MICROECONOMICS - pearson.com.au

MICROECONOMICS

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MICHAEL PARKIN

M

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DOUGLAS McTAGGART CHRISTOPHER FINDLAY MICHAEL PARKIN

MICROECONOMICSSEVENTH EDITION

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National Library of AustraliaCataloguing-in-Publication Data

Author: McTaggart, Douglas, 1953-Title: Microeconomics / Douglas McTaggart, Christopher Findlay, Michael Parkin.Edition: 7th ed.ISBN: 9781442550780 (pbk.) Notes: Includes index.Subjects: Microeconomics – Textbooks.Other Authors/Contributors: Findlay, Christopher C. (Christopher Charles), Parkin, Michael, 1939-.Dewey Number: 338.5

Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them.

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Doug McTaggart is recently retired as Chief Executive Officer of theQueensland Investment Corporation (a fund manager with over $65 billion in assets undermanagement). He was a student at the Australian National University, earned his PhD atthe University of Chicago, and has held academic appointments at the Virginia PolytechnicInstitute, the University of Adelaide and Bond University. He is a former Under Treasurerand Under Secretary of the Queensland Treasury, a past President of the Economic Societyof Australia, a former member of the Australian Accounting Standards Board, and a formerChairman of the Investment and Financial Services Association (now Financial ServicesCouncil). Currently he is a Councillor on the National Competition Council and the CoagReform Council. He is also a director on a number of listed and unlisted companies.Dr McTaggart’s research and publications spanned a wide area and covermacroeconomics, monetary theory, game theory and applied microeconomics.

Christopher Findlay was educated at the University of Adelaide and theAustralian National University (ANU). He was Professor of Economics in the Asia PacificSchool of Economics and Government at the ANU before moving in late 2005 to theUniversity of Adelaide to become Professor of Economics and Head of the School ofEconomics. He is now Executive Dean of the University of Adelaide Faculty of theProfessions. His chief interests are Australia’s economic links with Asia and internationaltrade and investment in services, air transport in particular.

Michael Parkin received his training as an economist at the Universities ofLeicester and Essex in England. He is Professor Emeritus in the Department of Economics atthe University of Western Ontario, Canada. Professor Parkin has held faculty appointmentsat Brown University, the University of Manchester, the University of Essex and BondUniversity. He is a past president and fellow of the Canadian Economics Association andhas served on the editorial boards of the American Economic Review and the Journal ofMonetary Economics and as managing editor of the Canadian Journal of Economics.Professor Parkin’s research on macroeconomics, monetary economics and internationaleconomics has resulted in over 160 publications in journals and edited volumes, includingthe American Economic Review, the Journal of Political Economy, the Review of EconomicStudies, the Journal of Monetary Economics, and the Journal of Money, Credit andBanking. He became most visible to the public with his work on inflation that discredited theuse of wage and price controls. Michael Parkin also spearheaded the movement towardsEuropean monetary union.

ABOUT THE AUTHORS

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Dedications

Douglas McTaggart dedicates this book to Pam, Cameron, Lachlan and especially Andrew.

Christopher Findlay dedicates this book to Tania, Marek and Kasia.

Michael Parkin dedicates this book to all his students.

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ix

PART ONEINTRODUCTION 1CHAPTER 1 What Is Economics? 1CHAPTER 2 The Economic Problem 29CHAPTER 3 Demand and Supply 51CHAPTER 4 Elasticity 79

PART TWOHOW MARKETS WORK 101CHAPTER 5 Efficiency and Equity 101CHAPTER 6 Government Actions in Markets 123CHAPTER 7 Global Markets in Action 147CHAPTER 8 Public Choices and Public Goods 171CHAPTER 9 Economics of the Environment 193CHAPTER 10 Monopoly 215CHAPTER 11 Economic Inequality 239

PART THREEDECISIONS AND STRATEGIES IN MARKETS 261CHAPTER 12 Consumer Choices and Constraints

261CHAPTER 13 Producer Choices and Constraints 281CHAPTER 14 Perfect Competition 305CHAPTER 15 Monopolistic Competition 331CHAPTER 16 Oligopoly Games and Strategies 349CHAPTER 17 Decisions in Factor Markets 373

BRIEF CONTENTS

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The future is always uncertain. But at some times,and now is one such time, the range of possiblefutures is enormous. As a small economy tightlyintegrated into the global economy, it is uncertaintyabout external forces that dominates Australia’soutlook.There is uncertainty about monetary policy with

the European Central bank and the U.S. FederalReserve Bank holding interest rates at historical lowsand injecting billions of dollars of money in anattempt to stimulate a flagging recovery from a globalfinancial crisis. And there is extraordinary uncertaintyabout fiscal policy as budget deficits in the UnitedStates and Europe seem ever harder to control.Whether or when economic growth in China and

India will slow and dampen the growth of the rest ofthe world is a big unknown.Since the global financial crisis of August 2007

moved economics from the business page of the news-paper to the front page, fear has gripped producers,consumers, financial institutions and governments.Even the idea that the market is an efficient mecha-

nism for allocating scarce resources came into ques-tion as some political leaders trumpeted the end ofcapitalism and the dawn of a new economic order inwhich tighter regulation reined in unfettered greed.Rarely do teachers of economics have such a rich

feast on which to draw. And rarely are the principlesof economics more surely needed to provide the solidfoundation on which to think about economic eventsand navigate the turbulence of economic life.Although thinking like an economist can bring a

clearer perspective to and a deeper understanding oftoday’s events, students don’t find the economic wayof thinking easy or natural. Economics seeks to putclarity and understanding in the grasp of the studentthrough its careful and vivid exploration of thetension between self-interest and the social interest,the role and power of incentives – of opportunity costand marginal benefit – and the possibility thatmarkets supplemented by other mechanisms mightallocate resources efficiently.McTaggart, Findlay and Parkin students begin to

think about issues the way real economists do andlearn how to explore difficult policy problems andmake more informed decisions in their own lives.

