a market ideology which is not justifiedby the theory of perfect markets.

• One fallacy is that the survivor principle assumes that any organisation willfall apart if its stakeholders fail to optimise profit above all, because theywill be able to get higher profits elsewhere and thus will withdraw their cap-ital. But real organisations can choose to take lower profits (or no profits)and continue tosurvive if they choose to be content with the lower profits,even if they are operating in a competitive market for goods or servicesand even if they do not minimise costs quite as much as some competition.Thus the statement in the text concerning survivorship is not an explana-tory principle, but follows a normative ideology that all organisations andcapital holders should be solely profit-motivated. This NEED NOT BE SO,even in competitive markets.

• A second problem is that this language perpetuates the confusion betweenthe rate of profit incomeπ (which is not by itself of interest to a firm)and the total profit (money!), which is the product (or time integral) ofthe rate with some time period of interest. The typical time-blind viewof the analysis in this text amounts to ignoring half of the two terms inthe optimisation of total profit. In varying any factor of productionq, theoptimumtotal profit π · t is maximised where

0 =d(π · t)

dq=

dπdq

t +πdtdq

The analysis in the text considers mathematically only the first term. Thesecond represents extending the life of the firm for a long time, withoutmaximising the rate of profit. The academic emphasis on short-term op-timisations in firm management may be motivated by the capital holder’svalue of seeking ever-shorter timescales in money capital mobility.

37

3. How is marginal revenue related to a firm’s ideal output?

0

10

20

30

40

50 To

tal c

ost

TC

TC-FC

TR

0 20 40 60 80 0

0.2

0.4

0.6

0.8

Quantity

Uni

t cos

ts

MC

ATC

AVC

P=AR MR

90 95 100 Quantity

Figure 4: Short run output selection. The panels on the right are closeups of the panelson the left. In the limit of an infinitesimal firm size, MR and P=AR are coincident andhorizontal.

Figure~4 shows an example of marginal revenue (MR) and marginal cost (MC)and associated relationships. The profit is positive for quantities where totalrevenue (TR) is greater than total cost (TC) and the profit is maximum whereMR is equal to MC.

4. In figure 10.3, explain why producers would not choose outputQ0 or Q2.

This claim is only applicable to the perfect competition model. The produceris assumed to be able on short timescales to vary the output level across theentire range shown in Figure~4 with endless demand. If the marginal revenueis less than the marginal cost, therate of profitcan be increased by decreasingproduction. If the marginal revenue is more than marginal cost, an increase inproduction will lead to an increase inrate of profit.

5. Compare figure 10.2 with 10.3 relating to short-run proft.

The TC and TR curves in figure 10.2 are the integrals of the MC (with MC(0)=FC)and price=MR=demand curves. Theπ curve is the area of the blue region in fig-ure 10.3, which is a rectangle formed between the ordinate and a line showingthe difference between MR and ATC. The intersection of MC and MR in figure10.3 corresponds to an equality between the slopes of TC and TR in figure 10.2.

38

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

marginal cost

pricemarginal revenue

pric

e or

cos

t per

uni

t

quantity produced

fixed costsπ+

π−

Figure 5: Short run break-even thresholds. In the limit of an infinitesimal firm (perfectcompetition), the price and marginal revenue curves are horizontal.

Figure 5 shows the operating thresholds in a different way (per unit costs) fromthe text. Here area corresponds to money. The coloured areas are the fixed costs(FC), the positive profit(π+) and the negative profit(π−). For a firm to turn aprofit, π+ > π− +FC. Foranyproduction to happen,π+ > π−. If this conditionis not met, the firm is better off producing nothing.

7. By using figure 10.5, explain the competitive firm’s short-run supply curve.

See Figures 4 and 5. The short-run supply curve is the curve whose intersectionwith demand (price) yields the amount produced. If the demand curve is veryclose to the marginal revenue curve (identical in the case of infinitesimal firms),the marginal cost curve behaves like a supply curve, since its intersection withdemand determines the firms output.

8. If a firm can’t cover its costs it will go out of business. Explain.

See Figure 5. There are two possible meanings of “can’t cover its costs.” Inthe short-run model, the firm will stop producing immediately if no amount ofproduction will help its finances. However, even if no amount of production canrecover the fixed costs, but they can help to defray them(π− < π+ < π− +FC),the firm may choose to continue production at a loss until it is able to shut downits fixed costs, or improve its profitability.

9. By using figure 10.7, explain the short-run competitive industry supply curve.

Once again, the text shows an aggregation in sketchy terms but does not providethe “mathematical treatment” in the appendix, and attempts a bold-faced TRICK

39

to confuse the naïve student. I will explain how I understand this figure 10.7below, but personally I cannot believe that someone can write this section in thetext (or section 12.5 in the text) without realising the fallacy and knowing they arebeing dishonest. I can imagine this ideology could be motivated by the value ofwanting to promote more (outside) competition in others’ domestic markets andwanting to advocate for replacement of government provision of public goodsby private industry at all costs.

