Mankiw Principles of Microeconomics (4th ed)

470 The Theory of Consumer Choice

484	PART SEVEN ADVANCED TOPIC

Figur e 21-15

THE CONSUMPTION-SAVING

DECISION. This figure shows the budget constraint for a person deciding how much to consume in the two periods of his life, the indifference curves representing his preferences, and the optimum.

Consumption Budget

when Old constraint

$110,000

55,000	Optimum
			I 3
			I 2
			I 1
0	$50,000	100,000	Consumption
			when Young

Now consider what happens when the interest rate increases from 10 percent to 20 percent. Figure 21-16 shows two possible outcomes. In both cases, the budget constraint shifts outward and becomes steeper. At the new higher interest rate, Sam gets more consumption when old for every dollar of consumption that he gives up when young.

The two panels show different preferences for Sam and the resulting response to the higher interest rate. In both cases, consumption when old rises. Yet the response of consumption when young to the change in the interest rate is different in the two cases. In panel (a), Sam responds to the higher interest rate by consuming less when young. In panel (b), Sam responds by consuming more when young.

Sam’s saving, of course, is his income when young minus the amount he consumes when young. In panel (a), consumption when young falls when the interest rate rises, so saving must rise. In panel (b), Sam consumes more when young, so saving must fall.

The case shown in panel (b) might at first seem odd: Sam responds to an increase in the return to saving by saving less. Yet this behavior is not as peculiar as it might seem. We can understand it by considering the income and substitution effects of a higher interest rate.

Consider first the substitution effect. When the interest rate rises, consumption when old becomes less costly relative to consumption when young. Therefore, the substitution effect induces Sam to consume more when old and less when young. In other words, the substitution effect induces Sam to save more.

Now consider the income effect. When the interest rate rises, Sam moves to a higher indifference curve. He is now better off than he was. As long as consumption in both periods consists of normal goods, he tends to want to use this increase in well-being to enjoy higher consumption in both periods. In other words, the income effect induces him to save less.

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The Theory of Consumer Choice

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		CHAPTER 21
	(a) Higher Interest Rate Raises Saving
Consumption		Consumption
when Old	BC2	when Old

1. A higher interest rate rotates the budget constraint outward . . .

BC1

I 2

I 1

THE THEORY OF CONSUMER CHOICE

485

(b) Higher Interest Rate Lowers Saving

BC2

1. A higher interest rate rotates the budget constraint outward . . .

BC1

I 1 I 2

0				Consumption	0				Consumption
	2. . . . resulting in lower			when Young		2. . . . resulting in higher			when Young
	consumption when young					consumption when young
	and, thus, higher saving.					and, thus, lower saving.

	AN INCREASE IN THE INTEREST RATE. In both panels, an increase in the interest rate		Figur e 21-16
	shifts the budget constraint outward. In panel (a), consumption when young falls, and
	consumption when old rises. The result is an increase in saving when young. In panel (b),
	consumption in both periods rises. The result is a decrease in saving when young.

The end result, of course, depends on both the income and substitution effects. If the substitution effect of a higher interest rate is greater than the income effect, Sam saves more. If the income effect is greater than the substitution effect, Sam saves less. Thus, the theory of consumer choice says that an increase in the interest rate could either encourage or discourage saving.

Although this ambiguous result is interesting from the standpoint of economic theory, it is disappointing from the standpoint of economic policy. It turns out that an important issue in tax policy hinges in part on how saving responds to interest rates. Some economists have advocated reducing the taxation of interest and other capital income, arguing that such a policy change would raise the after-tax interest rate that savers can earn and would thereby encourage people to save more. Other economists have argued that because of offsetting income and substitution effects, such a tax change might not increase saving and could even reduce it. Unfortunately, research has not led to a consensus about how interest rates affect saving. As a result, there remains disagreement among economists about whether changes in tax policy aimed to encourage saving would, in fact, have the intended effect.

DO THE POOR PREFER TO RECEIVE CASH

OR IN-KIND TRANSFERS?

