Economic

Theory
Economic
Theory
Gary S. Becker
With the assistance of
Michael Grossman and Robert T. Michael

With a new introduction by the author

!3 Routledge
g^^ Taylor&.Francis Group
LONDON AND NEW YORK
Orginally published in 1971 by Alfred A. Knopf, Inc.

Published 2007 by Transaction Publishers

Published 2017 by Routledge
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and are used only for identification and explanation without intent to
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Library of Congress Catalog Number: 2006050072

Library of Congress Cataloging-in-Publication Data

Becker, Gary Stanley, 1930-
Economic theory / Gary S. Becker
p. cm.
Reprint, originally published: New York : Knopf, 1971.
Includes bibliographical references and index.
ISBN 978-0-202-30980-4 (alk. paper)
1. Microeconomics. I. Title.

HB171.5.B36 2007

ISBN 13: 978-0-202-30980-4 (pbk)

To my girls JUDY and CATHY
 Contents

Introduction to the Transaction Edition xi

Preface xvii

chapter 1 Introduction 1

1 What Is Economics? 1
The Role of Prices 3
2 Supply and Demand Analysis 4

PART ONE
Demand Analysis

chapter 2 The Scarcity Principle 11

3 Definition of Demand 11
Elasticity of Demand 12
4 The Opportunity Set 14
Income Effects 16
5 Substitution Effects 19

chapter 3 Indifference Curves 25

6 Rational Behavior 25
The Indifference System 26
7 Demand Curves 29
Engel Curves 31
8 Combined Demand Curves 35
Market Demand and Engel Curves 38
vii
viii Contents

9 Differences in Tastes 42

*1 0 Revised Approach to Consumer Choice 45

Environmental Variables 47
Appendix 48

11 Utility Analysis 50

chapter 4 Uncertainty 57

12 Uncertainty 57
Expected Utility Theory 58
*1 3 Insurance and States of the World 61

14 Uncertainty and Search 65

PART TWO
Supply of Products

chapter 5 Fundamentals of Supply 69

15 The Firm and Profit Maximization 69

Firm and Market Supply Curves 71

16 Marginal and Average Cost 74

Economic Rent 77
17 Short and Long Run 79

18 External Effects 84

chapter 6 Competition and Monopoly 89

19 The Comparative Statics of Competitive

Equilibrium 89
The Stability of Equilibrium 91

20 Monopoly 94
"Natural" Monopoly 95
21 Collusion 98
Price
22 Discrimination 102
23 Non-price Rationing 106
 1X
Contents

PART THREE
Production and the Demand for Factors

chapter 7 Production by the Firm and Industry 113

24 Production Functions 113

The Cost-Minimizing Conditions 115
Appendix 117
25 Cost Curves 119
Increasing and Decreasing Costs 120
26 Technological Change 124
Appendix 128
*27 Induced Technological Change 129

chapter 8 Demand for Factors 135

28 Derived Demand for Factors of Production 135

Fixed Quantities of Other Factors 136
Fixed Prices of Other Factors 137
29 Substitution Between Factors 139
Appendix 142
30 Substitution Between Industries: A Numerical
Example 144
A Single Industry 144
Two Industries 146
31 Substitution Between Industries: A General
Model 149
Appendix 150

PART FOUR
Supply of Factors of Production

chapters Human Capital 159

32 Land, Labor, and Capital 159

Population 160
33 Labor Force Participation 162
 Contents

34 Nonmarket Activities 165

Occupational Choice 166
Appendix 169
35 Investment in Training 172
36 Differences in Abilities and Opportunities 177
The Distribution of Earnings 179
Appendix 180

chapter 10 Accumulation of Capital over Time

37 Consumption and Savings 184

38 The Rate of Growth in Consumption 191
Appendix 193
*39 The Determination of Interest Rates 195
The Rate of Investment = Savings 200
*4Q Growth Paths 202
Appendix 204

