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Law And Economics

Law and Economics, 6th edition Robert Cooter Berkeley Law

�omas Ulen

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Authors’ Note

LAW AND ECONOMICS (pdf 6th edition)

by Robert Cooter and Thomas Ulen

This is a pdf version of the latest version (6th edition) of Law and Economics

by Cooter and Ulen. The ownership of this book has reverted from the publisher to

its authors, so we are posting it online for everyone freely to read or use as a

textbook. After more than thirty years as the field’s leading textbook, it continues to

cover the latest developments in the economic analysis of property, torts, contracts,

legal process, and crimes. Each new edition refines the analytical core, incorporates

new applications, and expands previous discussions of empirical legal studies and

behavioral law and economics. We hope that you enjoy reading this book as much as

we enjoyed writing it.

Looking forward to next year, this duet will become an internet symphony

that takes full advantage of the internet revolution in publishing. Improvements

will be posted to the internet continuously in small amounts (7.1, 7.2, 7.3, etc.), until

a new edition appears with large changes (8.0). Not just a textbook, the 7th edition

will have supporting materials, including translations. For updates, join the email

list found by googling “Cooter and Ulen Berkeley Law Repository”. Perhaps you will

have something to contribute to the website. For the best feast, the host supplies the

main course each guest contributes a dish.

Law&Economics

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T H E P E A R S O N S E R I E S I N E C O N O M I C S

Abel/Bernanke/Croushore Macroeconomics*

Bade/Parkin Foundations of Economics*

Berck/Helfand The Economics of the Environment

Bierman/Fernandez Game Theory with Economic Applications

Blanchard Macroeconomics*

Blau/Ferber/Winkler The Economics of Women, Men and Work

Boardman/Greenberg/Vining/ Weimer

Cost-Benefit Analysis

Boyer Principles of Transportation Economics

Branson Macroeconomic Theory and Policy

Brock/Adams The Structure of American Industry

Bruce Public Finance and the American Economy

Carlton/Perloff Modern Industrial Organization

Case/Fair/Oster Principles of Economics*

Caves/Frankel/Jones World Trade and Payments: An Introduction

Chapman Environmental Economics: Theory, Application, and Policy

Cooter/Ulen Law & Economics

Downs An Economic Theory of Democracy

Ehrenberg/Smith Modern Labor Economics

Ekelund/Ressler/Tollison Economics*

Farnham Economics for Managers

Folland/Goodman/Stano The Economics of Health and Health Care

Fort Sports Economics

Froyen Macroeconomics

Fusfeld The Age of the Economist

Gerber International Economics*

Gordon Macroeconomics*

Greene Econometric Analysis

Gregory Essentials of Economics

Gregory/Stuart Russian and Soviet Economic Performance and Structure

Hartwick/Olewiler The Economics of Natural Resource Use

Heilbroner/Milberg The Making of the Economic Society

Heyne/Boettke/Prychitko The Economic Way of Thinking

Hoffman/Averett Women and the Economy: Family, Work, and Pay

Holt Markets, Games and Strategic Behavior

Hubbard/O’Brien Economics*

Money, Banking, and the Financial System*

Hughes/Cain American Economic History

Husted/Melvin International Economics

Jehle/Reny Advanced Microeconomic Theory

Johnson-Lans A Health Economics Primer

Keat/Young Managerial Economics

Klein Mathematical Methods for Economics

Krugman/Obstfeld/Melitz International Economics: Theory & Policy*

Laidler The Demand for Money

Leeds/von Allmen The Economics of Sports

Leeds/von Allmen/Schiming Economics*

Lipsey/Ragan/Storer Economics*

Lynn Economic Development: Theory and Practice for a Divided World

Miller Economics Today*

Understanding Modern Economics

Miller/Benjamin The Economics of Macro Issues

Miller/Benjamin/North The Economics of Public Issues

Mills/Hamilton Urban Economics

Mishkin The Economics of Money, Banking, and Financial Markets*

The Economics of Money, Banking, and Financial Markets, Business School Edition*

Macroeconomics: Policy and Practice*

Murray Econometrics: A Modern Introduction

Nafziger The Economics of Developing Countries

O’Sullivan/Sheffrin/Perez Economics: Principles, Applications, and Tools*

Parkin Economics*

Perloff Microeconomics*

Microeconomics: Theory and Applications with Calculus*

Perman/Common/McGilvray/Ma Natural Resources and Environmental Economics

Phelps Health Economics

Pindyck/Rubinfeld Microeconomics*

Riddell/Shackelford/Stamos/ Schneider

Economics: A Tool for Critically Understanding Society

Ritter/Silber/Udell Principles of Money, Banking & Financial Markets*

Roberts The Choice: A Fable of Free Trade and Protection

Rohlf Introduction to Economic Reasoning

Ruffin/Gregory Principles of Economics

Sargent Rational Expectations and Inflation

Sawyer/Sprinkle International Economics

Scherer Industry Structure, Strategy, and Public Policy

Schiller The Economics of Poverty and Discrimination

Sherman Market Regulation

Silberberg Principles of Microeconomics

Stock/Watson Introduction to Econometrics

Introduction to Econometrics, Brief Edition

Studenmund Using Econometrics: A Practical Guide

Tietenberg/Lewis Environmental and Natural Resource Economics

Environmental Economics and Policy

Todaro/Smith Economic Development

Waldman Microeconomics

Waldman/Jensen Industrial Organization: Theory and Practice

Weil Economic Growth

Williamson Macroeconomics

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S I X T H E D I T I O N

Law& Economics

ROBERT COOTER University of California, Berkeley

THOMAS ULEN University of Illinois, Urbana-Champaign

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Copyright © 2012, 2008, 2004, 2000 Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www.pearsoned.com/legal/permission.htm.

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Library of Congress Cataloging-in-Publication Data Cooter, Robert.

Law and economics / Robert Cooter, Thomas Ulen.—6th ed. p. cm.

Rev. ed. of: Law & economics / Robert Cooter, Thomas Ulen. Includes index. ISBN 978-0-13-254065-0 1. Law and economics. I. Ulen, Thomas. II. Cooter, Robert. Law & economics. III. Title. K487.E3C665 2011 340’.11—dc22

2010049060 10 9 8 7 6 5 4 3 2 1

ISBN-10: 0-13-254065-7 ISBN-13: 978-0-13-254065-0

vii

Preface x

1. An Introduction to Law and Economics 1

I. What Is the Economic Analysis of Law? 3

II. Some Examples 4

III. The Primacy of Efficiency Over Distribution in Analyzing Private Law 7

IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? 9

V. The Plan of This Book 10

2. A Brief Review of Microeconomic Theory 11

I. Overview: The Structure of Microeconomic Theory 11

II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency 12

III. Mathematical Tools 14

IV. The Theory of Consumer Choice and Demand 18

V. The Theory of Supply 26

VI. Market Equilibrium 28

VII. Game Theory 33

VIII. The Theory of Asset Pricing 37

IX. General Equilibrium and Welfare Economics 37

X. Decision Making Under Uncertainty: Risk and Insurance 43

XI. Profits and Growth 49

XII. Behavioral Economics 50

3. A Brief Introduction to Law and Legal Institutions 55

I. The Civil Law and the Common Law Traditions 56

II. The Institutions of the Federal and the State Court Systems in the United States 59

III. The Nature of a Legal Dispute 62

IV. How Legal Rules Evolve 64

Contents

4. An Economic Theory of Property 70

I. The Legal Concept of Property 73

II. Bargaining Theory 74

III. The Origins of the Institution of Property: A Thought Experiment 76

IV. An Economic Theory of Property 81

V. How are Property Rights Protected? 94

VI. What Can be Privately Owned?—Public and Private Goods 102

VII. What May Owners Do with Their Property? 105

VIII. On Distribution 106

Appendix: The Philosophical Concept of Property 109

5. Topics in the Economics of Property Law 112

I. What can be Privately Owned? 112

II. How are Property Rights Established and Verified? 143

III. What May Owners Do with Their Property? 156

IV. What are the Remedies for the Violation of Property Rights? 166

6. An Economic Theory of Tort Law 187

I. Defining Tort Law 189

II. An Economic Theory of Tort Liability 199

Appendix: Liability and Symmetry 228

7. Topics in the Economics of Tort Liability 230

I. Extending the Economic Model 230

II. Computing Damages 253

III. An Empirical Assessment of the U.S. Tort Liability System 261

8. An Economic Theory of Contract Law 276

I. Bargain Theory: An Introduction to Contracts 277

II. An Economic Theory of Contract Enforcement 283

III. An Economic Theory of Contract Remedies 287

IV. Economic Interpretation of Contracts 291

V. Relational Contracts: The Economics of the Long-Run 299

viii Contents

9. Topics in the Economics of Contract Law 307

I. Remedies as Incentives 307

II. Formation Defenses and Performance Excuses 341

Appendix: Mathematical Appendix 373

10. An Economic Theory of the Legal Process 382

I. The Goal of the Legal Process: Minimizing Social Costs 384

II. Why Sue? 386

III. Exchange of Information 391

IV. Settlement Bargaining 399

V. Trial 403

VI. Appeals 410

11. Topics in the Economics of the Legal Process 419

I. Complaints, Lawyers, Nuisances, and Other Issues in the Legal Process 419

II. An Empirical Assessment of the Legal Process 442

12. An Economic Theory of Crime and Punishment 454

I. The Traditional Theory of Criminal Law 455

II. An Economic Theory of Crime and Punishment 460

13. Topics in the Economics of Crime and Punishment 485

I. Crime and Punishment in the United States 485

II. Does Punishment Deter Crime? 491

III. Efficient Punishment 501

IV. The Death Penalty 510

V. The Economics of Addictive Drugs and Crime 518

VI. The Economics of Handgun Control 522

VII. Explaining the Decline in Crime in the United States 526

Case Index 533

Name Index 535

Subject Index 539

Contents ix

x

Preface

This sixth edition of Law and Economics arrives as the field celebrates its(roughly) 30th birthday. What began as a scholarly niche has grown into one ofthe most widely used tools of legal analysis. The subject has spread from the United States to many other countries. As scholarship deepens, the concepts in the core of law and economics become clearer and more stable, and new applications develop from the core like biological species evolving through specialization. With each new edition, we continue to refine the explanation of the analytical core and to incorporate new applications selectively as space permits. This edition expands previous discus- sions of empirical legal studies and behavioral law and economics. As we incorporate new material and respond to the suggestions that so many people have sent us, the book feels more like a symphony and less like a duet. We hope that you enjoy reading this book as much as we enjoyed writing it.

The book continues to cover the economic analysis of the law of property, torts, contracts, the legal process and crimes. Instructors and students who have used previ- ous editions will notice that we have reversed the order in which we treat torts and con- tracts, and we have divided the material on legal process into two chapters—one on theory and one on topics—in parallel with our treatment of all the other substantive ar- eas of the law. Below we describe what is new in this edition, followed by an account of the book’s website.

New to This Edition The Sixth Edition has been revised and updated to reflect the latest developments in law and economics. Major changes to the text are as follows:

• Tables and graphs have been updated. • New boxes and suggested readings have been added throughout the text. • Web Notes have been updated and added. • Chapter 6 contains additional information on liability and customs in trade. • Chapter 8 improves the explanation of contractual commitments through a better

representation of the principal-agent problem.

