As explained in the previous chapter, there are only two main methods of microeconomic analysis. The first is finding an optimum: what's the best thing to do? The second is finding the equilibrium: when everyone's actions are taken into account, what's the overall result? Here in Part Two of the book, we apply the first of these methods to analyze the optimum of the consumer. Specifically, what is the best bundle of goods for a consumer to purchase?

People in a market economy face two fundamental choices: how to earn an income, and how to spend it. Part Two deals with how income is spent, taking earnings (income) as given. Part Four will analyze the decisions that generate income – for example, whether or not to work overtime.

THE LAWS OF PREFERENCE

The economist thinks of the individual as aiming to maximize utility. The logic of utility analysis is the central topic of this chapter.

Theories or models are pictures that simplify reality. Irrelevant details are stripped away to concentrate on essentials. The economist's picture (theory) of preferences is based on two axioms:

1. The Axiom of Comparison: A person can compare any two baskets A and B of commodities. Such a comparison must lead to one of the three following results: he or she (i) prefers basket A over B, or (ii) prefers basket B over A, or (iii) is indifferent between A and B.

2. The Axiom of Transitivity: Consider any three baskets A, B, and C. If a consumer prefers A to B, and also prefers B to C, he or she must prefer A to C. Similarly, a person who is indifferent between A and B, and is also indifferent between B and C, must be indifferent between A and C.

This chapter analyzes consumer decisions. Your choice among different consumption bundles, if you are rational, will depend upon your preferences (what you want to do) and your opportunities (what you are able to do). And, in a market economy, opportunities will in turn depend upon your income and upon the prices you face. Individual consumption choices respond to all three of these variables: preferences, incomes, and market prices.

THE OPTIMUM OF THE CONSUMER

The Geometry of Consumer Choice

Dealing for simplicity with only two goods, Figure 4.1 shows the baskets of goods X and Y that a consumer with a given income can afford (the shaded triangle). The upper boundary of the shaded area, the budget line KL, shows the baskets attainable by a person who spends all of his or her income on the two goods X and Y.

Suppose that Mary's income is I = $100 and that the market prices are Px = $2 and Py = $1. Spending all of her income on X, Mary could buy x = 100/2 = 50 units. This would put her at point L in the diagram. At the other extreme she could buy y = 100/1 = 100 units of good Y (point K). More generally she could afford any combination of X and Y lying on her budget line – the straight line between points K and L.

Part II of this text analyzed consumer choices – the demand side of the market for goods and services. Part III now deals with the supply side. This chapter explains the nature of business firms and the relations among entrepreneurs, owners, and managers. The chapter then describes the firm's cost and revenue functions and its profit-maximizing level of production.

WHY FIRMS? ENTREPRENEUR, OWNER, MANAGER

Business firms are artificial creations, organized to produce goods and services for the market. But individuals or groups can produce for the market without creating a firm. So if firms are not essential, why are they formed?

Firms exist to take advantage of team production while minimizing costs of contracting. All but the simplest production processes call for team effort. Manufacturing typically requires machine operators, inspectors, and clerks together with nonlabor inputs such as electricity, materials, and buildings. The same holds for mining, transportation, retail sales, and so forth. Still, team production could take place without forming a firm. A movie could be produced via a multilateral contract specifying the types and quantities of inputs to be provided, at stated places and times, by the producer, director, actors, camera operators, and so on. The contract would also need to define each person's financial obligations and rewards. Such multilateral deals do occur. But the high costs of negotiation and enforcement make them rare. If instead a firm produced the movie, only bilateral contracting would be required.

The previous chapter surveyed the demand side of the markets for resource services. This chapter deals with the supply side – how people choose among possible uses of the productive assets they possess, and especially their labor power. The analysis then brings supply and demand together to show how prices and quantities are determined in the factor markets.

THE OPTIMUM OF THE RESOURCE-OWNER

In Chapter 4 the individual was assumed already endowed with a certain amount of income. But income does not come out of thin air. To earn income, owners of resources offer them for hire in the market. Or, alternatively, owners can retain the resources for personal reservation uses. A person's time, for example, considered as an owned resource, can be divided between market work and leisure. (In economics “leisure” does not mean merely lazing away the hours. It includes time devoted to biological necessities like sleep as well as socially valuable nonmarket activities such as homemaking and community service.)

Figure 13.1 shows a resource-owner's possible choices between income I and leisure R. The arrows (preference directions) indicate that income and leisure are both “goods” rather than “bads.” Note the similarity with the choice situation of the consumer in Chapter 4, Figure 4.1. At the initial “endowment” position E in the diagram, the individual starts with R̄ units of time available (24 hours per day, let us say) plus Ī dollars of income from other sources (possibly from gifts or property earnings).

The book to this point has dealt mainly with economics as a positive science. It analyzed how the market economy works, whether or not the outcomes are regarded as desirable. But economists also study normative issues – public policy. Are price controls wise? Should immigration be limited? Are low taxes with small government better than high taxes with big government? Are regulations to protect the environment a good idea?