General Problems 210

Bibliography—Reading List 214

Index 219
 Introduction to the
Transaction Edition

This book is a combination of a reprint of my 1971 book, Economic Theory, and

a collection of more than fifty unpublished problems from the graduate course on
price theory that Kevin Murphy and I have taught at the University of Chicago.
Economic Theory was essentially a written version of a year-long graduate course
on price theory that I gave for many years at Columbia University. The problem
book is joint work by Kevin Murphy, Ivan Werning, and myself. Ivan was an out-
standing student at Chicago who helped work out the answers, and he wrote them
up. He is fast becoming an important economist in his own right.
Ordinarily, in an economics book that combines systematic discussion of theo-
retical materials with many problems, the discussion is the foundation of the book,
while the problems test understanding of the theoretical analysis, and illustrate how
it can be applied to real-world issues. Only by doing many challenging problems
can students really gain command of the concepts that are the essence of economics,
and appreciate how these help understand issues that arise in the real world.
The emphasis in this book is somewhat different because the systematic analysis
is a reprint and the problems are new. So in an important sense, the reprinted Eco-
nomic Theory is background material for the problems published for the first time.
These problems cover four fields: (1) consumption, including household production,
aggregation, and choices over time through investments in capital; (2) uncertainty
that includes expected utility and the role of lotteries; (3) the role of competitive
equilibrium in analyzing social interactions, crime, hedonics, economic growth,
and many other questions; 4) imperfect competition, including monopoly, hold-ups
in bargaining, and price controls.
Few of the problems simply ask to prove that a set of conclusions Y follows from
a set of assumptions X. Instead the problems mainly require the use of economic

xi
xii Introduction to the Transaction Edition

theory to analyze issues that arise in the real world. Technical exercises are useful
in learning the technical concepts that form the basis of economic theory, but an
economist must know how to apply these concepts to real-world problems.
Of course, highly technical exercises may be quite difficult, but my experience
is that students nowadays generally have less trouble with technique than students
in the past had because students now are much better prepared in mathematics,
probability theory, engineering, and other technical subjects. However, a technical
background does not better prepare students to use economic concepts to under-
stand behavior, the consequences of public policies, and natural events in the world
around us, or in worlds that existed in the past. Some even argue, I am not sure they
are right, that better technical training is partly at the expense of a greater study of
history and the humanities that would have helped students get a better "feel" or
intuition for economic applications.
The fact is that the vast majority of advanced undergraduates or graduate eco-
nomics students, whether in the past or at present, start out with little intuition for
economics. Fortunately, economic intuition, like a command of technical concepts,
can be learned despite the dictionary association of the word "intuition" with the
ability to know something without the need for reasoning. Economic intuition can
be greatly improved through lectures that give many applications of economic
theory and analysis. But no matter how many applications in the lectures, a working
command of economic tools, a good economic "intuition," requires trying to solve
problems that deal with individual and market responses to changes in incomes,
prices, technologies, market structure, institutions, policies, and natural events.
The problems in this book will help provide such a working command of econom-
ics. Most of the new problems are not easy, many are difficult, and trying to solve
them will help improve one's working knowledge of economic theory. To assist
in learning how to apply this theory to particular questions, detailed answers are
provided to all but a small number of the new problems. Studying these answers,
after trying to answer them before reading our answers, is an important part of the
training in how to use economic concepts.
Some of the problems and answers deal with important economic questions that I
believe are "new," and could be converted into articles for economics journals. Examples
include aggregation and household production exercises in Part 1, the approach to
non-convexities and lotteries in Part 2, in Part 3 the "referral" exercise, the discussion
of the optimal slaughtering of turkeys, the analysis of migration and social capital,
and some of the common property exercises, and in Part 4 the pricing of durable
goods when there is expected technological progress, the determination and effects
of geographic clusters, and economic aspects of the determination of queues.
Economic Theory also contains problems at the end of each lecture. Many of
these are still interesting and useful, and also test knowledge of economic concepts.
These problems are on the whole easier than the new ones, but some are challenging
(they are marked with an asterisk [*], including parts of some problems). These
harder problems include one on social interactions (problem 8.4), on why educa-
Introduction to the Transaction Edition xiii