• Chapter 9 now includes new material on lapses, vicarious liability, incomprehensi- ble harms, punitive damages, mass torts, medical malpractice, and some behav- ioral aspects of contract remedies.

• Chapter 10 contains a new treatment of decision making by potential litigants and their lawyers, and new figures and decision trees.

• Chapter 11, a new chapter, combines new material on the legal process and an updated empirical assessment of various aspects of legal disputes.

• Chapter 12 now contains the theoretical material on crime and punishment, updated and clarified.

• Chapter 13 applies the theoretical insights of the previous chapter to wide-ranging policy issues in criminal justice and updates data and information from previous editions.

Online Resources The Companion Website presents a wealth of supplementary materials to help in teaching and learning law and economics. “Web Notes” throughout the book indi- cate the points at which there is additional material on the Companion Website at www.pearsonhighered.com/cooter_ulen. These notes extend the text presentations, provide guides and links to new articles and books, and contain excerpts from cases. We also include some examples of examinations and problem sets.

An updated Instructor’s Manual, reflective of changes to the new edition, will be available for instructors’ reference. The Instructor’s Manual is available for download on the Instructor's Resource center at www.pearsonhighered.com/irc.

Acknowledgments We continue to be extremely grateful to our colleagues at Boalt Hall of the University of California, Berkeley, and at the University of Illinois College of Law for the superb scholarly environments in which we work. Our colleagues have been extremely generous with their time in helping us to understand the law better. And in one of the great, ongoing miracles of the academic enterprise, we continue to learn much from the students whom we have the pleasure to teach at Berkeley, Illinois, and elsewhere.

We should also thank the many colleagues and students at other universities who have used our book in their classes and sent us many helpful suggestions about how to improve the book. We particularly thank Joe Kennedy of Georgetown, who has given us remarkably thorough and singularly helpful comments on improvements in the text.

We’d like to thank the following reviewers for their thoughtful commentary on the fifth edition: Howard Bodenhorn, J. Lon Carlson, Joseph M. Jadlow, and Mark E. McBride.

We would also like to thank those who have provided research assistance for this sixth edition: Theodore Ulen, Timothy Ulen, and Brian Doxey. And, also, for their long-time support and help: Jan Crouter, Dhammika Dharmapala, Lee Ann Fennell,

Preface xi

Nuno Garoupa, John Lopatka, Richard McAdams, Andy Morriss, Tom Nonnenmacher, Noel Netusil, Dan Vander Ploeg, and David Wishart.

Finally, we owe particular thanks to our assistants, Ida Ng at Boalt Hall and Sally Cook at the University of Illinois College of Law. They do many big things to help us get our work done, as well as many little things without which much of our work would be impossible to do. Thanks so much.

ROBERT D. COOTER Berkeley, CA

THOMAS S. ULEN Champaign, IL

November, 2010

xii Preface

For the rational study of the law the black-letter man may be the man of the present, but the man of the future is the man of statistics and the master of economics. . . . We learn that for everything we have to give up something else, and we are taught to set the advantage we gain against the other advantage we lose, and to know what we are doing when we elect.

Oliver Wendell Holmes. THE PATH OF THE LAW, 10 HARV. L. REV. 457, 469, 474 (1897)1

To me the most interesting aspect of the law and economics movement has been its as- piration to place the study of law on a scientific basis, with coherent theory, precise hypotheses deduced from the theory, and empirical tests of the hypotheses. Law is a social institution of enormous antiquity and importance, and I can see no reason why it should not be amenable to scientific study. Economics is the most advanced of the social sciences, and the legal system contains many parallels to and overlaps with the systems that economists have studied successfully.

Judge Richard A. Posner, in MICHAEL FAURE & ROGER VAN DEN BERGH, EDS., ESSAYS IN LAW AND ECONOMICS (1989)

UNTIL RECENTLY, LAW confined the use of economics to antitrust law, regulated in-dustries, tax, and some special topics like determining monetary damages. Inthese areas, law needed economics to answer such questions as “What is the de- fendant’s share of the market?”; “Will price controls on automobile insurance reduce its availability?”; “Who really bears the burden of the capital gains tax?”; and “How much future income did the children lose because of their mother’s death?”

Beginning in the early 1960s, this limited interaction changed dramatically when the economic analysis of law expanded into the more traditional areas of the law, such as property, contracts, torts, criminal law and procedure, and constitutional law.2 This

1

1 An Introduction to Law and Economics

1 Our citation style is a variant of the legal citation style most commonly used in the United States. Here is what the citation means: the author of the article from which the quotation was taken is Oliver Wendell Holmes; the title of the article is “The Path of the Law”; and the article may be found in volume 10 of the Harvard Law Review, which was published in 1897, beginning on page 457. The quoted material comes from pages 469 and 474 of that article.

2 The modern field is said to have begun with the publication of two landmark articles—Ronald H. Coase, The Problem of Social Cost, 3 J. L. & ECON. 1 (1960) and Guido Calabresi, Some Thoughts on Risk Distribution and the Law of Torts, 70 YALE L.J. 499 (1961).

2 C H A P T E R 1 An Introduction to Law and Economics

new use of economics in the law asked such questions as, “Will private ownership of the electromagnetic spectrum encourage its efficient use?”; “What remedy for breach of contract will cause efficient reliance on promises?”; “Do businesses take too much or too little precaution when the law holds them strictly liable for injuries to con- sumers?”; and “Will harsher punishments deter violent crime?”

Economics has changed the nature of legal scholarship, the common understanding of legal rules and institutions, and even the practice of law. As proof, consider these in- dicators of the impact of economics on law. By 1990 at least one economist was on the faculty of each of the top law schools in North America and some in Western Europe. Joint degree programs (a Ph.D. in economics and a J.D. in law) exist at many prominent universities. Law reviews publish many articles using the economic approach, and there are several journals devoted exclusively to the field.3 An exhaustive study found that ar- ticles using the economic approach are cited in the major American law journals more than articles using any other approach.4 Many law school courses in America now in- clude at least a brief summary of the economic analysis of law in question. Many sub- stantive law areas, such as corporation law, are often taught from a law-and-economics perspective.5 By the late 1990s, there were professional organizations in law and eco- nomics in Asia, Europe, Canada, the United States, Latin America, Australia, and else- where. The field received the highest level of recognition in 1991 and 1992 when consecutive Nobel Prizes in Economics6 were awarded to economists who helped to found the economic analysis of law—Ronald Coase and Gary Becker. Summing this up, Professor Bruce Ackerman of the Yale Law School described the economic approach to law as “the most important development in legal scholarship of the twentieth century.”

The new field’s impact extends beyond the universities to the practice of law and the implementation of public policy. Economics provided the intellectual foundations for the deregulation movement in the 1970s, which resulted in such dramatic changes in America as the dissolution of regulatory bodies that set prices and routes for airlines, trucks, and railroads. Economics also served as the intellectual force behind the revolu- tion in antitrust law in the United States in the 1970s and 1980s. In another policy area, a commission created by Congress in 1984 to reform criminal sentencing in the federal courts explicitly used the findings of law and economics to reach some of its results. Furthermore, several prominent law-and-economics scholars have become federal judges and use economic analysis in their opinions—Associate Justice Stephen Breyer of the U.S. Supreme Court; Judge Richard A. Posner and Judge Frank Easterbrook of the U.S. Court of Appeals for the Seventh Circuit; Judge Guido Calabresi of the U.S.

3 For example, the Journal of Law and Economics began in 1958; the Journal of Legal Studies in 1972; Research in Law and Economics, the International Review of Law and Economics, and the Journal of Law, Economics, and Organization in the 1980s; and the Journal of Empirical Legal Studies in 2004.

4 William M. Landes & Richard A. Posner, The Influence of Economics on Law: A Quantitative Study, 36 J. L. & ECON. 385 (1993).

5 See, e.g., STEPHEN M. BAINBRIDGE, CORPORATION LAW AND ECONOMICS (2002). 6 The full name of the Nobel Prize in Economics is the Bank of Sweden Prize in the Economic Sciences in

Memory of Alfred Nobel. See our book’s website for a full list of those who have won the Nobel Prize and brief descriptions of their work.

I. What Is the Economic Analysis of Law? 3

Court of Appeals for the Second Circuit; Judge Douglas Ginsburg, and former Judge Robert Bork of the U.S. Court of Appeals for the D.C. Circuit; and Judge Alex Kozinski of the U.S. Court of Appeals for the Ninth Circuit.

I. What Is the Economic Analysis of Law? Why has the economic analysis of law succeeded so spectacularly, especially in

the United States but increasingly also in other countries?7 Like the rabbit in Australia, economics found a vacant niche in the “intellectual ecology” of the law and rapidly filled it. To explain the niche, consider this classical definition of some kinds of laws: “A law is an obligation backed by a state sanction.”

Lawmakers often ask, “How will a sanction affect behavior?” For example, if punitive damages are imposed upon the maker of a defective product, what will happen to the safety and price of the product in the future? Or will the amount of crime de- crease if third-time offenders are automatically imprisoned? Lawyers answered such questions in 1960 in much the same way as they had 2000 years earlier—by consulting intuition and any available facts.

Economics provided a scientific theory to predict the effects of legal sanctions on behavior. To economists, sanctions look like prices, and presumably, people respond to these sanctions much as they respond to prices. People respond to higher prices by consuming less of the more expensive good; presumably, people also respond to more severe legal sanctions by doing less of the sanctioned activity. Economics has mathe- matically precise theories (price theory and game theory) and empirically sound methods (statistics and econometrics) for analyzing the effects of the implicit prices that laws attach to behavior.

Consider a legal example. Suppose that a manufacturer knows that his product will sometimes injure consumers. How safe will he make the product? For a profit- maximizing firm, the answer depends upon three costs: First, the cost of making the product safer, which depends on its design and manufacture; second, the manufac- turer’s legal liability for injuries to consumers; and third, the extent to which injuries discourage consumers from buying the product. The profit-maximizing firm will adjust safety until the cost of additional safety equals the benefit from reduced liability and higher consumer demand for the good.

Economics generally provides a behavioral theory to predict how people respond to laws. This theory surpasses intuition just as science surpasses common sense. The re- sponse of people is always relevant to making, revising, repealing, and interpreting laws. A famous essay in law and economics describes the law as a cathedral—a large, ancient, complex, beautiful, mysterious, and sacred building.8 Behavioral science resembles the mortar between the cathedral’s stones, which support the structure everywhere.

7 See Nuno Garoupa & Thomas S. Ulen, The Market for Legal Innovation: Law and Economics in Europe and the United States, 59 ALA. L. REV. 1555 (2008).

8 Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, 85 HARV. L. REV. 1089 (1972).

4 C H A P T E R 1 An Introduction to Law and Economics

A prediction can be neutral or loaded with respect to social values. A study finds that higher fines for speeding on the highway will presumably cause less of it. Is this good or bad on balance? The finding does not suggest an answer. In contrast, suppose that a study proves that the additional cost of collecting higher fines exceeds the result- ing benefit from fewer accidents, so a higher fine is “inefficient.” This finding suggests that a higher fine would be bad. Efficiency is always relevant to policymaking, because public officials never advocate wasting money. As this example shows, besides neutral predictions, economics makes loaded predictions. Judges and other officials need a method for evaluating laws’ effects on important social values. Economics provides such a method for efficiency.

