Microeconomics (Chapters 10-17)
1. Tunnel Vision, Tunnel Use, and Advance of Theory The Midnight Economist
The notions of demand and supply, when appropriately used, can help in explaining the
world. But they are not perfectly self-evident notions and their fruitful use is not perfectly simple.
Consider what have been called two “laws” of demand. The first law says that, at a
given moment, less of a good will be bought at sufficiently higher prices than at lower prices. The
second law says that the full impact of, or the total adjustment to, a higher price takes time.
No economist denies the validity of the first Law: right now, when you must pay more for
gasoline, you will choose to buy less gas.
When the toll for private car and taxi use of a Hong Kong tunnel was doubled in mid–
1984, automobile use of the tunnel immediately fell appreciably, and at the end of 1986, it
remained smaller than it had been before the toll increase. This is consistent with the first law.
But all of the reduction in purchase of tunnel use took place in the first month; after that, use of
the tunnel gradually crept up. And this does not support the second law.
Perhaps it turned out that knowledge was initially so inadequate that the first step of
adjustment to the toll increase was quickly deemed to be exaggerated. In particular, use of the
harbor ferry, which immediately rose greatly and then trended back down, turned out to be less
Questions for Thought and Discussion:
1. Why does the second law of demand, often stated by saying that demand curves are more
elastic in the long run than in the short run, generally make sense?
2. Why could being over-optimistic at first about how good the substitutes for a particular good
were lead to a violation of the second law of demand?
2. Poets, Comedians, and Replacement Costs The Midnight
Economist
If you would understand how the world works economically, put not your faith in journalists or
politicians.
When the dictator of Iraq decided to take civilization to the oligarchies of Kuwait, the rate
of increase in oil prices rose abruptly in fears of curtailed supplies. But why should a motorist
have to pay a higher price on Tuesday for gas which was sold to the filling station on Monday at a
low, pre-invasion price? Shouldn’t yesterday’s low cost to the retailer mean a Iow price to today’s
customer?
The august New York Times provided–in the words of one of its own columnists–-“one of
those fuller-explanation stories that make The Times indispensable to people who would…know
expenditures, the firm will not be long for this world.
A firm sells an asset this morning; it uses proceeds of the sale to replenish inventory this
afternoon in order to make another sale tomorrow. If the firm is to survive, it must sell assets at
prices high enough to replace those assets. The relevant expenditure of the firm is the
replacement cost of the asset today, not the historical cost in acquiring the asset yesterday.
You sell a house to buy another house. The price you charge now had better
reflect today’s market valuation if you hope to replace it. The fact that you bought the house for
less–or perhaps acquired it at a zero price through inheritance–has nothing to do with its present
value.
A savings institution acquired loanable funds last year when interest rates were low.
Questions for Thought and Discussion:
1. Is there any way prices cannot reflect anticipations about the future?
2. Is the opportunity cost of an item in your inventory correctly measured by what you paid for it
in the past? What difference does it make whether you intend to replace that item in your
inventory?
3. Costs Competition, and Prices The Midnight
Economist
A reader has written bitterly to the consumer editor of a newspaper, “What kind of rip-off are the
airlines pulling,” he asks, Awhen the fare from Los Angeles to Indianapolis is more than twice that
from Los Angeles to New York?”
The editor agrees that such pricing gouges” Indianapolis customers. After all, the airline
costs of flying to Indianapolis are smaller than the costs of a New York flight, so the Indianapolis
fare should be smaller. Everyone knows that.
The brokerage analyst finally–and grudgingly–lets the cat largely out of the bag.
“Unfortunately,” he observes, “price is a product of competition, and the competition between Los
Angeles to New York is fierce, while the competition for traffic between Los Angeles and
Indianapolis is nil.”
So the direct basis of the fares is not respective costs; nor is it mysteriously a matter of
discriminatory subsidization. Rather, it is a matter of competition in supply and the amount of
demand. How many suppliers seek the favor of how many demanders?
Curiously, many more people want to travel to New York than to Indianapolis. If there
were only one airline to New York and no imposed price control, the profit-maximizing fare and
the amount of profit would be very considerable. But these profit possibilities have attracted
many carriers. And that competition has driven down the priceBand the profits.
Questions for Thought and Discussion:
1. Is the opportunity cost of providing a hotel room today determined by the cost to construct,
maintain and operate it or by what someone else would be willing to pay for that room today?
2. Why would profit-seeking airlines not find it in their interest to use earnings from profitable
routes to subsidize unprofitable routes?