Paul is a pauper. Because of his low income, he has a meager standard of living. The government wants to help. It can either give Paul $1,000 worth of food

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472	The Theory of Consumer Choice
486	PART SEVEN			ADVANCED TOPIC
				(a) The Constraint Is Not Binding
				Cash Transfer			In-Kind Transfer
	Food				Food
			BC2 (with $1,000 cash)				BC2 (with $1,000 food stamps)
		BC1				BC1
				B			B
	$1,000			I2	$1,000				I2
			A				A
				I1			I1
	0			Nonfood	0					Nonfood
				Consumption						Consumption
				(b) The Constraint Is Binding
				Cash Transfer			In-Kind Transfer
	Food				Food
			BC2 (with $1,000 cash)				BC2 (with $1,000 food stamps)
		BC1				BC1
	$1,000			B	$1,000		A		B
				A
				I2					I1	I2
				I1						I3
	0			Nonfood	0					Nonfood
				Consumption						Consumption

Figur e 21-17

CASH VERSUS IN-KIND TRANSFERS. Both panels compare a cash transfer and a similar in-kind transfer of food. In panel (a), the in-kind transfer does not impose a binding constraint, and the consumer ends up on the same indifference curve under the two policies. In panel (b), the in-kind transfer imposes a binding constraint, and the consumer ends up on a lower indifference curve with the in-kind transfer than with the cash transfer.

(perhaps by issuing him food stamps) or simply give him $1,000 in cash. What does the theory of consumer choice have to say about the comparison between these two policy options?

Figure 21-17 shows how the two options might work. If the government gives Paul cash, then the budget constraint shifts outward. He can divide the extra cash

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CHAPTER 21 THE THEORY OF CONSUMER CHOICE	487

between food and nonfood consumption however he pleases. By contrast, if the government gives Paul an in-kind transfer of food, then his new budget constraint is more complicated. The budget constraint has again shifted out. But now the budget constraint has a kink at $1,000 of food, for Paul must consume at least that amount in food. That is, even if Paul spends all his money on nonfood consumption, he still consumes $1,000 in food.

The ultimate comparison between the cash transfer and in-kind transfer depends on Paul’s preferences. In panel (a), Paul would choose to spend at least $1,000 on food even if he receives a cash transfer. Therefore, the constraint imposed by the in-kind transfer is not binding. In this case, his consumption moves from point A to point B regardless of the type of transfer. That is, Paul’s choice between food and nonfood consumption is the same under the two policies.

In panel (b), however, the story is very different. In this case, Paul would prefer to spend less than $1,000 on food and spend more on nonfood consumption. The cash transfer allows him discretion to spend the money as he pleases, and he consumes at point B. By contrast, the in-kind transfer imposes the binding constraint that he consume at least $1,000 of food. His optimal allocation is at the kink, point C. Compared to the cash transfer, the in-kind transfer induces Paul to consume more food and less of other goods. The in-kind transfer also forces Paul to end up on a lower (and thus less preferred) indifference curve. Paul is worse off than if he had the cash transfer.

Thus, the theory of consumer choice teaches a simple lesson about cash versus in-kind transfers. If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer. If the in-kind transfer does not force the recipient to consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on the consumption and welfare of the recipient.

QUICK QUIZ: Explain how an increase in the wage can potentially decrease the amount that a person wants to work.

CONCLUSION: DO PEOPLE

REALLY THINK THIS WAY?

The theory of consumer choice describes how people make decisions. As we have seen, it has broad applicability. It can explain how a person chooses between Pepsi and pizza, work and leisure, consumption and saving, and on and on.

At this point, however, you might be tempted to treat the theory of consumer choice with some skepticism. After all, you are a consumer. You decide what to buy every time you walk into a store. And you know that you do not decide by writing down budget constraints and indifference curves. Doesn’t this knowledge about your own decisionmaking provide evidence against the theory?

The answer is no. The theory of consumer choice does not try to present a literal account of how people make decisions. It is a model. And, as we first discussed in Chapter 2, models are not intended to be completely realistic.

The best way to view the theory of consumer choice is as a metaphor for how consumers make decisions. No consumer (except an occasional economist) goes

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through the explicit optimization envisioned in the theory. Yet consumers are aware that their choices are constrained by their financial resources. And, given those constraints, they do the best they can to achieve the highest level of satisfaction. The theory of consumer choice tries to describe this implicit, psychological process in a way that permits explicit, economic analysis.

The proof of the pudding is in the eating. And the test of a theory is in its applications. In the last section of this chapter we applied the theory of consumer choice to four practical issues about the economy. If you take more advanced courses in economics, you will see that this theory provides the framework for much additional analysis.

Summar y

A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods.

The consumer’s indifference curves represent his preferences. An indifference curve shows the various bundles of goods that make the consumer equally happy. Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution—the rate at which the consumer is willing to trade one good for the other.