tion improves health even when more educated persons spend less on medical care
(10.1), on the interaction between self-protection and market insurance (13.1), on
whether racial discrimination occurs under perfect competition (16.5), on whether
there is over-or under-investment in new knowledge (27.2), on the effects of unions
on wages (28.7), on the effects of migration between countries on wages and rental
rates on capital (31.2), and on how changes in mortality rates impact consumption
and savings (38.4).
As this course on price theory has evolved over time, it has preserved the em-
phasis on providing a useful command of economic tools and concepts, but we now
use more mathematics than is found in Economic Theory. This is partly because
students nowadays have better math backgrounds than my Columbia students had,
and partly because economics has evolved toward a much greater use of mathemat-
ics. I was fortunate to have studied much mathematics and statistical theory as an
undergraduate and graduate student, which allowed me to keep up with the transition
to the greater emphasis on mathematical analysis and reasoning.
The course has evolved in content as well as in tools used. Although Economic
Theory discusses capital theory, especially in lectures 17 and 35-40, we now pay
more attention to capital accumulation by firms and industries. This is partly in re-
sponse to significant developments in the analysis of dynamic choices over time.
Lectures 39-40 use basic price-theoretical tools to analyze savings and invest-
ments for whole economies. Lecture 40 even sketches out a model of economic
growth that is in the same spirit as modern models of endogenous economic growth.
Any course in price theory that extends over at least two semesters should show
how the tools the course develops are applicable to interest rate determination,
investment by an economy, and economic progress, even when such materials are
also discussed in courses on macroeconomics.
Economic Theory discusses decision making under uncertainty, as seen from
lectures 12-14,17, and 21, but our course now pays greater attention to uncertainty.
This is mainly in response to the considerable progress since the book was published
in understanding decision making with private information, portfolio, and option
theory in finance, consumption, and investment over time when individuals, firms,
and governments must form expectations about future events and behavior, and
laboratory and field experiments that study choices of individuals and firms when
faced with uncertainty in controlled settings. Our course and the new problems
cover a few of these topics.
Economic Theory has essentially nothing on game theory, and the new set of
problems has little. I studied game theory closely when an undergraduate since I
was a student of Oskar Morgenstern, and graduate students at Princeton that I knew,
including John Nash, Lloyd Shapley, and Martin Shubik, were very interested in
the then new subject of game theory. Some of them went on to make pioneering
contributions to the progress of that field, such as Nash's dissertation on what is
now called "Nash equilibrium." Game theory surely now deserves serious attention
in any two-semester course on microeconomics.
xiv Introduction to the Transaction Edition

Yet I would be amiss if I failed to express my belief that while developments in

game theory have been important to economics, many graduate courses in microeco-
nomics exaggerate its significance for understanding how actual economies operate.
These economies mainly organize resources with markets, and strategic decisions
against opponents play a secondary role in most of these markets. Examples include
agriculture, equities, bonds, and derivatives in developed financial markets, retail and
wholesale markets, computers, and many other high-tech markets, and most services,
such as those provided by doctors, hospitals, and schools. This is why our course
and the new problems emphasize how behavior in implicit and explicit markets is
affected by different variables, and gives less attention to strategic considerations
than would be merited in a more complete treatment of economic principles.
Economic Theory and the new problems discuss several subjects that should but
are not usually included in microeconomics courses. One example is the extensive
analysis of household production, and the allocation of time between and within
the market and non-market sectors (see lectures 9-10, and 32-34), and many of the
problems in section 1 of the new set). Analysis of the allocation of time is now
used in economics not only in discussing hours worked for pay, but also the time
students invest in producing education and other human capital, and changes in the
allocation of time in the course of economic development. Household production
theory has become crucial to analyzing human capital and fertility decisions, and
also increasingly in both micro and macro aspects of technological progress not
only in markets but also in households.
In its discussion of both demand and supply, Economic Theory pays more atten-
tion to heterogeneity (see, for example, lectures 8, 34, and 36) than is common in
other textbooks. Heterogeneity is important because both supply and demand for
outputs and inputs are greatly influenced by the cumulative distribution of "entry
points" of individuals and firms to an occupation, industry, or consumer market.
Market demand and supply functions cannot be analyzed by a representative agent
formulation when heterogeneous responses make a big difference to results.
Economic Theory discusses systematically the theory of investment in educa-
tion and other human capital (see lectures 35-36). This discussion also includes
an interesting model of the distribution of earnings based on differences among
individuals in their rates of return on investments in human capital, in their in-
vestments, and in the interaction between their investments and rates of return.
The theory of investment in human capital has many elements in common with
the theory of investment in physical capital since in both cases investments now
produce benefits in the future. However, human capital theory has to be treated
separately because it has important aspects that are very different from the theory
of physical and financial capital. These differences include the crucial significance
of the time of investors, such as college students, in the creation of human capital,
the importance of parental human capital and parental resources in determining
the accumulation of human capital by children, and the close links between human
capital investments in children and parental decisions about family size.
Introduction to the Transaction Edition xv

