Readings in Applied Microeconomics
A central concern of economics is how society allocates its resources. Modern
economies rely on two institutions to allocate: markets and governments. But
how much of the allocating should be performed by markets and how much by
governments? This collection of readings will help students appreciate the
power of the market. It supplements theoretical explanations of how markets
work with concrete examples, addresses questions about whether markets
actually work well and offers evidence that supposed “market failures” are not
as serious as claimed.
Featuring readings from Friedrich Hayek, William Baumol, Harold
Demsetz, Daniel Fischel and Edward Lazear, Benjamin Klein and Keith B.
Leffl er, Stanley J. Liebowitz and Stephen E. Margolis, and John R. Lott, Jr.,
this book covers key topics such as:
• Why markets are effi cient allocators
• How markets foster economic growth
• Property rights
• How markets choose standards
• Asymmetric Information
• Whether fi rms abuse their power
• Non-excludable goods
• Monopolies
The selections should be comprehended by undergraduate students who have
had an introductory course in economics. This reader can also be used as a
supplement for courses in intermediate microeconomics, industrial organiza-
tion, business and government, law and economics, and public policy.
Craig M. Newmark is Associate Professor of Economics at North Carolina
State University, USA. His research focuses on U.S. antitrust policy and
has been published in the Journal of Political Economy, Journal of Law
and Economics, Review of Economic Statistics, and other journals. He teaches
graduate courses in microeconomics and writing for economists, and an

HB 172.R328 2009
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This edition published in the Taylor & Francis e-Library
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To my wife, Betsy, and to my children, Katie and Meredith

Notes on Contributors xi
Acknowledgments xiii
Preface xvii
PART ONE
Information and Incentives
Introduction
2
1 F. A. Hayek 4
THE USE OF KNOWLEDGE IN SOCIETY
2 Leonard E. Read 14
I, PENCIL
3 Charles Maurice and Charles W. Smithson 19
THE TIMBER CRISIS
AND

FROM THE WHALING INDUSTRY
13 Michael Satchell 183
SAVE THE ELEPHANTS: START SHOOTING THEM
PART FOUR
Externalities and Coordination Problems
Introduction
190
14 Michael C. Munger 192
ORANGE BLOSSOM SPECIAL: EXTERNALITIES AND THE COASE THEOREM
15 Fred E. Foldvary and Daniel B. Klein 197
THE HALF-LIFE OF POLICY RATIONALES: HOW NEW
TECHNOLOGY AFFECTS OLD POLICY ISSUES
viii CONTENTS
16 S. J. Liebowitz and Stephen E. Margolis 208
THE FABLE OF THE KEYS
PART FIVE
Non-Excludable Goods
Introduction
232
17 John R. Lott, Jr. 233
COMMERCIALIZATION OF RADIO
18 Daniel B. Klein 235
PRIVATE HIGHWAYS IN AMERICA, 1792–1916
19 Richard L. Stroup 241
FREE RIDERS AND COLLECTIVE ACTION REVISITED
PART SIX
Asymmetric Information
Introduction
258
20 Benjamin Klein and Keith B. Leffl er 259

SHIPPING THE GOOD APPLES OUT
30 Daniel R. Fischel and Edward P. Lazear 366
COMPARABLE WORTH AND DISCRIMINATION IN LABOR MARKETS
31 Harold Demsetz and Kenneth Lehn 383
THE STRUCTURE OF CORPORATE OWNERSHIP: CAUSES
AND CONSEQUENCES
32 Charles R. Knoeber 402
GOLDEN PARACHUTES, SHARK REPELLENTS, AND HOSTILE
TENDER OFFERS
33 Benjamin Klein 419
TRANSACTION COST DETERMINANTS OF “UNFAIR” CONTRACTUAL
ARRANGEMENTS
34 John R. Lott, Jr. 428
TWO EXCERPTS FROM FREEDOMNOMICS
x CONTENTS
Notes on Contributors
Richard Alm is Senior Economics Writer at the Federal Reserve Bank of
Dallas.
Ronald Bailey is Science Editor at Reason magazine.
William J. Baumol is Professor of Economics and Director of the C.V. Starr
Center for Applied Economics at New York University and Senior Research
Economist and Professor of Economics, Emeritus, Princeton University.
He is a past president of the American Economic Association (1981).
Eric W. Bond is the Joe Roby Professor of Economics at Vanderbilt
University.
Geoffrey Colvin is Senior Editor-at-Large at Fortune magazine.
W. Michael Cox is Senior Vice President and Chief Economist at the Federal
Reserve Bank of Dallas.
Harold Demsetz is Professor Emeritus of Economics at the University of
California, Los Angeles.

