Chapter 1

/>“The case for looting”

/>“Why are we getting so fat? A few theories on America’s
weight problem”

/>“Is your life worth $10 million?”

/>“The readers weigh in: your theories on why America
is getting fatter”

/>“Phony Generosity: economics Nobelist Vernon Smith’s
alarming discovery about human nature”
/>“Click, Clack and Car Talk”

Chapter 4
/>“Putting all your potatoes in one basket: the economic
lessons of the Great Famine”

Chapter 5

/>“Flying pork barrels: the airline bailout enriches stockholders
at the expense of taxpayers”
/>“Making your tax rebate pay”
/>“The first one now will be last: a foolproof method to
shorten queues”

/>“One small step for man…and one giant step for economics”

Chapter 9
Chapter 6
/>“The crazy incentives of the drug war”

/>“Great expectations? The war’s going worse than expected.
So what?”
/>“Afghanistan after the war: don’t give them democracy.
Give them capitalism”

Chapter 8
/>“How much should hotel web access cost?”

Chapter 11
/>“Is housing too expensive?”

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Chapter 13

Chapter 18

/>“We find ourselves guilty: should we punish juries that
get it wrong?”

/>“The NFL’s party perplexity: the salary cap is one of
the mysteries of the universe”

Chapter 14


Chapter 19

/>“Short changed: why do tall people make more money?”

/>“Why do gays smoke so much?”
/>“Beat on the brat: the economics of spanking”

Chapter 16
/>“Why Jews don’t farm”
/>“Hey, gorgeous, here’s a raise”
/>“Microwave oven liberation”

/>“The great banana revolution: should you peel bananas
from the bottom up?”
/>“Sell me a story: two skyscrapers, built in the same block.
One’s much taller. Why?”
/>“Don’t ask, don’t tell: campaign-finance reform”

Chapter 17

/>“If eBay ran the election: who would buy the votes and
what would they pay?”

/>“No relief: why we shouldn’t aid Katrina’s victims too much”

/>“Why God created junk food”

/>“Don’t pay down the national debt”


/>“Why men pay to stay married”
/>“Attack of the Giant Shopping Carts!!!”
/>“The Return of the Giant Shopping Carts!!!”

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PRICE THEORY
and Applications
EIGHTH EDITION

Steven E. Landsburg
University of Rochester

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

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Price Theory and Applications
Eighth Edition
Steven E. Landsburg
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About the Author
Steven E. Landsburg is a Professor of Economics at the University of Rochester. His
articles have appeared in the Journal of Political Economy, the Journal of Economic
Theory, and many other journals of economics, mathematics, and philosophy. He is
the author of six books, including More Sex Is Safer Sex: The Unconventional Wisdom
of Economics (Free Press/Simon and Schuster 2006) and *The Big Questions: Tackling
the Problems of Philosophy with Ideas from Mathematics, Economics and Physics (Free
Press/Simon and Schuster 2009). He writes regularly for Slate magazine and has written
for Forbes, the New York Times, the Washington Post, and dozens of other publications.

He blogs regularly at www.ThebigQuestions.com/blog.

Dedication:
To the Red-Headed Snippet

iii
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Brief Contents
Chapter 1

Supply, Demand, and Equilibrium 1

Chapter 2

Prices, Costs, and the Gains from Trade 31

Chapter 3

The Behavior of Consumers 45
Appendix: Cardinal Utility 77

Chapter 4


Consumers in the Marketplace 81

Chapter 5

The Behavior of Firms 115

Chapter 6

Production and Costs 137

Chapter 7

Competition 171

Chapter 8

Welfare Economics and the Gains from Trade 223
Appendix: Normative Criteria 275

Chapter 9

Knowledge and Information 283

Chapter 10

Monopoly 317

Chapter 11

Market Power, Collusion, and Oligopoly 357


Chapter 12

The Theory of Games 399

Chapter 13

External Costs and Benefits 417

Chapter 14

Common Property and Public Goods 459

Chapter 15

The Demands for Factors of Production 477

Chapter 16

The Market for Labor 501

Chapter 17

Allocating Goods Over Time 525

Chapter 18

Risk and Uncertainty 563

Chapter 19


What Is Economics? 599
Appendix A Calculus Supplement 619
Appendix B Answers to All the Exercises 645
Appendix C Answers to Problem Sets 657
Glossary 673
Index 681

v
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Contents
Preface xiii

CHAPTER 3

The Behavior of Consumers 45
3.1 Tastes

CHAPTER 1

Supply, Demand,
and Equilibrium 1
1.1

Demand

1


Demand versus Quantity
Demanded 1
Demand Curves 2
Changes in Demand 3
Market Demand 7
The Shape of the Demand Curve 7
The Wide Scope of Economics 10

1.2 Supply

10

Supply versus Quantity Supplied 10

1.3 Equilibrium

13

The Equilibrium Point 13
Changes in the Equilibrium Point 15

Summary 23
Author Commentary 24
Review Questions 25
Numerical Exercises 25
Problem Set 26

