# ECONOMIC THEORY AND OPERATIONS ANALYSIS

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1 WILLIAM J. BAUMOL Professor of Economics Princeton University ECONOMIC THEORY AND OPERATIONS ANALYSIS Second Edition Prentice-Hall, I Inc. Engkwood Cliffs, New Jersey

2 CONTENTS PART 7 ANALYTIC TOOLS OF OPTIMIZATION 1 1 Optimization and an Example from Inventory Analysis 3 1. Optimization a Basic Viewpoint. 2. Optimality Analysis in Operations Research. 3. The Role of Optimality in Economic Analysis. 4. Illustration: A Simple Inventory Problem. 5. Determination of the Cost Relationship. 6. The Optimality Calculation. 2 Some Elementary Mathematics Functions. 2. Slope. 3. Linear and Other Simple Equations. 4. Exponents: Definitions and Elementary Rules of Manipulation. 5. Logarithms Notation. 3 Marginal Analysis Marginal Reasoning and the Logic of Decision-Making. 2. Theorems on Resource Allocation. 3. Totals, Averages, and Marginals: Their Arithmetic Relationships. 4. Geometry of Marginal Analysis: Total x Curves. 5. Marginal and Average x Curves. 6. Marginal Analysis and Fixed Costs. 7. Average vs. Marginal Figures in Business Practice. 8. Averages as Approximations to Marginal Figures. 9. First- and Second-Order Optimality Conditions. 10. Global, Local, and. Corner Maxima. 11. The Second-Order Conditions and Stability. 4 Maximization, Minimization, and Elementary Differential Calculus Differential Calculus and Marginal Analysis. 2. Rules of Differentiation. 3. Geometric Interpretation: The First-Order Maximum Condition. 4. Nondifferentiability and Limited Variable Range Problems. 5. Second-Order Conditions of Maximization and Minimization. 6. Local and Global Optima. 7. Maximization in Many-Variable Relationships: Partial Differentiation. 8. Constrained Maxima: Lagrange Multipliers. 9. Some Economic Applications of the Differential Calculus. ix

3 Contents 5 Linear Programming Some Standard Programming Problems. 2. Characteristics of Programming. 3. Algebra and Geometry. 4. Slack Variables, Feasible Solutions, and Basic Solutions. 5. The Basic Theorem and the Simplex Method. 6. The Initial Basic Solution, Feasibility, and Optimality Criteria. 7. The Next Basic Solution: The Pivoting Process. 8. Special Pivoting Rules. 9. Choosing the Pivot. 10. Illustration: Another Pivot Step. 11. The Initial Basic Solution and the "Feasibility Program." 6 Duality The Dual Problem. 2. Economic Interpretation of the Dual Problem. 3. Some Duality Theorems. 4. Duality and Decentralized Decision-Making. 5. Solution of the Primal and Dual Programs. Appendix: On the Derivation of the Duality Theorems. 7 Nonlinear Programming Algebraic Notation and Example. 2. Geometric Representation: Nonlinear Constraints. 3. Geometry of Nonlinear Objective Functions. 4. Convex and Nonconvex Regions. 5. Concave and Convex (Objective) Functions. 6. Nonlinearities and the Basic Theorem of Linear Programming. 7. Methods of Nonlinear Computation. 8. The Kuhn-Tucker Theorems. 8 Integer Programming Problems Where Noninteger Solutions Are Meaningless. 2. Nonconvex Feasible Region Problems. 3. Increasing Returns: The Fixed Charges Problem. 4. The Method of Solution. 5. Illustrations of the Integer Programming Computation. 6. The Dual Prices and Marginal Valuation. PART 2 MICROECONOMIC ANALYSIS Theory of Demand ' Demand Curves. 2. Shifting Demand Curves: Demand Functions. 3. Elasticity: A Measure of Responsiveness. 4. Properties of the Elasticity Measure. 5. Utility Analysis of Demand. 6. Indifference Maps: Ordinal and Cardinal Utility. 7. Properties of Indifference Curves. 8. Price Lines: Consumer Income and Prices. 9. Equilibrium of the Consumer. 10. Responses to Price and Income Changes. 11. Income and Substitution Effects: The Slutsky Theorem. 12. Revealed Preference. 13. Revealed Preference and Index Numbers of Real Income. 14. Elementary Mathematics of Demand Analysis. 15. The n Commodity Slutsky Theorem and Revealed Preference.