The material in this book is partly composed of a reprint of a book that empha-
sizes developing an understanding of how to use economic analysis. This reprinted
book also contains some materials that are not yet fully absorbed into the teaching
of economics. In addition, the new book contains a previously unpublished collec-
tion of problems with answers that essentially is a book itself. This problem book
is more formal and mathematical than the reprinted book of lectures, and discusses
some issues and forms of analysis that had not yet been developed when Economic
Theory was published. The combination of the emphasis on economic intuition and
formal analysis, and on both older and newer developments in economics provide, I
believe, a stimulating, valuable, and challenging way to help master the concepts and
results of economics that are so important in understanding the world we live in.
 Preface

For more than a decade I gave a course on price theory to first-

year graduate students at Columbia. The course tries to
present a rigorous and systematic statement of the principles
economists have developed to understand the allocation of re-
sources. The emphasis of the course, however, has been on the
value of these principles in understanding the world about us.
The lectures during the academic year 1967-1968 were re-
corded, and Michael Grossman and Robert Michael converted
the transcribed oral presentation into a readable written draft.
Their task was formidable since an oral presentation is more
repetitive and relies more on diagrams, discussion, and even
"atmosphere" than a written presentation should. They did an
excellent job and their appearance on the title page is only a
small expression of my indebtedness to them.
Although I converted their draft into a final draft, I tried to
preserve the flavor and content, including the informality, of
the lectures rather than to aim at a complete text on theory. In
particular, since the lectures reflect my own interests and ap-
proach to different subjects, some important subjects, such as
activity analysis, are only discussed in passing, and the approach
to consumer behavior, for example, is not the typical one. The
more difficult lectures are marked with an asterisk (*) and can
be omitted on a first reading.
The most efficient way to learn economic theory is to solve
many problems that test one's understanding. To this end I en-
courage discussion during the lectures, including the discussion
XVll
 Preface

of queries that I put to the class. Many of these queries are

included, usually in the form of a Why? after a sentence, and
students should try seriously to answer them before passing on
to new materials. More difficult problems have been assigned
each week for students to take home, write up, and discuss at a
weekly lab session. A number of these are included at the end of
each lecture, as well as some easier ones from written examina-
tions. Students should try to solve all the easier problems and at
least some of the more difficult ones (marked with an asterisk).
It is difficult to choose the appropriate mathematical level of
the presentation, especially since the mathematical sophistica-
tion of students has improved rapidly in recent years. I have
placed extended mathematical discussions in footnotes and
appendixes, and mathematically prepared readers should study
these carefully. Practically all statements proved mathematically
are also proved geometrically or verbally in the body of the text,
and other students can rely on these.
The perhaps presumptuous title of Economic Theory is used
instead of a title like Micro Theory or Price Theory because of my
belief that there is only one kind of economic theory, not
separate theories for micro problems, macro problems, nonmarket
decisions, and so on. Indeed, the most promising development
in recent years in the literature on unemployment and other macro
problems has been the increasing reliance on utility maximization
and the other principles used to study micro problems.
Armen Alchian read an earlier draft thoroughly and gave me
numerous valuable suggestions and criticisms. I also received
helpful comments from Jack Hirshliefer, Jacob Mincer, and
George Stigler. Sara Paroush drew the charts. Last, but far from
least, let me record my appreciation to the able students who were
in charge of the lab sessions and did much of the teaching in the
course: Isaac Ehrlich, Reuben Gronau, Gerald Jantscher, William
Landes, John Owen, Michael Rahm, and Robert Reischauer.
Gary S. Becker
 chapter
1
Introduction