45


Indifference Curves 45
Marginal Values 48
More on Indifference Curves 53

3.2 The Budget Line and the
Consumer’s Choice 53
The Budget Line 54
The Consumer’s Choice 56

3.3 Applications of Indifference
Curves 59
Standards of Living 59
The Least Bad Tax 64

Summary 69
Author Commentary 69
Review Questions 70
Numerical Exercises 70
Problem Set 71
Appendix to Chapter 3 77
Cardinal Utility 77
The Consumer’s Optimum 79

CHAPTER 4

Consumers in the Marketplace 81
CHAPTER 2

Prices, Costs, and the Gains
from Trade 31

2.1 Prices

31

Absolute versus Relative Prices 32
Some Applications 34

2.2 Costs, Efficiency, and Gains from
Trade 35
Costs and Efficiency 35
Specialization and the Gains from
Trade 37
Why People Trade 39

Summary 41
Author Commentary 41
Review Question 41
Numerical Exercises 42
Problem Set 42

4.1 Changes in Income

81

Changes in Income and Changes in the
Budget Line 81
Changes in Income and Changes in the
Optimum Point 82
The Engel Curve 84


4.2 Changes in Price

85

Changes in Price and Changes in the
Budget Line 85
Changes in Price and Changes in the
Optimum Point 86
The Demand Curve 88

4.3 Income and Substitution
Effects 90
Two Effects of a Price Increase 90
Why Demand Curves Slope
Downward 94
The Compensated Demand Curve 99

vi
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vii

CONTENTS

4.4 Elasticities

Short-Run Average Cost versus
Long-Run Average Cost 163


100

Income Elasticity of Demand 100
Price Elasticity of Demand 102

Summary 164
Author Commentary 165
Review Questions 165
Numerical Exercises 166
Problem Set 167

Summary 105
Author Commentary 106
Review Questions 106
Numerical Exercises 107
Problem Set 109

CHAPTER 7
CHAPTER 5

Competition 171

The Behavior of Firms 115

7.1

Revenue 173
The Firm’s Supply Decision 174
Shutdowns 177

The Elasticity of Supply 180

5.1 Weighing Costs and
Benefits 116
A Farmer’s Problem 116
The Equimarginal Principle 120

5.2 Firms in the Marketplace

The Competitive Firm 171

121

Revenue 122
Costs 125

Summary 131
Author Commentary 131
Review Questions 131
Numerical Exercises 132
Problem Set 133
CHAPTER 6

Production and Costs 137
6.1 Production and Costs in the
Short Run 137
The Total, Marginal, and Average
Products of Labor 138
Costs in the Short Run 141


6.2 Production and Costs in the
Long Run 147
Isoquants 147
Choosing a Production Process 151
The Long-Run Cost Curves 154
Returns to Scale and the Shape
of the Long-Run Cost Curves 157

6.3 Relations Between the Short Run
and the Long Run 159
From Isoquants to Short-Run Total
Cost 159
From Isoquants to Long-Run Total
Cost 160
Short-Run Total Cost versus Long-Run
Total Cost 161
A Multitude of Short Runs 162

7.2 The Competitive Industry in the
Short Run 180
Defining the Short Run 180
The Competitive Industry’s Short-Run
Supply Curve 181
Supply, Demand, and Equilibrium 182
Competitive Equilibrium 182
The Industry’s Costs 185

7.3 The Competitive Firm in the Long
Run 186
Long-Run Marginal Cost and

Supply 186
Profit and the Exit Decision 186
The Firm’s Long-Run Supply
Curve 188

7.4 The Competitive Industry in the
Long Run 189
The Long-Run Supply Curve 190
Equilibrium 193
Changes in Equilibrium 195
Application: The Government as a
Supplier 198
Some Lessons Learned 199

7.5 Relaxing the Assumptions

199

The Break-Even Price 200
Constant-Cost Industries 201
Increasing-Cost Industries 201
Decreasing-Cost Industries 203
Equilibrium 204

7.6 Applications

204

Removing a Rent Control 204
A Tax on Motel Rooms 207

Tipping the Busboy 208

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viii

CONTENTS

7.7 Using the Competitive Model
Summary 211
Author Commentary 212
Review Questions 212
Numerical Exercises 213
Problem Set 217

209

9.2 Asymmetric Information

CHAPTER 8

Welfare Economics and the Gains
from Trade 223

9.3 Financial Markets

Summary 311
Author Commentary 311

Review Questions 311
Problem Set 312

Consumers’ and Producers’
Surplus 224

233

Consumers’ Surplus and the Efficiency
Criterion 234
Understanding Deadweight Loss 238
Other Normative Criteria 241

8.3 Examples and Applications

242

CHAPTER 10

Monopoly 317
10.1

Subsidies 242
Price Ceilings 244
Tariffs 247
Theories of Value 252

8.4 General Equilibrium and the
Invisible Hand 254
The Fundamental Theorem of Welfare

Economics 255
An Edgeworth Box Economy 257
General Equilibrium with
Production 260