The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals the slope of the budget constraint (the relative price of the goods).

When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The income effect is reflected in the movement from a lower to a higher indifference curve, whereas the substitution effect is reflected by a movement along an indifference curve to a point with a different slope.

The theory of consumer choice can be applied in many situations. It can explain why demand curves can potentially slope upward, why higher wages could either increase or decrease the quantity of labor supplied, why higher interest rates could either increase or decrease saving, and why the poor prefer cash to in-kind transfers.

Key Concepts

budget constraint, p. 465	perfect complements, p. 470	substitution effect, p. 475
indifference curve, p. 466	normal good, p. 473	Giffen good, p. 479
marginal rate of substitution, p. 467	inferior good, p. 473
perfect substitutes, p. 470	income effect, p. 475

Questions for Review

1.A consumer has income of $3,000. Wine costs $3 a glass, and cheese costs $6 a pound. Draw the consumer’s

budget constraint. What is the slope of this budget constraint?

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2.Draw a consumer’s indifference curves for wine and cheese. Describe and explain four properties of these indifference curves.

3.Pick a point on an indifference curve for wine and cheese and show the marginal rate of substitution. What does the marginal rate of substitution tell us?

4.Show a consumer’s budget constraint and indifference curves for wine and cheese. Show the optimal consumption choice. If the price of wine is $3 a glass and the price of cheese is $6 a pound, what is the marginal rate of substitution at this optimum?

5.A person who consumes wine and cheese gets a raise, so his income increases from $3,000 to $4,000. Show what happens if both wine and cheese are normal goods. Now show what happens if cheese is an inferior good.

6.The price of cheese rises from $6 to $10 a pound, while the price of wine remains $3 a glass. For a consumer with a constant income of $3,000, show what happens to consumption of wine and cheese. Decompose the change into income and substitution effects.

7.Can an increase in the price of cheese possibly induce a consumer to buy more cheese? Explain.

8.Suppose a person who buys only wine and cheese is given $1,000 in food stamps to supplement his $1,000 income. The food stamps cannot be used to buy wine.

Might the consumer be better off with $2,000 in income? Explain in words and with a diagram.

Problems and Applications

1.Jennifer divides her income between coffee and croissants (both of which are normal goods). An early frost in Brazil causes a large increase in the price of coffee in the United States.

a.Show the effect of the frost on Jennifer’s budget constraint.

b.Show the effect of the frost on Jennifer’s optimal consumption bundle assuming that the substitution effect outweighs the income effect for croissants.

c.Show the effect of the frost on Jennifer’s optimal consumption bundle assuming that the income effect outweighs the substitution effect for croissants.

2.Compare the following two pairs of goods:Coke and Pepsi

Skis and ski bindings

In which case do you expect the indifference curves to be fairly straight, and in which case do you expect the indifference curves to be very bowed? In which case will the consumer respond more to a change in the relative price of the two goods?

3.Mario consumes only cheese and crackers.

a.Could cheese and crackers both be inferior goods for Mario? Explain.

b.Suppose that cheese is a normal good for Mario whereas crackers are an inferior good. If the price of cheese falls, what happens to Mario’s consumption of crackers? What happens to his consumption of cheese? Explain.

4.Jim buys only milk and cookies.

a.In 2001, Jim earns $100, milk costs $2 per quart, and cookies cost $4 per dozen. Draw Jim’s budget constraint.

b.Now suppose that all prices increase by 10 percent in 2002 and that Jim’s salary increases by 10 percent as well. Draw Jim’s new budget constraint. How would Jim’s optimal combination of milk and cookies in 2002 compare to his optimal combination in 2001?

5.Consider your decision about how many hours to work.

a.Draw your budget constraint assuming that you pay no taxes on your income. On the same diagram, draw another budget constraint assuming that you pay a 15 percent tax.

b.Show how the tax might lead to more hours of work, fewer hours, or the same number of hours. Explain.

6.Sarah is awake for 100 hours per week. Using one diagram, show Sarah’s budget constraints if she earns $6 per hour, $8 per hour, and $10 per hour. Now draw indifference curves such that Sarah’s labor supply curve is upward sloping when the wage is between $6 and $8 per hour, and backward sloping when the wage is between $8 and $10 per hour.