Besides efficiency, economics predicts the effects of laws on another important value: the distribution of income. Among the earliest applications of economics to public policy was its use to predict who really bears the burden of alternative taxes. More than other so- cial scientists, economists understand how laws affect the distribution of income across classes and groups. While almost all economists favor changes that increase efficiency, some economists take sides in disputes about distribution and others do not take sides.

Instead of efficiency or distribution, people in business mostly talk about profits. Much of the work of lawyers aims to increase the profits of businesses, especially by helping businesses to make deals, avoid litigation, and obey regulations. These three ac- tivities correspond to three areas of legal practice in large law firms: transactions, litiga- tion, and regulation. Efficiency and profitability are so closely related that lawyers can use the efficiency principles in this book to help businesses make more money. Economic efficiency is a comprehensive measure of public benefits that include the profits of firms, the well-being of consumers, and the wages of workers. The logic of maximizing the comprehensive measure (efficiency) is very similar to the logic of maximizing one of its components (profits). A good legal system keeps the profitability of business and the wel- fare of people aligned, so that the pursuit of profits also benefits the public.

II. Some Examples To give you a better idea of what law and economics is about, we turn to some ex-

amples based upon classics in the subject. First, we try to identify the implicit price that the legal rule attaches to behavior in each example. Second, we predict the conse- quences of variations in that implicit price. Finally, we evaluate the effects in terms of efficiency and, where possible, distribution.

Example 1: A commission on reforming criminal law has identified cer- tain white-collar crimes (such as embezzling money from one’s employer) that are typically committed after rational consideration of the potential gain and the risk of getting caught and punished. After taking extensive testimony, much of it from economists, the commission decides that a monetary fine is the appropriate pun- ishment for these offenses, not imprisonment. The commission wants to know, “How high should the fine be?”

The economists who testified before the commission have a framework for an- swering this question. The commission focused on rational crimes that seldom occur unless the expected gain to the criminal exceeds the expected cost. The expected cost

II. Some Examples 5

depends upon two factors: the probability of being caught and convicted and the sever- ity of the punishment. For our purposes, define the expected cost of crime to the crimi- nal as the product of the probability of a fine times its magnitude.

Suppose that the probability of punishment decreases by 5 percent and the magni- tude of the fine increases by 5 percent. In that case, the expected cost of crime to the criminal roughly remains the same. Because of this, the criminal will presumably re- spond by committing the same amount of crime. (In Chapter 12 we shall explain the exact conditions for this conclusion to be true.) This is a prediction about how illegal behavior responds to its implicit price.

Now we evaluate this effect with respect to economic efficiency. When a decrease in the probability of a fine offsets an increase in its magnitude, the expected cost of crime remains roughly the same for criminals, but the costs of crime to the criminal justice sys- tem may change. The costs to the criminal justice system of increasing a fine’s probabil- ity include expenditures on apprehending and prosecuting criminals—for example, on the number and quality of auditors, tax and bank examiners, police, prosecuting attor- neys, and the like. While the cost of increasing the probability of catching and convicting white-collar criminals is relatively high, administering fines is relatively cheap. These facts imply a prescription for holding white-collar crime down to any specified level at least cost to the state: Invest little in apprehending and prosecuting offenders, and fine se- verely those who are apprehended. Thus, the commission might recommend very high monetary fines in its schedule of punishments for white-collar offenses.

Professor Gary Becker derived this result in a famous paper cited by the Nobel Prize Committee in its award to him. Chapters 12 and 13 discuss these findings in detail.

Example 2: An oil company contracts to deliver oil from the Middle East to a European manufacturer. Before the oil is delivered, war breaks out and the oil company cannot perform as promised. The lack of oil causes the European manu- facturer to lose money. The manufacturer brings an action (that is, files a lawsuit) against the oil company for breach of contract. The manufacturer asks the court to award damages equal to the money that it lost. The contract is silent about the risk of war, so that the court cannot simply read the contract and resolve the dispute on the contract’s own terms. The oil company contends that it should be excused from performance because it could do nothing about the war and neither of the con- tracting parties foresaw it. In resolving the suit, the court must decide whether to excuse the oil company from performance on the ground that the war made the performance “impossible,” or to find the oil company in breach of contract and to require the oil company to compensate the manufacturer for lost profits.9

War is a risk of doing business in the Middle East that one of the parties to the con- tract must bear, and the court must decide which one it is. What are the consequences of different court rulings? The court’s decision simultaneously accomplishes two things. First, it resolves the dispute between the litigants—“dispute resolution.” Second, it guides future parties who are in similar circumstances about how courts might resolve their dispute—“rule creation.” Law and economics is helpful in resolving

9 For a full discussion of the cases on which this example is based, see Richard A. Posner & Andrew Rosenfield, Impossibility and Related Doctrines in Contract Law, 6 J. LEGAL STUD. 88 (1977).

6 C H A P T E R 1 An Introduction to Law and Economics

disputes, but it particularly shines in creating rules. Indeed, a central question in this book is, “How will the rule articulated by the lawmaker to resolve a particular dispute affect the behavior of similarly situated parties in the future?” And, “Is the predicted behavior desirable?”

The oil company and the manufacturer can take precautions against war in the Middle East, although neither of them can prevent it. The oil company can sign backup contracts for delivery of Venezuelan oil, and the manufacturer can store oil for emer- gency use. Efficiency requires the party to take precaution who can do so at least cost. Is the oil company or the manufacturer better situated to take precautions against war? Since the oil company works in the Middle East, it is probably better situated than a European manufacturer to assess the risk of war in that region and to take precautions against it. For the sake of efficiency, the court might hold the oil company liable and cite the principle that courts will allocate risks uncovered in a contract to the party who can bear them at least cost. This is the principle of the least-cost risk-bearer,10 which is consistent with some decisions in cases that arose from the Middle Eastern war of 1967. Chapters 8 and 9 consider this principle’s foundation.

Example 3: Eddie’s Electric Company emits smoke that dirties the wash hanging at Lucille’s Laundry. Eddie’s can completely abate the pollution by in- stalling scrubbers on its stacks, and Lucille’s can completely exclude the smoke by installing filters on its ventilation system. Installing filters is cheaper than installing scrubbers. No one else is affected by this pollution because Eddie’s and Lucille’s are near to each other and far from anyone else. Lucille’s initiates court proceed- ings to have Eddie’s declared to be a “nuisance.” If the action succeeds, the court will order Eddie’s to abate its pollution. Otherwise, the court will not intervene in the dispute. What is the appropriate resolution of this dispute?

Efficiency requires Lucille’s to install filters, which is cheaper than Eddie’s in- stalling scrubbers. How can the court produce this result? The answer depends on whether or not Eddie’s and Lucille’s can cooperate. First, assume that Eddie’s and Lucille’s cannot bargain together or cooperate. If Lucille’s wins the action and the court orders Eddie’s to abate the pollution, Eddie’s will have to install scrubbers, which is ef- ficient. However, if Lucille’s loses the action, then Lucille’s will have to install filters, which is inefficient. Consequently, it is efficient for Lucille’s to lose the action.

Now, consider how the analysis changes if Eddie’s and Lucille’s can bargain together and cooperate. Their joint profits (the sum of the profits of Eddie’s and Lucille’s) will be higher if they choose the cheaper means of eliminating the harm from pollution. When their joint profits are higher, they can divide the gain between them in order to make both of them better off. The cheaper means is also the efficient means. Efficiency is achieved in this example when Lucille’s and Eddie’s bargain together and cooperate, regardless of the rule of law. Ronald Coase derived this result in a famous paper cited by the Nobel Prize Committee when he received the award. Chapter 4 elaborates on this famous result.

10 The principle assumes that the entire loss from nonperformance must be allocated by the court to one of the parties. Alternatively, the court might divide the loss between the parties.

III. The Primacy of Efficiency Over Distribution in Analyzing Private Law 7

III. The Primacy of Efficiency Over Distribution in Analyzing Private Law

We explained that economists are experts on two policy values—efficiency and distribution. The stakes in most legal disputes have monetary value. Deciding a legal dispute almost always involves allocating the stakes between the parties. The decision about how much of the stakes each party gets creates incentives for future behavior, not just for the parties to this dispute but also for everyone who is similarly situated. In this book we use these incentive effects to make predictions about the consequences of le- gal decisions, policies, rules, and institutions. In evaluating these consequences, we will focus on efficiency rather than distribution. Why?

By making a rule, the division of the stakes in a legal dispute affects all similarly situated people. If a plaintiff in a case is a consumer of a particular good, an investor in a particular stock, or the driver of a car, then a decision for the plaintiff may benefit everyone who consumes this good, invests in this stock, or drives a car. Most propo- nents of income redistribution, however, have something else in mind. Instead of con- templating distribution to consumers, investors, or drivers, advocates of income redistribution usually target social groups, such as the poor, women, or minorities. Some people passionately advocate government redistribution of income by class, gen- der, or race for the sake of social justice. A possible way to pursue redistribution is through private law—the law of property, contracts, and torts. According to this philos- ophy, courts should interpret or make private laws to redistribute income to deserving groups of people. For example, if consumers are poorer on average than investors, then courts should interpret liability rules to favor consumers and disfavor corporations.

This book rejects the redistributive approach to private law. Pursuing redistributive goals is an exceptional use of private law that special circumstances may justify but that ought not be the usual use of private law. Here is why. Like the rest of the population, economists disagree among themselves about redistributive ends. However, economists generally agree about redistributive means. By avoiding waste, efficient redistribution benefits everyone relative to inefficient redistribution. By avoiding waste, efficient re- distribution also builds support for redistribution. For example, people are more likely to donate to a charitable organization that efficiently redistributes income than to one that spends most of its revenue on administration.

A piquant example will help you to appreciate the advantages of efficient redistri- bution. Assume that a desert contains two oases, one of which has ice cream and the other has none. The advocates of social justice who favor redistribution obtain control over the state and declare that the first oasis should share its ice cream with the second oasis. In response, the first oasis fills a large bowl with ice cream and sends a youth running across the desert carrying the bowl to the second oasis. The hot sun melts some of the ice cream, so the first oasis gives up more ice cream than the second oasis re- ceives. The melted ice cream represents the cost of redistribution. People who disagree vehemently about how much ice cream the first oasis should give to the second oasis may agree that a fast runner should transport it. Also they might agree to choose an honest runner who will not eat the ice cream along the route.

8 C H A P T E R 1 An Introduction to Law and Economics

Many economists believe that progressive taxation and social welfare programs— the “tax-and-transfer system,” as it is usually called—can accomplish redistributive goals in modern states more efficiently than can be done through modifying or reshuf- fling private legal rights. There are several reasons why reshuffling private legal rights resembles giving the ice cream to a slow runner.