LECTURE 1

What Is Economics?
What is economics? One definition by a well-known economist is that
economics is what economists do. This is obviously circular and was meant
to illustrate the difficulty of rigidly defining a subject matter that has changed
so much over time. A more serious definition is that economics is the study
of the allocation of scarce means to satisfy competing ends. Air is not usually
scarce, and ordinarily there is no economic problem in the use of air since
nothing else must be forfeited. In recent years, however, especially in our
urban communities, there has been considerable interest in and concern about
air pollution. We can make the air cleaner than it is; for example, Con Edison
and the City Government of New York (probably the two major polluters in
New York City) can use more costly methods to reduce their discharge of
air pollutants. So clean air is often scarce, and cleaner air can be achieved
only by using resources that could be used to satisfy some other end. The
ends must be competing in order that value judgments or choices of different
kinds are involved. When there are no alternatives, there is no problem of
choice and, therefore, no economic problem.
Most important, observe how wide the definition is. It includes the choice
of a car, a marriage mate, and a religion; the allocation of resources within a
family; and political discussions about how much to spend on education or on
fighting a Vietnam war. These all use scarce resources to satisfy competingends.
In terms of what most economists generally do, however, this definition is
too broad. Particularly in Western countries, economists are primarily con-
cerned with the operation of the market sector in an industrialized economy.
Yet I will often argue, and this is perhaps the unique theme of these lectures,
that the economic principles developed for this sector are relevant to all
problems of choice.
For example, economic analysis has been useful in understanding the labor
force participation of children and wives, the allocation of time to various
nonmarket activities, and family formation. It has also been used with some

1
2 Introduction

insight in understanding competition among political parties for elected

office. Even illegal behavior and the forces, both monetary and psychic, that
determine entry into criminal activities can be usefully analyzed within an
economic framework.
Similarly, in recent years economists in Communist countries, such as
Russia, Yugoslavia, Hungary, and Czechoslovakia, have discovered that the
principles developed by Western economists—involving profits, prices, and
interest rates—are of great relevance to their own economies. They often
call them by different names, but the concepts are the same. Within our own
economy, economic principles are currently being applied with some effect
to rather inefficient nonprofit organizations like hospitals and universities.
It is frequently asserted that traditional economic principles are of little
relevance in underdeveloped countries having large subsistence sectors and
small market sectors. Dean1 has studied the allocation of labor in a poor
African country between a subsistence, a cash crop (tobacco), and a hired
labor sector. He shows that shifts among these sectors resulting from changes
in wages and tobacco prices are similar to those observed in the United States
and other developed countries.
Although much of our discussion is also related to the market sector in
industrialized economies, the principles being developed are frequently
applied to other sectors and different kinds of choices. It is my belief that
economic analysis is essential in understanding much of the behavior tradi-
tionally studied by sociologists, anthropologists, and other social scientists.
This is a true example of economic imperialism! In other words, I argue that
the broad definition of economics in terms of scarce means and competing
ends should be taken seriously and should be a source of pride rather than
embarrassment to economists since it provides insights into a wide variety
of problems.
At the same time, our coverage is severely limited in a number of ways.
The emphasis is on the allocation of resources under full employment condi-
tions, and little attention is given to fluctuations in the price level, unemploy-
ment, or aggregate output. We do not, however, abstract from growth, and
we plan to say a fair amount about growth in output, capital, labor, and
technology. But fluctuations around trends, including serious fluctuations
like the Great Depression, are not covered even though the same basic
economic principles are also useful in understanding fluctuations.
In different words, we can say that microeconomics, not macroeconomics,
is the subject matter of these lectures. The lectures are most emphatically,
however, not confined to microeconomics in the literal sense of microunits
like firms or households. Our main interest, as is that of most economists,
is in the market behavior of aggregations of firms and households. Although
important inferences are drawn about individual firms and households, we
try mainly to understand aggregate responses to changes in basic economic
parameters like tax rates, tariff schedules, technology, or antitrust provisions.
1
Edwin Dean, The Supply Response of African Farmers (The Netherlands: North Holland
Publishing Company, 1966).
Introduction: Lecture 1 3

Another important restriction is that these are primarily lectures on what

is called positive economics—the actual, not the desired, behavior of markets
and economies. We try to determine, for example, what happens to employ-
ment or housing when the government imposes a minimum wage or rent
control, without asking very extensively whether these policies should be
followed. It is significant that the analysis developed by economists to under-
stand actual behavior has been their major contribution to determining
desired behavior, so that indirectly these lectures are also of great relevance to
what is called welfare economics.