Foundation.
Michael T. Maloney is Professor of Economics at Clemson University.
Stephen E. Margolis is Professor of Economics at North Carolina State
University.
Charles Maurice was Professor Emeritus of Economics at Texas A & M
University. He died in 1999.
J. Harold Mulherin is Professor of Banking and Finance at the University of
Georgia.
Michael C. Munger is Professor of Political Science, Economics, and Public
Policy at Duke University. He served as President of the Public Choice
Society and as North American editor of Public Choice.
Craig M. Newmark is Associate Professor of Economics at North Carolina
State University.
David G. Raboy is Chief Economic Consultant at Patton Boggs LLP.
Leonard E. Read was the founder of the Foundation for Economics Education.
He died in 1983.
Russell Roberts is Professor of Economics at George Mason University, the
J. Fish and Lillian F. Smith Distinguished Scholar at the Mercatus Center,
and a research fellow at Stanford University’s Hoover Institution.
Michael Satchell is a writer at U.S. News & World Report.
Eugene Silberberg is Professor Emeritus of Economics, University of
Washington.
Charles W. Smithson is a Partner with Rutner Associates, New York, NY.
Richard L. Stroup is Adjunct Professor of Economics at North Carolina State
University and an Adjunct Scholar at the Cato Institute.
Steven N. Wiggins is Professor of Economics at Texas A & M University.
xii
NOTES ON CONTRIBUTORS
The publisher would like to thank the following for their permission to reprint their
material:

2 (October 1984), pp. 495–502.
Springer for permission to reprint Fred E. Foldvary and Daniel B. Klein, “The Half-Life
of Policy Rationales: How New Technology Affects Old Policy Issues,” Knowledge,
Technology, & Policy, 15, 3 (Fall 2002), pp. 82–92.
The American Economic Association for permission to reprint F. A. Hayek, “The Use of
Knowledge in Society,” American Economic Review, 35, 4 (September 1945), pp. 519–
30; Harold Demsetz, “Toward a theory of Property Rights,” American Economics Review,
57, 2 (May 1967), pp. 347–359; Eric W. Bond, “A Direct Test of the ‘Lemons’ Model:
The Market for Used Pickup Trucks,” American Economics Review 72, 4 (September
1982), pp. 836–840; Charles R. Knoeber. “Golden Parachutes, Shark Reppellents,
and Hostile Tender Offers,” American Economics Review, 76, 1 (March 1986), pp. 155–
167; Benjamin Klein, “Transaction Cost Determinants of ‘Unfair’ Contractual
Arrangements,” American Economics Review, 70, 2 (May 1980), pp. 356–362.
The Freeman for permission to reprint Leonard E. Read, “I, Pencil,” The Freeman, 46, 5 (May
1996), pp. 274–278; Daniel B. Klein, “Private Highways in America, 1792–1916,” The
Freeman, 44, 2 (February 1994), pp. 75–79.
The Independent Institute for permission to reprint Richard L. Stroup, “Free Riders and
Collective Action Revisited,” The Independent Review, 4, 4 (Spring 2000), pp. 485–500.
The Liberty Fund for permission to reprint Michael C. Munger, “Orange Blossom Special:
Externalities and the Coase Theorem,” The Liberty Fund, Library of Economics
and Liberty, www.econlib.org/library/Columns/y2008/Mungerbees.html.
The National Interest for permission to reprint Ronald Bailey, “The Law of Increasing
Returns,” The National Interest, 59 (Spring 2000), pp. 113–121.
The University of Chicago Press for permission to reprint William J. Baumol,
“Entrepreneurship: Productive, Unproductive, and Destructive,” Journal of Political
Economy, 98, 5, part 1 (October 1990), pp. 893–921; S. J. Liebowitz and Stephen E.
Margolis, “The Fable of the Keys,” Journal of Law and Economics, 33, 1 (April 1990), pp.
1–25; Benjamin Klein and Keith B. Leffl er, “The Role of Market Forces in Assuring
Contractual Performance,” Journal of Political Economy, 89, 4 (August 1981), pp. 615–
641; Harold Demsetz, “Industry Structure, Market Rivalry, and Public Policy,” Journal