Summary 265
Author Commentary 266
Review Questions 266
Problem Set 267
Appendix to Chapter 8

275

Normative Criteria 275
Some Normative Criteria 276
Optimal Population 280

Author Commentary 281
CHAPTER 9

Knowledge and Information 283
9.1 The Informational Content of
Prices 283
Prices and Information 283
The Costs of Misallocation 288

308

Efficient Markets for Financial
Securities 308

Stock Market Crashes 310

8.1 Measuring the Gains from
Trade 224

8.2 The Efficiency Criterion

297

Signaling: Should Colleges Be
Outlawed? 297
Adverse Selection and the Market
for Lemons 300
Moral Hazard 302
Principal–Agent Problems 303
A Theory of Unemployment 306

Price and Output under
Monopoly 318
Monopoly Pricing 318
Elasticity and Marginal
Revenue 319
Measuring Monopoly
Power 320
Welfare 323
Monopoly and Public Policy 324

10.2 Sources of Monopoly
Power 328
Natural Monopoly 328

Patents 330
The History of Photography: Patents in
the Public Domain 331
Resource Monopolies 332
Economies of Scope 332
Legal Barriers to Entry 332

10.3 Price Discrimination

333

First-Degree Price Discrimination 334
Third-Degree Price Discrimination 336
Two-Part Tariffs 345

Summary 348
Author Commentary 349
Review Questions 349
Numerical Exercises 350
Problem Set 351

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


ix

CONTENTS

Pareto Optima versus Nash

Equilibria 410

CHAPTER 11

Market Power, Collusion,
and Oligopoly 357
11.1

Acquiring Market Power

12.2 Sequential Games
358

Mergers 358
Horizontal Integration 358
Vertical Integration 361
Predatory Pricing 363
Resale Price Maintenance 365

11.2

Collusion and the Prisoner’s
Dilemma: An Introduction to
Game Theory 369
Game Theory and the Prisoner’s
Dilemma 370
The Prisoner’s Dilemma and the
Breakdown of Cartels 373

11.3


Regulation

Summary 413
Author Commentary 414
Problem Set 414
CHAPTER 13

External Costs and Benefits 417
13.1

Oligopoly

13.2 The Coase Theorem

13.3 Transactions Costs

Contestable Markets 385
Oligopoly with a Fixed Number
of Firms 387

11.5

Monopolistic Competition and
Product Differentiation 390

417

424


The Doctor and the Confectioner 425
The Coase Theorem 427
The Coase Theorem in the
Marketplace 429
External Benefits 432
Income Effects and the Coase
Theorem 433

377

385

The Problem of Pollution

Private Costs, Social Costs, and
Externalities 417
Government Policies 420

Examples of Regulation 377
What Can Regulators Regulate? 382
Creative Response and Unexpected
Consequences 382
Positive Theories of Regulation 384

11.4

411

An Oligopoly Problem 411


436

Trains, Sparks, and Crops 436
The Reciprocal Nature of the
Problem 438
Sources of Transactions Costs 439

13.4 The Law and Economics

Monopolistic Competition 390
The Economics of Location 392

443

The Law of Torts 443
A Positive Theory of the Common
Law 446
Normative Theories of the Common
Law 448
Optimal Systems of Law 449

Summary 392
Author Commentary 393
Review Questions 393
Numerical Exercises 394
Problem Set 396

Summary 449
Author Commentary 450
Review Questions 450

Problem Set 451

CHAPTER 12

The Theory of Games 399
12.1

Game Matrices

399

Pigs in a Box 399
The Prisoner’s Dilemma Revisited 401
Pigs in a Box Revisited 402
The Copycat Game 405
Nash Equilibrium as a Solution
Concept 405
Mixed Strategies 407
Pareto Optima 408

CHAPTER 14

Common Property and Public
Goods 459
14.1

The Tragedy of the
Commons 459
The Springfield Aquarium 459
It Can Pay to Be Different 463

Common Property 465

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x

CONTENTS

14.2 Public Goods

467

16.2 Labor Market Equilibrium

Some Market Failures 467
The Provision of Public Goods 468
The Role of Government 469
Schemes for Eliciting Information 471
Reaching the Efficient Outcome 471

Summary 472
Review Questions 473
Numerical Exercises 473
Problem Set 473

509

Changes in Nonlabor Income 510

Changes in Productivity 510

16.3 Differences in Wages

514

Human Capital 514
Compensating Differentials 515
Access to Capital 516

16.4 Discrimination

517

CHAPTER 15

Theories of Discrimination 518
Wage Differences Due to Worker
Preferences 519
Human Capital Inheritance 519

The Demand for Factors of
Production 477

Summary 520
Review Questions 521
Problem Set 521

15.1


The Firm’s Demand for Factors
in the Short Run 477
The Marginal Revenue Product
of Labor 477
The Algebra of Profit Maximization 479
The Effect of Plant Size 482

15.2 The Firm’s Demand for Factors
in the Long Run 483
Constructing the Long-Run Labor
Demand Curve 483
Substitution and Scale
Effects 485
Relationships Between the Short Run
and the Long Run 488