The Role of Prices

Every society, regardless of its methods of organization, must somehow
determine what is produced, how it is produced, and how that product is
distributed. The basis of economics is choice, and an economy certainly has
many choices among different products, including the choice of how much
to set aside for future growth. Choice enters again in determining how to
produce, for a variety of techniques and combinations of factors (different
kinds of labor, capital, and raw materials) can usually be used to produce
the same thing. Finally, there is choice in how to distribute what is produced,
that is, choice about the personal distribution of income.
In a complete dictatorship, which even the most centralized economies have
never experienced, one person or group makes all these choices. In decen-
tralized market economies like our own, families, governments, and other
organizations influence what to produce. They do so not primarily through
the ballot box but by the way they spend their resources in the market place.
There is a kind of proportional representation in which the influence of each
person is not fixed nor shared equally, but is strictly proportional to his
command over resources. Influence is exerted by offering to exchange these
resources for the goods and services that are desired.
In this process prices play a crucial role even in the nonmarket sector where
monetary prices do not exist, for economists have ingeniously discovered
"shadow prices" that perform the same function. Because prices are so
important, lectures on microeconomic theory can be said to be lectures on
price theory. For example, an increase in the demand for product A and a
decrease in that for B will bid up the price of A and force down that of B.
These price movements encourage resources to enter the industry producing
A and leave the industry producing B and thus help accommodate the change
in influence.
In addition, prices determine how production is organized. If the price of
capital decreased relative to the price of labor, firms would use more capital
relative to labor, or if the price of skilled labor decreased relative to that of
unskilled labor, they would use relatively more skilled labor. It is quite
obvious that prices of factors, together with the personal distribution of the
supplies of factors, in turn determine the personal distribution of income.
4 Introduction

The latter determines the distribution of influence, and the process starts over
again.
A central planning bureau could in principle determine what to produce,
methods of production, and the distribution of products without relying on
prices, but relying instead on input-output tables, resource constraint equa-
tions, and the like. Efforts to downgrade prices, however, have led to
bottlenecks, unwanted surpluses, and a myriad of problems and complaints.
This is why the main thrust of economic reform in Eastern Europe countries
has been toward greater reliance on market prices in guiding economic
decisions. One of the important goals of these lectures is to demonstrate how
market prices influence these decisions.
These lectures cover systematically the various parts of price theory. We
begin at one end of the economic system with the demand for final products,
and move from there into the rest of the system. A discussion of the supply
of final products leads directly into cost conditions. Implicit in the latter is
the derived demand for factors of production, which in turn leads into an
analysis of production functions. Finally, the supply of factors of production
is considered—the supply of labor in general and to particular occupations
and the supply of nonhuman capital. This discussion naturally directs our
attention to savings, investment, and other forces determining economic
growth, that is, to changes over time in the aggregate level of resources.

LECTURE 2
Supply and Demand Analysis
The three basic economic decisions are obviously closely related: what to
produce may depend on the distribution of income, just as the latter may
depend on what and how it is produced. Thus it has been said that in
economics everything depends upon everything else. Critics have even
accused economists of circular reasoning when describing the operation
of the interdependent pricing mechanism.
The French economist Walras analyzed this problem of interdependence
and showed that there is no circular reasoning, just mutual determination or
general equilibrium. Anyone who has studied high school algebra knows
that each of the unknowns in a system of simultaneous equations can
be determined1 provided a sufficient number of independent relations are
1
Assume that the variable X-i depends on X2 according to the relation
Xi = 5*2-4
and that X2 at the same time depends on X^ according to
X2 = Xj. - 8
The reader can easily verify that these equations are mutually consistent if, and only if, X2 = 3
and X± = 11.
Introduction: Lecture 2 5