First, the income tax precisely targets inequality, whereas redistribution by private legal rights relies on crude averages. To illustrate, assume that courts interpret a law to favor consumers over corporations in order to redistribute income from rich to poor.11

“Consumers” and “investors” imperfectly correspond to “poor” and “rich.” Consumers of Ferrari automobiles, skiing vacations, and the opera tend to be relatively rich. Many small businesses are organized as corporations. Furthermore, the members of unions with good pension plans own the stocks of large companies. By taxing income progres- sively, law distinguishes more precisely between rich and poor than by taking the indi- rect approach of targeting “consumers” and “investors.”

Second, the distributive effects of reshuffling private rights are hard to predict. To illustrate, the courts cannot be confident that holding a corporation liable to its con- sumers will reduce the wealth of its stockholders. Perhaps the corporation will pass on its higher costs to consumers in the form of higher prices, in which case the court’s holding will redistribute costs from some consumers to other consumers.

Third, the transaction costs of redistribution through private legal rights are typi- cally high. To illustrate, a plaintiff’s attorney working on a contingency fee in the United States routinely charges one-third of the judgment. If the defendant’s attorney collects a similar amount in hourly fees, then attorneys for the two sides will absorb two-thirds of the stakes in dispute. The tax-and-transfer system is more efficient.

Besides these three reasons, there is a fourth: Redistribution by private law distorts the economy more than progressive taxation does. In general, relying on broad-based taxes, rather than narrowly focused laws, reduces the distorting effects of redistributive policies. For example, assume that a law to benefit consumers of tomatoes causes a de- cline in the return enjoyed by investors in tomato farms. Investors will respond by with- drawing funds from tomato farms and investing in other businesses. Consequently, the supply of tomatoes will be too small and consumers will pay too high a price for them. This law distorts the market for tomatoes.

For these reasons and more, economists who favor redistribution and economists who oppose it can agree that private legal rights are usually the wrong way to pursue distributive justice. Unfortunately, lawyers without training in economics seldom ap- preciate these facts.

We have presented several reasons against basing private law on redistributive goals. Specifically, we discussed imprecise targeting, unpredictable consequences, high transac- tion costs, and distortions in incentives. For these reasons, the general principles of private law cannot rest on income redistribution. (In special circumstances, however, a private law can redistribute relatively efficiently, such as a well-designed law giving crippled people the right to sue employers for not providing wheelchair access to the workplace.)

11 Courts might always find in favor of the individual consumer when he or she sues a corporation regarding liability for harms arising in the use of the corporation’s products.

IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? 9

Web Note 1.1

Besides efficiency, what other policy values should matter to making law and applying it? In Fairness Versus Welfare (2002), Louis Kaplow and Steven Shavell of the Harvard Law School say “None.” Others disagree. See Chris Sanchirico, Deconstructing the New Efficiency Rationale, 86 CORNELL L. REV. 1005 (2001), and Daniel Farber, What (If Anything) Can Economics Say About Equity?, 101 MICH. L. REV. 1791 (2003).

There is a more complete discussion of this literature under Chapter 1 at the website for this book and links to additional sites of interest.

IV. Why Should Lawyers Study Economics? Why Should Economists Study Law?

The economic analysis of law unites two great fields and facilitates understanding each of them. You probably think of laws as promoting justice; indeed, many people can think in no other way. Economics conceives of laws as incentives for changing behavior (implicit prices) and as instruments for policy objectives (efficiency and distribution). However, economic analysis often takes for granted such legal institutions as property and contract, which dramatically affect the economy. Thus, differences in laws cause capital markets to be organized differently in Japan, Germany, and the United States. Failures in financial laws and contracting contributed to the banking collapse of 2008 in the United States and the subsequent recession, which was less severe in Japan and Germany. Also, the absence of secure property and reliable contracts paralyzes the economies of some poor nations. Improving the effectiveness of law in poor countries is important to their economic development. Law needs economics to understand its be- havioral consequences, and economics needs law to understand the underpinnings of markets.

Economists and lawyers can also learn techniques from each other. From econo- mists, lawyers can learn quantitative reasoning for making theories and doing empiri- cal research. From lawyers, economists can learn to persuade ordinary people—an art

Stern Warning for Students

If you are like most students who read this book—scholars of the highest moral caliber—you need not upset yourself by reading the rest of this paragraph. If you are one of those wicked students—we get a few every year—here is a stern warning for you. According to traditional Chinese beliefs, sinners are tried and punished in ten courts of hell after they die. The sixth court tries the sin of “abusing books,” punishable by being sawn in half from head to toe. The eighth court tries the sin of “cheating on exams,” punishable by being cut open and having your intes- tines ripped out. So don’t you dare abuse this book or cheat on the exams!

10 C H A P T E R 1 An Introduction to Law and Economics

that lawyers continually practice and refine. Lawyers can describe facts and give them names with moral resonance, whereas economists are obtuse to language too often. If economists will listen to what the law has to teach them, they will find their models be- ing drawn closer to what people really care about.

V. The Plan of This Book To benefit from each other, lawyers must learn some economics and economists

must learn some law. Readers can do so in the next two chapters. Chapter 2 briefly re- views microeconomic theory. If you are familiar with that theory, then you can read the material quickly as a review or skim the headings for unfamiliar topics. As a check, you might try the problems at the end of Chapter 2.

Chapter 3 is an introduction to the law and the legal process, which is essential reading for those without legal training. We explain how the legal system works, how the U.S. legal system differs from the rest of the world, and what counts as “law.”

Chapter 4 begins the substantive treatment of the law from an economic viewpoint. The chapters on substantive legal issues are arranged in pairs. Chapters 4 and 5 focus on property law; Chapters 6 and 7, on tort law; Chapters 8 and 9, on contract law; Chapters 10 and 11, on resolving legal disputes; and 12 and 13, on criminal law. The first chapter of each pair explains the basic economic analysis of that area of law, and the second chap- ter applies the core economic theory to a series of topics. So, Chapter 6 develops an eco- nomic theory of tort liability, and Chapter 7 applies it to automobile accidents, medical practice, and defective products. Chapters 4 through 11 deal with laws where the typical plaintiff in a suit is a private person (“private law”), and Chapters 12 and 13 deal with criminal law where the plaintiff is the public prosecutor (“public law”).

Suggested Readings

At the end of every chapter we shall list some of the most important writings on the subject. Please check the website for this book (www.cooter-ulen.com) for additional resources.

BOUCKAERT, BOUDEWIJN, & GERRIT DE GEEST, EDS., ENCYCLOPEDIA OF LAW AND ECONOMICS (rev. ed., 2011).

DAU-SCHMIDT, KEN, & THOMAS S. ULEN, EDS., A LAW AND ECONOMICS ANTHOLOGY (1997).

MICELI, THOMAS J, THE ECONOMIC APPROACH TO LAW (2d ed. 2008).

NEWMAN, PETER, ED., THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND LAW (3 vols., 1998).

POLINSKY, A. MITCHELL, AN INTRODUCTION TO LAW AND ECONOMICS (3rd, 2003).

POLINSKY, A. MITCHELL, & STEVEN SHAVELL, EDS., HANDBOOK OF LAW AND ECONOMICS, vs. 1 AND 2 (2007).

Posner, Richard A., The Decline of Law as an Autonomous Discipline, 1962–1987, 100 HARV. L. REV. 761 (1987).

POSNER, RICHARD A., ECONOMIC ANALYSIS OF LAW (7th ed., 2007).

SHAVELL, STEVEN, FOUNDATIONS OF THE ECONOMIC ANALYSIS OF LAW (2003).

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. . . . It is ideas, not vested interests, which are dangerous for good or evil.

JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST, AND MONEY (1936)

In this state of imbecility, I had, for amusement, turned my attention to political economy.

THOMAS DEQUINCEY, CONFESSIONS OF AN ENGLISH OPIUM EATER (1821)

Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.

LIONEL CHARLES ROBBINS, LORD ROBBINS, AN ESSAY ON THE NATURE AND SIGNIFICANCE OF ECONOMIC SCIENCE (1932)

THE ECONOMIC ANALYSIS of law draws upon the principles of microeconomic the-ory, which we review in this chapter. For those who have not studied this branchof economics, reading this chapter will prove challenging but useful for under- standing the remainder of the book. For those who have already mastered microeco- nomic theory, reading this chapter is unnecessary. For those readers who are somewhere in between these extremes, we suggest that you begin reading this chapter, skimming what is familiar and studying carefully what is unfamiliar. If you’re not sure where you lie on this spectrum of knowledge, turn to the questions at the end of the chapter. If you have difficulty answering them, you will benefit from studying this chapter carefully.

I. Overview: The Structure of Microeconomic Theory Microeconomics concerns decision making by individuals and small groups, such

as families, clubs, firms, and governmental agencies. As the famous quote from Lord Robbins at the beginning of the chapter says, microeconomics is the study of how

11

2 A Brief Review ofMicroeconomic Theory

12 C H A P T E R 2 A Brief Review of Microeconomic Theory

scarce resources are allocated among competing ends. Should you buy that digital au- diotape player you’d like, or should you buy a dapper suit for your job interview? Should you take a trip with some friends this weekend or study at home? Because you have limited income and time and cannot, therefore, buy or do everything that you might want to buy or do, you have to make choices. Microeconomic theory offers a general theory about how people make such decisions.

We divide our study of microeconomics into five sections. The first is the theory of consumer choice and demand. This theory describes how the typical consumer, con- strained by a limited income, chooses among the many goods and services offered for sale.

The second section deals with the choices made by business organizations or firms. We shall develop a model of the firm that helps us to see how the firm decides what goods and services to produce, how much to produce, and at what price to sell its out- put. In the third section, we shall consider how consumers and firms interact. By com- bining the theory of the consumer and the firm, we shall explain how the decisions of consumers and firms are coordinated through movements in market price. Eventually, the decisions of consumers and firms must be made consistent in the sense that some- how the two sides agree about the quantity and price of the good or service that will be produced and consumed. When these consumption and production decisions are con- sistent in this sense, we say that the market is in equilibrium. We shall see that power- ful forces propel markets toward equilibrium, so that attempts to divert the market from its path are frequently ineffectual or harmful.

The fourth section of microeconomic theory describes the supply and demand for inputs into the productive process. These inputs include labor, capital, land, and mana- gerial talent; more generally, inputs are all the things that firms must acquire in order to produce the goods and services that consumers or other firms wish to purchase.

The final section of microeconomics deals with the area known as welfare economics. There we shall discuss the organization of markets and how they achieve efficiency.

These topics constitute the core of our review of microeconomic theory. There are four additional topics that do not fit neatly into the sections noted above but that we think you should know about them in order to understand the economic analysis of legal rules and institutions. These are game theory, the economic theory of decision making under uncertainty, growth theory, and behavioral economics. We shall cover these four topics in the final sections of this chapter.

II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency

Economists usually assume that each economic actor maximizes something: Consumers maximize utility (that is, happiness or satisfaction), firms maximize profits, politicians maximize votes, bureaucracies maximize revenues, charities maximize social welfare, and so forth. Economists often say that models assuming maximizing behavior work because most people are rational, and rationality requires maximization.