◆ The Seventh Edition RevisionSimpler where possible, stripped of some technicaldetail, more copiously illustrated with well-chosenphotographs, reinforced with improved chapter sum-maries and problem sets, and even more tightly inte-grated with MyEconLab: These are the hallmarks ofthis seventh edition of Economics.This comprehensive revision also incorporates and

responds to the detailed suggestions for improve-ments made by reviewers and users, both in the broadarchitecture of the text and in each chapter. The revi-sion builds on the improvements achieved in previ-ous editions and retains its thorough and detailedpresentation of the principles of economics, itsemphasis on real-world examples and applications, itsdevelopment of critical thinking skills, its diagramsrenowned for pedagogy and precision and its path-breaking technology.

Most chapters have been fine-tuned to achieveeven greater clarity and to present the material in amore straightforward, visual and intuitive way.Some chapters have been thoroughly reworked tocover new issues, particularly those that involve current policy problems. These changes are aimed atbetter enabling students to learn how to use the economic toolkit to analyse their own decisions andunderstand the events and issues they are confrontedwith in the media and at the ballot box.

Current issues organise each chapter. News storiesabout today’s major economic events tie a chaptertogether, from new, briefer chapter-opening questionsto end-of-chapter problems and online practice. Eachchapter includes a discussion of a critical issue of ourtime to demonstrate how economic theory can beapplied to explore a particular debate or question. Among the many issues covered are�

■ The rising cost of food in Chapter 2■ The fluctuating price of bananas and coffee inChapter 3

■ Expanding the universities in Chapter 8■ Climate change and the carbon tax in Chapter 9■ Monopoly and competition policy in Chapter 10■ The top 1 per cent, rising inequality in Australiaand falling inequality across nations in Chapter 11

PREFACE

xi

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Real-world examples and applications appear in the body of each chapter and in the end-of-chapterproblems and applications, which are available inMyEconLab for assignment as homework, quizzes ortests.A selection of the questions that appear weekly in

MyEconLab in Economics in the News is also availablefor assignment as homework, quizzes or tests.

Highpoints of the RevisionIn addition to being thoroughly updated and revisedto include the topics and features just described, themicro chapters feature the following five notablechanges:1. What Is Economics? (Chapter 1): We have re -worked the explanation of the economic way of thinking around six key ideas, all illustrated with student-relevant choices. The graphing appendix tothis chapter has an increased focus on scatter diagramsand their interpretation and on understanding shiftsof curves.2. Economics of the Environment (Chapter 9): Thischapter has been revised to deal more thoroughly withthe economics of pollution and carbon emission andthe role of the carbon tax. The section on the tragedyof the commons has also been extensively revised toexplain the problem of overfishing using an analysisthat matches that of negative externalities.3. Economic Inequality (Chapter 11): This chapternow includes a section on inequality in the worldeconomy and compares Australian inequality withthat in nations at the two extremes of equality andinequality. It also looks at the reasons why the superrich are getting richer.4. Consumer Choices and Constraints (Chapter 12):Students find the analysis of the price effect in termsof an income effect and a substitution effect difficult,so we have reworked this material to make the expla-nation clearer. We have omitted the work–leisurechoice coverage of earlier editions and given thechapter a student-friendly application on choicesabout movies and DVDs.5. Oligopoly Games and Strategies (Chapter 16): We have omitted the kinked demand curve and dominant firm coverage of earlier editions and giventhe chapter a stronger game theory focus. AGillette–Schick battle for the razor market illustratesgame theory in action.

◆ Features to Enhance Teachingand Learning

Reading Between the LinesThis McTaggart, Findlay and Parkin hallmark helpsstudents think like economists by connecting chaptertools and concepts to the world around them. InReading Between the Lines at the end of each chapterstudents apply the tools they have just learned byanalysing an article from a newspaper or news website. Each article sheds additional light on thequestions first raised in the chapter opener.Questions about the article also appear with the

end-of-chapter problems and applications.

xii PREFACE

Coffee Surges on Poor Colombian HarvestsFT.com30 July 2010

Coffee prices hit a 12-year high on Friday on the back of low supplies of premium Arabicacoffee from Colombia after a string of poor crops in the Latin American country.

The strong fundamental picture has also encouraged hedge funds to reverse their previousbearish views on coffee prices.

In New York, … Arabica coffee jumped 3.2 per cent to 178.75 cents per pound, the highestsince February 1998. It traded later at 177.25 cents, up 6.8 per cent on the week.

The London-based International Coffee Organization on Friday warned that the ‘currenttight demand and supply situation’ was ‘likely to persist in the near to medium term’.

Coffee industry executives believe prices could rise towards 200 cents per pound in New Yorkbefore the arrival of the new Brazilian crop laterthis year.

‘Until October it is going to be tight on highquality coffee,’ said a senior executive at one ofEurope’s largest coffee roasters. He said: ‘Theindustry has been surprised by the scarcity ofhigh quality beans’.

Colombian coffee production, key for suppliesof premium beans, last year plunged to a33-year low of 7.8 m bags, each of 60 kg, downnearly a third from 11.1 m bags in 2008, tight -ening supplies worldwide …

Excerpted from ‘Coffee Surges on Poor Colombian Harvests’ by JavierBlas, Financial Times. © The Financial Times Limited (2010). All rights reserved.

READING BETWEEN THE L INES

Demand and Supply: The Price of Coffee

■ The price of premium Arabica coffee increasedby 3.2 per cent to almost 180 cents per pound inJuly 2010, the highest price since February1998.

■ A sequence of poor crops in Colombia cut theproduction of premium Arabica coffee to a33-year low of 7.8 million 60 kilogram bags,down from 11.1 million bags in 2008.

■ The International Coffee Organization said thatthe ‘current tight demand and supply situation’was ‘likely to persist in the near to medium term’.

■ Coffee industry executives say prices might approach 200 cents per pound before the arrivalof the new Brazilian crop later this year.

■ Hedge funds previously expected the price of coffee to fall but now expect it to rise further.