available. Walras similarly demonstrated that all prices and quantities in

the economic system can be simultaneously determined because there are a
sufficient number of independent supply and demand equations. Walras'
demonstration was a major achievement with far-reaching implications,
perhaps the greatest achievement of nineteenth-century economics—simple
as it appears to a modern student.
The problem facing someone trying to learn about the economic world is:
Given its apparent complexity and interdependency, how can it be made
amenable to analysis? One approach is to say: "The world is complex,
there is no escape from this. Realistically, it must be recognized that the
demand for, say, butter, depends not only on the price of butter but also
on the prices of margarine, lard, apples, beef, automobiles, machinists,
economists; you name it, it is relevant." This approach takes the Walrasian
equations and their interdependencies seriously and makes no attempt to
reduce them to a simpler form.
A second approach, more pragmatic and in the English tradition, argues
that to solve practical problems one must find a way to break into Walras'
complex system. The analyst must be able to concentrate on the few variables
he considers important for a particular problem and neglect the variables he
considers unimportant. In the economist's own language, he must allocate
the limited resources available to him for a particular study in the most efficient
manner, which means considering just enough variables to obtain sufficiently
accurate answers.
To continue with the butter illustration, the more pragmatic economist
would want to consider the price of butter and probably the level of income,
the price of margarine, and the size of the population as well. But he would
neglect thousands and thousands of other variables that in principle might
have an influence—the prices of beef, labor, and capital, tariff policies, and so
on. The variables considered would not always remain the same. A law that
prevents the artificial coloring of margarine could be quite important because
it would reduce the demand for margarine and increase the demand for butter.
Although the variables considered are not rigidly fixed, they are always a
small fraction of the number entering Walras' system.
The major tool that has been invented to simplify the economic world is
supply and demand analysis, brought to its highest development by Alfred
Marshall. Supply and demand are the "engines of analysis" that enable an
investigator to discuss systematically the variables he considers pertinent for
a particular problem. They enable him to use his limited resources efficiently
to obtain sufficiently accurate answers. Although often called partial-
equilibrium analysis, a more accurate name for the supply-demand approach
would be "practical general equilibrium analysis."
On one level, supply and demand analysis is simply a language or classifica-
tion scheme: How does variable X affect the demand function, variable Y the
supply function, and variable Z both ? The classification of animals has been
a useful language in zoology, and many other languages have been extremely
useful in other scientific fields. The language of supply and demand has been
 Introduction

I
I
I
Relative price 1
of butter

D'

Quantity/unit time
FIGURE 2.1

especially fruitful in solving economic problems because of the assumption

that many variables affect either demand functions or supply functions, but not
both. This assumption is no longer simply part of a language, but is a strong
condition imposed on behavior. Its great empirical significance is that it
permits one to reach conclusions about the effects of various changes on prices
and outputs with relatively little information.
Suppose, for example, the price of margarine declined because an excise
tax was removed. This would shift the supply curve of margarine to the right,
lowering its price and thereby inducing the public to substitute margarine for
butter, which would shift the demand curve for butter to the left. But it would
have a negligible impact on the supply curve since butter and margarine are
produced with very different resources, although soybean fields can make good
cow feed. The hypothesis that the demand curve and not the supply curve for
butter is altered by a change in the price of margarine, along with some other
assumptions, permits a simple analysis of the responses in the butter market.
In Figure 2.1, DD and SS are the initial supply and demand curves for butter
drawn on the assumption that the price of margarine is fixed, and the
initial market equilibrium is given by their intersection. Removal of the tax
reduces the price of margarine and thus reduces the demand for butter at
any given butter price, but does not change supply conditions. The leftward
shift of the demand curve to D'D' reduces both the price and quantity
of butter.
To reach these important qualitative conclusions, we assumed (1) the
direction of shift in the demand curve, (2) no shift in the supply curve, and (3)
the signs of the slopes of the demand and supply curves. From such limited
information, the direction of price and quantity movements in the butter
market could be predicted. These predictions explain why butter producers
lobby for higher taxes on margarine regardless of whether the form is anti-
coloring provisions or a straight excise tax.