15.3 The Industry’s Demand Curve for
Factors of Production 490
Monopsony 490

15.4 The Distribution of
Income 492
Factor Shares and Rents 492
Producers’ Surplus 494

CHAPTER 16

The Market for Labor 501
Individual Labor Supply


Allocating Goods Over
Time 525
17.1

Bonds and Interest Rates

525

Relative Prices, Interest Rates, and
Present Values 526
Bonds Denominated in Dollars 529
Default Risk 530

17.2 Applications

531

Valuing a Productive Asset 531
Valuing Durable Commodities:
Is Art a Good Investment? 532
Should You Pay with Cash or Credit? 533
Government Debt 534
Planned Obsolescence 535
Artists’ Royalties 536
Old Taxes Are Fair Taxes 537
The Pricing of Exhaustible
Resources 538

17.3 The Market for Current
Consumption 539


Summary 496
Review Questions 497
Numerical Exercises 498
Problem Set 499

16.1

CHAPTER 17

501

Consumption versus Leisure 501
Changes in the Budget Line 504
The Worker’s Supply of Labor 506

The Consumer’s Choice 539
The Demand for Current
Consumption 542
Equilibrium and the Representative
Agent 544
Changes in Equilibrium 546

17.4 Production and Investment

552

The Demand for Capital 552
The Supply of Current
Consumption 553

Equilibrium 554

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xi

CONTENTS

19.2 The Rationality Assumption

Summary 556
Author Commentary 556
Review Questions 556
Problem Set 557

19.3 What Is an Economic
Explanation? 606

CHAPTER 18

Celebrity Endorsements 606
The Size of Shopping Carts 607
Why Is There Mandatory
Retirement? 608
Why Rock Concerts Sell Out 609
99¢ Pricing 610
Rationality Revisited 611


Risk and Uncertainty 563
18.1

Attitudes Toward Risk

563

Characterizing Baskets 565
Opportunities 566
Preferences and the Consumer’s
Optimum 568
Gambling at Favorable Odds 573
Risk and Society 575

18.2 The Market for Insurance

19.4 The Scope of Economic
Analysis 611

576

Laboratory Animals as Rational
Agents 611

Imperfect Information 576
Uninsurable Risks 578

18.3 Futures Markets

603


The Role of Assumptions in Science 603
All We Really Need: No Unexploited
Profit Opportunities 604

Author Commentary 615
Problem Set 615

578

Speculation 579

18.4 Markets for Risky Assets

581

Portfolios 582
The Geometry of Portfolios 583
The Investor’s Choice 585
Constructing a Market Portfolio 588

18.5 Rational Expectations

589

A Market with Uncertain Demand 589
Why Economists Make Wrong
Predictions 592

Summary 595

Author Commentary 596
Review Questions 596
Problem Set 597

APPENDIX A

Calculus Supplement 619
APPENDIX B

Answers to All the Exercises 645
APPENDIX C

Answers to Problem Sets 657
Glossary
Index

673

681

CHAPTER 19

What Is Economics? 599
19.1

The Nature of Economic
Analysis 599
Stages of Economic Analysis 599
The Value of Economic Analysis 602


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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


Preface
To the Student
Price theory is a challenging and rewarding subject. The student who masters price
theory acquires a powerful tool for understanding a remarkable range of social phenomena. How does a sales tax affect the price of coffee? Why do people trade? What
happens to ticket prices when a baseball player gets a raise? How does free agency affect
the allocation of baseball players to teams? Why might the revenue of orange growers
increase when there is an unexpected frost—and what may we infer about the existence
of monopoly power if it does?
Price theory teaches you how to solve similar puzzles. Better yet, it poses new ones.
You will learn to be intrigued by phenomena you might previously have considered
unremarkable. When rock concerts predictably sell out in advance, why don’t the promoters raise prices? Why are bank buildings fancier than supermarkets? Why do ski
resorts sell lift tickets on a per-day basis rather than a per-ride basis?
Throughout this book, such questions are used to motivate a careful and rigorous
development of microeconomic theory. New concepts are immediately illustrated with
entertaining and informative examples, both verbal and numerical. Ideas and techniques are allowed to arise naturally in the discussion, and they are given names (like
“marginal value”) only after you have discovered their usefulness. You are encouraged
to develop a strong economic intuition and then to test your intuition by submitting it
to rigorous graphical and verbal analysis.
I think that you will find this book inviting. There are neither mathematical
demands nor prerequisites and no lists of axioms to memorize. At the same time, the
level of economic rigor and sophistication is quite high. In many cases, I have carried
analysis beyond what is found in most other books at this level. There are digressions,

examples, and especially problems that will challenge even the most ambitious and
talented students.