exploit their “power”? If markets work well, why are people forced to use infe-
rior products such as Windows software? Won’t market exploitation of vital
natural resources, such as oil, cause us to run out? How can markets work well
if information is costly? How can consumers trust what fi rms tell them?
As I write this in October 2008, concerns about the market system are
especially intense. But people have always feared and suspected markets.
Markets—and the idea of capitalism—don’t inspire loyalty or love like other
ideas. Peter Saunders wrote:
Capitalism lacks romantic appeal. It does not set the pulse racing in the
way that opposing ideologies like socialism, fascism, or environmentalism
can. It does not stir the blood, for it identifi es no dragons to slay. It offers
no grand vision for the future, for in an open market system the future is
shaped not by the imposition of utopian blueprints, but by billions of indi-
viduals pursuing their own preferences.
Peter Saunders, “Why Capitalism is Good for the Soul,”
Policy, 23, 4 (Summer 2007–8, pp. 3–9)
Preface
This collection of readings is intended to address that problem. The book
will help students appreciate the power of the market. It supplements theo-
retical explanations of how markets work with concrete examples. It addresses
questions about whether markets actually work well. And it offers evidence
that supposed “market failures” are not as serious as claimed.
Over one-third of the readings focus on vital aspects of markets that are
insuffi ciently stressed in economics courses. Part one of the book looks at
how market prices effi ciently aggregate and transmit information while simul-
taneously also providing individuals with incentives to take good actions, good
for both themselves and society. Part two’s readings look at how and why
markets create wealth. Part three reminds students that property rights are
important to the market system.
The other parts of the book present more standard topics but from a per-

Introduction
The power of the market comes from prices. Prices do two important things
simultaneously. First, they aggregate and transmit information—information about
consumers’ demands and suppliers’ costs—cheaply and quickly. And second, they
provide everyone incentives to act in ways that benefi t not only themselves, but benefi t
others.
In the classic article, “The Use of Knowledge in Society,” Friedrich Hayek
explains how important it is that prices transmit information and provide incentives.
Hayek notes that solving the fundamental economic problem—coping with scar-
city—would be easy for a “central planner” if the planner had perfect information
about all the tastes, skills, and technologies in the economy. But the planner doesn’t
have that all information. He doesn’t have it because much valuable information is
known only at specifi c places and times by widely dispersed individuals.
A market economy, on the other hand, obtains that information through the
price system. Prices induce people who have valuable information to use it, because
using it will make them money. The information is thereby revealed in the market
price.
And the market price then induces people to act in desirable ways. If a new
source of tin is discovered, demanders will conserve tin and suppliers will produce
more. These are the same actions a central planner would want to take, but they
happen quickly and automatically through the power of market prices.
The other four readings in Part One provide examples of the power of prices at
work. Leonard E. Read notes that a pencil is a simple product. So simple that pencils
are extremely common: billions of them are sold each year.
1
But Read’s article states
a surprising fact about the simple pencil: there isn’t a single person on Earth that
knows everything about how to manufacture one. The manufacture of a single pencil
involves, directly or indirectly, literally thousands of people and dozens of technolo-
gies. To manufacture a typical pencil, cedar trees are grown in California, graphite is