II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency 13

One conception of rationality holds that a rational actor can rank alternatives according to the extent that they give her what she wants. In practice, the alternatives available to the actor are constrained. For example, a rational consumer can rank alternative bun- dles of consumer goods, and the consumer’s budget constrains her choice among them. A rational consumer should choose the best alternative that the constraints allow. Another common way of understanding this conception of rational behavior is to rec- ognize that consumers choose alternatives that are well suited to achieving their ends.

Choosing the best alternative that the constraints allow can be described mathe- matically as maximizing. To see why, consider that the real numbers can be ranked from small to large, just as the rational consumer ranks alternatives according to the extent that they give her what she wants. Consequently, better alternatives can be asso- ciated with larger numbers. Economists call this association a “utility function,” about which we shall say more in the following sections. Furthermore, the constraint on choice can usually be expressed mathematically as a “feasibility constraint.” Choosing the best alternative that the constraints allow corresponds to maximizing the utility function subject to the feasibility constraint. So, the consumer who goes shopping is said to maximize utility subject to her budget constraint.

Turning to the second fundamental concept, there is no habit of thought so deeply ingrained among economists as the urge to characterize each social phenomenon as an equilibrium in the interaction of maximizing actors. An equilibrium is a pattern of in- teraction that persists unless disturbed by outside forces. Economists usually assume that interactions tend toward an equilibrium, regardless of whether they occur in mar- kets, elections, clubs, games, teams, corporations, or marriages.

There is a vital connection between maximization and equilibrium in microeco- nomic theory. We characterize the behavior of every individual or group as maximizing something. Maximizing behavior tends to push these individuals and groups toward a point of rest, an equilibrium. They certainly do not intend for an equilibrium to result; instead, they simply try to maximize whatever it is that interests them. Nonetheless, the interaction of maximizing agents usually results in an equilibrium.

A stable equilibrium is one that will not change unless outside forces intervene. To illustrate, the snowpack in a mountain valley is in stable equilibrium, whereas the snowpack on the mountain’s peak may be in unstable equilibrium. An interaction headed toward a stable equilibrium actually reaches this destination unless outside forces divert it. In social life, outside forces often intervene before an interaction reaches equilibrium. Nevertheless, equilibrium analysis makes sense. Advanced micro- economic theories of growth, cycles, and disequilibria exist, but we shall not need them in this book. The comparison of equilibria, called comparative statics, will be our basic approach.

Turning to the third fundamental concept, economists have several distinct defini- tions of efficiency. A production process is said to be productively efficient if either of two conditions holds:

1. It is not possible to produce the same amount of output using a lower-cost combination of inputs, or

2. It is not possible to produce more output using the same combination of inputs.

14 C H A P T E R 2 A Brief Review of Microeconomic Theory

Consider a firm that uses labor and machinery to produce a consumer good called a “widget.” Suppose that the firm currently produces 100 widgets per week using 10 workers and 15 machines. The firm is productively efficient if

1. it is not possible to produce 100 widgets per week by using 10 workers and fewer than 15 machines, or by using 15 machines and fewer than 10 work- ers, or

2. it is not possible to produce more than 100 widgets per week from the com- bination of 10 workers and 15 machines.

The other kind of efficiency, called Pareto efficiency after its inventor1 or sometimes referred to as allocative efficiency, concerns the satisfaction of individual preferences. A particular situation is said to be Pareto or allocatively efficient if it is impossible to change it so as to make at least one person better off (in his own estimation) without making another person worse off (again, in his own estimation). For simplicity’s sake, assume that there are only two consumers, Smith and Jones, and two goods, umbrellas and bread. Initially, the goods are distributed between them. Is the allocation Pareto effi- cient? Yes, if it is impossible to reallocate the bread and umbrellas so as to make either Smith or Jones better off without making the other person worse off.2

These three basic concepts—maximization, equilibrium, and efficiency—are fun- damental to explaining economic behavior, especially in decentralized institutions like markets that involve the coordinated interaction of many different people.

III. Mathematical Tools You may have been anxious about the amount of mathematics that you will find in

this book. There is not much. We use simple algebra and graphs.

A. Functions Economics is rife with functions: production functions, utility functions, cost func-

tions, social welfare functions, and others. A function is a relationship between two sets of numbers such that for each number in one set, there corresponds exactly one number in the other set. To illustrate, the columns below correspond to a functional relationship between the numbers in the left-hand column and those in the right-hand column. Thus, the number 4 in the x-column below corresponds to the number 10 in the y-column.

In fact, notice that each number in the x-column corresponds to exactly one number in the y-column. Thus, we can say that the variable y is a function of the variable x, or in the most common form of notation.

y = f(x).

1 Vilfredo Pareto was an Italian-Swiss political scientist, lawyer, and economist who wrote around 1900. 2 There is another efficiency concept—a potential Pareto improvement or Kaldor-Hicks efficiency—that we

describe in section IX.C that follows.

III. Mathematical Tools 15

Note that the number 4 is not the only number in the x-column that corresponds to the number 10 in the y-column; the number 6 also corresponds to the number 10. In this table, for a given value of x, there corresponds one value of y, but for some values of y, there corresponds more than one value of x. A value of x determines an exact value of y, whereas a value of y does not determine an exact value of x. Thus, in is called the dependent variable, because it depends on the value of x, and x is called the independent variable. Because y depends upon x in this table, y is a function of x, but because x does not (to our knowledge) depend for its values on y, x is not a function of y.

Now suppose that there is another dependent variable, named z, that also depends upon x. The function relating z to x might be named g:

When there are two functions, g(x) and f(x), with different dependent variables, z and y, remembering which function goes with which variable can be hard. To avoid this difficulty, the same name is often given to a function and the variable determined by it. Following this strategy, the preceding functions would be renamed as follows:

Sometimes an abstract function will be discussed without ever specifying the exact numbers that belong to it. For example, the reader might be told that y is a function of x, and never be told exactly which values of y correspond to which values of x. The point then is simply to make the general statement that y depends upon x but in an as yet unspecified way. If exact numbers are given, they may be listed in a table, as we have seen. Another way of showing the relationship between a dependent and an inde- pendent variable is to give an exact equation. For example, a function might be given the exact form

which states that the function z matches values of x with values of z equal to five plus one-half of whatever value x takes. The table below gives the values of z associated with several different values of x:

z = z(x) = 5 + x>2, z = z(x)

z = g(x)Q z = z(x). y = f(x)Q y = y(x),

z = g(x).

y = f(x), y

y-column x-column

2 3 3 0

10 4 10 6 12 9 7 12

This is read as “y is a function of x” or “y equals some f of x.”

16 C H A P T E R 2 A Brief Review of Microeconomic Theory

A function can relate a dependent variable (there is always just one of them to a function) to more than one independent variable. If we write we are saying that the function h matches one value of the dependent variable y to every pair of values of the independent variables x and z. This function might have the specific form

according to which y decreases by 3 units when x increases by 1 unit, and y increases by 1 unit when z increases by 1 unit.

B. Graphs We can improve the intuitive understanding of a functional relationship by visual-

izing it in a graph. In a graph, values of the independent variable are usually read off the horizontal axis, and values of the dependent variable are usually read off the verti- cal axis. Each point in the grid of lines corresponds to a pair of values for the variables. For an example, see Figure 2.1. The upward-sloping line on the graph represents all of the pairs of values that satisfy the function You can check this by find- ing a couple of points that ought to be on the line that corresponds to that function. For example, what if What value should x have? If then a little arithmetic will reveal that x should equal Thus, the pair is a point on the line de- fined by the function. What if What value will y have? In that case, the secondx = 0?

(0, -10)-10. y = 0,y = 0?

y = 5 + x>2.

y = h(x, z) = -3x + z,

y = h(x, z),

y

x

–y

–x

15

10

0

5

5 10 15– 5

– 5

– 10

– 10– 15

y = 5 – x!2

y = 5 + x!2

FIGURE 2.1 Graphs of the linear relationships

(with a positive slope) and (with a negative slope).y = 5 - x>2y = 5 + x>2

z-column x-column

6.5 3 12.5 15 8.0 6 6.0 2 9.5 9

III. Mathematical Tools 17

term in the right-hand side of the equation disappears, so that Thus, the pair of values (5, 0) is a point on the line defined by the function.

The graph of reveals some things about the relationship between y and x that we otherwise might not so easily discover. For example, notice that the line representing the equation slopes upward, or from southwest to northeast. The positive slope, as it is called, reveals that the relationship between x and y is a direct one. Thus, as x increases, so does y. And as x decreases, y decreases. Put more generally, when the independent and dependent variables move in the same direction, the slope of the graph of their relationship will be positive.

The graph also reveals the strength of this direct relationship by showing whether small changes in x lead to small or large changes in y. Notice that if x increases by 2 units, y increases by 1 unit. Another way of putting this is to say that in order to get a 10-unit increase in y, there must be a 20-unit increase in x.3

The opposite of a direct relationship is an inverse relationship. In that sort of rela- tionship, the dependent and independent variables move in opposite directions. Thus, if x and y are inversely related, an increase in x (the independent variable) will lead to a decrease in y. Also, a decrease in x will lead to an increase in y. An example of an in- verse relationship between an independent and a dependent variable is The graph of this line is also shown in Figure 2.1. Note that the line is downward- sloping; that is, the line runs from northwest to southeast.

QUESTION 2.1: Suppose that the equation were Show in a graph like the one in Figure 2.1 what the graph of that equation would look like. Is the relationship between x and y direct or inverse? Is the slope of the new equation greater or less than the slope shown in Figure 2.1?

Now suppose that the equation were Show in a graph like the one in Figure 2.1 what the graph of that equation would look like. Is the rela- tionship between x and y direct or inverse? Is the slope of the new equation positive or negative? Would the slope of the equation be steeper or shallower than that of the one in

The graph of in Figure 2.1 also reveals that the relationship between the variables is linear. This means that when we graph the values of the independent and dependent variables, the resulting relationship is a straight line. One of the impli- cations of linearity is that changes in the independent variable cause a constant rate of change in the dependent variable. In terms of Figure 2.1, if we would like to know the effect on y of doubling the amount of x, it doesn’t matter whether we investigate that effect when x equals 2 or 3147. The effect on y of doubling the value of x is proportion- ally the same, regardless of the value of x.

The alternative to a linear relationship is, of course, a nonlinear relationship. In general, nonlinear relationships are trickier to deal with than are linear relationships.

y = 5 + x>2 y = 5 - x? y = 5 - x>2

y = 5 - x.

y = 5 + x.

y = 5 - x>2.

y = 5 + x>2 y = 5.

3 The slope of the equation we have been dealing with in Figure 2.1 is which is the coefficient of x in the equation. In fact, in any linear relationship the coefficient of the independent variable gives the slope of the equation.

1 2,

18 C H A P T E R 2 A Brief Review of Microeconomic Theory

They frequently, although not always, are characterized by the independent variable be- ing raised to a power by an exponent. Examples are and Figure 2.2 shows a graph of Another common nonlinear relationship in economics is given by the example where A is a constant. A graph of that function is given in Figure 2.3.

IV. The Theory of Consumer Choice and Demand The economist’s general theory of how people make choices is referred to as the

theory of rational choice. In this section we show how that theory explains the con- sumer’s choice of what goods and services to purchase and in what amounts.