4. Losses, Profits, and Use of Resources The Midnight Economist
“I try to be tolerant,” said mouse Karl quite intolerantly, “of the open, competitive market. But one
thing wrong with it is that it doesn’t work very well. If widget output is greatly increased, widget
prices crash and profits turn into losses. In a world of scarcity, it is a ridiculous economy in which
great output means disaster for producers.”
Mouse Adam tried to tolerate the intolerance. “Losses for widget producers,” he said
gently, “are evidence of bad use of the community’s resources and incentive to shift some of
“Costs,” replied Adam, “reflect the value of other goods which could have been produced
by the resources embodied in the widgets. To produce widgets, labor and other inputs must be
bid away from other uses. Inputs derive their value from the value of the outputs they produce.
The price which must be paid for inputs is a measure of the most valuable alternative good which
is not produced when we make widgets.”
Karl’s beady little eyes sparkled with comprehension. “So,” he said, “if business receipts
indicate the value of our product and business costs indicate the value of the best alternative
product, and if receipts are smaller than costs, then the community prefers that the resources we
Questions for Thought and Discussion:
1. When would an increase in widget production increase the total revenues of widget producers
and when would it decrease their total revenues?
2. Even though we want more goods in a world of scarcity, why are losses and consequent
output reductions an important part of an efficient economy?
5. On Monopoly and Competition The Midnight Economist
Mouse Karl was customarily belligerent but uncharacteristically somber. He turned to the
characteristically composed mouse Adam.
“If you really are concerned with the efficiency of the economy,” said Karl, “you would try to
do something about monopolies. The game Daddy Warbucks tries to play is monopolization, and
he is pretty good at it. The community in general is at the mercy of big businesses, who decide
by whim what and how much to produce and what prices to charge.”
“Pure theory,” sniffed Karl, “otherwise known as mythology.”
“On the contrary,” replied Adam quite sternly. “I am speaking of the uncertain real world of
blood, sweat and tears. In a single recent issue of the Wall Street Journal, there were at least
half a dozen stories of various sorts of enterprises–sizable and small, sophisticated and simple—
fighting for their lives in hard, changing markets.
“One story,” Adam went on, “dealt with the gambles and experiments of magazines who are
suffering from a long slump in advertising income. Another recounts the difficulties and possible
strategies and tactics of a struggling metropolitan newspaper. There are the various retailers who
Questions for Thought and Discussion:
amount of market power?
2. Why are competitors typically far more likely to accuse firms of monopolization than
customers?
6. Prices and Production The Midnight
Economist
Prices are important. Prices are critical in determining how much of different goods is demanded
and how much is produced. Market-determined prices reflect preferences, anticipations and
costs. People, both consumers and producers, make decisions in light of prices of some goods
Some of the underlying changes are cyclical, following a well-defined path over the hours
of a day or the seasons of a year. And so prices of goods can appropriately rise and fall over a
cycle even when production costs per unit vary little.
Thus, ski-resort, cruise-ship, airline, telephone, restaurant, and theater prices often vary
greatly, depending on the month or the hour. Demands for evening plays are greater than for
matinees, while more telephone calls are made during the day than in the night. The optimal
price to charge for the product varies with changing demand. To put the matter differently, the
product itself is defined not only by its physical characteristics but also by the time of its supply
Problems are compounded if production expenses are higher in peak periods because of
utilization of equipment with higher operating costs, requiring, say, use of an oil–fired plant to
supplement a hydroelectric dam.
Raising peak-load prices and lowering slack-period prices may leave total electricity
consumption unchanged. But it would go some way to even-out consumption over the cycle.
And that, in turn, would reduce both immediate operating expenses and the costs of producing
more plant to satisfy peak demands. Smoothing the consumption cycle means making fuller and
better use of smaller plant investment.
Questions for Thought and Discussion:
1. Is charging lower prices for matinees than for evening movies price discrimination–charging
different customers different prices for the same good–or are matinees and evening movie
viewings different goods?
7. Competition and Efficiency, Innovation and Monopoly The Midnight Economist
One of my wise friends warned me of the worth and the limitations of mathematical doodling in
economics. “The blackboard can be a very useful device,” he said, “but do not confuse it with the
real world.”
Economic theory–and the curve bending and equation solving in which it is often
exposited–is highly useful when used well. It helps to identify key variables and their functional
interrelations in the problem at hand. It heIps to turn general wonderment into coherent thought,
to convert unstructured conjecture into consistent deduction, to provide systematic speculation
amenable to real-world examination.
now available to the community.