Quick and effi cient actions fostered by the market are emphasized in the article
by Steven Horwitz about the aftermath of Hurricane Katrina. After Katrina devas-
tated parts of Louisiana and Mississippi, residents desperately needed relief. Which
organization provided especially effective relief? The huge retailer, Wal-Mart.
According to Horwitz, Wal-Mart was effective because the market gave it “the right
incentives to respond well and [it] could tap into local information necessary to
know what the response should be” emphasis added.
Finally, following the tragic explosion of the U.S. space shuttle Challenger,
a blue-ribbon panel of distinguished engineers and scientists determined that the
explosion should be blamed on faulty parts manufactured by the fi rm Morton Thiokol.
The panel took more than four months to reach that conclusion. The U.S. stock
market, on the other hand, identifi ed Morton Thiokol as the likely culprit, on the day
of the crash, within less than fi ve hours. The article by Michael T. Maloney and
J. Harold Mulherin illustrates how the market is an extremely effi cient processor of
information.
Note
1 Baron D. (2007) “Don’t Write Off the Pencil,” Los Angeles Times, January 23, A-15.
INFORMATION AND INCENTIVES 3
I
W
HAT IS THE PROBLEM, we wish to solve when we try to construct a
rational economic order?
On certain familiar assumptions the answer is simple enough. If we possess all the
relevant information, if we can start out from a given system of preferences and if we
command complete knowledge of available means, the problem which remains is
purely one of logic. That is, the answer to the question of what is the best use of the
available means is implicit in our assumptions. The conditions which the solution of
this optimum problem must satisfy have been fully worked out and can be stated best
in mathematical form: put at their briefest, they are that the marginal rates of substi-
tution between any two commodities or factors must be the same in all their different

misconception about the nature of the economic problem of society. This misconcep-
tion in turn is due to an erroneous transfer to social phenomena of the habits of thought
we have developed in dealing with the phenomena of nature.
II
In ordinary language we describe by the word “planning” the complex of interrelated
decisions about the allocation of our available resources. All economic activity is in
this sense planning; and in any society in which many people collaborate, this
planning, whoever does it, will in some measure have to be based on knowledge
which, in the fi rst instance, is not given to the planner but to somebody else, which
somehow will have to be conveyed to the planner. The various ways in which the
knowledge on which people base their plans is communicated to them is the crucial
problem for any theory explaining the economic process. And the problem of what is
the best way of utilizing knowledge initially dispersed among all the people is at least
one of the main problems of economic policy—or of designing an effi cient economic
system.
The answer to this question is closely connected with that other question which
arises here, that of who is to do the planning. It is about this question that all the
dispute about “economic planning” centers. This is not a dispute about whether plan-
ning is to be done or not. It is a dispute as to whether planning is to be done centrally,
by one authority for the whole economic system, or is to be divided among many
individuals. Planning in the specifi c sense in which the term is used in contemporary
controversy necessarily means central planning—direction of the whole economic
system according to one unifi ed plan. Competition, on the other hand, means
decentralized planning by many separate persons. The half-way house between the
two, about which many people talk but which few like when they see it, is the
delegation of planning to organized industries, or, in other words, monopoly.
Which of these systems is likely to be more effi cient depends mainly on the
question under which of them we can expect that fuller use will be made of the exist-
ing knowledge. And this, in turn, depends on whether we are more likely to succeed
in putting at the disposal of a single central authority all the knowledge which ought

machine not fully employed, or somebody’s skill which could be better utilized, or to
be aware of a surplus stock which can be drawn upon during an interruption of
supplies, is socially quite as useful as the knowledge of better alternative techniques.
And the shipper who earns his living from using otherwise empty or half-fi lled
journeys of tramp-steamers, or the estate agent whose whole knowledge is almost
exclusively one of temporary opportunities, or the arbitrageur who gains from local
differences of commodity prices, are all performing eminently useful functions based
on special knowledge of circumstances of the fl eeting moment not known to others.
It is a curious fact that this sort of knowledge should today be generally regarded
with a kind of contempt, and that anyone who by such knowledge gains an advantage
over somebody better equipped with theoretical or technical knowledge is thought to
have acted almost disreputably. To gain an advantage from better knowledge of facilities
of communication or transport is sometimes regarded as almost dishonest, although it is
quite as important that society make use of the best opportunities in this respect as in
using the latest scientifi c discoveries. This prejudice has in a considerable measure affected
the attitude toward commerce in general compared with that toward production. Even
economists who regard themselves as defi nitely above the crude materialist fallacies of
the past constantly commit the same mistake where activities directed toward the
acquisition of such practical knowledge are concerned—apparently because in their
6 F . A . HAYEK