ESSENCE OF THE STORY

Figure 2 The Effects of the Expected Future Price

D

S1

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Figure 1 The Effects of the Colombian Crop

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ECONOMIC ANALYSIS

■ This news article reports two sources of changes insupply and demand that changed the price of coffee.

■ The first source of change is the sequence of poorharvests in Colombia. These events decreased theworld supply of Arabica coffee. (Arabica is the typethat Starbucks uses.)

■ Before the reported events, the world production ofArabica was 120 million bags per year and its pricewas 174 cents per pound.

■ The decrease in the Colombian harvest decreasedworld production to about 116 million bags, which isabout 3 per cent of world production.

■ Figure 1 shows the situation before the poorColombian harvests and the effects of those poorharvests. The demand curve is D and initially thesupply curve was S0. The market equilibrium is at120 million bags per year and a price of 174 centsper pound.

■ The poor Colombian harvests decreased supply andthe supply curve shifted leftward to S1. The priceincreased to 180 cents per pound and the quantitydecreased to 116 million bags.

■ The second source of change influenced both supplyand demand. It is a change in the expected futureprice of coffee.

■ The hedge funds referred to in the news article arespeculators that try to profit from buying at a low priceand selling at a high price.

■ With the supply of coffee expected to remain low, theprice was expected to rise further – a rise in theexpected future price of coffee.

■ When the expected future price of coffee rises, somepeople want to buy more coffee (so they can sell itlater) – an increase in the demand today. And somepeople offer less coffee for sale (so they can sell it laterfor a higher price) – a decrease in the supply today.

■ Figure 2 shows the effects of these changes in the demand and supply today.

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PREFACE xiii

Graphs That Show the ActionThrough the past six editions, this book has set newstandards of clarity in its graphs; the seventh editioncontinues to uphold this tradition. Our goal hasalways been to show ‘where the economic action is’.Our graphs continue to generate an enormously positive response, which confirms our view thatgraphical analysis is the most powerful tool availablefor teaching and learning economics.Because many students find graphs hard to work

with, we have developed the entire art program withthe study and review needs of the student in mind.The graphs feature

■ Original curves consistently shown in blue■ Shifted curves, equilibrium points and otherimportant features highlighted in red

■ Colour-blended arrows to suggest movement■ Graphs paired with data tables■ Graphs labelled with boxed notes■ Extended captions that make each graph and itscaption a self-contained object for study andreview.

Chapter ObjectivesEach chapter begins with a list of learning objectives,which enables students to see exactly where thechapter is going and to set their goals before theyembark on their detailed study.

Chapter OpenersEach chapter opens with a carefully chosen photo-graph, question and student-friendly vignettedesigned to give students a quick sense of what thechapter is about and how it connects with their owneconomic world and experience. The chapter openingstory is woven into the body of the chapter andexplored further in the Reading Between the Linesfeature that ends the chapter.

Economics in Action BoxesThis new feature addresses current events and eco-nomic occurrences that highlight and amplify thetopics covered in the chapter. Instead of simplyreporting the current events, the material applies theevent to an economics lesson, enabling students to seehow economics plays a part in the world around themas they read through the chapter.Some of the many issues covered in this feature

include the global market for crude oil, the best afford-able choice of movies and DVDs, the cost of selling apair of shoes, how Apple doesn’t make the iPhone, thetrends and cycles in real GDP and the price level, andthe size of the fiscal stimulus multipliers.

Quantity

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Decrease in supply

Increase in supply

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Decrease inquantitysupplied

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S2 S0 S1

6

Economics in ActionThe Global Market for Crude OilThe demand and supply model provides insights intoall competitive markets. Here, we’ll apply what you’velearned about the effects of an increase in demand tothe global market for crude oil.

Crude oil is like the life-blood of the globaleconomy. It is used to fuel our cars, aeroplanes, trainsand buses, to generate electricity and to produce awide range of plastics. When the price of crude oilrises, the costs of transportation, power and materialsall increase.

In 2001, the price of a barrel of oil was $20 (usingthe value of money in 2010). In 2008, before theglobal financial crisis ended a long period of eco-nomic expansion, the price peaked at $127 a barrel.

While the price of oil was rising, the quantity ofoil produced and consumed also increased. In 2001,the world produced 65 million barrels of oil a day. By2008, that quantity was 72 million barrels.

Who or what has been raising the price of oil? Is itthe action of greedy oil producers? Oil producersmight be greedy and some of them might be bigenough to withhold supply and raise the price, but itwouldn’t be in their self-interest to do so. The higherprice would bring forth a greater quantity suppliedfrom other producers and the profit of the producerlimiting supply would fall.

Oil producers could try to cooperate and jointlywithhold supply. The Organisation of PetroleumExporting Countries, OPEC, is such a group of pro-ducers. But OPEC doesn’t control the world supplyand its members’ self-interest is to produce the quanti-ties that give them the maximum attainable profit.

So even though the global oil market has some bigplayers, they don’t fix the price. Instead, the actionsof thousands of buyers and sellers and the forces ofdemand and supply determine the price of oil.

So how have demand and supply changed?Because both the price and the quantity have

increased, the demand for oil must have increased.Supply might have changed too, but here we’llsuppose that supply has remained the same.

The global demand for oil has increased for onemajor reason: World income has increased. Theincrease has been particularly large in the emergingeconomies of China, India and Brazil. Increasedworld income has increased the demand for oil-usinggoods such as electricity, petrol and plastics, which inturn has increased the demand for oil.

The figure illustrates the effects of the increase indemand on the global oil market. The supply of oilremained constant along supply curve S. The demandfor oil in 2001 was D2001, so in 2001 the price was$20 a barrel and the quantity was 65 million barrelsper day. The demand for oil increased and by 2008 ithad reached D2008. The price of oil increased to $127 abarrel and the quantity increased to 72 million barrelsa day. The increase in the quantity is an increase in thequantity supplied, not an increase in supply.

200

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The Global Market for Crude Oil

Price ofoil rises ...

