CONTENTS Preface xix The Market Constructing a Model 1 Optimization and Equilibrium 3 The De- mand Curve 3. The Supply Curve 5 Market Equilibrium 7 Com- parative Statics 9 Other Ways to Allocate Apartments 11 The Dis- criminating Monopolist ¢ The Ordinary Monopolist « Rent Control « Which Way Is Best? 14 Pareto Efficiency 15 Comparing Ways to AL locate Apartments 16 Equilibrium in the Long Run 17 Summary 18 Review Questions 19 Budget Constraint The Budget Constraint 20 Two Goods Are Often Enough 21 Prop- erties of the Budget Set 22 How the Budget Line Changes 24 The Numeraire 26 Taxes, Subsidies, and Rationing 26 Example: The Food Stamp Program Budget Line Changes 31 Summary 31 Review Questions 32VIL CONTENTS Preferences Consumer Preferences 34 Assumptions about Preferences 35 Indif- ference Curves 36 Examples of Preferences 37 Perfect Substitutes © Perfect Complements ¢ Bads # Neutrals © Satiation « Discrete Goods « Well-Behaved Preferences 44 ‘The Marginal Rate of Substitu- tion 48 Other Interpretations of the MRS 50 Behavior of the MRS 51 Summary 52 Review Questions 52 Utility Cardinal Utility 57 Constructing a Utility Funetion 58 Some Exam- ples of Utility Functions 59 Example: Indifference Curves from Utility Perfect Substitutes © Perfect Complements * Quasilinear Preferences * Cobb-Douglas Preferences © Marginal Utility 65 Marginal Utility and MRS 66 Utility for Commuting 67 Summary 69 — Review Questions 70 Appendix 70 — Brrample: Cobb-Douglas Preferences Choice Optimal Choice 73 Consumer Demand 78 Some Examples 78 Perfect Substitutes * Perfect Complements * Neutrals and Bads « Discrete Goods © Concave Preferences © Cobb-Douglas Preferences © Estimating Utility Functions 83 Implications of the MRS Condition 85 Choosing Taxes 87 Summary 89 Review Questions 89 — Appen- dix 90 Example: Cobb-Douglas Demand Functions Demand Normal and Inferior Goods 96 Income Offer Curves and Engel Curves 97 Some Examples 99 Perfect Substitutes © Perfect Complements * Cobb-Douglas Preferences © Homothetic Preferences * Quasilinear Preferences Ordinary Goods and Giffen Goods 104 The Price Offer Curve and the Demand Curve 106 Some Examples 107 Perfect Substitutes © Perfect Complements © A Discrete Good Substitutes and Complements 111 The Inverse Demand Function 112 Summary 114 Review Questions 115 Appendix 115CONTENTS 1K 7 Revealed Preference The Idea of Revealed Preference 119 From Revealed Preference to Pref- erence 120 Recovering Preferences 122 The Weak Axiom of Re- vealed Preference 124 Checking WARP 125 The Strong Axiom of Revealed Preference 128 How to Check SARP 129 — Index Numbers 130 Price Indices 182 Example: Indexing Social Security Payments Summary 135 Review Questions 135 8 Slutsky Equation ‘The Substitution Effect 137 Example: Calculating the Substitution Ef- fect The Income Effect 141 Brample: Calculating the Income Effect Sign of the Substitution Effect 142 The Total Change in Demand 143 Rates of Change 144 The Law of Demand 147 Examples of Income and Substitution Effects 147 Example: Rebating a Taz Example: Voluntary Real Time Pricing Another Substitution Effect. 158 Com. pensated Demand Curves 155 Summary 156 Review Questions 157 Appendix 157 — Example: Rebating a Small Tax 9 Buying and Selling Net and Gross Demands 160 The Budget Constraint 161 Changing the Endowment 163 Price Changes 164 Offer Curves and Demand Curves 167 The Slutsky Equation Revisited 168 Use of the Slut sky Equation 172 Example: Calculating the Endowment Income Bffect Labor Supply 173 The Budget Constraint « Comparative Statics of Labor Supply 174 Example: Overtime and the Supply of Labor Sum- mary 178 Review Questions 179 Appendix 179xX CONTENTS Intertemporal Choice ‘The Budget Constraint 182 Preferences for Consumption 185 Com- parative Statics 186 The Slutsky Equation and Intertemporal Choice 187 Inflation 189 Present Value: A Closer Look 191 Analyz- ing Present Value for Several Periods 193 Use of Present Value 194 Example: Valuing a Stream of Payments Example: The True Cost of a Credit Card Bonds 197 Example: Installment Loans Taxes 199 Example: Scholarships and Savings Choice of the Interest Rate 200 Summary 201 Review Questions 201 Asset Markets Rates of Return 202 Arbitrage and Present Value 204 Adjustments for Differences among Assets 204 Assets with Consumption Returns 205 Taxation of Asset Returns 206 Applications 207 —Depletable Resources © When to Cut a Forest ¢ Example: Gasoline Prices during the Gulf War Financial Institutions 211 Summary 212 Review Questions 213 Appendix 213 Uncertainty Contingent Consumption 215 Example: Catastrophe Bonds Utility Functions and Probabilities. 