The theory of perfect competition tells us the conditions–-conditions of costs and
production, price and purchase–which must be satisfied in a market of many sellers and many
buyers if efficiency is to be attained. But it is a theory of a particular kind of market in a context
that is largely static, not to process and evolution over a substantial period of time.
A major economist of the twentieth century, Joseph Schumpeter, tried to push out the
boundaries of our concern. The real world is one of change, and the life of the market is one of
flux and adjustment stemming, in part, from innovations. Innovations may involve a new product,
a new method of production, a new market, a new source of supplies, a new organization.
Being first–first in lowering cost, first in merchandising–establishes a degree of monopoly.
Monopoly power tends to be quickly diluted. Still, progress calls for innovation, and the
innovating entrepreneur is trying to get a monopolistic edge which generates profit. Some degree
Questions for Thought and Discussion:
1. If you could not have a monopoly for a period of time on a substantial new innovation, would
there be more or fewer innovations as a result?
2. If a completely new product is created by an innovator, does the consumer welfare cost of
monopoly output restriction accurately reflect the change in consumer welfare that results?
8. The Sense of Auntie Trust The Midnight Economist
Mouse Karl wiggled his tail with joy. “It s wonderful to have Auntie visit us,” he squeaked to his
mouse friend Adam.
“Yes, indeed,” affirmed Adam. “Tell us, Auntie Trust, about your work as the
government’s top guardian against monopoly.”
“You must have your whiskers full,” suggested Karl, “trying to wiggle a little competition
into the marketplace.”
“Correct!” chortled Karl crudely. “That would mean less competition. Don’t you outlaw
monopolistic mergers?”
“Hold on,” said Auntie Trust calmly. “Neither the number nor the size of businesses in a
given market is a good indicator of the degree of ‘monopoly power.’ A smaller number of larger
firms can be more efficient, and that means lower prices for consumers. If a merger would create
a more efficient enterprise, other firms in the industry would have to become more competitive to
survive. Rather than confronting increased competition with greater efficiency of their own, the
firms often try to use my authority to block the merger in the first place–and they do so in the
other oil companies, but that strategy takes us back to evaluating the effects of mergers.”
“Then why do many who complain about predatory pricing ask you to restrain price
cutting in the name of competition?” asked Karl.
“Mostly because they want to prevent a more efficient company from underselling them,”
replied Auntie Trust. “It may seem as though these complainants are trying to preserve
competition, but actually they are trying to restrict it. What they want is not competition, but
protection from competitors. In the world of your dear old Auntie Trust, what seemingly is, often
actually isn t.”
Questions for Thought and Discussion:
1. When would consumers oppose mergers of suppliers? Would rival producers oppose those
same mergers?
2. Would the fact that more than 90% of antitrust suits are brought by rivals tend to make you
think their primary effect is to encourage or discourage competition?
9. Small Firms, Opportunity and Growth The Midnight Economist
is often said. Well, perhaps
not always–as with wives and children. But many and much can be promising in some
categories and circumstances.
selling are done mainly through business firms. Business firms are born and organized and
directed through the coordinated efforts of innovators and investors and managers. Resources
It generally takes much time and always takes much success for a firm to grow to great
size. Most firms are born small. The vitality of the economy is reflected largely in the rate of birth
and growth of small firms. And small companies are proliferating.
From 1970 to 1983, corporations expanded impressively in number, receipts, and assets.
In numbers and receipts, at least, the picture is dominated by firms with assets no more than one
million dollars. Such firms doubled in number over the thirteen year period, accounting for more
than 99 percent of the increase in all corporations; in 1983, they were over 91 percent of the total.
Questions for Thought and Discussion
1. Why would the number of new firms being formed be a useful indicator of economic
opportunity?
2. How did firms that started as proprietorships and partnerships become some of the largest
corporations today?
10. Choices, Advertising, and Freedom The Midnight
Economist
It is sometimes said that the private-property, free-market economy is subject to “consumer
sovereignty”–consumers reveal their preferences by “voting” with their dollars for what they want.
There is no dominating consumer sovereignty, economist Harold Demsetz points out.
Exchanges will be made when they appear advantageous to all parties involved. Neither
consumers that that is what consumers want.
Now, at any given moment, people are characterized by certain preferences. And we
can have some interest in how those wants came into being.
Wants are shaped–but by many forces in addition to advertising. Not only Madison
Avenue, but also Washington, D.C., the Church, Mother, schools and Galbraith himself are
among the forces which form wants. Our beliefs and tastes are to a large extent learned:
civilization itself is, in considerable measure, a matter of teaching and learning beliefs and tastes.