7.Draw the indifference curve for someone deciding how much to work. Suppose the wage increases. Is it possible that the person’s consumption would fall? Is this

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490	PART SEVEN ADVANCED TOPIC

plausible? Discuss. (Hint: Think about income and substitution effects.)

8.Suppose you take a job that pays $30,000 and set some of this income aside in a savings account that pays an annual interest rate of 5 percent. Use a diagram with a budget constraint and indifference curves to show how your consumption changes in each of the following situations. To keep things simple, assume that you pay no taxes on your income.

a.Your salary increases to $40,000.

b.The interest rate on your bank account rises to 8 percent.

9.As discussed in the text, we can divide an individual’s life into two hypothetical periods: “young” and “old.” Suppose that the individual earns income only when young and saves some of that income to consume when old. If the interest rate on savings falls, can you tell what happens to consumption when young? Can you tell what happens to consumption when old? Explain.

10.Suppose that your state gives each town $5 million in aid per year. The way in which the money is spent is currently unrestricted, but the governor has proposed that towns be required to spend the entire $5 million on education. You can illustrate the effect of this proposal on your town’s spending on education using a budget constraint and indifference-curve diagram. The two goods are education and noneducation spending.

a.Draw your town’s budget constraint under the existing policy, assuming that your town’s only source of revenue besides the state aid is a property tax that yields $10 million. On the same diagram, draw the budget constraint under the governor’s proposal.

b.Would your town spend more on education under the governor’s proposal than under the existing policy? Explain.

c.Now compare two towns—Youngsville and Oldsville—with the same revenue and the same state aid. Youngsville has a large school-age population, and Oldsville has a large elderly population. In which town is the governor’s proposal most likely to increase education spending? Explain.

11.(This problem is challenging.) The welfare system provides income to some needy families. Typically, the maximum payment goes to families that earn no income; then, as families begin to earn income, the welfare payment declines gradually and eventually

disappears. Let’s consider the possible effects of this program on a family’s labor supply.

a.Draw a budget constraint for a family assuming that the welfare system did not exist. On the same diagram, draw a budget constraint that reflects the existence of the welfare system.

b.Adding indifference curves to your diagram, show how the welfare system could reduce the number of hours worked by the family. Explain, with reference to both the income and substitution effects.

c.Using your diagram from part (b), show the effect of the welfare system on the well-being of the family.

12.(This problem is challenging.) Suppose that an individual owed no taxes on the first $10,000 she earned and 15 percent of any income she earned over $10,000. (This is a simplified version of the actual U.S. income tax.) Now suppose that Congress is considering two ways to reduce the tax burden: a reduction in the tax rate and an increase in the amount on which no tax is owed.

a.What effect would a reduction in the tax rate have on the individual’s labor supply if she earned $30,000 to start? Explain in words using the income and substitution effects. You do not need to use a diagram.

b.What effect would an increase in the amount on which no tax is owed have on the individual’s labor supply? Again, explain in words using the income and substitution effects.

13.(This problem is challenging.) Consider a person deciding how much to consume and how much to save for retirement. This person has particular preferences: Her lifetime utility depends on the lowest level of consumption during the two periods of her life. That is,

Utility Minimum {consumption when young, consumption when old}.

a.Draw this person’s indifference curves. (Hint: Recall that indifference curves show the combinations of consumption in the two periods that yield the same level of utility.)

b.Draw the budget constraint and the optimum.

c.When the interest rate increases, does this person save more or less? Explain your answer using income and substitution effects.

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GLOSSARY

ability-to-pay principle—the idea that taxes should be levied on a person according to how well that person can shoulder the burden

absolute advantage—the comparison among producers of a good according to their productivity

accounting profit—total revenue minus total explicit cost

average fixed cost—fixed costs divided by the quantity of output

average revenue—total revenue divided by the quantity sold average tax rate—total taxes paid

divided by total income

average total cost—total cost divided by the quantity of output

average variable cost—variable costs divided by the quantity of output

benefits principle—the idea that people should pay taxes based on the benefits they receive from government services

budget constraint—the limit on the consumption bundles that a consumer can afford

budget deficit—a shortfall of tax revenue from government spending budget surplus—an excess of government receipts over government

spending

capital—the equipment and structures used to produce goods and services

cartel—a group of firms acting in unison

ceteris paribus—a Latin phrase, translated as “other things being equal,” used as a reminder that all variables other than the ones being studied are assumed to be constant

circular-flow diagram—a visual model of the economy that shows how dollars flow through markets among households and firms