Using This Book
This is a book about how the world works. When you finish the first chapter, you will
know how to analyze the effects of sales and excise taxes, and you will have discovered
the surprising result that a tax on buyers and a tax on sellers have exactly the same
effects. When you finish the second chapter, you will understand why oranges, on average, taste better in New York than in Florida. In each succeeding chapter, you will be
exposed to new ideas in economics and to their surprising consequences for the world
around you.
To learn what price theory is, dig in and begin reading. The next few paragraphs
give you a hint of what it’s all about.
Price theory, or microeconomics, is the study of the ways in which individuals and
firms make choices, and the ways in which these choices interact with each other. We
assume that individuals have certain well-defined preferences and limits to their behavior. For example, you might enjoy eating both cake and ice cream, but the size of your
xiii
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


xiv

PREFACE

stomach limits your ability to pursue these pleasures; moreover, the amount of cake
that you eat affects the amount of ice cream you can eat, and vice versa.
In predicting behavior, we assume that individuals behave rationally, which is to
say that they make themselves as well-off as possible, as measured by their own preferences, and within the limitations imposed on them. While this assumption (like any
assumption in any science) is only an approximation to reality, it is an extraordinarily
powerful one, and it leads to many profound and surprising conclusions.

Price theory is made richer by the fact that each individual’s choices can affect the
opportunities available to others. If you decide to eat all of the cake, your roommate
cannot decide to eat some too. An equilibrium is an outcome in which each person’s
behavior is compatible with the restrictions imposed by everybody else’s behavior. In
many situations, it is possible to say both that there is only one possible equilibrium
and that there are good reasons to expect that equilibrium to actually come about. This
enables the economist to make predictions about the world.
Thus, price theory is most often concerned with two sorts of questions: those that
are positive and those that are normative. A positive question is a question about what
is or will be, whereas a normative question is a question about what ought to be. Positive
questions have definite, correct answers (which may or may not be known), whereas
the answers to normative questions depend on values.
For example, suppose that a law is proposed that would prohibit any bank
from foreclosing on any farmer’s mortgage. Some positive questions are: How will
this law affect the incomes of bankers? How will it affect the incomes of farmers?
What effect will it have on the number of people who decide to become farmers
and on the number of people who decide to start banks? Will it indirectly affect
the average size of farms or of banks? Will it indirectly affect the price of land?
How will it affect the price of food and the well-being of people who are neither
farmers nor bankers? and so forth. A normative question is: Is this law, on balance, a good thing?
Economics can, at least in principle, provide answers to the positive questions.
Economics by itself can never answer a normative question; in this case your answer to
the normative question must depend on how you feel about the relative merits of helping farmers and helping bankers.
Therefore, we will be concerned in this book primarily with positive questions.
However, price theory is relevant in the consideration of normative questions as
well. This is so in two ways. First, even if you are quite sure of your own values, it
is often impossible to decide whether you consider some course of action desirable
unless you know its consequences. Your decision about whether to support the
antiforeclosure law will depend not only on your feelings about farmers and bankers, but also on what effects you believe the law will have. Thus, it can be important
to study positive questions even when the questions of ultimate interest are normative ones.

For another example, suppose that you have decided to start recycling newspapers
to help preserve large forests. One of your friends tells you that in fact recycling leads to
smaller forests because it lowers the demand for trees and induces paper companies to
do less planting. Whether or not your friend is correct is a positive question. You might
want the answer to that positive question before returning to the normative question:
Should I continue to recycle?
The second way in which price theory can assist us in thinking about normative
questions is by showing us the consequences of consistently applying a given normative
criterion. For example, if your criterion is “I am always for anything that will benefit
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
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PREFACE

farmers, provided that it does not drive any bankers out of business,” the price theorist
might be able to respond, “In that case, you must support such-and-such law, because
I can use economic reasoning to show that such-and-such law will indeed benefit farmers without driving any bankers out of business.” If such-and-such law does not sound
like a good idea to you, you might want to rethink your normative criterion.
In the first seven chapters of this book, you will receive a thorough grounding in the positive aspects of price theory. You will learn how consumers make
decisions, how firms make decisions, and how these decisions interact in the
competitive marketplace. In Chapter 8, you will examine the desirability of
these outcomes from the viewpoints of various normative criteria. Chapter
9 rounds out the discussion of the competitive price system by examining
the role of prices as conveyors of information. In Chapters 10 through 14, you
will learn about various situations in which the competitive model does not
fully apply. These include conditions of monopoly and oligopoly, and circumstances in which the activities of one person or firm affect others involuntarily
(e.g., factories create pollution that their neighbors must breathe).
The first 14 chapters complete the discussion of the market for goods, which are
supplied by firms and purchased by individuals. In Chapters 15 through 17 you will

learn about the other side of the economy: the market for inputs to the production
process (such as labor) that are supplied by individuals and purchased by firms. In
Chapter 17, you will study the market for the productive input called capital and examine the way that individuals allocate goods across time, consuming less on one day so
that they can consume more on another.
Chapter 18 concerns a special topic: the role of risk.
Chapter 19 provides an overview of what economics in general, and price theory
in particular, is all about. Most of the discussion in that final chapter could have been
included here. However, we believe that the discussion will be more meaningful after you
have seen some examples of price theory in action, rather than before. Therefore, we make
the following suggestion: Dip into Chapter 19. Not all of it will make sense at this point, but
much of it will. After you have been through a few chapters of the book, dip into Chapter 19
again. Even the parts you understood the first time will be more meaningful now. Later
on—say, after you have finished Chapter 7—try it yet again. You will get the most from the
final chapter if you read it one last time, thoroughly, at the end of the course.