A. Consumer Preference Orderings The construction of the economic model of consumer choice begins with an ac-

count of the preferences of consumers. Consumers are assumed to know the things they like and dislike and to be able to rank the available alternative combinations of goods and services according to their ability to satisfy the consumer’s preferences. This in- volves no more than ranking the alternatives as better than, worse than, or equally as good as one another. Indeed, some economists believe that the conditions they impose on the ordering or ranking of consumer preferences constitute what an economist means by the term rational. What are those conditions? They are that a consumer’s preference ordering or ranking be complete, transitive, and reflexive. For an ordering to be complete simply means that the consumer be able to tell us how she ranks all the

A = xy, y = x2.

y = 5>x12.y = x2

y

x– x 0

y = x2

FIGURE 2.2 The graph of a nonlinear relationship, given by the equation y = x 2.

y

x0

A = xy

FIGURE 2.3 The graph of a nonlinear relationship, A = xy.

IV. The Theory of Consumer Choice and Demand 19

possible combinations of goods and services. Suppose that A represents a bundle of certain goods and services and B represents another bundle of the same goods and serv- ices but in different amounts. Completeness requires that the consumer be able to tell us that she prefers A to B, or that she prefers B to A, or that A and B are equally good (that is, that the consumer is indifferent between having A and having B). The consumer is not allowed to say, “I can’t compare them.”

Reflexivity is an arcane condition on consumer preferences. It means that any bun- dle of goods, A, is at least as good as itself. That condition is so trivially true that it is difficult to give a justification for its inclusion.

Transitivity means that the preference ordering obeys the following condition: If bundle A is preferred to bundle B and bundle B is preferred to bundle C, then it must be the case that A is preferred to C. This also applies to indifference: If the consumer is indifferent between A and B and between B and C, then she is also in- different between A and C. Transitivity precludes the circularity of individual pref- erences. That is, transitivity means that it is impossible for A to be preferred to B, B to be preferred to C, and C to be preferred to A. Most of us would probably feel that someone who had circular preferences was extremely young or childish or crazy.

QUESTION 2.2: Suppose that you have asked James whether he would like a hamburger or a hot dog for lunch, and he said that he wanted a hot dog. Five hours later you ask him what he would like for dinner, a hamburger or a hot dog. James answers, “A hamburger.” Do James’s preferences for hot dogs ver- sus hamburgers obey the conditions above? Why or why not?

It is important to remember that the preferences of the consumer are subjective. Different people have different tastes, and these will be reflected in the fact that they may have very different preference orderings over the same goods and services. Economists leave to other disciplines, such as psychology and sociology, the study of the source of these preferences. We take consumer tastes or preferences as given, or, as economists say, as exogenous, which means that they are determined outside the eco- nomic system.4

An important consequence of the subjectivity of individual preferences is that economists have no accepted method for comparing the strength of people’s prefer- ences. Suppose that Stan tells us that he prefers bundle A to bundle B, and Jill tells us that she feels the same way: She also prefers A to B. Is there any way to tell who would prefer having A more? In the abstract, the answer is, “No, there is not.” All we have from each consumer is the order of preference, not the strength of those preferences. Indeed, there is no metric by which to measure the strength of preferences, although economists sometimes jokingly refer to the “utils” of satisfaction that a consumer is enjoying. The inability to make interpersonal comparisons of well-being has some

4 Many people new to the study of microeconomics will find this assumption of the exogeneity of preferences to be highly unrealistic. And there is some controversy about this assumption even within economics, some economists contending that preferences are endogenous—that is, determined within the economic system by such things as advertising. We cannot elaborate on this controversy here but are well aware of it.

20 C H A P T E R 2 A Brief Review of Microeconomic Theory

important implications for the design and implementation of public policy, as we shall see in the section on welfare economics.

B. Utility Functions and Indifference Curves Once a consumer describes what his or her preference ordering is, we may derive

a utility function for that consumer. The utility function identifies higher preferences with larger numbers. Suppose that there are only two commodities or services, x and y, available to a given consumer. If we let u stand for the consumer’s utility, then the func- tion describes the utility that the consumer gets from different combina- tions of x and y.

A very helpful way of visualizing the consumer’s utility function is by means of a graph called an indifference map. An example is shown in Figure 2.4. There we have drawn several indifference curves. Each curve represents all the combinations of x and y that give the consumer the same amount of utility or well-being. Alternatively, we might say that the consumer’s tastes are such that he is indifferent among all the combinations of x and y that lie along a given curve—hence, the name indifference curve. Thus, all those combinations of x and y lying along the indifference curve marked give the consumer the same utility. Those combinations lying on the higher indifference curve marked give this consumer similar utility, but this level of utility is higher than that of all those combinations of x and y lying along indiffer- ence curve

QUESTION 2.3: Begin at point Now decrease x from to How much must y increase to offset the decrease in x and keep the consumer indifferent?

The problem of consumer choice arises from the collision of the consumer’s pref- erences with obstacles to his or her satisfaction. The obstacles are the constraints that force decision makers to choose among alternatives. There are many constraints, including time, energy, knowledge, and one’s culture, but foremost among these is

x1.x0(x0, y0).

U0.

U1 U0

u = u(x, y)

y

x0 U0

U1 U2

U3

x0x1

y0 (x0, y0)

FIGURE 2.4 The consumer’s indifference map.

IV. The Theory of Consumer Choice and Demand 21

y

x0

I = pxx + pyy

FIGURE 2.5 The consumer’s income constraint or budget line.

limited income. We can represent the consumer’s income constraint or budget line by the line in Figure 2.5. The area below the line and the line itself represent all the com- binations of x and y that are affordable, given the consumer’s income, I.5 Presumably, the consumer intends to spend all of her income on purchases of these two goods and services, so that the combinations upon which we shall focus are those that are on the budget line itself.

QUESTION 2.4: In a figure like the one in Figure 2.5 and beginning with a budget line like the one in Figure 2.5, show how you would draw the new in- come constraint to reflect the following changes?

1. An increase in the consumer’s income, prices held constant. 2. A decrease in the consumer’s income, prices held constant. 3. A decrease in the price of x, income and the price of y held constant. 4. An increase in the price of y, income and the price of x held constant.

C. The Consumer’s Optimum We may now combine the information about the consumer’s tastes given by the

indifference map and the information about the income constraint given by the budget line in order to show what combination of x and y maximizes the consumer’s utility, subject to the constraint imposed by her income. See Figure 2.6. There the consumer’s optimum bundle is shown as point M, which contains and Of all the feasible combinations of x and y, that combination gives this consumer the great- est utility.6

y*.x*

5 The equation for the budget line is where is the price per unit of x and is the price per unit of y. As an exercise, you might try to rearrange this equation, with y as the dependent variable, in order to show that the slope of the line is negative. When you do so, you will find that the coefficient of the x-term is equal to Economists refer to this ratio as relative price.-px>py.

pypxI = pxx + pyy,

6 Because we have assumed that the normal indifference curves are convex to the origin, there is a unique bundle of x and y that maximizes the consumer’s utility. For other shapes of the indifference curves it is possible that there is more than one bundle that maximizes utility.

22 C H A P T E R 2 A Brief Review of Microeconomic Theory

D. A Generalization: The Economic Optimum as Marginal Cost ! Marginal Benefit Because of the central importance of constrained maximization in microeconomic

theory, let us take a moment to examine a more general way of characterizing such a maximum:

A constrained maximum, or any other economic optimum, can be described as a point where marginal cost equals marginal benefit.

Let’s see how this rule characterizes maximizing decisions.7 Begin by assuming that the decision maker chooses some initial level of whatever it is he is interested in maximizing. He then attempts to determine whether that initial level is his maximum; is that level as good as he can do, given his constraints? He can answer the question by making very small, what an economist calls marginal, changes away from that initial level. Suppose that the decision maker proposes to increase slightly above his initial level whatever it is he is doing. There will be a cost associated with this small increase called marginal cost. But there will also be a benefit of having or doing more of what- ever it is that he is attempting to maximize. The benefit of this small increase is called marginal benefit. The decision maker will perceive himself as doing better at this new level, by comparison to his initial level, so long as the marginal benefit of the small in- crease is greater than the marginal cost of the change. He will continue to make these small, or marginal, adjustments so long as the marginal benefit exceeds the marginal cost, and he will stop making changes when the marginal cost of the last change made equals (or is greater than) the marginal benefit. That level is the decision maker’s maximum.

QUESTION 2.5: Suppose that, instead of increasing his level above the ini- tial choice, the decision maker first tries decreasing the amount of whatever it is he is attempting to maximize. Explain how the comparison of marginal cost

7 This rule could describe equally well an economic optimum where the goal of the decision maker is to minimize something. In that case, the optimum would still be the point at which but the demonstration of the stylized decision making that got one to that point would be different from that given in the text.

MC = MB,

y

y*

x* x0

M

U = xy

FIGURE 2.6 The consumer’s optimum.

IV. The Theory of Consumer Choice and Demand 23

and marginal benefit for these decreases is made and leads the decision maker to the optimum. (Assume that the initial level is greater than what will ulti- mately prove to be the optimum.)

We can characterize the consumer’s income-constrained maximum, M in Figure 2.6, in terms of the equality of marginal cost and benefit. Small changes in either di- rection along the budget line, I, represent a situation in which the consumer spends a dollar less on one good and a dollar more on the other. To illustrate, assume the consumer decides to spend a dollar less on y and a dollar more on x. Purchasing a dollar less of y causes a loss in utility that we may call the marginal cost of the budget reallocation. But the dollar previously spent on y can now be spent on x. More units of x mean greater utility, so that we may call this increase the marginal benefit of the budget reallocation.

Should the consumer spend a dollar less on good y and a dollar more on x? Only if the marginal cost (the decrease in utility from one dollar less of y) is less than the mar- ginal benefit (the increase in utility from having one dollar more of x). The rational consumer will continue to reallocate dollars away from the purchase of y and toward the purchase of x until the marginal benefit of the last change made equals the marginal cost. This occurs at the point M in Figure 2.6.

Figure 2.7 applies constrained maximization to reduce the amount of pollution. Along the vertical axis are dollar amounts. Along the horizontal axis are units of pollu- tion reduction. At the origin there is no effort to reduce pollution. At the vertical line labeled “100%,” pollution has been completely eliminated.

The curve labeled MB shows the marginal benefit to society of reducing pollution. We assume that this has been correctly measured to take into account health, scenic, and all other benefits that accrue to members of society from reducing pollution at var- ious levels. This line starts off high and then declines. This downward slope captures the fact that the very first efforts at pollution reduction confer large benefits on society. The next effort at reducing pollution also confers a social benefit, but not quite as great as the initial efforts. Finally, as we approach the vertical line labeled “100%” and all vestiges of pollution are being eliminated, the benefit to society of achieving those last steps is positive, but not nearly as great as the benefit of the early stages of pollution reduction.

$

MC = MB

Reduction in pollution

Marginal cost of pollution reduction

MC

MB

Marginal benefit of pollution reduction

0 100%P*

FIGURE 2.7 The socially optimal amount of pollution-reduction effort.