220 Example: Some Examples of Utility Functions Expected Utility 221 Why Expected Utility Is Reasonable 222 Risk Aversion 224 Example: The Demand for Insurance Di- versification 228 Risk Spreading 228 Role of the Stock Market 229 Summary 230 Review Questions 230 Appendix 231 Bzample: The Effect of Taxation on Investment in Risky Assets Risky Assets Mean-Variance Utility 234 Measuring Risk 239 Equilibrium in a Market for Risky Assets 241 How Returns Adjust 242 Example. Ranking Mutual Funds Summary 246 Review Questions 24614 15 16 CONTENTS x1 Consumer's Surplus Demand for a Discrete Good 248 Constructing Utility from Demand 249 Other Interpretations of Consumer’s Surplus 250 From Con- sumer’s Surplus to Consumers’ Surplus 251 Approximating a Continu- ous Demand 251 Quasilinear Utility 251 Interpreting the Change in Consumer's Surplus 252 Example: The Change in Consumer's Surplus Compensating and Equivalent Variation 254 Example: Compensating and Equivalent Variations Example: Compensating and Equivalent Vari- ation for Quasilinear Preferences Producer's Surplus 258 Benefit-Cost Analysis 260 Rationing © Calculating Gains and Losses 262 Sum- mary 263 Review Questions 263 Appendix 264 — Example: A Few Demand Functions Example: CV, EV, and Consumer's Surplus Market Demand From Individual to Market Demand 266 The Inverse Demand Function 268 © Example: Adding Up “Linear” Demand Curves Discrete Goods 269 The Extensive and the Intensive Margin 269 Elasticity 270 Example: The Elasticity of a Linear Demand Curve Elasticity and De- mand 272 Elasticity and Revenue 273 Example: Strikes and Profits Constant Elasticity Demands 276 Elasticity and Marginal Revenue 277 Example: Setting a Price Marginal Reveme Curves 279 Income Elas- ticity 280 Summary 281 Review Questions 282 Appendix 283 Example: The Laffer Curve Example: Another Expres sion for Elasticity Equilibrium Supply 289 Market Equilibrium 289 Two Special Cases 290 In verse Demand and Supply Curves 291 Brample: Equilibrium with Lin- car Curves Comparative Staties 293 — Example: Shifting Both Curves ‘axes 294 Brample: Taxation with Linear Demand and Supply Pass- ing Along a Tax 298 The Deadweight Loss of a Tax 300 Example. The Market for Loans Example: Food Subsidies Example: Subsidies in Iraq Pareto Efliciency 306 Example: Waiting in Line Summary 309 Review Questions 309Xil_ CONTENTS Auctions Classification of Auctions 312 Bidding Rules Auction Design 313 Other Auction Forms 316 Example: Late Bidding on eBay — Example: Online Ad Auctions Problems with Auctions 319 The Winner's Curse 320. Summary 320 Review Questions 321 Technology Inputs and Outputs 322 — Deseribing Technological Constraints 323 Examples of Technology 324 Fired Proportions © Perfect Substitutes © Cobb-Douglas © Properties of Technology 326 The Marginal Product 328 The Technical Rate of Substitution 328 Diminishing Marginal Product 329 Diminishing Technical Rate of Substitution 329 The Long Run and the Short Run 330 Returns to Scale 330 Summary 332 Review Questions 333 Profit Maximization Profits 334 The Organization of Firms 386 Profits and Stock Market Value 336 The Boundaries of the Firm 338 Fixed and Variable Fac- tors 339 Short-Run Profit Maximization 339 Comparative Statics 341 Profit Maximization in the Long Run 342 Inverse Factor Demand Curves 343 Profit Maximization and Returns to Scale 344 — Revealed Profitability 345 Example: How Do Farmers React to Price Supports? Cost Minimization 349 Summary 349 Review Questions 350 Ap- pendix 351 Cost Minimization Cost Minimization 353 Example: Minimizing Costs for Specific Tech- nologies Revealed Cost Minimization 357 Returns to Seale and the Cost Function 358 Long-Run and Short-Run Costs 360 Fixed and Quasi-Fixed Costs 362 Sunk Costs 362 Summary 363 Review Questions 363 Appendix 36421 22 23 CONTENTS xl Cost Curves Average Costs 367 Marginal Costs 369 Marginal Costs and Variable Costs 371 Example: Specific Gost Curves Example: Marginal Cost Curves for Two Plants Long-Run Costs 375 Discrete Levels of Plant Size 377 Long-Run Marginal Costs 379 Summary 380 Review Questions 381 Appendix 381 Firm Supply Market Environments 383 Pure Competition 384 The Supply Deci- sion of a Competitive Firm 386 An Exception 388 Another