… and quantityof oil suppliedincreases

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Key TermsHighlighted terms simplify the student’s task of learn-ing the vocabulary of economics. Each highlightedterm appears in an end-of-chapter list with its pagenumber, in an end-of-book glossary with its pagenumber, bold-faced in the index, and in MyEconLabin the interactive glossary and flashcards.

End-of-Chapter SummaryEach chapter closes with a concise summary organisedby major topics and list of key terms with page refer-ences. These learning tools provide students with asummary for review and exam preparation.

In-Text Review Quizzes and End-of-ChapterProblems and ApplicationsA Review Quiz at the end of each major sectionenables students to determine whether a topic needsfurther study before moving on, and Problems andApplications at the end of each chapter provide anopportunity to practise and apply the topics of thechapter.All the Review Quizzes and end-of-chapter

Problems and Applications are in the MyEconLabStudy Plan (see p. xv) where students can work themand receive instant feedback and explanations.

◆ For the LecturerThis book enables you to focus on the economic wayof thinking and choose your own course structure.

Focus on the Economic Way of ThinkingAs a teacher, you know how hard it is to encourage astudent to think like an economist. But that is yourgoal. Consistent with this goal, the text focuses on andrepeatedly uses the central ideas: choice; tradeoff;opportunity cost; the margin; incentives; the gainsfrom voluntary exchange; the forces of demand,supply and equilibrium; the pursuit of economic rent;the tension between self-interest and the social inter-est; and the scope and limitations of governmentactions.

Flexible StructureYou have preferences for how you want to teach yourcourse. We have organised this book to enable you todo so. The flexibility chart on p. xix illustrate thebook’s flexibility. By following the arrows through thecharts you can select the path that best fits your pref-erence for course structure. Whether you want toteach a traditional course that blends theory andpolicy, or one that takes a fast track through eithertheory or policy issues, Economics gives you thechoice.

Supplemental ResourcesAll instructor supplements are available via:■ the Pearson catalogue page(www.pearson.com.au/9781442550773)

■ MyEconLab (www.pearson.com.au/mctaggart)

Computerised Test Banks The seventh edition testbank (Test Item File) with more than 3,000 multiple-choice questions has been prepared by Mark Dodd ofthe University of Adelaide and Tikiri Agalewatte of theUniversity of Wollongong. Mark and Tikiri reviewedall existing questions to ensure their clarity and consis-tency with the seventh edition. New questions followthe style and format of the end-of-chapter text prob-lems and they provide the lecturer with a new set oftesting opportunities and/or homework assignments.Test Item File questions are available in MyEconLabfor instructors to use in a test, a quiz or as homework.Pearson’s TestGen enables instructors to view and

edit test bank questions, generate tests, and printthem in a variety of formats. Search and sort functionsmake it easy to locate questions and arrange them inany order desired. TestGen also enables instructors toadminister tests on a local area network, have testsgraded electronically, and have the results prepared inelectronic or printed reports.Pearson TestGen is compatible with Windows or

Macintosh systems.

Solutions Manual For ease of use and instructor refer-ence, a comprehensive Solutions Manual provides lecturers with detailed solutions to the ReviewQuizzes and the end-of-chapter Study Plan Problems

xiv PREFACE

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PREFACE xv

and Applications and Additional Problems andApplications. John Snelling of the University ofAdelaide has prepared the Solutions Manual. For anelectronic version of the Solutions Manual go towww.pearson.com.au/9781442550773.

PowerPoint Resources Robin Bade has developed thefull-colour Microsoft PowerPoint Lecture Presen -tation for each chapter, which includes animated versions of the textbook figures, tables from the text-book and speaking notes.A separate set of PowerPoint files containing large-

scale animated versions of all the textbook’s figuresand the tables from the text is available. Use the presentations electronically in the classroom orprinted to create hard-copy transparency masters.This item is available for Macintosh and Windows.

Instructor’s Resource Centre Lecturers can downloadsupplements from a secure, instructor-only source atwww.pearson.com.au/9781442550773.

MyEconLab MyEconLabMyEconLab’s assessment and tutorial system workshand-in-hand with Economics. With comprehensivehomework, quiz, test and tutorial options, lecturerscan manage all assessment needs in one program.■ All of the Review Quiz questions and end-of-chapter Problems and Applications are assignableand automatically graded.

■ Students can work the Review Quiz questionsand end-of-chapter Study Plan Problems andApplications as part of the MyEconLab Study Plan.

■ Instructors can assign the end-of-chapterAdditional Problems and Applications asautograded assignments. These Problems andApplications are not available to students inMyEconLab unless assigned by the instructor.

■ Many of the Problems and Applications arealgorithmic, draw-graph and numerical exercises.

■ Test Item File questions are available forassignment as homework.

■ The Custom Exercise Builder gives instructors theflexibility of creating their own problems forassignment.

■ The Gradebook records each student’sperformance and the time spent on Tests, StudyPlan and Homework and generates reports bystudent or by chapter.

■ Economics in the News is a turn-key solution tobringing daily news into the classroom. Updatedweekly during the academic year, we upload tworelevant articles (one micro, one macro) andprovide links for further information andquestions that may be assigned for homework orfor classroom discussion.

■ A suite of ABC News (U.S.) videos, which addresscurrent topics such as education, energy, U.S.Federal Reserve policy and business cycles, isavailable for classroom use. Video-specific exercisesare available for instructor assignment. Michael Parkin and Robin Bade, assisted by

Jeannie Gillmore and Laurel Davies, author andoversee all of the MyEconLab content for Economics.Our peerless MyEconLab team has worked hard toensure that it is tightly integrated with the book’scontent and vision. For more information go towww.pearson.com.au/mctaggart.

Experiments in MyEconLabExperiments are a fun and engaging way to promoteactive learning and mastery of important economicconcepts. Pearson’s experiments program is flexibleand easy for lecturers and students to use.■ Single-player experiments allow your students toplay against virtual players from anywhere at any time with an Internet connection.