What economists call welfare economics, the subject of this chapter, asks how public policies should be evaluated. Such an evaluation will of course depend upon the goals of policy, especially the need to balance between efficiency and equity, discussed in the first section of the chapter. The second section reviews the Theorem of the Invisible Hand, a proposition suggesting that the market economy may achieve efficiency. The section that follows covers “market failures” – ways in which the Invisible Hand might go wrong. Two related areas of possible failure, the commons and the problem of public goods, are treated next. It turns out that these failures stem from unsuitable or incomplete assignment of property rights. The next main section therefore deals with attempts to acquire property rights over resources or to defend against others' efforts to gain such control.

Economics concerns decisions – choices among actions. Every action has its pros and cons, pluses and minuses, benefits and costs. Are you thinking about taking up tennis? The game may trim your figure and improve your disposition, but will take time from your studies and could damage your joints. How about dropping out of college to take a job? You would likely earn more money now, but earn less later in life. Similarly in business and government. Whether it's a small action, as when your neighborhood market sets its price for potatoes, or a big one, as when Congress decides on declaring war, almost always there are valid arguments for and against. Faced with such opposed considerations, how should individuals, firms, or governments make decisions? Economics shows how to determine the best action, through a systematic assessment of the costs and benefits.

Few decisions are made in a vacuum. Other people are likely to react. Thinking like an economist means taking these reactions into account. A law firm that raises its billing rates may find customers switching to another provider of legal services – so the higher price might not increase profit after all. Or imagine that Congress, aiming to widen use of the Internet, were to require Internet service providers (ISPs) to charge very low prices. Before concluding that this is a good idea we would need to know how the ISPs would react. They might provide access at those low prices.

A monopoly exists when an industry contains only a single firm. If a firm can drive out competitors because its costs of production are lower, it enjoys a natural monopoly. Not all monopolies, however, are natural. Governments often award monopoly privileges. Cities grant exclusive franchises to firms providing cable television. The Federal government confers patents that give inventors a monopoly for a period of years. And even without government aid, a firm may possess monopoly power owing to entry barriers – for example, if banks believe that financing a new competitor in the industry would be too risky.

In perfect competition, as studied in Chapter 7, the number of firms is large enough to make product price substantially independent of any single firm's level of output. Each competitive firm is a “price-taker.” But a monopolist, facing the entire industry demand curve, must take account of its own influence upon price: it is a “price-maker.” Geometrically, a competitive firm faces a horizontal demand curve, whereas a monopolist faces a downward-sloping demand curve.

Actually, the number of firms is economically significant only as a clue to behavior. By forming a cartel, as will be seen later in the chapter, a number of firms can sometimes get together and behave like a collective monopolist. On the other hand, even if only a single firm is active in the industry, such a firm may be unable to exploit its market as a monopolist if outside potential competitors stand ready to enter.

Up to now consumers have been assumed to be entirely aware of their incomes and personal preferences, and suppliers fully informed as to the technology and costs of production. Although assuming complete certainty is not realistic, most of the results obtained so far – for example, that demand curves are negatively sloped – hold even when people are less than perfectly informed. Nevertheless, uncertainty is often crucial. Without uncertainty there would be no insurance industry, no need for consultants, no litigation, no advertising, no reason to engage in scientific research.

Another crucial aspect of uncertainty is that some market participants are likely to be better informed than others. A jeweler usually knows a lot more about the quality of a diamond offered for sale than do potential buyers. This chapter introduces the tools necessary to deal with imperfect information and with unbalanced distributions of knowledge.

DECISIONS UNDER UNCERTAINTY

Expected Gain versus Expected Utility

Suppose an airline must decide whether to send off a flight from Los Angeles to Chicago, despite being unsure about the weather at O'Hare Airport in Chicago by the time the flight arrives. The plane already has 100 people aboard. If the flight is dispatched and O'Hare is open, suppose the airline will gain $40,000. If the airline holds the flight until the weather clears, the disruption in the schedule will make its gain smaller, say only $20,000.

The Fundamental Theorem of Exchange – that buyers and sellers both gain from trade – was introduced in Chapter 7. Many economic fallacies, for example, the most common arguments for protective tariffs, overlook the point that voluntary trade benefits both sides.

Still, some objections might be raised. Suppose a buyer paid good money for a beachfront lot that proves to be miles out to sea. The answer is that the parties here did not truly agree on an exchange. Owing to trickery, there was no “meeting of the minds.” Another problem: a momentary want may misrepresent a person's true preferences. Esau sold his birthright to Jacob for a mess of pottage (Genesis, Chapter 25) and regretted the transaction afterward. Third and most serious, many of us would be better off not satisfying even our most intense desires. Think of a drug addict. Getting what you wish for is often the worst thing that could happen to you. Still, it can always be said that rational participants in voluntary exchange believe they will both gain.

Mutual gain from trade involves two distinct elements. The first is an improved (mutually preferred) allocation of consumption goods. Suppose Ida and John are endowed with equal quantities of tea and coffee, but Ida prefers tea and John prefers coffee. The potential gain from trade is obvious. Alternatively, suppose Ida and John both prefer bread with butter, but Ida is initially endowed with all the bread and John with all the butter.