Exception 389 Example: Pricing Operating Systems ‘The Inverse Supply Func- tion 391 Profits and Producer's Surplus 391 Example: The Supply Curve for a Specific Cost Function ‘The Long-Run Supply Curve of a Firm 395 Long-Run Constant Average Costs 397 Surmmary 398 Review Questions 399 Appendix 399 Industry Supply Short-Run Industry Supply 401 Industry Equilibrium in the Short Rum 402 Industry Equilibrium in the Long Run 403. The Long-Run Supply Curve 405 — Brample: Tazation in the Long Run and in the Short Run The Meaning of Zero Profits 409 Fixed Factors and Economie Rent 410 Example: Tawi Licenses in New York City Economic Rent 412 Rental Rates and Prices 414 Example: Liquor Licenses The Politics of Rent 415 Example: Farming the Government Energy Policy 417 Two-Tiered Oil Pricing * Price Controls « The Entitlement Program Summary 421 Review Questions 422XIV CONTENTS Monopoly Maximizing Profits 424 Linear Demand Curve and Monopoly 425 Markup Pricing 427 Example: The Impact of Taxes on a Monopo- list Inefficiency of Monopoly 429 Deadweight Loss of Monopoly 431 Example: The Optimal Life of a Patent Example: Patent Thickets Nat- ural Monopoly 435 What Causes Monopolies? 437 Example: Di- amonds Are Forever Example: Pooling in Auction Markets Example: Price Fiving in Computer Memory Markets Summary 441 Review Questions 442 Appendix 443 Monopoly Behavior Price Di ample: First-degree Price Discrimination in Prac Discrimination 448 Example: Price Discrimination in Airfares Ex- ample: Prescription Drug Prices ‘Third-Degree Price Discrimination 452 Example: Linear Demand Curves Example: Calculating Optimal Price Discrimination Example: Price Discrimination in Academic Journals Bundling 457 — Example: Software Suites. Two-Part Tariffs 458 Mo- nopolistic Competition 459 A Location Model of Product Differentiation 463 Product Differentiation 465 More Vendors 466 Summary 467 Review Questions 467 Factor Markets Monopoly in the Output Market 468 Monopsony 471 Example: The Minimum Wage Upstream and Downstream Monopolies 475 Summary ATT Review Questions 478 Appendix 47827 28 29 CONTENTS. XV Oligopoly Choosing a Strategy 481 Quantity Leadership 481 The Follower’s Problem « The Leader's Problem ¢ Price Leadership 487 Comparing Price Leadership and Quantity Leadership 489 Simultaneous Quantity Setting 489 An Example of Cournot Equilibrium 491 Adjustment to Equilibrium 493 Many Firms in Cournot Equilibrium 493. Simulta- neous Price Setting 494 Collusion 495 Punishment Strategies 498 Example: Price Matching and Competition Example: Voluntary Export Restraints Comparison of the Solutions 501 Summary 502 Review Questions 503 Game Theory The Payoff Matrix of a Game 504 Nash Equilibrium 506 Mixed Strategies 507 Example: Rock Paper Scissors ‘The Prisoner's Dilemma 509 Repeated Games 511 Enforcing a Cartel 512 Example: Tit for Tat in Airline Pricing Sequential Games 514 A Game of Entry Deterrence 516 Summary 518 Review Questions 519 Game Applications Best Response Curves 520 Mixed Strategies 522 Games of Coordi- nation 524 Battle of the Sezes © Prisoner's Dilemma Assurance Games ¢ Chicken ¢ How to Coordinate # Games of Competition 528 Games of Coexistence 533 Games of Commitrnent 535 The Frog and the Scorpion * The Kindly Kidnapper ¢ When Strength Is Weakness © Savings and Social Security ¢ Hold Up « Bargaining 543° The Ultimatum Game «Summary 546 Review Questions 547XVE_ CONTENTS Framing Effects in Consumer Choice 549 The Disease Dilemma Anchoring Effects * Bracketing # Too Much Choice * Constructed Preferences @ Uncertainty 553 Law of Small Numbers ¢ Asset In- tegration and Loss Aversion ¢ Time 556 Discounting ¢ Self-control * Example: Overconfidence Strategic Interaction and Social Norms 558 Ultimatum Game ¢ Fairness « Assessment of Behavioral Economics 560 Summary 561 Review Questions 563 Exchange ‘The Edgeworth Box 565 ‘Trade 567 Pareto Efficient Allocations 568 Market Trade 570 The Algebra of Equilibrium 572 Walras’ Law 574 Relative Prices 575 Example: An Algebraic Example of Equilibrium The Existence of Equilibrium 577 Equilibrium and Effi- ciency 578 The Algebra of Efficiency 579 Example: Monopoly in the Edgeworth Bor Efficiency and Equilibrium 582 Implications of the First Welfare Theorem 584 Implications of the Second Welfare Theorem 586 Summary 588 Review Questions 589 Appendix 589 Production The Robinson Crusoe Economy 591 Crusoe, Inc. 593 The Firm 594 Robinson’s Problem 595 Putting