Features
This book provides many tools to help you learn. Here are a few hints on how to use
them.

Exhibits
Most of the exhibits have extensive explanatory captions that summarize key points
from the discussion in the text.

Exercises
Exercises are sprinkled throughout the text. They are intended to slow you down
and make sure that you understand one paragraph before going on to the next. If
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xv



xvi

PREFACE

you cannot do an exercise quickly and accurately, you have probably missed an
important point. In that case, it is wise to pause and reread the preceding few paragraphs. Answers to all of the exercises are provided in Appendix B at the back of
the book.

Dangerous Curves
The dangerous curve symbol appears periodically to warn you against the most common misunderstandings. Passages marked with this symbol describe mistakes that
students and theorists often make and explain how to avoid them.

Marginal Glossary
Each new term is defined in bold in the text and in the margin, where you can easily
find it. All of the definitions in the margin glossary are gathered in alphabetical order
in the Glossary at the back of the book.

Chapter Summaries
The summaries at the end of each chapter provide concise descriptions of the main
ideas. You will find them useful in organizing your study.

Author Commentaries
I’ve written a number of magazine articles that use price theory to illuminate every
aspect of human behavior. Many of these can be found on the text Web site at http://
www.cengage.com/economics/landsburg. Click on the companion site for the
text, select a chapter from the drop-down list at the left of the screen, and click on
the Author Commentaries link in the left menu. Finally, click the download link to
download the commentary. Slate articles can also be accessed on this companion site.

Additional articles can be found through an archive search on the Slate magazine home
page at . Magazine articles, featuring examples that are relevant to
many chapters, are noted on the inside cover of this text. The author regularly blogs at
www.TheBigQuestions.com/blog, where you will often find material directly related to
what you are learning in this book.

Review Questions
The Review Questions at the end of each chapter test to see whether you have learned
and can repeat the main ideas of the chapter.

Numerical Exercises
About half of the chapters have Numerical Exercises at the end. By working these, you
apply economic theory to data to make precise predictions. For example, at the end of
Chapter 7, you are given some information about the costs of producing kites and the
demand for kites. Using this and the theory that you have learned, you will be able to
deduce the price of kites, the number of kites sold by each firm, and the number of
firms in the industry.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PREFACE

xvii

Problem Sets
The extensive Problem Sets at the end of each chapter occupy a wide range of difficulty.
Some are quite straightforward. Others are challenging and open-ended and give you
the opportunity to think deeply and creatively. Often, problems require additional

assumptions that are not explicitly stated. Learning to make additional assumptions is a
large part of learning to do economics. In some cases there will be more than one correct answer, depending on what assumptions you made. Thus, in answering problems
you should always spell out your reasoning very carefully. This is particularly important in “true or false” problems, where the quality of your explanations will usually matter far more than your conclusion.
About one third of the problems are discussed in Appendix C at the end of the
book. These problems are indicated by a shaded box around the problem number. The
discussions in Appendix C range from hints to complete answers. In many cases, the
answer section lists only conclusions without the reasoning necessary to support them;
your instructor will probably require you to provide that reasoning.
If your instructor allows it, you will learn a lot by working on problems together
with your classmates. You may find that you and they have different answers to the
same problem, and that both you and they are equally sure of your answers. In attempting to convince each other, and in trying to pinpoint the spot at which your thinking
diverged, you will be forced to clarify your ideas and you will discover which concepts
you need to study further. Now you are ready to begin.

To the Instructor
One advantage of teaching the same course every semester is that you constantly discover new ways to help students understand and enjoy the subject. I’ve taught price
theory 50 times now, and am eager to share the best of my recent discoveries.
The seventh edition of this book, like the six that preceded it, was well received
by both students and instructors. I’ve therefore continued to preserve the book’s basic
structure and the many features that have been recognized as highlights—the clarity
of the writing, the careful pedagogy (including “Dangerous Curves” signals to warn
students of common misunderstandings), the lively examples, and the wide range of
exercises and problems.
At the same time, I’ve continued my practice of rewriting several sections for even
greater clarity. These include discussions of Giffen goods in Chapter 4 and a of long
run competitive equilibrium (including the break-even condition) in Chapter 7. In
Chapter 8, I’ve added a passage to emphasize that economic inefficiency always entails
a missed opportunity to do good, and in Chapter 9 I’ve added some discussion of the
extraordinary series of economic events that began in 2008. The biggest change is
in Chapter 13, on externalities, which I’ve extensively reorganized to emphasize the

importance of both Pigovian and Coasian insights.
But I’ll repeat here what I said in the previous edition: While I am very pleased
with these improvements and innovations, I have not tampered with the fundamental
structure and content of the book, which I expect will be as satisfactory to the next
generation of students as it was to the previous. The standard topics of intermediate
price theory are covered in this edition, and in the previous versions. I have retained all
of the book’s unique features, of which the following are the most important.

