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accessible, affordable,active learning

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MICROECONOMICSFOURTH EDITION

DAVID A. BESANKONorthwestern University,Kellogg School of Management

RONALD R. BRAEUTIGAMNorthwestern University,Department of Economics

with Contributions from

Michael J. GibbsThe University of Chicago,Booth School of Business

JOHN WILEY & SONS, INC.

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Library of Congress Cataloging-in-Publication Data

Besanko, David, 1955-Microeconomics / David Besanko, Ronald Braeutigam. —4th ed.

p. cm.Includes index.

ISBN 978-0-470-56358-8 (hardback)1. Microeconomics. I. Braeutigam, Ronald R. (Ronald Ray) II. Title.

HB172.B49 2010338.5—dc22

2010032314

To order books or for customer service, please call 1-800-CALL WILEY (225-5945).

Main Book ISBN: 978-0-470-56358-8

Binder-Ready Version ISBN: 978-0-470-91756-5

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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DAVID BESANKO is the Alvin J. Huss Distinguished Professor of Management andStrategy at the Kellogg School of Management at Northwestern University. From 2007 to 2009he served as Senior Associate Dean for Academic Affairs: Strategy and Planning and from 2001to 2003 served as Senior Associate Dean for Academic Affairs: Curriculum and Teaching.Professor Besanko received his AB in Political Science from Ohio University in 1977, his MSin Managerial Economics and Decision Sciences from Northwestern University in 1980, andhis PhD in Managerial Economics and Decision Sciences from Northwestern University in1982. Before joining the Kellogg faculty in 1991, Professor Besanko was a member of the fac-ulty of the School of Business at Indiana University from 1982 to 1991. In addition, in 1985, heheld a postdoctorate position on the Economics Staff at Bell Communications Research.Professor Besanko teaches courses in the fields of Management and Strategy, CompetitiveStrategy, and Managerial Economics. In 1995 and 2010, the graduating classes at Kelloggawarded Professor Besanko the L.G. Lavengood Professor of the Year, the highest teachinghonor a faculty member at Kellogg can receive. He is only one of two faculty members ofKellogg to have received this award twice. At the Kellogg School, he has also received theAlumni Choice Teaching Award in 2006, the Sidney J. Levy Teaching Award (1998, 2000, 2009)and the Chair’s Core Teaching Award (1999, 2001, 2003, 2005).

Professor Besanko does research on topics relating to competitive strategy, industrial or-ganization, the theory of the firm, and economics of regulation. He has published two booksand over 40 articles in leading professional journals in economics and business, including theAmerican Economic Review, Econometrica, the Quarterly Journal of Economics, the RAND Journal ofEconomics, the Review of Economic Studies, and Management Science. Professor Besanko is aco-author of Economics of Strategy with David Dranove, Mark Shanley, and Scott Schaefer.

RONALD R. BRAEUTIGAM is the Harvey Kapnick Professor of Business Institutionsin the Department of Economics at Northwestern University. He is currently Associate Provostfor Undergraduate Education, and he has served as Associate Dean for Undergraduate Studiesin the Weinberg College of Arts and Sciences. He received a BS in Petroleum Engineeringfrom the University of Tulsa in 1970 and then attended Stanford University, where he receivedan MS in engineering and a PhD in Economics in 1976. He has taught at Stanford Universityand the California Institute of Technology, and he has also held an appointment as a SeniorResearch Fellow at the Wissenschaftszentrum Berlin (Science Center Berlin). He has alsoworked in both government and industry, beginning his career as a petroleum engineer withStandard Oil of Indiana. He served as research economist in The White House Office ofTelecommunications Policy and as an economic consultant to Congress, many governmentagencies, and private firms on matters of pricing, costing, managerial strategy, antitrust, andregulation.

Professor Braeutigam has received many teaching awards, including the NorthwesternUniversity Alumni Association Excellence in Teaching Award (1991), and recognition as aCharles Deering McCormick Professor of Teaching Excellence at Northwestern (1997–2000),the highest teaching award that can be received by a faculty member at Northwestern.