Coase theorem—the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own

collusion—an agreement among firms in a market about quantities to produce or prices to charge

common resources—goods that are rival but not excludable

comparable worth—a doctrine according to which jobs deemed comparable should be paid the same wage

comparative advantage—the comparison among producers of a good according to their opportunity cost compensating differential—a difference in wages that arises to offset

the nonmonetary characteristics of different jobs

competitive market—a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker complements—two goods for which

an increase in the price of one leads to a decrease in the demand for the other

constant returns to scale—the property whereby long-run average total cost stays the same as the quantity of output changes

consumer surplus—a buyer’s willingness to pay minus the amount the buyer actually pays

cost—the value of everything a seller must give up to produce a good cost-benefit analysis—a study that compares the costs and benefits

to society of providing a public good

cross-price elasticity of demand—a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price

deadweight loss—the fall in total surplus that results from a market distortion, such as a tax

demand curve—a graph of the relationship between the price of a good and the quantity demanded

demand schedule—a table that shows the relationship between the price of a good and the quantity demanded

diminishing marginal product—the property whereby the marginal product of an input declines as the quantity of the input increases

discrimination—the offering of different opportunities to similar individuals who differ only by race, ethnic group, sex, age, or other personal characteristics

diseconomies of scale—the property whereby long-run average total cost rises as the quantity of output increases

491

dominant strategy—a strategy that is best for a player in a game regardless of the strategies chosen by the other players

economic profit—total revenue minus total cost, including both explicit and implicit costs

economics—the study of how society manages its scarce resources

economies of scale—the property whereby long-run average total cost falls as the quantity of output increases

efficiency—the property of society getting the most it can from its scarce resources

efficiency wages—above-equilibrium wages paid by firms in order to increase worker productivity

efficient scale—the quantity of output that minimizes average total cost

elasticity—a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

equilibrium—a situation in which supply and demand have been brought into balance

equilibrium price—the price that balances supply and demand

equilibrium quantity—the quantity supplied and the quantity demanded when the price has adjusted to balance supply and demand

equity—the property of distributing economic prosperity fairly among the members of society

excludability—the property of a good whereby a person can be prevented from using it

explicit costs—input costs that require an outlay of money by the firm

exports—goods and services that are produced domestically and sold abroad

externality—the impact of one person’s actions on the well-being of a bystander

factors of production—the inputs used to produce goods and services

fixed costs—costs that do not vary with the quantity of output produced

free rider—a person who receives the benefit of a good but avoids paying for it

477

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478 Glossary

492 GLOSSARY

game theory—the study of how people behave in strategic situations

Giffen good—a good for which an increase in the price raises the quantity demanded

horizontal equity—the idea that taxpayers with similar abilities to pay taxes should pay the same amount human capital—the accumulation of investments in people, such as edu-

cation and on-the-job training

implicit costs—input costs that do not require an outlay of money by the firm

import quota—a limit on the quantity of a good that can be produced abroad and sold domestically

imports—goods and services that are produced abroad and sold domestically

in-kind transfers—transfers to the poor given in the form of goods and services rather than cash

income effect—the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve

income elasticity of demand—a measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income

indifference curve—a curve that shows consumption bundles that give the consumer the same level of satisfaction

inferior good—a good for which, other things equal, an increase in income leads to a decrease in demand

inflation—an increase in the overall level of prices in the economy internalizing an externality—altering incentives so that people take ac-

count of the external effects of their actions

law of demand—the claim that, other things equal, the quantity demanded of a good falls when the price of the good rises

law of supply—the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises

law of supply and demand—the claim that the price of any good adjusts to

bring the supply and demand for that good into balance

liberalism—the political philosophy according to which the government should choose policies deemed

to be just, as evaluated by an impartial observer behind a “veil of ignorance”

libertarianism—the political philosophy according to which the government should punish crimes and enforce voluntary agreements but not redistribute income

life cycle—the regular pattern of income variation over a person’s life

lump-sum tax—a tax that is the same amount for every person

macroeconomics—the study of econ- omy-wide phenomena, including inflation, unemployment, and economic growth

marginal changes—small incremental adjustments to a plan of action

marginal cost—the increase in total cost that arises from an extra unit of production

marginal product—the increase in output that arises from an additional unit of input

marginal product of labor—the increase in the amount of output from an additional unit of labor

marginal rate of substitution—the rate at which a consumer is willing to trade one good for another