Them Together 595 Different Tech- nologies 597 Production and the First Welfare Theorem 599 Produc- tion and the Second Welfare Theorem 600 Production Possibilities 600 Comparative Advantage 602 Pareto Efficiency 604 Castaways, Inc. 606 Robinson and Friday as Consumers 608 Decentralized Resource Allocation 609 Summary 610 Review Questions 610 Appen- dix 611CONTENTS XVII 33 Welfare Aggregation of Preferences 614 Social Welfare Functions 616 Welfare Maximization 618 — Individualistic Social Welfare Functions 620 Fair Allocations 621 Envy and Equity 622 Summary 624 Review Questions 624 Appendix 625 34 Externalities Smokers and Nonsmokers 627 Quasilinear Preferences and the Coase Theorem 630 Production Externalities 682 Example: Pollution Vouchers Interpretation of the Conditions 637 Market Signals 640 Example: Bees and Almonds The Tragedy of the Commons 641 Ex- ample: Overfishing Example: New England Lobsters Automobile Pollu- tion 645 Summary 647 Review Questions 647 35 Information Technology Systems Competition 650 The Problem of Complements 650 Re- lationships among Complementors « Lock-In 654 A Model of Com- petition with Switching Costs e Example: Online Bill Payment — Ex- ample: Number Portability on Cell Phones Network Externalities 658 Markets with Network Externalities 658 Market Dynamics 660 Bx- ample: Network Externalities in Computer Software Implications of Net- work Externalities 664 Example: The Yellow Pages Rights Manage- ment 665 Example: Video Rental Sharing Intellectual Property 667 Summary 669 Review Questions 669 36 Public Goods When to Provide a Public Good? 671 Private Provision of the Public Good 675 Free Riding 675 Different Levels of the Public Good 677 Quasilinear Preferences and Public Goods 679 Example: Pollution Re- visited ‘The Free Rider Problem 681 Comparison to Private Goods 683 Voting 684 Example: Agenda Manipulation Demand Revelation 687 Example: An Example of the Clarke Tax Problems with the Clarke Tax 691 Summary 692 Review Questions 692 Appendix 693Xvi CONTENTS Asymmetric Information The Market for Lemons 695 Quality Choice 696 Choosing the Qual- ity Adverse Selection 698 Moral Hazard 700 Moral Hazard and Adverse Selection 701 Signaling 702 Example: The Sheepskin Effect Incentives 706 Example: Voting Rights in the Corporation Example: Chinese Economic Reforms Asymmetric Information 711 Example. Monitoring Costs Example: The Grameen Bank Summary 714 Re- view Questions 715 Mathematical Appendix Functions Al Graphs A2 Properties of Functions A2 Inverse Functions A3 Equations and Identities AS Linear Functions A4 Changes and Rates of Change A4 Slopes and Inter: Absolute Values and Logarithms A6 Derivatives A6 Sec: The Product Rule and the Chain Rule A8 Partial Derivatives A8 Optimization A9 Constrained Optimization A10 Answers AIL Index A3LPREFACE The success of the first six editions of Intermediate Microeconomics has pleased me very much. It has confirmed my belief that the market would welcome an analytic approach to microeconomics at the undergraduate level My aim in writing the first edition was to present a treatment of the methods of microeconomics that would allow students to apply these tools on their own and not just passively absorb the predigested cases described in the text. I have found that the best way to do this is to emphasize the fundamental conceptual foundations of microeconomics and to provide concrete examples of their application rather than to attempt to provide an encyclopedia of terminology and anecdote. ‘A challenge in pursuing this approach arises from the lack of mathemat- ical prerequisites for economics courses at many colleges and universities. ‘The lack of calculus and problem-solving experience in general makes it difficult to present some of the analytical methods of economies. How- ever, it is not impossible. One can go a long way with a few simple facts about linear demand functions and supply functions and some elementary algebra. It is perfectly possible to be analytical without being excessively mathematical. The distinction is worth emphasizing. An analytical approach to eco- nomies is one that uses rigorous, logical reasoning. This does not neces- sarily require the use of advanced mathematical methods. The language of mathematics certainly helps to ensure a rigorous analysis and using it is undoubtedly the best way to proceed when possible, but it may not be appropriate for all students.