Professor Braeutigam’s research interests are in the field of microeconomics and industrialorganization. Much of his work has focused on the economics of regulation and regulatory reform, particularly in the telephone, transportation, and energy sectors. He has publishedmany articles in leading professional journals in economics, including the American EconomicReview, the RAND Journal of Economics, the Review of Economics and Statistics, and theInternational Economic Review. Professor Braeutigam is a co-author of The Regulation Game withBruce Owen, and Price Level Regulation for Diversified Public Utilities with Jordan J. Hillman. Hehas also served as President of the European Association for Research in Industrial Economics.

v

A B O U T T H E A U T H O R S

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vi ABOUT THE AUTHORS

MICHAEL GIBBS is Clinical Professor of Economics and Human Resources at theUniversity of Chicago Booth School of Business, and a Research Fellow at the Institute for theStudy of Labor. He received a BA, MA and PhD in Economics from the University of Chicago.Professor Gibbs has also taught at Harvard, the University of Michigan, USC, Sciences Po(Paris), and conducted research at the Aarhus School of Business (Denmark). Professor Gibbsis a leading scholar in personnel economics. He has received several teaching and researchawards. Professor Gibbs is a co-author of Personnel Economics in Practice with Edward Lazear.

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vii

After many years of experience teaching microeconomics at the undergraduate and MBAlevels, we have concluded that the most effective way to teach it is to present the contentwith a variety of engaging applications, coupled with an ample number of practice problems and exercises. The applications ground the theory in the real world, and the exercises and problems sets enable students to master the tools of economic analysis andmake them their own. The applications and the problems are combined with verbal intu-ition and graphs, so that they are reinforced and amplified. This approach enables studentsto see clearly the interplay of key concepts, to thoroughly grasp these concepts throughabundant practice, and to see how they apply in actual markets and business firms.

Our reviewers and adopters of the first edition have told us that this approachworked for them and their students. In the second edition, we built on this approach,adding even more applications and problems and revisiting every explanation, everygraph, and every Learning-By-Doing example to make sure the text was as clear as pos-sible. In the third edition, we continued in the spirit of the second edition, adding morecurrent applications and problems. In fact, we added at least five problems to eachchapter (nearly 90 new problems in all). In the fourth edition, we added still more newproblems, and we put in over 30 new current applications. In addition, we added a newAppendix to Chapter 4 that introduces the basic concepts of time value of money, suchas present and future value. Finally, every chapter now begins with a set of concrete,actionable learning goals based on Bloom’s Taxonomy of Educational Objectives.

• The Solution Is in the Problems. Our emphasis on practice exercises and numer-ous, varied problems sets this book apart from others. Based on our experience, studentsneed drill in order to internalize microeconomic theory. They need to work through manyproblems that are tangible, problems that have specific equations and numbers in them.Anyone who has mastered a skill or a sport, whether it be piano, ballet, or golf, understands that a fundamental part of the learning process involves repetitive drills thatseemingly bear no relation to how one would actually execute the skill under “real” con-ditions. We feel that drill problems in microeconomics serve the same purpose. A studentmay never have to do a numerical comparative statics analysis after completing the micro-economics course. However,having seen concretely, throughthe use of numbers and equa-tions, how a shift in demand orsupply affects the equilibrium, astudent will have a deeper ap-preciation for comparative stat-ics analysis and will be betterprepared to interpret events inreal markets.

L e a r n i n g - B y - D o i n gExercises, embedded in the textof each chapter, guide the stu-dent through specific numericalproblems. We use three to tenLearning-By-Doing exercises

P R E F A C E

Problem

(a) Suppose a constant elasticity demand curve is givenby the formula . What is the price elasticityof demand?

(b) Suppose a linear demand curve is given by the formula . What is the price elasticity ofdemand at P 30? At P 10?

Solution

(a) Since this is a constant elasticity demand curve, theprice elasticity of demand is equal to everywherealong the demand curve.

(b) For this linear demand curve, we can find the priceelasticity of demand by using equation (2.4):

1 2

Q 400 10P

Q 200P12

Elasticities along Special Demand Curves. Since b 10 and Q 400 10P,

when P 30,

and when P 10,

Note that demand is elastic at P 30, but it is inelastic atP 10 (in other words, P 30 is in the elastic region ofthe demand curve, while P 10 is in the inelastic region).