In the ideal of short run production flexibility, each firm will always be able toproduce at an output level where the marginal cost (MC) is rising, unless the price(demand) is so low that it is below even the lowest average variable cost (AVC).Thus, for a (nearly) horizontal MC, (almost) only upward-sloping portions (thusassumed to be monotonic) of MC will apply for firms with non-zero production;see Figure 4. In the ideal/limit of “free entry and exit,” all the MC’s of differentfirms are independent. Based on these assumptions, the monotonic quantitiesproduced can be added as a function of MC (i.e. the inverse functions of MC(q))to produce the total industry production as a function of each firm’s marginalcost.

If firms are interested in maximising therate of profit, they will choose produc-tion outputs for which MC=MR. Is, therefore, this aggregated MC curve equalto the industry supply curve? NO! The “price” (i.e. demandpD) curve seen by afirm is not the same as the marginal revenueMR (see Figure 4)6. For an infinitelysmall firm, the differencepD −MR is vanishing, but when adding up over manyfirms, the difference is finite even within the model of perfect competition and in-deed this differencepD−MR is, after aggregation, IDENTICAL TO THE CASEOF THE MONOPOLY. This mistake or trick is a second major instance of the“divide X by a large numberN, approximate the small valueX/N as zero, mul-tiply X/N ≈ 0 back byN, and conclude thatX is zero” method used previouslyin aggregating individual demand. To summarize, if individual firms maximisetheir profit, they will not individually produce at the intersection of the priceand the marginal cost (though very nearly) and they will not (even nearly), asan industry, produce at the intersection of demand and the horizontally-summedmarginal cost curve. The aggregated marginal cost curve is NOT the industrysupply curve. This situation is identical to that of a monopoly. This well-knownflaw in the teaching of introductory microeconomics is presumably admitted andtreated (?!?) in higher level courses(?), but I can only see it as a blatant decep-tion if hidden amongst dogmatic teaching at lower levels. Have I got somethingwrong?

6RevenueR= pD ·q, so marginal revenuedR/dq is

MR= pD +dpD

dqq

Here,dpD/dq is negative for a downward-sloping demand, and becomes zero for a single firm only inthe limit of infinitesimal firm size (i.e. small as compared with the size of the market). Thus the differencepD −MR is only small in a model of perfect competition if the caveat is given that the difference is not beingaggregated together over many firms!

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10. By reference to figure 10.9, explain long-run profit maximization of a competi-tive firm.

I think this long-run picture is identical to the short-run picture in Figure 4 onpage 38. The confusion remains between the concepts of price (demand pre-sented) and marginal revenue (even though these two have the same value in thelimit of zero-sized firm).

11. Does the firm in figure 10.9 earn any profits in the long-run? Explain.

In the long run, if profits are specified by society or by the larger economy (thisis an ADDITIONAL assumption over those of a perfect competition!) and thuscounted as fixed costs, then in a perfectly competitive industry, the firm will findthat average cost per item of production is equal to average revenue:AC = AR.Average revenue is the price (not the marginal revenue, in general!) given by thecompetitive demand. In this sense, the profit in the long term is always zero.

12. With reference to figure 10.11, explain long-run supply in a constant-cost indus-try.

If factor costs for the firms in an industry do not vary with the size of the industryand do not vary for any other reason either, then in the long run it is reasonableto expect that the industry supply curve will also be horizontal (infinite long-runprice elasticity of supply). In other words, the price will not depend on demand.

Absolutely no justification is offered for the possibility that the cost of inputs isflat. Since the text seems to think this is a likely scenario even while preach-ing that production always happens against long-run rising costs, it is no lesslikely for the input costs to decrease as the industry grows (demand increases).Indeed, many raw materials and intermediate products are cheaper to produce ifthe (producer) market for them is large.

13. With reference to figure 10.12, explain long-run supply in an increasing-costindustry.

Similarly, if the cost of inputs increases with quantity of production, then thelong-run industry supply curve will rise with quantity, just as the text has as-sumed is the case for the final goods and services in the short run.

14. Since economic profits are zero for a competitive industry’s long-run supplycurve, does anyone gain? Explain.

This question is asked three or four times in two assignments, so it must beimportant! The meaning of “gain” is political, but those who receive interest, awage, rent, or dividends all gain money, and those whose ownership of physicalcapital in the firm grows gain physical capital.

15. In a constant-cost industry each firm’s MC curve is upward sloping, yet all thefirst together — the industry — have a horizontal supply curve. Explain whythere is no contradiction.

Firms can go in and out of business; the number of firms forming the aggregatesupply is not constant as a function of price. Thus a horizontal supply curve

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means that the rate at which firms join the market is perfectly balanced by therate at which each firm’s marginal cost curve increases.

16. Discuss the meaning of zero profits for firms in an industry.

The rhetoric of hiding profit as a cost in the description of businesses, and thenspeaking of zero profits in markets, rather than speaking of a normal/expected/optimumrate of profit on financial capital, is problematic. It puts the microeconomic mar-ket analysis at the mercy of a macroeconomic equilibrium to explain the appro-priate rate of profit (10% per year is proposed several times in the text!). It alsohelps to promote the false assertion that the money system (financial capital) hasas natural / neutral a rôle as physical and human capital, when in fact the chosenimplementation of debt and money has a huge effect on the issues at hand (e.g.,growth and expected rate of profit). It also discriminates against the farmer andsmall family-owned business (i.e., the ones which come closest to the perfectmarket), for which the ideas of easy reinvestment and a fixed rate of profit aremost absurd (for example, owners live on the business property).

Thank you!Chris

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