Income and Substitution Effects

A fall in the price of a good has two effects: Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. This response to a change in the relative prices of goods is called the substitu- tion Because one of

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Market Demand

So far, we have discussed the demand curve for an individual consumer. Now we turn to the market demand curve. Recall from Chapter 2 that a market demand curve shows how much of a good consumers overall are willing to buy as its price changes. In this section, we show how market demand curves

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Consumer Surplus

Consumers buy goods because the purchase makes them better off. Consumer sur- plus measures how much better off individuals are, in the aggregate, because they can buy goods in the market. Because different consumers place different values on the consumption of particular goods, the maximum amount they are willing to pay for those goods

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Network Externalities

So far, we have assumed that people’s demands for a good are independent of one another. In other words, Tom’s demand for coffee depends on Tom’s tastes and income, the price of coffee, and perhaps the price of tea. But it does not depend on Dick’s or Harry’s demand for coffee. This assumption has

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Empirical Estimation of Demand

Later in this book, we will explain how demand information is used as input into a firm’s economic decision-making process. General Motors, for example, must understand automobile demand to decide whether to offer rebates or below-market-rate loans for new cars. Knowledge about demand is also impor- tant for public policy decisions. Understanding the demand

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Demand Theory – A Mathematical Treatment

This appendix presents a mathematical treatment of the basics of demand theory. Our goal is to provide a short overview of the theory of demand for students who have some familiarity with the use of calculus. To do this, we will explain and then apply the concept of constrained optimization. 1. Utility Maximization The

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Describing Risks concerning consumer behavior

To describe risk quantitatively, we begin by listing all the possible outcomes of a particular action or event, as well as the likelihood that each outcome will occur.1  Suppose, for example, that you are considering investing in a company that explores for offshore oil. If the exploration effort is successful, the compa- ny’s stock

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Preferences of consumer Toward Risk

We used a job example to show how people might evaluate risky outcomes, but the principles apply equally well to other choices. In this section, we concentrate on consumer choices generally and on the utility that consumers obtain from choosing among risky alternatives. To simplify things, we’ll consider the util- ity that a consumer

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Reducing Risk concerning consumer behavior

As the recent growth in state lotteries shows, people sometimes choose risky alternatives that suggest risk-loving rather than risk-averse behavior. Most people, however, spend relatively small amounts on lottery tickets and casinos. When more important decisions are involved, they are generally risk averse. In this section, we describe three ways by which both consumers

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The Demand for Risky Assets

Most people are risk averse. Given a choice, they prefer fixed monthly incomes to those which, though equally large on average, fluctuate randomly from month to month. Yet many of these same people will invest all or part of their savings in stocks, bonds, and other assets that carry some risk. Why do risk-

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Bubbles of consumer behavior

During 1995 to 2000, the stock prices of many Internet companies rose sharply. What was behind these sharp price increases? One could argue—as many stock analysts, investment advisors, and ordinary investors did at the time—that these price increases were justified by fundamentals. Many peo- ple thought that the Internet’s potential was virtually unbounded, particu-

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Behavioral Economics 189

Recall that the basic theory of consumer demand is based on three assumptions: (1) consumers have clear preferences for some goods over others; (2) consumers face budget constraints; and (3) given their preferences, limited incomes, and the prices of different goods, consumers choose to buy combinations of goods that maximize their satisfaction (or utility).

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Firms and Their Production Decisions

Firms as we know them today are a relatively new invention. Prior to the mid-1800s, almost all production was done by farmers, craftsmen, individuals who wove cloth and made clothing, and merchants and traders who bought and sold various goods. This was true in the U.S., Europe, and everywhere else in the world. The

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Production with One Variable Input (Labor)

When deciding how much of a particular input to buy, a firm has to compare the benefit that will result with the cost of that input. Sometimes it is useful to look at the benefit and the cost on an incremental basis by focusing on the additional out- put that results from an incremental

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Production with Two Variable Inputs

We have completed our analysis of the short-run production function in which one input, labor, is variable, and the other, capital, is fixed. Now we turn to the long run, for which both labor and capital are variable. The firm can now pro- duce its output in a variety of ways by combining different

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Returns to Production Scale

Our analysis of input substitution in the production process has shown us what happens when a firm substitutes one input for another while keeping output constant. However, in the long run, with all inputs variable, the firm must also consider the best way to increase output. One way to do so is to change

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Measuring Cost of Production: Which Costs Matter?

Before we can analyze how firms minimize costs, we must clarify what we mean by cost in the first place and how we should measure it. What items, for example, should be included as part of a firm’s cost? Cost obviously includes the wages that a firm pays its workers and the rent that

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Cost in the Short Run

In this section we focus our attention on short-run costs. We turn to long-run costs in Section 7.3. 1. The Determinants of Short-Run Cost The data in Table 7.1 show how variable and total costs increase with output in the short run. The rate at which these costs increase depends on the nature of

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Cost in the Long Run

In the long run, a firm has much more flexibility. It can expand its capacity by expanding existing factories or building new ones; it can expand or contract its labor force, and in some cases, it can change the design of its products or intro- duce new products. In this section, we show how

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Long-Run versus Short-Run Cost Curves

We saw earlier (see Figure 7.1— page 239) that short-run average cost curves are U-shaped. We will see that long-run average cost curves can also be U-shaped, but different economic factors explain the shapes of these curves. In this section, we discuss long-run average and marginal cost curves and highlight the differ- ences between

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