Similar Problems: 2.5, 2.6, 2.12

Q, P 10 a 10400 10(10)

b 0.33

Q,P 10 a 30400 10(30)

b 3

Q, P ( b)(P Q)

L E A R N I N G - B Y- D O I N G E X E R C I S E 2 . 6E

S

D

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viii PREFACE

in each chapter and have designed them to illustrate the core ideas of the chapter. Theyare integrated with the graphical and verbal exposition, so that students can clearly see,through the use of numbers and tangible algebraic relationships, what the graphs andwords are striving to teach. These exercises set the student up to do similar practiceproblems as well as more difficult analytical problems at the end of each chapter and inthe study guide that accompanies this text.

As noted above, we have added to the already complete end-of-chapter problemsets to give students and instructors more opportunity to assess student understand-ing. Chapters 1–13 have between 25 and 35 end-of-chapter exercises, while Chapters14–17 have between 20 and 25 exercises. There is at least one exercise for each of thetopics covered in the chapter, and the topics covered by the exercises generally followthe order of topics in the chapter. At the end of the book, there are fully worked-outsolutions to selected exercises.

• It Works in Theory, butDoes It Work in the RealWorld? Numerous “real-world” examples illustrate howmicroeconomics applies tobusiness decision-making andpublic policy issues. We begineach chapter with an extendedexample that introduces thekey themes of the chapter anduses real markets and compa-

nies to reinforce particular concepts and tools. Each chapter contains, on average,seven examples, called Applications, woven into the narrative or highlighted in side-bars. In this fouth edition, we have taken care to update our applications and to addto them, so that we now have over 120 Applications. A full list may be found on thefront endpapers of this text. New applications include health care reform in the U.S.,the collapse of AIG, parking meter privatization in Chicago, and the bailout of theParmesan cheese industry in Italy.

• Graphs Tell theStory. We use graphsand tables more abun-dantly than most texts,because they are centralto economic analysis, en-abling us to depict com-plex interactions simply.In economics, a picturetruly is worth a thousandwords. In each new edi-tion we have worked tomake the graphs evenclearer and more usefulfor students.Quantity (billions of bushels per year)

Pric

e (d

olla

rs p

er b

ushe

l)

13 14118 9

$5

$3

Excess supplywhen price

is $5

$4E

S

D

Excess demand

when price is $3

FIGURE 2.5 Excess Demand and ExcessSupply in Market for CornIf the price of corn were $3, per bushel, excessdemand would result because 14 billion bushelswould be demanded, but only 9 billion bushelswould be supplied. If the price of corn were $5per bushel, excess supply would result because13 billion bushels would be supplied but only 8billion bushels would be demanded.

prices usually rise in the spring through late sum-mer, due to warmer weather, closed schools, andsummer vacations. They are usually lower in winter.Gasoline prices can also fluctuate due to changes in crude oil prices, since gasoline is refined fromcrude oil.

In addition to these factors, gasoline prices arehighly responsive to changes in supply. Prices maychange dramatically if there are disruptions to the supply chain. Typical inventory levels of commer-cial gasoline usually amount to only a few days of

Gasoline prices tend to be highly volatile. Figure 2.23illustrates this by plotting the average retail gasolineprice in the United States in 2005.21 Large swings inprice in short periods of time are common, as areseasonal fluctuations. The seasonal changes arelargely attributable to shifts in demand. Gasoline

A P P L I C A T I O N 2.7

What Hurricane Katrina Tells Usabout the Price Elasticity of Demandfor Gasoline

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PREFACE ix

• Get to the Point. All too often, verbal explanations of economic ideas and con-cepts seem convoluted and unintuitive. Tables and graphs are powerful economictools, but many students cannot interpret them readily at first. We believe our expo-sition of the economic intuition underlying the graphs is clear and easy to follow. Wehave worked through every line to streamline the exposition. Patient step-by-step ex-planations with examples enable even nonvisual learners to understand how graphsare constructed and what they mean.