4 Confenfs x; 70 On Empirical Determination of Demand Relationships Why Demand Functions? 2. Interview Approaches to Demand Determination. 3. Direct Market Experiments. 4. Standard Statistical Approaches. 5. Omission of Important Variables. 6. Inclusion of Mutually Correlated Variables. 7. Simultaneous Relationship Problems. 8. The Identification Problem. 9. Least Squares Bias in Simultaneous Systems. 10. Concluding Comments. Appendix: Notes on Identification and Simultaneous Equation Estimation. 1. Some Identification Theorems. 2. Criteria for Evaluating Simultaneous Equation Estimation Methods. S. Maximum Likelihood Method: General Description. 4- Advantages and Disadvantages of the Full-Information Maximum-Likelihood Method. 5. Structural Equations and Reduced-Form Equations: Definitions. 8. The Reduced-Form Method. 7. The Limited-Information Method. 8. The Method of Instrumental Variables. 9. The Method of Two- Stage Least Squares. 11 Production and Cost Production, Inputs, and Outputs. 2. The Production Function. 3. Relative Input Levels and Production. 4. Diminishing Returns. 5. Returns to Scale. 6. Production Indifference-Curve Analysis. 7. Price Line and Expansion Path. 8. Linear Homogeneous Production Functions. 9. Derivation of Cost Curves. 10. Long Run and Short Run: Definitions. 11. Long-Run and Short-Run Average Costs. 12. Some Elementary Mathematics of Production Theory. 7 2 Linear Programming and the Theory of Production Why a Programming Reexamination of Production Theory? 2. An Alternative Linear Programming Diagram. 3. Illustrative Example. 4. The Feasible Region. 5. Representation of a Process. 6. Production Indifference Curves: Construction. 7. Some Properties of the Indifference Curves. 8. Profit Indifference Curves. 9. Graphic Solution of the Programming Problem. 10. Alternative Types*of Solutions. 11. Cost Curves in Linear Programming. 12. Marginal, Total, and Average Input Products. 13. Conclusion. 73 The Firm and Its Objectives Alternative Objectives of the Firm. 2. The Profit-Maximizing Firm. 3. Application: Pricing and Cost Changes. 4. Extension: Multiple Products and Inputs. 5. Price-Output Determination: Sales Maximization. 6. Advertising. 7. Choice of Input and Output Combinations. 8. Pricing and Changes in Fixed Costs and Taxes. 9. Satisficing and Behavior Analysis. 10. Profit and Sales Maximization: Sample Calculations.

5 xii Contents 14 Market Structure, Pricing, and Output Classification of Market Structures. 2. The Profit-Maximizing Competitive Firm. 3. Equilibrium in the Competitive Industry. 4. Supply Curves: Some Comments. 5. Pure Monopoly. 6. Monopolistic Competition (Product Differentiation). 7. Monopsony. 8. Remarks on Discriminating Monopoly. 9. Bilateral Monopoly. 10. Oligopolistic Interdependence. 11. Stability of Oligopoly Arrangements: Kinked Demand Curves. 12. Reaction Curves and Oligopolistic Pricing. 13. Monopoly, Duopoly, and Discrimination: Elementary Mathematical Analysis. 7 5 Genera/ Equilibrium and the Theory of Money Interdependence in the Economy: Substitutes and Complements. 2. Equations of General Equilibrium. 3. The Redundant Equation: Walras' Law. 4. Pitfalls in Determination of the Price Level. 5. The Real Balance Effect. 6. Comparative Statics: General Equilibrium Analysis. 7. Optimal Cash Balances. 7 6 General Equilibrium and Welfare Economics Resource Allocation and General Equilibrium. 2. Marginal Rules for Optimal Resource Allocation. 3. Optimal Distribution of Products Among Consumers. 4. Optimal Use of Resources in Producing Given Outputs. 5. Marginal Rule for Optimal Output Levels. 6. An Optimal Price System. 7. Pure Competition and Monopoly. 8. Centralized Planning Without Central Direction. 9. External Economies and Diseconomies of Production and Consumption. 10. Some Standard Theorems of Welfare Economics. 11. Criteria for Welfare Judgments. 12. A Theorem on Democratic Group Decisions. 13. Concluding Remarks. 17 Theory of Distribution Inputs in Fixed Supply. 2. Backward-Rising Input Supply Curves. 3. Labor Supply Institutions: Keynes' Hypothesis. 4. Unions as Monopolies: Alternative Union Goals. 5. Demand for Inputs: Marginal Productivity. 6. Demand for Heterogeneous Inputs: Differential Rents. 7. Summary: Outline of a Theory of Distribution. 8. A Macroeconomic Model of Distribution. 9. The Constancy of Labor's Share. 10. The Adding-Up Controversy. 7 8 Theory of Capital Origins of Capital Theory. 2. The Meaning of "Capital" and "Investment." 3. Neoclassical Interest Theory: Introduction. 4. Supply of Capital Resources: Time Preference. 5. Demand for Capital Resources: Roundabout Production Processes. 6. Digression on Marshallian Interest Theory. 7. Attempts to Measure Capital: Average ^Periods. 8. The Point-Input Point-Output Case. 9. Discounting and Present Value. 10. Continuous Compounding and Discounting. 11. Discount Rate and Interest Rate: Their