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xviii

PREFACE

Use of Social Welfare as a Unifying Concept
Consumers’ and producers’ surplus are introduced in Chapter 8, immediately following the theory of the competitive. There they are used to analyze the effects of various
forms of market interference. Thereafter, most new concepts are related to social welfare and analyzed in this light.

The Economics of Information
Chapter 9 (Knowledge and Information) surveys the key role of prices in disseminating information and relates this to their key role in equilibrating markets. Section 9.1
emphasizes the price system’s remarkable success in this regard while Section 9.3 surveys some of its equally remarkable failures. Section 9.2 studies information in financial
markets.

Treatment of Theory of the Firm
It is often difficult for students to understand the importance of production functions,
average cost curves, and the like until after they have been asked to study them for several weeks. To remedy this, Chapter 5 (The Behavior of Firms) provides an overview of
how firms make decisions, introducing the general principle of equating marginal costs
with marginal benefits and relating this principle back to the consumer theory that the

student has just learned.
Having seen the importance of cost curves, students may be more motivated to
study their derivation in Chapter 6 (Production and Costs). The material on firms is
presented in a manner that gives a lot of flexibility to the instructor. Those who prefer
the more traditional approach of starting immediately with production can easily skip
Chapter 5 or postpone it until after Chapter 6. Chapter 6 itself has been organized to
rigorously separate the short-run theory (in Section 6.1) from the long-run theory (in
Section 6.2). Relations between the short and the long run are thoroughly explored in
Section 6.3. Instructors who want to defer the more difficult topic of long-run production will find it easy to simply cover Section 6.1 and then move directly on to Chapter 7.

Extended Analysis of Market Failures, Property Rights,
and Rules of Law
This is the material of Chapter 13, which I have found to be very popular with students.
The theory of externalities is developed in great detail, using a series of extended examples and illustrated with actual court cases. Section 13.4 (The Law and Economics)
analyzes various legal theories from the point of view of economic efficiency.

Relationships to Macroeconomics
The topic coverage provides a solid preparation for a rigorous course in macroeconomics. In addition, several purely “micro” topics are illustrated with “macro” applications. (None of these applications is central to the book, and all can be skipped easily
by instructors who wish to do so.) There are sections on information, intertemporal
decision making, labor markets in general equilibrium, and rational expectations. In
the chapter on interest rates, there is a purely microeconomic analysis of the effects

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PREFACE

xix


of federal deficits, including Ricardian Equivalence, the hypotheses necessary for it
to hold, and the consequences of relaxing these hypotheses. (This material has been
extensively rewritten and simplified for this edition.) The section on rational expectations, in Chapter 18, is presented in the context of a purely micro problem, involving
agricultural prices, but it includes a discussion of “why economists make wrong predictions” with a moral that applies to macroeconomics.

Other Nontraditional Topics
There are extensive sections devoted to topics excluded from many standard intermediate textbooks. Among these are alternative normative criteria, efficient asset
markets, contestable markets, antitrust law, mechanisms for eliciting private information about the demand for public goods, human capital (including the external
effects of human capital accumulation), the role of increasing returns in economic
growth, the Capital Asset Pricing Model, and the pricing of stock options. The
book concludes with a chapter on the methods and scope of economic analysis
(titled What Is Economics?), with examples drawn from biology, sociology, and
history.

Supplements
The Instructor’s Manual contains the following features in each chapter: general discussion, teaching suggestions, suggested additional problems, and solutions to all of the
end-of-chapter problems in the textbook. The Manual can be downloaded by instructors from the text Web site.
The Test Bank, prepared by Brett Katzman, Kennesaw State University, Kennesaw,
GA, offers true/false questions, multiple-choice questions, and essay questions for each
chapter. It has been significantly expanded for this edition.
The Study Guide, prepared by William V. Weber, Eastern Illinois University,
Charleston, IL, has chapters that correspond to the textbook. Each chapter contains
key terms, key ideas, completion exercises, graphical analyses, multiple-choice
questions, questions for review, and problems for analysis. Artwork from the text is
reprinted in the Study Guide, with ample space to take notes during classroom discussion.
PowerPoint slides of exhibits from the text are also available for classroom use,
and can be accessed at the text Web site. PowerPoint slides incorporating lecture notes
and exhibits, also available on the Web site, were prepared by Raymonda Burgman,
DePauw University, Greencastle, IN.