ORGANIZATION AND COVERAGEThis book is traditional in its coverage and organization. To the extent that we have madea trade-off, it is to cover traditional topics more thoroughly, as opposed to adding a broadrange of additional topics that might not easily fit into a one-quarter or one-semester microeconomics course. Thus an instructor teaching a one-semester microeconomicscourse could use all or nearly all of the chapters in the book, and an instructor teachinga one-quarter microeconomics or managerial economics course could use more thantwo-thirds of the chapters. The following chart shows how the book is organized.

ImperfectlyPerfectly Competitive

Introduction to Consumer Production and Competitive Monopoly and Markets andMicroeconomics Theory Cost Theory Markets Monopsony Strategic Behavior Special Topics

1 3 6 9 11 13 15

Overview and Introduction Production Profit-maximizing Theories of Price determina- Risk,uncertainty,introduction to consumer function, output choice by a monopoly and tion in imperfectly and information,to constrained choice marginal price-taking firm monopsony competitive including aoptimization, and average and prices in short- price setting markets utility-theoreticequilibrium product, and run and long-run approach to analysis, and returns equilibrium uncertainty and comparative to scale decision treestatics analysis analysis, Insurance

markets andasymmatric infor-mation, and auctions

2 4 7 10 12 14 16

Introduction Budget lines, Concept of Using the Price discrimi- Simultaneous- Overview ofto demand utility maxi- cost, input competitive nation move games general equi-curves, supply mization, and choice and market model and sequential librium theorycurves, market analysis of cost minimiza- to analyze move games and economicequilibrium, revealed tion public policy efficiencyand elasticity preference interventions

5 8 17

Comparative Construction Externalitiesstatics of of total, and publicconsumer average, and goodschoice and marginal costconsumer curvessurplus

ALTERNATIVE COURSE DESIGNSIn writing this book, we have tried to serve the needs of instructors teaching micro-economics in a variety of different formats and time frames.

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x PREFACE

• One-quarter course (10 weeks): An instructor teaching a one-quarter under-graduate microeconomics course that fully covers all of the traditional topics(including consumer theory and production and cost theory) would probably assign Chapters 1–11. If the instructor prefers to deemphasize consumer theoryor production theory, he or she might also be able to cover Chapters 13 and 14.

• One-semester course (15 weeks): In a one-semester undergraduate course, aninstructor should be able to cover Chapters 1–15. If the course must includegeneral equilibrium theory, public goods, and externalities, then Chapter 15could be dropped and the instructor could assign Chapters 1–14, 16, and 17.

• Two-quarter course (20 weeks): For a two-quarter sequence (the structure we have at Northwestern), the first quarter could cover Chapters 1–11, and the second quarter could pick up where the first quarter left off and coverChapters 12–17.

• MBA-level managerial economics course (10 weeks or 15 weeks): For aone-quarter course, the instructor would probably want to skip the chapters onconsumer theory, production functions, and cost minimization (Chapters 3–6and the second half of Chapter 7) and cover Chapters 1–2, the first half ofChapter 7—economic concepts of cost—Chapter 8, and Chapters 9–14.Extending such a course to a full semester would allow the instructor to includethe material on production and cost minimization as well as Chapter 15.

SUPPLEMENTARY RESOURCESThank you to Katharine Rockett, University of Essex; Dorothea Herreiner, LoyolaMarymount University; David Spigelman, University of Miami; Daya Muralidharan,University of California, Riverside; Brian Kench, University of Tampa; Douglas W. Copeland, Kansas State University; and Lanny Arvan for preparing the followingresources:

COMPANION WEB SITE (www.wiley.com/college/besanko) includes resources forboth students and instructors. Provides many of the resources listed here as well asLecture Outline PowerPoint presentations, and Excel-based problems that providegraphical illustrations related to key concepts within the text.

INSTRUCTOR’S MANUAL includes additional examples related to the chapter topics, references to relevant written works, Web site addresses, and so on, which enhance the material within each chapter of the text, additional problem sets, andsample exams. Found on the companion Web site.