■ Multiplayer experiments allow you to assign andmanage a real-time experiment with your class.

Pre- and post-questions for each experiment areavailable for assignment in MyEconLab.

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◆ For the StudentWith this textbook, you get access to some powerfullearning tools.

MyEconLab MyEconLabMyEconLab’s tutorial system provides lots of opportu-nities to practise and review what you are learning.

■ Take a ‘Sample Test’ to create your personalised‘Study Plan’.

■ Work the Review Quiz questions and end-of-chapter Study Plan Problems and Applicationsin your MyEconLab Study Plan and get instant feedback.

■ Use the ‘Help Me Solve This’ problem tools whenyou need extra help.

■ Use the Pearson e-text version of your textbook tosearch, make notes, view animated versions of thetextbook figures and check a definition in the electronic glossary.

■ Use the ‘Ask the Authors’ tool to send an email tothe authors and get help when you need it.

Registering for MyEconLab with an access card Ifyour textbook came bundled with a MyEconLabaccess code, refer to the card for registration instruc-tions.

Purchasing access If your textbook did not comebundled with a MyEconLab access code, you can purchase an access code at www.pearson.com.au/mctaggart.

Study on the GoAt the end of each chapter, you will find a unique QRcode providing access to Study on the Go, an unprece-dented mobile integration between text and onlinecontent. You can link to Pearson’s unique Study onthe Go content directly from your smartphone, allow-ing you to study whenever and wherever you wish! Goto one of the sites below to see how you can downloadan app to your smartphone for free. Once the app isinstalled, scan the code and your phone will link to awebsite containing Pearson’s Study on the Go content,including the popular study tools: glossary, flashcards,audio summaries and multiple-choice quizzes, whichcan be accessed at any time.ScanLife: http://get.scanlife.comNeoReader: http://get.neoreader.comQuickMark: http://www.quickmark.com.tw

PowerPoint Lecture NotesRobin Bade has developed the full-colour MicrosoftPowerPoint Lecture Notes for each chapter, whichinclude animated versions of the textbook figures.Take these notes to class and edit them to create yourown personal summary for review.

VitalSource EditionVitalSource is an electronic version of the text to fityour mobile lifestyle. Download it to your computerand search for key concepts, words and phrases, makehighlights and notes as you study and share your noteswith your friends.

xvi PREFACE

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PREFACE xvii

◆ AcknowledgementsAs we said in earlier editions, one of the great pleas-ures of writing an introductory text is the opportunityit affords to learn from so many generous friends andcolleagues. Although the extent of our debt cannot befully acknowledged here, it is nevertheless a joy torecord our gratitude to the many people who havehelped, some without realising just how helpful theyhave been.We thank our many exceptional reviewers whose

names are listed on the following pages. Many ofthem spent much more time than we could have reasonably expected and provided detailed commentson drafts of the manuscript. Their comments and suggestions have been extremely helpful and we havemade every attempt to heed their advice.We thank the several thousand students whom we

have been privileged to teach. The instant responsethat comes from the look of puzzlement or enlighten-ment has taught us how to teach economics.We also thank Doon-Louise Williams and David

Tucker, students at Griffith University, for pointingout an error in the sixth edition.We thank Richard Parkin for his work on the elec-

tronic art manuscript, the PowerPoint animations andthe Flash animations of the figures in the e-text onMyEconLab. We thank Jeannie Gillmore and LaurelDavies for creating and managing our evergrowingand ever more complex MyEconLab database. We alsothank John Snelling of the University of Adelaide forhelping with news-based end-of-chapter problemsand applications.

Finally, we are deeply grateful to the editorial teamat Pearson Australia. Vision, energy, enthusiasm, pro-fessionalism, flair and commitment are just some ofthe characteristics of the team. Editor in Chief FrancesEden, Manager – Product Development MichaelStone, Senior Acquisitions Editor Simone Bella, SeniorProject Editor Rebecca Pomponio and EditorialCoordinator Germaine Silva have again confirmedwith this new edition their reputation as Australia’sfinest academic publishers. They have built a culturethat brings out the best in their editors and authors.They have been supported by Copyright and

Pictures Editor Lisa Woodland, copy editor FelicityMcKenzie, proofreader Nicole Le Grand and typeset-ter Leonie Ryan. We are grateful for their commitmentto the project and their excellent attention to detail.Classroom experience will test the value of this

book. We would appreciate hearing from instructorsand students about how we can continue to improve itin future editions.

Douglas McTaggartQueensland Investment Corporationemail: [email protected]

Christopher FindlayUniversity of Adelaideemail: [email protected]

Michael ParkinUniversity of Western Ontarioemail: [email protected]

Prelims MICRO Aus 7e_ECO Prelims 7e 14/06/12 2:55 PM Page xvii

◆ Reviewers of the Seventh EditionRod Duncan, Charles Sturt UniversityRichard Dutu, Deakin UniversityCatherine Fletcher, Monash UniversityPeter Harkness, Swinburne UniversityYolanta Kwiecien, Monash UniversityPaul Morris, University of NewcastleMunirul Nabin, Deakin UniversityPeter Schuwalow, Monash UniversityZulfan Tadjoeddin, University of Western Sydney

◆ Reviewers of the Sixth EditionJayanath Ananda, La Trobe UniversitySiobhan Austen, Curtin Business SchoolCarol Barry, Swinburne University of TechnologyJohn Bevacqua, Charles Sturt UniversityJonathan Boymal, Royal Melbourne Institute ofTechnology

Mark Buchanek, Deakin UniversityBob Catley, University of NewcastleBronwyn Coate, Royal Melbourne Institute ofTechnology

Maxine Darnell, University of New EnglandSinclair Davidson, Royal Melbourne Institute ofTechnology

Catherine Fletcher, Monash University Gigi Foster, University of South AustraliaChris Gellar, Deakin UniversityMary Graham, Deakin UniversityBranka Krivokapic-Skoko, Charles Sturt UniversityYun-Lok Lee, Southern Cross UniversityElizabeth Manning, Deakin UniversityAnn Marsden, University of TasmaniaStephen Mason, Southern Cross UniversityPundarik Mukhopadhaya, Macquarie UniversityMuni Perumal, University of CanberraElla Reeks, University of TasmaniaJohn Rice, University of AdelaideGraham Richards, Trinity College, University of Melbourne

Sveta Risman, Royal Melbourne Institute ofTechnology

Ali Saleh, University of WollongongPasquale Sgro, Deakin UniversityBaljit Singh, La Trobe UniversityHazbo Skoko, Charles Sturt UniversitySam Tang, University of Western AustraliaMehmet Ulubasoglu, Deakin UniversitySpiro George Vlachos, University of AdelaideMark Weder, University of Adelaide

xviii PREFACE

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Chapter 1

What Is Economics?

