WILLIAM J.

BAUMOL
Professor of Economics
Princeton University

ECONOMIC THEORY
AND
OPERATIONS ANALYSIS

Second Edition

Prentice-Hall, I Inc. Engkwood Cliffs, New Jersey

 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. Deter-
mination of the Cost Relationship. 6. The Optimality Calculation.

2 Some Elementary Mathematics 12

1. Functions. 2. Slope. 3. Linear and Other Simple Equations.
4. Exponents: Definitions and Elementary Rules of Manipulation.
5. Logarithms. 6. 2 Notation.

3 Marginal Analysis 21
1. Marginal Reasoning and the Logic of Decision-Making. 2. Theo-
rems 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 42
1. Differential Calculus and Marginal Analysis. 2. Rules of Differ-
entiation. 3. Geometric Interpretation: The First-Order Maximum
Condition. 4. Nondifferentiability and Limited Variable Range
Problems. 5. Second-Order Conditions of Maximization and Mini-
mization. 6. Local and Global Optima. 7. Maximization in
Many-Variable Relationships: Partial Differentiation. 8. Con-
strained Maxima: Lagrange Multipliers. 9. Some Economic
Applications of the Differential Calculus.

ix
 Contents

5 Linear Programming 70
1. 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 Solu-
tion and the "Feasibility Program."

6 Duality 103
1. The Dual Problem. 2. Economic Interpretation of the Dual
Problem. 3. Some Duality Theorems. 4. Duality and Decen-
tralized Decision-Making. 5. Solution of the Primal and Dual
Programs. Appendix: On the Derivation of the Duality Theorems.

7 Nonlinear Programming 129

1. Algebraic Notation and Example. 2. Geometric Representation:
Nonlinear Constraints. 3. Geometry of Nonlinear Objective Func-
tions. 4. Convex and Nonconvex Regions. 5. Concave and
Convex (Objective) Functions. 6. Nonlinearities and the Basic
Theorem of Linear Programming. 7. Methods of Nonlinear Com-
putation. 8. The Kuhn-Tucker Theorems.

8 Integer Programming 148

1. Problems Where Noninteger Solutions Are Meaningless. 2. Non-
convex Feasible Region Problems. 3. Increasing Returns: The
Fixed Charges Problem. 4. The Method of Solution. 5. Illus-
trations of the Integer Programming Computation. 6. The Dual
Prices and Marginal Valuation.

PART 2 MICROECONOMIC ANALYSIS 167

9 Theory of Demand ' 169

1. Demand Curves. 2. Shifting Demand Curves: Demand Func-
tions. 3. Elasticity: A Measure of Responsiveness. 4. Properties
of the Elasticity Measure. 5. Utility Analysis of Demand. 6. In-
difference 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 Prefer-
ence and Index Numbers of Real Income. 14. Elementary Mathe-
matics of Demand Analysis. 15. The n Commodity Slutsky
Theorem and Revealed Preference.
Confenfs x;

70 On Empirical Determination of Demand Relationships 210

1. 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 Eval-
uating Simultaneous Equation Estimation Methods. S. Maximum
Likelihood Method: General Description. 4- Advantages and Dis-
advantages 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 250

1. 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 Pro-
duction 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.

72 Linear Programming and the Theory of Production 270

1. Why a Programming Reexamination of Production Theory?
2. An Alternative Linear Programming Diagram. 3. Illustrative
Example. 4. The Feasible Region. 5. Representation of a Proc-
ess. 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 295

- 1. 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 Out-
put Combinations. 8. Pricing and Changes in Fixed Costs and
Taxes. 9. Satisficing and Behavior Analysis. 10. Profit and Sales
Maximization: Sample Calculations.
xii Contents

14 Market Structure, Pricing, and Output 37 7

1. 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. Mo-
nopolistic Competition (Product Differentiation). 7. Monopsony.
8. Remarks on Discriminating Monopoly. 9. Bilateral Monopoly.
10. Oligopolistic Interdependence. 11. Stability of Oligopoly Ar-
rangements: Kinked Demand Curves. 12. Reaction Curves and
Oligopolistic Pricing. 13. Monopoly, Duopoly, and Discrimination:
Elementary Mathematical Analysis.

75 Genera/ Equilibrium and the Theory of Money 338

1. Interdependence in the Economy: Substitutes and Complements.
2. Equations of General Equilibrium. 3. The Redundant Equa-
tion: 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.

76 General Equilibrium and Welfare Economics 355

1. 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 Pro-
ducing 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 Con-
sumption. 10. Some Standard Theorems of Welfare Economics.
11. Criteria for Welfare Judgments. 12. A Theorem on Demo-
cratic Group Decisions. 13. Concluding Remarks.

17 Theory of Distribution 386

1. 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.

78 Theory of Capital 407

1. 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. Digres-
sion 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
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.

79 Capital Budgeting 434

1. Determinants of Investment: General. 2. The Standard In-
vestment Criteria: Preliminary Comments. 3. Payout Period.
4. Marginal Efficiency of Investment. 5. Discounted Present
Value vs. Marginal Efficiency. 6. Illustration: Use of the Dis-
counted Present Value Criterion. 7. Indivisibility, Interdepend-
ence, 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 477

20 Input-Output Analysis 479

1. The Economic Problem and the Assumptions. 2. The Mathe-
matics. 3. A Dynamized Input-Output Model. 4. Some Theo-
rems of Input-Output Analysis.

27 Activity Analysis and General Equilibrium 491

1. 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. Activ-
ity Analysis and Welfare Economics. 6. Dual Prices and Decen-
tralized 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 529

.1. 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.
x/v Contents

24 Decision Theory 550

1. 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 569

25 Observations on Electronic Computers 571

1. Problems Suited for Machine Computation. 2. Components,
Computer Types, and Prices. 3. Programming Languages, Com-
pilers, and Other Aids. 4. How Does It Work? '

ANSWERS TO PROBLEMS 587

INDEX 595