SOLUTIONS MANUAL provides answers to end-of-chapter material and worked outsolutions to any additional material not already provided within the text. Found on thecompanion Web site.

TEST BANK contains nearly 1,000 multiple-choice and short answer questions as wellas a set of problems varying in level of difficulty and correlated to all learning objec-tives. Found on the companion Web site.

COMPUTERIZED TEST BANK consists of content from the Test Bank providedwithin a test-generating program that allows instructors to customize their exams.Found on the companion Web site.

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PREFACE xi

STUDY GUIDE includes a Chapter Summary, Exercises with multiple-choice answers(answers provided at the end of the chapter), Chapter Review Questions withAnswers, Problems with Answers, and Practice Exam Questions with Answers foreach chapter.

STUDENT PRACTICE QUIZZES contain at least 10–15 practice questions per chapter.Multiple choice and short answer questions, of varying difficulty, help students evalu-ate individual progress through a chapter.

BUSINESS EXTRA SELECT Wiley’s Business Extra Select program is a simple, inte-grated, online custom-publishing process that allows you to combine content fromWiley’s leading business publications with copyright-cleared content from such re-spected sources as INSEAD, Fortune, The Economist, The Wall Street Journal, HarvardBusiness School cases, and much more. In just a few simple steps you can help your stu-dents make the connection between the concepts you teach in your class and theirreal-world applications! Contact your Wiley representative for more information.

APLIA Aplia is a basic course management system which includes a gradebook, andoffers additional text-correlated tutorials, problems, graphing tools, news analysis,and experiments. An electronic version of Microeconomics, 4e is also included. Formore information, visit www.aplia.com/wiley or ask your local Wiley respresentative.

WILEYPLUS is an innovative, research-based, online environment for effective teach-ing and learning.

What do Students receive with WileyPLUS?A Research-based Design. Provides an online environment that integrates relevant resources, including the entire digital textbook, in an easy-to-navigate framework thathelps students study more effectively.

• WileyPLUS adds structure by organizing textbook content into smaller, moremanageable “chunks”.

• Related media, examples, and sample practice items reinforce the learning objectives.

• Innovative features such as calendars, visual progress tracking, and self-evaluationtools improve time management and strengthen areas of weakness.

One-on-one Engagement. Students receive 24/7 access to resources that promotepositive learning outcomes. Students engage with related examples (in various media)and sample practice items, including:

• Animated Learning-By-Doing Exercises• Excel Templates• Concept Questions

Measurable Outcomes. Throughout each study session, students can assess theirprogress and gain immediate feedback. WileyPLUS provides precise reporting ofstrengths and weaknesses, as well as individualized quizzes, so that students are confi-dent they are spending their time on the right things. With WileyPLUS, students alwaysknow the exact outcome of their efforts.

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xii PREFACE

What do Instructors receive with WileyPLUS?WileyPLUS provides reliable, customizable resources that reinforce course goals in-side and outside of the classroom as well as visibility into individual student progress.Pre-created materials and activities help instructors optimize their time:

Customizable Course Plan: WileyPLUS comes with a pre-created Course Plandesigned by a subject matter expert uniquely for this course. Simple drag-and-drop tools make it easy to assign the course plan as-is or modify it to reflect yourcourse syllabus.

Pre-created Activity Types Include:• Questions• Readings and resources• Presentations• Print Tests• Concept Mastery

Course Materials and Assessment Content:• Instructor’s Manual• Solutions Manual• Test Bank• PowerPoint Presentation Slides• Classroom Response System (Clicker) Questions• Gradable Reading Assignment Questions (embedded with online text)• Question Assignments: all end-of-chapter problems coded with hints, links to

text, whiteboard/show work feature and instructor controlled problem-solvinghelp.

Gradebook: WileyPLUS provides instant access to reports on trends in class perform-ance, student use of course materials and progress towards learning objectives, helpinginform decisions and drive classroom discussions.

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While the book was in development, we benefited enormously from the guidance ofa host of individuals both from within John Wiley & Sons and outside. We appreciatethe vision and guidance of the economics team at Wiley. Their commitment to thisbook has remained strong from the beginning of the first edition. We are grateful fortheir support.