Chapter 2

The Economic Problem

Chapter 5

Efficiency and Equity

Chapter 4

Elasticity

Chapter 11

Economic Inequality

Chapter 3

Demand and Supply

Start here ... … then jump toany of these …

… and jump to any of these afterdoing the prerequisites indicated

Chapter 7

Global Marketsin Action

Chapter 6

Government Actionsin Markets

Chapter 9

Economics ofthe Environment

Chapter 10

Monopoly

Chapter 15

MonopolisticCompetition

Chapter 16

Oligopoly Gamesand Strategies

Chapter 17

Decisions inFactor Markets

Chapter 13

Producer Choicesand Constraints

Chapter 12

Consumer Choicesand Constraints

Micro Flexibility

Chapter 8

Public Choices andPublic Goods

Chapter 14

Perfect Competition

xix

ALTERNATIVE PATHWAYS THROUGH THE MICRO CHAPTERS

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PART ONEINTRODUCTION 1

CHAPTER 1 ◆ WHAT IS ECONOMICS? 1

Definition of Economics 2

Two Big Economic Questions 3What, How and for Whom? 3Can the Pursuit of Self-Interest Promote the Social Interest? 5

The Economic Way of Thinking 8A Choice Is a Tradeoff 8Making a Rational Choice 8Benefit: What You Gain 8Cost: What You Must Give Up 8How Much? Choosing at the Margin 9Choices Respond to Incentives 9

Economics as Social Science and Policy Tool 10Economist as Social Scientist 10Economist as Policy Adviser 10

Summary 11Study Plan Problems and Applications 12Additional Problems and Applications 12

APPENDIX Graphs in Economics 13

Graphing Data 13Scatter Diagrams 14

Graphs Used in Economic Models 16Variables That Move in the Same Direction 16Variables That Move in Opposite Directions 17Variables That Have a Maximum or a Minimum 18

Variables That Are Unrelated 19

The Slope of a Relationship 20The Slope of a Straight Line 20The Slope of a Curved Line 21

Graphing Relationships Among More Than Two Variables 22

Ceteris Paribus 22When Other Things Change 23

MATHEMATICAL NOTEEquations of Straight Lines 24A Linear Equation 24Slope of Line 24Position of Line 25Positive Relationships 25Negative Relationships 25Example 25

Summary 26Study Plan Problems and Applications 27Additional Assignable Problems and Applications 28

CHAPTER 2 ◆ THE ECONOMIC PROBLEM 29

Production Possibilities and Opportunity Cost 30Production Possibilities Frontier 30Production Efficiency 31Tradeoff Along the PPF 31Opportunity Cost 31

Using Resources Efficiently 33The PPF and Marginal Cost 33 Preferences and Marginal Benefit 34Allocative Efficiency 35

Economic Growth 36The Cost of Economic Growth 36A Nation’s Economic Growth 37

Gains from Trade 38Comparative Advantage and Absolute Advantage 38

Achieving the Gains from Trade 39

Economic Coordination 41Firms 41Markets 42Property Rights 42Money 42Circular Flows Through Markets 42Coordinating Decisions 42

READING BETWEEN THE LINESThe Rising Opportunity Cost of Food 44


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TABLE OF CONTENTS

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CHAPTER 3 ◆ DEMAND AND SUPPLY 51

Markets and Prices 52

Demand 53The Law of Demand 53Demand Curve and Demand Schedule 53A Change in Demand 54A Change in the Quantity Demanded Versus aChange in Demand 56

Supply 58The Law of Supply 58Supply Curve and Supply Schedule 58A Change in Supply 59A Change in the Quantity Supplied Versus aChange in Supply 60

Market Equilibrium 62Price as a Regulator 62Price Adjustments 63

Predicting Changes in Price and Quantity 64An Increase in Demand 64A Decrease in Demand 64An Increase in Supply 66A Decrease in Supply 66All the Possible Changes in Demand andSupply 68

READING BETWEEN THE LINESDemand and Supply: The Price of Coffee 70

MATHEMATICAL NOTEDemand, Supply and Equilibrium 72Demand Curve 72Supply Curve 72Market Equilibrium 73An Example 73


CHAPTER 4 ◆ ELASTICITY 79

Price Elasticity of Demand 80Calculating Price Elasticity of Demand 81Inelastic and Elastic Demand 82Elasticity Along a Linear Demand Curve 83Total Revenue and Elasticity 84Your Expenditure and Your Elasticity 85The Factors That Influence the Elasticity ofDemand 85

More Elasticities of Demand 87Cross Elasticity of Demand 87Income Elasticity of Demand 88

Elasticity of Supply 90Calculating the Elasticity of Supply 90The Factors That Influence the Elasticity of Supply 91

READING BETWEEN THE LINESWhy a Crackdown on Illicit Drugs IncreasesCrime 94


xxii CONTENTS

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PART TWOHOW MARKETS WORK 101

CHAPTER 5 ◆ EFFICIENCY AND EQUITY 101

Resource Allocation Methods 102Market Price 102Command 102Majority Rule 102Contest 102First-Come, First-Served 102Lottery 103Personal Characteristics 103Force 103