®

Text Web Site
The text Web site is located at On
the Price Theory Web site are several of the text supplements, teaching resources, learning resources, links to the Author Commentary articles, and additional Slate articles.
In addition, easy access is provided to the EconNews, EconDebate, EconData, and
EconLinks Online features at the South-Western Economics Resource Center.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


xx

PREFACE

Acknowledgments
I first learned economics at the University of Chicago in the 1970s, which means
that I learned most of it, directly or indirectly, from Dee McCloskey. Generations of
Chicago graduate students were infected by Dee’s enthusiasm for economics as a tool
for understanding the world, and the members of one generation communicated their
exuberance to me. They, and consequently I, learned from Dee that the world is full of
puzzles—not the abstract or technical puzzles of formal economic theory, but puzzles
like: Could the advent of free public education cause less education to be consumed?
We learned to see puzzles everywhere and to delight in their solutions. Later, I had the
privilege to know Dee as a friend, a colleague, and the greatest of my teachers. Without
Dee, this book would not exist. The exuberance that Dee personifies is endemic at
Chicago, and I had the great good fortune to encounter it every day. I absorbed ideas
and garnered examples in cafeterias, the library’s coffee lounge, and especially in allnight seminars at Jimmy’s Woodlawn Tap. Many of those ideas and examples appear in
this book, their exact sources long forgotten. To all who contributed, thank you.

Among the many Chicago students who deserve explicit mention are Craig Hakkio,
Eric Hirschhorn, and Maury Wolff, who were there from the beginning. John Martin
and Russell Roberts taught me much and contributed many valuable suggestions
specifically for this book. Ken Judd gave me a theory of executive compensation. Dan
Gressell taught me the two ways to get a chicken to lay more eggs.
I received further education, and much encouragement, from the Chicago faculty. I
thank Gary Becker, who enticed me to think more seriously about economics; Sherwin
Rosen, who had planted the seeds of all this years before; and José Scheinkman, who
listened to my ideas even when they were foolish. Above all, Bob Lucas can have no
idea of how grateful I have been for his many gracious kindnesses. I remember them
all, and value his generosity as I value the inspiration of his intellectual depth, honesty,
and rigor.
Since leaving Chicago, my good fortune in colleagues followed me to Iowa and
Cornell, and especially to Rochester, where this book was written. There is no faculty
member in economics at Rochester who did not contribute to this book in one way
or another. Some suggested examples and problems; others helped me learn material
that I had thought I understood until I tried to write about it; and many did both. I
should name them all, but have space for only a few. William Thomson taught me
about mechanisms for revealing the demand for public goods and suggested that they
belonged in a book at this level. Walter Oi contributed more entertaining ideas and
illustrations than I can remember and told me how Chinese bargemen were paid. Ken
McLaughlin dazzled me with insights on pretty much a daily basis. And the late Alan
Stockman started teaching me both economics and the joys of economics from the day
I met him until the day he died.
I must also mention the contributions of the daily lunch group at the Hillside
Restaurant, where no subject is off limits and no opinion too outrageous for consideration. The daily discussions about how society is or should be structured were punctuated by numerous tangential discussions of how various ideas could best be presented
in an intermediate textbook. I thank especially Stockman, McLaughlin, Mark Bils, John
Boyd, Jim Kahn, Marvin Goodfriend (the first inductee into the Hillside Hall of Fame),
and various part-time members.
Harold Winter’s extensive written criticism of Chapter 11 led to substantial

improvements. His many contributions specifically for this edition are acknowledged

Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


PREFACE

above and gratefully acknowledged again here. Wendy Betts gave me the epigram for
Section 9.3.
We gratefully acknowledge the contributions of the following reviewers whose
comments and suggestions have improved this project:
Ted Amato, University of North Carolina—Charlotte
John Antel, University of Houston
Charles A. Berry, University of Cincinnati
Jay Bloom, SUNY—New Paltz
James Bradfield, Hamilton College
Victor Brajer, California State University—Fullerton
Raymonda Burgman, DePauw University
Satyajit Chatterjee, University of Iowa
Jennifer Coats, St. Louis University
John Conant, Indiana State University
John P. Conley, University of Illinois
John Conley, University of Illinois—Urbana
John Devereux, University of Miami
Arthur M. Diamond, University of Nebraska—Omaha
John Dodge, Calvin College
Richard Eastin, University of Southern California
Carl E. Enomoto, New Mexico State University
Claire Holton Hammond, Wake Forest University

Dean Hiebert, Illinois State University
John B. Horowitz, Ball State University
Roberto Ifill, Williams College
Paul Jonas, University of New Mexico
Kenneth Judd, University of Chicago
Elizabeth Sawyer Kelly, University of Wisconsin—Madison
Edward R. Kittrell, Northern Illinois University
Vicky C. Langston, Austin Peay State University
Daniel Y. Lee, Shippensburg University
Luis Locay, University of Miami
Barry Love, Emory & Henry College
Chris Brown Mahoney, University of Minnesota
Devinder Malhotra, University of Akron
Joseph A. Martellaro, Northern Illinois University
John Martin, Baruch College
Scott Masten, University of Michigan
J. Peter Mattila, Iowa State University
Sharon Megdal, Northern Arizona University
Jack Meyer, Michigan State University
Robert J. Michaels, California State University—Fullerton
John Miller, Clarkson University
David Mills, University of Virginia
H. Brian Moehring, Ball State University
Robert Molina, Colorado State University
John Mullen, Clarkson University
Kathryn A. Nantz, Fairfield University

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.


xxi