But it is not clear that business firms have a unique advantage in want-creating activity.
Questions for Thought and Discussion:
1. Why might mutual sovereignty be a better term to describe market results than consumer
sovereignty ?
2. Would it be more accurate to say that consumers are sovereign over what goods are
produced in a market system or that consumers are sovereign over which of the goods will
continue to be produced and which producers survive to continue in production?
11. Advertising and the Demand for Mouse Wash The Midnight Economist
I have spoken before of Adam and Karl, the two mice who live in my office. Their conversations
often profoundly analyze important economic issues which affect us as well as mice. The other
day they argued the merits of advertising. Adam had returned from shopping and surprised Karl,
who was nibbling on a piece of honey wheat berry bread, his favorite food.
“Look at what I bought,” said Adam excitedly as he reached into a bag of mouseries and
pulled out a red bottle of mysterious fluid.
consumers want what producers make.”
“Nobody forced me to buy the mouse wash,” retorted Adam. “It was my money; it was my
choice; and now it is my mouse wash.”
“But don’t you see,” persisted Karl, “that your desire for mouse wash is a contrived want–a
want which would never have existed without the persuasion of advertising. It’s a shame that so
few of your wants originated with you and not with advertising.”
“Poppycock,’ snapped Adam. “Is your preference for honey wheat berry bread wholly an
‘original’ want? Mice do not live by bread alone. Just about everything we want is learned to
Questions for Thought and Discussion:
1. Do you think there would be as much of honey wheat berry bread or other higher quality
products available for sale if advertising was not allowed?
2. If all our preferences and situations were very similar and stable, would advertising be more or
less valuable than if our preferences and situations were very different and changed often?
12. Duopoly and The Alehouse Rock The Midnight
Economist
If Parker Brothers had designed its game so that two people always won, it would have been
called “Duopoly” instead of ‘Monopoly.” Critics of the Justice Department’s antitrust policy argue
that its anti-merger antics are helping to create a duopoly in the beer industry.
The desire to collude and thereby to raise prices must be distinguished from the ability to
do so. Not only is it difficult for rival companies to agree on the production cuts each must make
in order to force up price, but it is difficult to prevent each company from undercutting the others
in order to increase its sales. It is unlikely that, without–and sometimes even with–government
support, firms will long curb their rivalry--even in industries with high levels of concentration.
The beer industry has become more concentrated: the number of breweries has dropped
sharply, and ten of them now account for over 95 percent of all beer sold. The combined shares
of the two biggest breweries, Anheuser-Busch and Miller, have also foamed sharply upward in
recent years. This growth does not necessarily mean that competition is being eroded or that
Questions for Thought and Discussion:
1. How can a merger, which decreases the number of competitors in an industry, increase
competition? How does your answer relate to economics of scale in production?
2. Suppose Anheuser-Busch and Miller grew to sell the majority of the beer in America by
spending megabucks on advertising and promotion. If rivals also had access to advertising and
promotion on the same terms, would there be any reason to term the results “unfair” or not in
consumers‘ interests?
13. OPEC and the Complications of Cartels The Midnight Economist
The course of true love has never been wholly smooth among the nations of OPEC. Still, the
cartel, with its price and production-control maneuvers, was a mighty force in the 1970s.
OPEC is not dead, but it is now a Samson with a crew cut. Its difficulties have steadily
grown since 1979. It now reacts to rather than dictates to the world petroleum market. And the
reactions are not entirely peacefully orchestrated within the family. Each member would like to
maintain sales at high prices; it has become apparent that either sales or prices will have to be
reduced; but the members differ on how much to adjust sales or price and on how to distribute
the adjustment costs among themselves.
It is not easy to organize a cartel, melding highly autonomous organizations into a
monopolistic facsimile. There are markets to divide, prices to set, and production quotas to
assign. Successful operation is even harder than initial organization. Members must remain
persuaded that they enjoy net benefits from collusion compared to acting as independent agents.
The more profitable the collusive efforts, the greater the incentive for outsiders to seek admission
or to organize their own club or individually to compete. The more numerous the participants and
the more lucrative the tightening of the screws on consumers, the greater the temptation for
individual members to cheat–and the greater the fear of each that some other member will cheat.
Questions for Thought and Discussion:
I. Why would government-sponsored or legal cartels tend to be more effective than ones that
aren t?
2. Why will even successful cartels tend to break down over time? Why might they break down
more in hard times than in good?