24 C H A P T E R 2 A Brief Review of Microeconomic Theory

The curve labeled MC represents the “social” as opposed to “private” marginal cost of achieving given levels of pollution reduction. The individuals and firms that pol- lute must incur costs to reduce pollution: They may have to adopt cleaner and safer pro- duction processes that are also more expensive; they may have to install monitoring devices that check the levels of pollution they generate; and they may have to defend themselves in court when they are accused of violating the pollution-reduction guide- lines. We have drawn the MC curve to be upward-sloping to indicate that the marginal costs of achieving any given level of pollution-reduction increase. This means that the cost of reducing the very worst pollution may not be very high, but that successive levels of reduction will be ever more expensive.

Given declining marginal benefit and rising marginal cost, the question then arises, “What is the optimal amount of pollution-reduction effort for society?” An examina- tion of Figure 2.7 shows that is the socially optimal amount of pollution-reduction effort. Any more effort will cost more than it is worth. Any less would cause a reduc- tion in benefits that would be greater than the savings in costs.

Note that, according to this particular graph, it would not be optimal for society to try to eliminate pollution entirely. Here it is socially optimal to tolerate some pollution. Specifically, when pollution reduction equals the remaining pollution equals

which is the “optimal amount of pollution.” Few goods are free. Much of the wisdom of economics comes from the recognition of this fact and of the derivation of techniques for computing the costs and benefits.

QUESTION 2.6: Suppose that we were to characterize society’s decision making with regard to pollution-reduction efforts as an attempt to maximize the net benefit of pollution-reduction efforts. Let us define net benefit as the difference between marginal benefit and marginal cost. What level of pollution- reduction effort corresponds to this goal?

QUESTION 2.7: Using a graph like Figure 2.7, show the effect on the deter- mination of the socially optimal amount of pollution-reduction effort of the following:

1. Some technological change that lowers the marginal cost of achieving every level of pollution reduction.

2. A discovery that there are greater health risks associated with every given level of pollution than were previously thought to be the case.

If you understand that for economists, the optimum for nearly all decisions occurs at the point at which marginal benefit equals marginal cost, then you have gone a long way toward mastering the microeconomic tools necessary to answer most questions that we will raise in this book.

E. Individual Demand We may use the model of consumer choice of the previous sections to derive a re-

lationship between the price of a good and the amount of that good in a consumer’s op- timum bundle. The demand curve represents this relationship.

100% - P*, P*,

P*

IV. The Theory of Consumer Choice and Demand 25

Starting from point M in Figure 2.6, note that when the price of x is that given by the budget line, the optimal amount of x to consume is But what amount of x will this consumer want to purchase so as to maximize utility when the price of x is lower than that given by the budget line in Figure 2.6? We can answer that question by hold- ing and I constant, letting fall, and writing down the amount of x in the succeed- ing optimal bundles. Not surprisingly, the result of this exercise will be that the price of x and the amount of x in the optimum bundles are inversely related. That is, when the price of x goes up, and I held constant (or ceteris paribus, “all other things equal,” as economists say), the amount of x that the consumer will purchase goes down, and vice versa. This result is the famous law of demand.

We may graph this relationship between and the quantity of x demanded to get the individual demand curve, D, shown in Figure 2.8. The demand curve we have drawn in Figure 2.8 could have had a different slope than that shown; it might have been either flatter or steeper. The steepness of the demand curve is related to an important concept called the price elasticity of demand, or simply elasticity of demand.8

This is an extremely useful concept: It measures how responsive consumer de- mand is to changes in price. And there are some standard attributes of goods that in- fluence how responsive demand is likely to be. For instance, if two goods are similar in their use, then an increase in the price of the first good with no change in the price of the second good causes consumers to buy significantly less of the first good. Generalizing, the most important determinant of the price elasticity of demand for a

Px

Py

PxPy

x*.

8 The measure is frequently denoted by the letter e, and the ranges of elasticity are called inelastic elastic and unitary elastic By convention, e, the price elasticity of demand, is a positive (or absolute) number, even though the calculation we suggested will lead to a negative number. For an in- elastically demanded good, the percentage change in price exceeds the percentage change in quantity demanded. Thus, a good that has is one for which a 50 percent decline in price will cause a 25 percent increase in the quantity demanded, or for which a 15 percent increase in price will cause a 7.5 percent de- cline in quantity demanded. For an elastically demanded good, the percentage change in price is less than the percentage change in quantity demanded. As a result, a good that has is one for which a 50 per- cent decline in price will cause a 75 percent increase in quantity demanded, or for which a 20 percent in- crease in price will cause a 30 percent decline in quantity demanded.

e = 1.5

e = 0.5

(e = 1).(e 7 1), (e 6 1),

P1

P0

Px

x0 x1

x0

D

FIGURE 2.8 An individual’s demand curve, showing the inverse relationship between price and quantity demanded.

26 C H A P T E R 2 A Brief Review of Microeconomic Theory

good is the availability of substitutes. The more substitutes for the good, the greater the elasticity of demand; the fewer the substitutes, the lower the elasticity. Substitution is easier for narrowly defined goods and harder for broad categories. If the price of cucumbers goes up, switching to peas or carrots is easy; if the price of vegetables goes up, switching to meat is possible; but if the price of food goes up, eating less is hard to do. So, we expect that demand is more elastic for cucumbers than vegetables and more elastic for vegetables than food. Also, demand is more elastic in the long run than the short run. To illustrate, if electricity prices rise rela- tive to natural gas, consumers will increasingly switch to burning gas as they gradu- ally replace furnaces and appliances. Economists often measure and remeasure the price elasticities of demand for numerous goods and services to predict responses to price changes.

V. The Theory of Supply We now turn to a review of the other side of the market: the supply side. The key

institution in supplying goods and services for sale to consumers is the business firm. In this section we shall see what goal the firm seeks and how it decides what to supply. In the following section, we merge our models of supply and demand to see how the inde- pendent maximizing activities of consumers and firms achieve a market equilibrium.

A. The Profit-Maximizing Firm The firm is the institution in which output (products and services) is fabricated

from inputs (capital, labor, land, and so on). Just as we assume that consumers ration- ally maximize utility subject to their income constraint, we assume that firms maximize profits subject to the constraints imposed on them by consumer demand and the tech- nology of production.

In microeconomics, profits are defined as the difference between total revenue and the total costs of production. Total revenue for the firm equals the number of units of output sold multiplied by the price of each unit. Total costs equal the costs of each of the inputs times the number of units of input used, summed over all inputs. The profit- maximizing firm produces that amount of output that leads to the greatest positive dif- ference between the firm’s revenue and its costs. Microeconomic theory demonstrates that the firm will maximize its profits if it produces that amount of output whose mar- ginal cost equals its marginal revenue. (In fact, this is simply an application of the gen- eral rule we discussed in section IV.D earlier: To achieve an optimum, equate marginal cost and marginal benefit.)

These considerations suggest that when marginal revenue exceeds marginal cost, the firm should expand production, and that when marginal cost exceeds marginal rev- enue, it should reduce production. It follows that profits will be maximized for that out- put for which marginal cost and marginal revenue are equal. Note the economy of this rule: To maximize profits, the firm need not concern itself with its total costs or total revenues; instead, it can simply experiment on production unit by unit in order to dis- cover the output level that maximizes its profits.

V. The Theory of Supply 27

In Figure 2.9 the profit-maximizing output of the firm is shown at the point at which the marginal cost curve, labeled MC, and marginal revenue curve of the firm are equal. The profit-maximizing output level is denoted Total profits at this level of production, denoted by the shaded area in the figure, equal the difference between the total revenues of the firm ( p times ) and the total costs of the firm (the average cost of producing times ).

There are several things you should note about the curves in the graph. We have drawn the marginal revenue curve as horizontal and equal to the prevailing price. This implies that the firm can sell as much as it likes at that prevailing price. Doubling its sales will have no effect on the market price of the good or service. This sort of behav- ior is referred to as price-taking behavior. It characterizes industries in which there are so many firms, most of them small, that the actions of no single firm can affect the mar- ket price of the good or service. An example might be farming. There are so many sup- pliers of wheat that the decision of one farmer to double or triple output or cut it in half will have no impact on its market price. (Of course, if all farms decide to double out- put, there will be a substantial impact on market price.) Such an industry is said to be “perfectly competitive.”

B. The Short Run and the Long Run In microeconomics the firm is said to operate in two different time frames: the

short run and the long run. These time periods do not correspond to calendar time. Instead they are defined in terms of the firm’s inputs. In the short run at least one input is fixed (all others being variable), and the usual factor of production that is fixed is capital (the firm’s buildings, machines, and other durable inputs). Because capital is fixed in the short run, all the costs associated with capital are called fixed costs. In the short run the firm can, in essence, ignore those costs: They will be incurred regardless of whether the firm produces nothing at all or 10 million units of output. (The only costs that change in the short run are “variable costs,” which rise or fall depending on how much output the firm produces.) The long run is distinguished by the fact that all factors of production become variable. There are no longer any fixed costs. Established firms may expand their productive capacity or leave the industry entirely, and new firms may enter the business.

q*q* q*

q*.

AC '

p

Price

q* q0

MC

AC

p= MR

FIGURE 2.9 The profit-maximizing output for a firm.

28 C H A P T E R 2 A Brief Review of Microeconomic Theory

Another important distinction between the long and the short run has to do with the equilibrium level of profits for each firm. At any point in time there is an average rate of return earned by capital in the economy as a whole. When profits being earned in a particular industry exceed the average profit rate for comparable investments, firms will enter the industry, assuming there are no barriers to entry. As entry occurs, the to- tal industry output increases, and the price of the industry output goes down, causing each firm’s revenue to decrease. Also, the increased competition for the factors of pro- duction causes input prices to rise, pushing up each firm’s costs. The combination of these two forces causes each firm’s profits to decline. Entry ceases when profits fall to the average rate.

Economists have a special way of describing these facts. The average return on capital is treated as part of the costs that are subtracted from revenues to get “economic profits.” Thus, when the rate of return on invested capital in this industry equals the average for the economy as a whole, it is said that “economic profits are zero.”9

This leads to the conclusion that economic profits are zero in an industry that is in long-run equilibrium. Because this condition can occur only at the minimum point of the firm’s average cost curve, where the average costs of production are as low as they can possibly be, inputs will be most efficiently used in long-run equilibrium. Thus, the condition of zero economic profits, far from being a nightmare, is really a desirable state.

VI. Market Equilibrium Having described the behavior of utility-maximizing consumers and profit-

maximizing producers, our next task is to bring them together to explain how they interact. We shall first demonstrate how a unique price and quantity are determined by the interaction of supply and demand in a perfectly competitive market and then show what happens to price and quantity when the market structure changes to one of monopoly. We conclude this section with an example of equilibrium analysis of an important public policy issue.

A. Equilibrium in a Perfectly Competitive Industry An industry in which there are so many firms that no one of them can influence the

market price by its individual decisions and in which there are so many consumers that the individual utility-maximizing decisions of no one consumer can affect the market price is called a perfectly competitive industry. For such an industry the aggregate de- mand for and the aggregate supply of output can be represented by the downward-sloping demand curve, and the upward-sloping supply curve, showns = s(p),d = d(p),

9 When profits in a given industry are less than the average in the economy as a whole, economic profits are said to be negative. When that is the case, firms exit this industry for other industries where the profits are at least equal to the average for the economy. As an exercise, see if you can demonstrate the process by which profits go to zero when negative economic profits in an industry cause exit to take place.