Benefit, Cost and Surplus 104Demand, Willingness to Pay and Value 104Individual Demand and Market Demand 104Consumer Surplus 105Supply and Marginal Cost 105Supply, Cost and Minimum Supply-Price 106Individual Supply and Market Supply 106Producer Surplus 107

Is the Competitive Market Efficient? 108Efficiency of Competitive Equilibrium 108Market Failure 109Sources of Market Failure 110Alternatives to the Market 111

Is the Competitive Market Fair? 112It’s Not Fair if the Result Isn’t Fair 112It’s Not Fair if the Rules Aren’t Fair 114Case Study: A Water Shortage in a NaturalDisaster 114

READING BETWEEN THE LINESIs the Global Market for Roses Efficient? 116


CHAPTER 6 ◆ GOVERNMENT ACTIONS INMARKETS 123

A Housing Market with a Rent Ceiling 124A Housing Shortage 124Increased Search Activity 124A Black Market 124Inefficiency of a Rent Ceiling 125Are Rent Ceilings Fair? 126

A Labour Market with a Minimum Wage 127Minimum Wage Brings Unemployment 127Inefficiency of a Minimum Wage 127Is the Minimum Wage Fair? 128

Taxes 129Tax Incidence 129A Tax on Sellers 129A Tax on Buyers 130Equivalence of Tax on Buyers and Sellers 130Tax Incidence and Elasticity of Demand 131Tax Incidence and Elasticity of Supply 132Taxes and Efficiency 133Taxes and Fairness 134

Production Quotas and Subsidies 135Production Quotas 135Subsidies 136

Markets for Illegal Goods 138A Free Market for a Drug 138A Market for an Illegal Drug 138Legalising and Taxing Drugs 139

READING BETWEEN THE LINESCreating a Fuel Shortage in China 140


CONTENTS xxiii

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CHAPTER 7 ◆ GLOBAL MARKETS IN ACTION 147

How Global Markets Work 148International Trade Today 148What Drives International Trade? 148Why Australia Imports Cars 149Why Australia Exports Coal 150

Winners, Losers and the Net Gain fromTrade 151Gains and Losses from Imports 151Gains and Losses from Exports 152Gains for All 152

International Trade Restrictions 153Tariffs 153Import Quotas 156Other Import Barriers 158Export Subsidies 158

The Case Against Protection 159The Infant-Industry Argument 159The Dumping Argument 159Saves Jobs 160Allows Us to Compete with Cheap ForeignLabour 160

Penalises Lax Environmental Standards 160Prevents Rich Countries from ExploitingDeveloping Countries 162

Avoiding Trade Wars 162Why Is International Trade Restricted? 162Compensating Losers 163

READING BETWEEN THE LINESThe Benefits of Free Trade 164


CHAPTER 8 ◆ PUBLIC CHOICES AND PUBLICGOODS 171

Public Choices 172Why Governments Exist 172Government Failure 172Public Choice and the Political Marketplace 172Political Equilibrium 174What Is a Public Good? 174Problems That Require Public Choices 176

Providing Public Goods 177The Free-Rider Problem 177Marginal Social Benefit of a Public Good 177Marginal Social Cost of a Public Good 178Efficient Quantity of a Public Good 178Inefficient Private Provision 178Efficient Public Provision 178Inefficient Public Overprovision 180

Providing Mixed Goods 181Private Benefits and Social Benefits 181Government Actions in the Face of ExternalBenefits 182

Bureaucratic Inefficiency 184Two Types of Political Equilibrium 185Why Government Is Large and Growing 185Voters Strike Back 185

READING BETWEEN THE LINESReform of University Funding 186


xxiv CONTENTS

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CHAPTER 9 ◆ ECONOMICS OF THEENVIRONMENT 193

Negative Externality: Pollution 194The Pollution Problem 194The Demand for a Clean Environment 194The Sources of Pollution 194Private Cost and the Social Cost of Pollution 197Production and Pollution: How Much? 198Property Rights 198The Coase Theorem 199Government Actions in the Face of ExternalCosts 200

The Tragedy of the Commons 202Unsustainable Use of a Common Resource 202Inefficient Use of a Common Resource 203Achieving an Efficient Outcome 204

READING BETWEEN THE LINESA Carbon Tax at Work 208


CHAPTER 10 ◆ MONOPOLY 215

Monopoly and How It Arises 216How Monopoly Arises 216A Monopoly’s Goals and Constraints 217Economic Rent and Rent Seeking 219

A Single-Price Monopoly’s Output and PriceDecision 220Price and Marginal Revenue 220Output and Price Decision 220Monopoly and Competition Compared 222

Price Discrimination 225Profiting by Price Discriminating 225Perfect Price Discrimination 226Efficiency, Equity and Rent Seeking with PriceDiscrimination 227

Monopoly Policy Issues 228Gains from Monopoly 228Natural Monopoly Regulation 229

READING BETWEEN THE LINESCompeting for Monopoly Power 232


CONTENTS xxv

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CHAPTER 11 ◆ ECONOMIC INEQUALITY 239

Measuring Economic Inequality 240The Distribution of Disposable Income 240The Income Lorenz Curve 241The Distribution of Wealth 242Wealth or Income? 242Annual or Lifetime Income and Wealth? 242Trends in Inequality 243Poverty 243

Inequality in the World Economy 244Income Distributions in Selected Countries 244Global Inequality and Its Trends 245

The Sources of Economic Inequality 246Human Capital 246Discrimination 248Tournament Winners and Superstars 249Unequal Wealth 250

Income Redistribution 251Direct Taxes 251Indirect Taxes 251Direct Benefits 251Indirect Benefits 253The Big Tradeoff 253The Benefit Trap 253

READING BETWEEN THE LINESThe Top 1 Per Cent 254


PART THREEDECISIONS AND STRATEGIES INMARKETS 261

CHAPTER 12 ◆ CONSUMER CHOICES ANDCONSTRAINTS 261

Consumption Possibilities 262Budget Line 262 Budget Equation 263

Preferences and Indifference Curves 265Marginal Rate of Substitution 266Degree of Substitutability 267