We would like to thank Lacey Vitetta, Acquisitions Editor, for guiding, encour-aging, and supporting us throughout this fourth edition. Jennifer Manias, ProjectEditor, provided editorial support and kept us on track with deadlines on this and pre-vious editions. Jeanine Furino of Furino Production, handled the production of thebook in a meticulous and constructive fashion. Amy Scholz, our Marketing Manager,worked tirelessly to reach our markets. Others at Wiley who contributed to the beau-tiful production and design include Dorothy Sinclair, Janet Foxman, Maddy Lesure,Sheena Goldstein, and Anna Melhorn.

We are extraordinarily grateful to Michael Gibbs, who made significant contribu-tions to the Applications in the Fourth edition. He updated existing Applications andadded many new Applications. In so doing, he has helped us keep the book fresh andup to date. Mike’s work was creative, thoughtful, well-organized, and conscientious. Ithas been a pleasure to work with him.

The clarity of the presentation and organization in this book owes a great dealto the efforts of Leonard Neufeld, who provided a close and insightful line and artedit. Len carefully worked through every line of the manuscript and made numerousthoughtful suggestions for sharpening and streamlining the exposition. MelissaHayes, a Northwestern undergraduate, made extensive suggestions for making thefirst edition of the book readable from a student’s point of view. We owe a specialdebt to Nick Kreisle. Nick has worked with us as a colleague, as a teaching assistantin our courses, and as an instructor using our text in his own course in intermediatemicroeconomics. He carefully reviewed drafts of the manuscripts of the first and sec-ond editions, and provided many valuable suggestions. We are pleased that he is nowDr. Kreisle.

We would also like especially to thank Eric Schulz, who offered suggestions forthe book while at Williams College and has used the book in his classes atNorthwestern. Ken Brown and Matthew Eichner also tested the manuscript in theirclasses prior to publication. Ken also put together a thorough and extremely usefuldiary that related his experiences in using the first edition and offered many construc-tive suggestions for improving the presentation of key topics in the book. We havealso benefited from many helpful suggestions from Yossi Spiegel, Mort Kamien, NabilAl-Najjar, Ambarish Chandra, Justin Braeutigam, and Kate Rockett.

Finally, we owe a large debt of gratitude to the students in Ron Braeutigam’s sec-tions of Economics 310-1 at Northwestern and to the students in Microeconomics430 at the Kellogg School at Northwestern. These students have helped us eliminatesome of the rough edges as the book has evolved over time. Their experience of learn-ing from the book helped make our chapters clearer and more accessible.

The development of this book was aided by colleagues who participated in focusgroups or reviewed early drafts of the manuscript. Our thanks go to all of the individ-uals listed below.

xiii

A C K N O W L E D G M E N T S

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xiv ACKNOWLEDGMENTS

We are grateful for the comments we received from those who reviewed for theFourth Edition of this book:

Donald Bumpass, Sam Houston State University; Tina A. Carter, Florida StateUniversity; Carl Davidson, Michigan State University; Helen Knudsen, University ofPittsburgh; Robert P. McComb, Texas Tech University; Zuohong Pan, WesternConnecticut State University; Irene Trela, University of Western Ontario; and several others who wish to remain anonymous.

THIRD EDITION REVIEWERS:

Javad Amid, Uppsala University, Sweden; Shahina Amin, University of NorthernIowa; Eihab Fathelrahman, Washington State University, Vancouver; Thomas Gresik,University of Notre Dame; Eric Jamelske, University of Wisconsin, Eau Claire; DeanKarlan, Yale University; Mark Killingsworth, Rutgers University, Qihong Liu, TheUniversity of Oklahoma; Robert P. McComb, Texas Technical University; BrianMcManus, Washington University; Silve Parviainen, University of Illinois; FranciscaG. C. Richter, Cleveland State University; Brain Simboli, Lehigh University; CharlesN. Steele, Montana State University.