VI. Market Equilibrium 29

in Figure 2.10. The market-clearing or equilibrium price and quantity occur at the point of intersection of the aggregate supply and demand curves. At that combination of price and quantity, the decisions of consumers and suppliers are consistent.

One way to see why the combination in Figure 2.10 is an equilibrium is to see what would happen if a different price-quantity combination were obtained. Suppose that the initial market price was At that price, producers would maximize their profits by supplying of output, and utility-maximizing consumers would be prepared to purchase units of output. These supply and demand decisions are in- consistent: At the amount that suppliers would like to sell exceeds the amount that consumers would like to buy. How will the market deal with this excess supply? Clearly, the market price must fall. As the price falls, consumers will demand more and producers will supply less, so the gap between supply and demand will diminish. Eventually the price may reach And at that price, as we have seen, the amount that suppliers wish to sell and the amount that consumers wish to purchase are equal.

B. Equilibrium in a Monopolistic Market Monopoly is at the other extreme of market structure. In a monopoly there is only

one supplier; so, that firm and the industry are identical. A monopoly can arise and per- sist only where there are barriers to entry that make it impossible for competing firms to appear. In general, such barriers can arise from two sources: first, from statutory and other legal restrictions on entry; and second, from technological conditions of produc- tion known as economies of scale. An example of a statutory restriction on entry was the Civil Aeronautics Board’s refusal from the 1930s until the mid-1970s to permit entry of new airlines into the market for passenger traffic on such major routes as Los Angeles–New York and Chicago–Miami.

The second barrier to entry is technological. Economies of scale are a condition of production in which the greater the level of output, the lower the average cost of pro- duction. Where such conditions exist, one firm can produce any level of output at less cost than multiple firms. A monopolist that owes its existence to economies of scale is sometimes called a natural monopoly. Public utilities, such as local water, telecommu- nications, cable, and power companies, are often natural monopolies. The technological advantages of a natural monopoly would be partially lost if the single firm is allowed

Pc.

P1, qd1

qs1 P1.

Pc, qc

Price

Quantity

s = s(p)

d = d(p)

0 qd1 qc qs1

Pc

P1

excess supply

FIGURE 2.10 Market equilibrium in a perfectly competitive market.

30 C H A P T E R 2 A Brief Review of Microeconomic Theory

to restrict its output and to charge a monopoly price. For that reason, natural monopo- lies are typically regulated by the government.

The monopolist, like the competitive firm, maximizes profit by producing that out- put for which marginal cost equals marginal revenue. Marginal cost of the monopolist, as for the competitive firm, is the cost of producing one more unit of output. This cost curve is represented in Figure 2.11 by the curve labeled MC. But marginal revenue for the monopolist is different from what it was for the competitive firm. Recall that mar- ginal revenue describes the change in a firm’s total revenues for a small, or marginal,

Opportunity Cost and Comparative Advantage

We have been implicitly using one of the most fundamental concepts in microeconomics: opportunity cost. This term refers to the economic cost of an alternative that has been fore- gone. When you decided to attend a college, graduate school, or law school, you gave up certain other valuable alternatives, such as taking a job, training for the Olympics, or traveling around the world on a tramp steamer. In reckoning the cost of going to college, graduate school, or law school, the true economic cost was that of the next best alternative. This point is true of the decisions of all economic actors: When maximizing utility, the consumer must consider the opportunities given up by choosing one bundle of consumer goods rather than another; when maximizing profits, the firm must consider the opportunities foregone by com- mitting its resources to the production of widgets rather than to something else.

In general, the economic notion of opportunity cost is more expansive than the more common notion of accounting cost. An example will make this point.10 Suppose that a rich relative gives you a car whose market value is $15,000. She says that if you sell the car, you may keep the proceeds, but that if you use the car yourself, she’ll pay for the gas, oil, mainte- nance, repairs, and insurance. In short she says, “The use of the car is FREE!” But is it? Suppose that the $15,000 for which the car could be sold would earn 12 percent interest per year in a savings account, giving $1800 per year in interest income. If you use the car for 1 year, its resale value will fall to $11,000—a cost to you of $4000. Therefore, the opportunity cost to you of using the car for 1 year is $4000 plus the foregone interest of $1800—a total of $5800. This is far from being free. The accounting cost of using the car is zero, but the op- portunity cost is positive.

Comparative advantage is another useful economic concept related to the notion of op- portunity cost. The law of comparative advantage asserts that people should engage in those pursuits where their opportunity costs are lower than others. For example, someone who is 7 feet tall has a comparative advantage in pursuing a career in professional basketball. But what about someone whose skills are such that she can do many things well? Suppose, for example, that a skilled attorney is also an extremely skilled typist. Should she do her own typing or hire someone else to do it while she specializes in the practice of law? The notion of comparative advantage argues for specialization: The attorney can make so much more money by specializing in the practice of law than by trying to do both jobs that she could easily afford to hire someone else who is less efficient at typing to do her typing for her.

10 The example is taken from ROY RUFFIN & PAUL GREGORY, PRINCIPLES OF MICROECONOMICS 156 (2d ed. 1986).

VI. Market Equilibrium 31

change in the number of units of output sold. For the competitive firm marginal rev- enue is equal to the price of output. Because the competitive firm can sell as much as it likes at the prevailing price, each additional unit of output sold adds exactly the sale price to the firm’s total revenues. But for the monopolist, marginal revenue declines as the number of units sold increases. This is indicated in Figure 2.11 by the downward- sloping curve labeled MR. Notice that the MR curve lies below the demand curve. This indicates that the marginal revenue from any unit sold by a monopolist is always less than the price. MR is positive but declining for units of output between 0 and thus, the sale of each of those units increases the firm’s total revenues but at a decreasing rate. The unit actually adds nothing to the firm’s total revenues and for each unit of output beyond MR is less than zero, which means that each of those units actually reduces the monopolist’s total revenues.

The reason for this complex relationship between marginal revenue and units sold by the monopolist is the downward-sloping demand curve. The downward-sloping de- mand curve implies that the monopolist must lower the price to sell more units; but in order to sell an additional unit of output he or she must lower the price not just on the last or marginal unit but on all the units sold.11 From this fact it can be shown, using calculus, that the addition to total revenues from an additional unit of output sold will always be less than the price charged for that unit. Thus, because MR is always less than the price for all units of output and because price declines along the demand curve, the MR curve must also be downward sloping and lie below the demand curve.

The monopolist maximizes his profit by choosing that output level for which mar- ginal revenue and marginal cost are equal. This output level, is shown in Figure 2.11. The demand curve indicates that consumers are willing to pay for that amount of output. Notice that if this industry were competitive instead of monopolized, the profit-maximizing actions of the firms would have resulted in an equilibrium price and quantity at the intersection of the aggregate supply curve, S, and the industry demand curve, D. The competitive price, is lower than the monopolistic price, and thePc,

Pm qm,

qc, (MR = 0),q0

qc;

Price

Quantity

d = d(p)

0 qm qc

Pc

Pm

MR

MC

FIGURE 2.11 Profit-maximizing output and price for a monopolist.

11 This assumes that the monopolist cannot price-discriminate (that is, charge different prices to different consumers for the same product).

32 C H A P T E R 2 A Brief Review of Microeconomic Theory

quantity of output produced and consumed under competition, is greater than under monopoly.

Economists distinguish additional market structures that are intermediate between the extremes of perfect competition and monopoly. The most important among these are oligopoly and imperfect competition. An oligopolistic market is one containing a few firms that recognize that their individual profit-maximizing decisions are interde- pendent. That means that what is optimal for firm A depends not only on its marginal costs and the demand for its output but also on what firms B, C, and D have decided to produce and the prices they are charging. The economic analysis of this interdepen- dence requires a knowledge of game theory, which we discuss below.

An imperfectly competitive market is one that shares most of the characteristics of a perfectly competitive market—for example, free entry and exit of firms and the pres- ence of many firms—but has one important monopolistic element: Firms produce differentiable output rather than the homogeneous output produced by perfectly com- petitive firms. Thus, imperfectly competitive firms distinguish their output by brand names, colors, sizes, quality, durability, and so on.

C. An Example of Equilibrium Analysis It is useful to have an example applying this theory to a real problem. Let us imag-

ine a market for rental housing like the one shown in Figure 2.12. The demand for rental housing is given by the curve D, and the supply of rental housing is given by the upward-sloping supply curve S. Assuming that the rental housing market is competi- tive, then the independent actions of consumers and of profit-maximizing housing own- ers will lead to a rental rate of being charged and of units of rental housing being supplied and demanded. Note that this is an equilibrium in the sense we discussed above: The decisions of those demanding the product and of those supplying it are con- sistent at the price Unless something causes the demand curve or the supply curve to shift, this price and output combination will remain in force.

But now suppose that the city government feels that is too high and passes an ordinance that specifies a maximum rental rate for housing of considerably belowrm,

r1

r1.

h1r1

qc,

Rental rate

Housing0 hs h1 hd

r1

rm

r2

S

D

excess demand

FIGURE 2.12 The consequences of a rent-control ordinance that prescribes rents below the market-clearing rental rate.

VII. Game Theory 33

the equilibrium market rate. The hope of the government is that at least the same amount of housing will be consumed by renters but at a lower rental rate. A look at Figure 2.12, however, leads one to doubt that result. At consumers demand units of rental housing, an increase over the quantity demanded at the higher rate, But at this lower rate suppliers are only prepared to supply units of rental housing. Apparently it does not pay them to devote as much of their housing units to renters at that lower rate; perhaps if is all one can get from renting housing units, suppliers prefer to switch some of their units to other uses, such as occupancy by the owner’s family or their sale as condominiums. The result of the rate ceiling imposed by the gov- ernment is a shortage of, or excess demand for, rental units equal to

If the rate ceiling is strictly enforced, the shortage will persist. Some non-price methods of determining who gets the units of rental housing must be found, such as queuing. Eventually, the shortage may be eased if either the demand curve shifts inward or the supply curve shifts outward. It is also possible that landlords will let their prop- erty deteriorate by withholding routine maintenance and repairs, so that the quality of their property falls to such an extent that provides a competitive rate of return to them.

If, however, the rate ceiling is not strictly enforced, then consumers and suppliers will find a way to erase the shortage. For example, renters could offer free services or secret payments (sometimes called side payments) to landlords in order to get the ef- fective rental rate above and induce the landlord to rent to them rather than to those willing to pay only Those services and side payments could amount to per housing unit.

VII. Game Theory The law frequently confronts situations in which there are few decision makers and

in which the optimal action for one person to take depends on what another actor chooses. These situations are like games in that people must decide upon a strategy. A strategy is a plan for acting that responds to the reactions of others. Game theory deals with any situa- tion in which strategy is important. Game theory will, consequently, enhance our under- standing of some legal rules and institutions. For those who would like to pursue this topic in more detail, there are now several excellent introductory books on game theory.12