marginal revenue—the change in total revenue from an additional unit sold

marginal tax rate—the extra taxes paid on an additional dollar of income

market—a group of buyers and sellers of a particular good or service

market economy—an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services

market failure—a situation in which a market left on its own fails to allocate resources efficiently

market power—the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices

maximin criterion—the claim that the government should aim to

maximize the well-being of the worst-off person in society

microeconomics—the study of how households and firms make decisions and how they interact in markets

monopolistic competition—a market structure in which many firms sell products that are similar but not identical

monopoly—a firm that is the sole seller of a product without close substitutes

Nash equilibrium—a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen

natural monopoly—a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms

negative income tax—a tax system that collects revenue from highincome households and gives transfers to low-income households

normal good—a good for which, other things equal, an increase in income leads to an increase in demand normative statements—claims that attempt to prescribe how the world

should be

oligopoly—a market structure in which only a few sellers offer similar or identical products

opportunity cost—whatever must be given up to obtain some item

perfect complements—two goods with right-angle indifference curves

perfect substitutes—two goods with straight-line indifference curves permanent income—a person’s nor-

mal income

Phillips curve—a curve that shows the short-run tradeoff between inflation and unemployment

Pigovian tax—a tax enacted to correct the effects of a negative externality

positive statements—claims that attempt to describe the world as it is

poverty line—an absolute level of income set by the federal government for each family size below which a family is deemed to be in poverty

poverty rate—the percentage of the population whose family income

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falls below an absolute level called the poverty line

price ceiling—a legal maximum on the price at which a good can be sold

price discrimination—the business practice of selling the same good at different prices to different customers

price elasticity of demand—a measure of how much the quantity demanded of a good responds to a change in the price of that good,

computed as the percentage change in quantity demanded divided by the percentage change in price

price elasticity of supply—a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price

price floor—a legal minimum on the price at which a good can be sold

prisoners’ dilemma—a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial

private goods—goods that are both excludable and rival

producer surplus—the amount a seller is paid for a good minus the seller’s cost

production function—the relationship between quantity of inputs used to make a good and the quantity of output of that good

production possibilities frontier— a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology

productivity—the amount of goods and services produced from each hour of a worker’s time

profit—total revenue minus total cost progressive tax—a tax for which

high-income taxpayers pay a larger fraction of their income than do low-income taxpayers

proportional tax—a tax for which high-income and low-income taxpayers pay the same fraction of income

public goods—goods that are neither excludable nor rival

quantity demanded—the amount of a good that buyers are willing and able to purchase

quantity supplied—the amount of a good that sellers are willing and able to sell

regressive tax—a tax for which highincome taxpayers pay a smaller fraction of their income than do low-income taxpayers

rivalry—the property of a good whereby one person’s use diminishes other people’s use

scarcity—the limited nature of society’s resources

shortage—a situation in which quantity demanded is greater than quantity supplied

strike—the organized withdrawal of labor from a firm by a union

substitutes—two goods for which an increase in the price of one leads to an increase in the demand for the other

substitution effect—the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution

sunk cost—a cost that has already been committed and cannot be recovered supply curve—a graph of the relation-

ship between the price of a good and the quantity supplied

supply schedule—a table that shows the relationship between the price of a good and the quantity supplied

surplus—a situation in which quantity supplied is greater than quantity demanded

tariff—a tax on goods produced abroad and sold domestically

tax incidence—the study of who bears the burden of taxation

total cost—the market value of the inputs a firm uses in production

total revenue (for a firm)—the amount a firm receives for the sale of its output

total revenue (in a market)—the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold

Glossary 479

GLOSSARY 493

Tragedy of the Commons—a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole

transaction costs—the costs that parties incur in the process of agreeing and following through on a bargain

union—a worker association that bargains with employers over wages and working conditions

utilitarianism—the political philosophy according to which the government should choose policies to maximize the total utility of everyone in society

utility—a measure of happiness or satisfaction

value of the marginal product—the marginal product of an input times the price of the output

variable costs—costs that do vary with the quantity of output produced

vertical equity—the idea that taxpayers with a greater ability to pay taxes should pay larger amounts

welfare—government programs that supplement the incomes of the needy

welfare economics—the study of how the allocation of resources affects economic well-being

willingness to pay—the maximum amount that a buyer will pay for a good

world price—the price of a good that prevails in the world market for that good

TLFeBOOK