6 Contents xiii Meaning. 12. The Optimal Length of an Investment: The Jevons Formula. 13. Comparative Statics: Effects of an Interest-Rate Change. 14. Comparative Statics: The Ricardo Effect. 7 9 Capital Budgeting Determinants of Investment: General. 2. The Standard Investment Criteria: Preliminary Comments. 3. Payout Period. 4. Marginal Efficiency of Investment. 5. Discounted Present Value vs. Marginal Efficiency. 6. Illustration: Use of the Discounted Present Value Criterion. 7. Indivisibility, Interdependence, and Capital Rationing Problems. 8. Risk and the Investment Decision. 9. Financing Investments: Alternative Methods. 10. On Optimal Financial Policy. 11. The Cost of Capital. 12. Concluding Comment. Appendix: Illustrative Probabilistic Calculation. Replacement of Items Which Fail. PART 3 RECENT DEVELOPMENTS IN MATHEMATICAL ECONOMICS Input-Output Analysis The Economic Problem and the Assumptions. 2. The Mathematics. 3. A Dynamized Input-Output Model. 4. Some Theorems of Input-Output Analysis. 27 Activity Analysis and General Equilibrium The Existence and Uniqueness Problems. 2. Solution of the Existence Problem. 3. Solution of the Uniqueness Problem. 4. The Von Neumann Model of an Expanding Economy. 5. Activity Analysis and Welfare Economics. 6. Dual Prices and Decentralized Decision Making. 7. Integer Programming and Welfare Economics. 22 Neumann-Morgenstern Cardinal Utility 512 I. Utility, Risk, and Game Theory. 2. Classes of Measures and Their Strength. 3. Construction of an N-M Index. 4. Expected Utility vs. Expected Payoff. 5. Psychological Premises Behind the Prediction. 6. N-M vs. Neoclassical Cardinal Utility. Appendix: The Psychological Premises and the Index. 23 Game Theory Taking Account of Competitive Decisions. 2. The Zero-Sum, Two-Person Game. 3. Maximin and Minimax Strategies. 4. Equilibrium (Saddle) Points. 5. Geometry of Equilibrium Points: Saddle Points. 6. Payoff Matrices Without Equilibrium Points. 7. Mixed Strategies. 8. Optimal Mixed Strategies and the Saddle-Point Theorem. 9. Strategy; the Extensive and Normal Form of a Game. lo.-two-person, Nonconstant-Sum Games. II. n-person Games: Some Concepts.

7 x/v Contents 24 Decision Theory The Subject Matter of Decision Theory. 2. Some Proposed Decision Rules. 3. Geometric Interpretation of the Decision Rules. 4. Axiomatization. 5. Neumann-Morgenstern Utility and the Bayes Criterion. 6. Decision Theory and the Foundations of Statistics. PART 4 POSTSCRIPT ON COMPUTERS Observations on Electronic Computers Problems Suited for Machine Computation. 2. Components, Computer Types, and Prices. 3. Programming Languages, Compilers, and Other Aids. 4. How Does It Work? ' ANSWERS TO PROBLEMS 587 INDEX 595

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