Predicting Consumer Choices 268Best Affordable Choice 268A Change in Price 269A Change in Income 271Substitution Effect and Income Effect 272

READING BETWEEN THE LINESPaper Books Versus e-Books 274


xxvi CONTENTS

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CHAPTER 13 ◆ PRODUCER CHOICES ANDCONSTRAINTS 281

The Firm and Its Economic Problem 282The Firm’s Goal 282Accounting Profit 282Economic Accounting 282A Firm’s Opportunity Cost of Production 282Economic Accounting: A Summary 283The Firm’s Constraints 283Decision Time Frames 284

Short-Run Technology Constraint 285Product Schedules 285Product Curves 285Total Product Curve 286Marginal Product Curve 286Average Product Curve 288

Short-Run Cost 289Total Cost 289Marginal Cost 290Average Cost 290Marginal Cost and Average Cost 290Why the Average Total Cost Curve is U-Shaped 290

Cost Curves and Product Curves 292Shifts in the Cost Curves 292

Long-Run Cost 294The Production Function 294Short-Run Cost and Long-Run Cost 294The Long-Run Average Cost Curve 296Economies and Diseconomies of Scale 296

READING BETWEEN THE LINESCutting the Cost of Producing Electricity 298


CHAPTER 14 ◆ PERFECT COMPETITION 305

What Is Perfect Competition? 306How Perfect Competition Arises 306Price Takers 306Economic Profit and Revenue 306The Firm’s Decisions 307

The Firm’s Output Decision 308Marginal Analysis and the Supply Decision 309Temporary Shutdown Decision 310The Firm’s Supply Curve 311

Output, Price and Profit in the Short Run 312Market Supply in the Short Run 312Short-Run Equilibrium 313A Change in Demand 313Profits and Losses in the Short Run 313Three Possible Short-Run Outcomes 314

Output, Price and Profit in the Long Run 315Entry and Exit 315A Closer Look at Entry 316A Closer Look at Exit 316 Long-Run Equilibrium 317

Changing Tastes and Advancing Technology 318A Permanent Change in Demand 318External Economies and Diseconomies 319Technological Change 321

Competition and Efficiency 322Efficient Use of Resources 322Choices, Equilibrium and Efficiency 322

READING BETWEEN THE LINESPerfect Competition in Wool 324


CONTENTS xxvii

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CHAPTER 15 ◆ MONOPOLISTICCOMPETITION 331

What Is Monopolistic Competition? 332Large Number of Firms 332Product Differentiation 332Competing on Quality, Price, Marketing andBranding 332

Entry and Exit 333

Price and Output in Monopolistic Competition 334The Firm’s Short-Run Output and Price Decision 334

Profit Maximising Might Be Loss Minimising 334

Long Run: Zero Economic Profit 335Monopolistic Competition and PerfectCompetition 336

Is Monopolistic Competition Efficient? 337

Product Development and Marketing 338Innovation and Product Development 338Advertising 338 Using Advertising to Signal Quality 340Brand Names 341Efficiency of Advertising and Brand Names 341

READING BETWEEN THE LINESProduct Differentiation in the Market forSmartphones 342


CHAPTER 16 ◆ OLIGOPOLY GAMES ANDSTRATEGIES 349

What Is Oligopoly? 350Barriers to Entry 350Small Number of Firms 351Examples of Oligopoly 351

Oligopoly Games 352What Is a Game? 352The Prisoners’ Dilemma 352An Oligopoly Price-Fixing Game 354Other Oligopoly Games 358The Disappearing Invisible Hand? 359A Game of Chicken 360

Repeated Games and Sequential Games 361A Repeated Duopoly Game 361A Sequential Entry Game in a ContestableMarket 362

Trade Practices Law 364Collusion 364Misuse of Market Power 364Vertical Restraints 365Mergers 365Consumer Protection 365Social Interest or Special Interest? 365

READING BETWEEN THE LINESGillette and Schick in a Duopoly Game 366


xxviii CONTENTS

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CHAPTER 17 ◆ DECISIONS IN FACTORMARKETS 373

The Anatomy of Factor Markets 374Markets for Labour Services 374Markets for Capital Services 374Markets for Land Services and Natural Resources 374

Entrepreneurship 374

The Demand for a Factor of Production 375Value of Marginal Product 375A Firm’s Demand for Labour 375A Firm’s Demand for Labour Curve 376Changes in a Firm’s Demand for Labour 377

Labour Markets 378A Competitive Labour Market 378A Labour Market with a Union 380Scale of the Union–Non-Union Wage Gap 382Trends and Differences in Wage Rates 383

Capital and Natural Resource Markets 384Capital Rental Markets 384Land Rental Markets 384Nonrenewable Natural Resource Markets 385

READING BETWEEN THE LINESResources and Labour Interact 388

MATHEMATICAL NOTE Present Value and Discounting 390Rent-Versus-Buy Decision 390Comparing Current and Future Dollars 390Compound Interest 390Discounting a Future Amount 390Present Value of a Sequence of Future Amounts 391

The Decision 391


Glossary G1Index I1

CONTENTS xxix

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Copyright holders for the photos used in this book areshown below.

Chapter 11 Andresr | Shutterstock; 5 AFP | Getty Images AustraliaPty Ltd; 6 (left) © JJM Stock Photography | Alamy;(right) © Dave Massey | Dreamstime.com; 7 Bloomberg |Getty Images Australia Pty Ltd.

Chapter 229 © Kadmy | Dreamstime.com; 32 Barbara Reddoch |Dreamstime.com; 41 (left) © Bloomberg via GettyImages; (right) © David R. Frazier Photolibrary, Inc. |Alamy.

Chapter 351 © Beau Lark | Corbis; 65 © Eyeidea |Dreamstime.com; 67 Australian Financial Review © 2011Fairfax Syndication.

Chapter 479 Bloomberg | Getty Images Australia Pty Ltd.

Chapter 5101 Picturebank | Alamy; 117 Picture Contact BV |Alamy.

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