SECOND EDITION REVIEWERS:

James Burnell, College of Wooster; Whewon Cho, Tennessee TechnologicalUniversity; Paul Cowgill, Duke University; Ron Deiter, Iowa State University;Martine Duchatelet, Barry University; Otis W. Gilley, California State University,L.A.; Marvin A. Gordon, University of Illinois at Chicago; Gregory Green, IndianaState University; Umit Gurun, Michigan State University; Russell F. Hardy,University of New Mexico at Carlsbad; Dr. Naphtali Hoffman, Elmira University;Don Holley, Boise State University; Jiandong Ju, University of Oklahoma; MaryKassis, State University of West Georgia; Sang H. Lee, Southeastern LouisianaUniversity; Charles Mason, University of Wyoming; John J. Nader, Grand ValleyState University; Charles M. North, Baylor University; Richard M. Peck, Universityof Illinois-Chicago; Brian Peterson, Manchester College; Thomas Pogue, Universityof Iowa; Malcolm Robinson, Thomas More College; Philip Rothman, East CarolinaUniversity; Christopher S. Ruebeck, Lafayette College; Barbara Schone, GeorgetownUniversity; Konstantinos Serfes, SUNY-Stony Brook; Mark Thoma, University ofOregon; Michele T. Villinski, DePauw University; Robert O. Weagley, Missouri StateUniversity.

FIRST EDITION REVIEWERS:

Anas Alhajji, Colorado School of Mines; Scott Atkinson, University of Georgia; DorisBennett, Jacksonville State University; Arlo Biere, Kansas State University; DouglasBlair, Rutgers University; Michael Bognanno, Temple University; Stephen Bronars,University of Texas, Austin; Douglas Brown, Georgetown University; KennethBrown, University of Northern Iowa; Don Bumpass, Sam Houston State University;Colin Campbell, Ohio State University; Corey S. Capps, University of Illinois;Manual Carvajal, Florida International University; Kousik Chakrabarti, University ofMichigan, Ann Arbor; Myong-Hun Chang, Cleveland State University; KenChapman, California State University; Yongmin Chen, University of Colorado-Boulder; Kui Kwon (Alice) Chong, University of North Carolina-Charlotte; Peter

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ACKNOWLEDGMENTS xv

Coughlin, University of Maryland; Steven Craig, University of Houston; MikeCurme, Miami University; Rudolph Daniels, Florida A & M University; JamesDearden, Lehigh University; Stacey Deirgerconlin, Syracuse University; JohnEdwards, Tulane University; Matthew Eichner, Johns Hopkins University; RonelElul, Brown University; Maxim Engers, University of Virginia; Raymond Fisman,Columbia University; Eric Friedman, Rutgers University; Susan Gensemer, SyracuseUniversity; Steven Marc Goldman, University of California, Berkeley; Barnali Gupta,Miami University; Claire Hammond, Wake Forest University; Shawkat Hammoudeh,Drexel University; Lyn Holmes, Temple University; Michael Jerison, SUNY-Albany;Jiandong Ju, University of Oklahoma; David Kamerschen, University of Georgia;Donald Keenan, University of Georgia; Mark Killingsworth, Rutgers University;Philip King, San Francisco State University; Charles Lamberton, South Dakota StateUniversity; Donald Lien, University of Kansas; Leonard Loyd, University ofHouston; Mark Machina, University of California at San Diego; Mukul K.Manjumdar, Cornell University; Gilbert Mathis, Murray State University; MichaelMckee, University of New Mexico; Claudio Mezzetti, University of North Carolina;Peter Morgan, University of Michigan; John Moroney, Texas A & M; WilhelmNeuefeind, Washington University; Peter Norman, University of Wisconsin,Madison; Mudziviri Nziramasanga, Washington State University; IyatokunboOkediji, University of Oklahoma; Ken Parzych, Eastern Connecticut StateUniversity; Donald Pursell, University of Nebraska-Lincoln; Michael Raith,University of Chicago; Sunder Ramaswamy, Middlebury College; Jeanne Ringel,Louisiana State University; Robert Rosenman, Washington State University; SantanuRoy, Florida International University; Jolyne Sanjak, SUNY-Albany; David Schmidt,Indiana University; Mark Schupack, Brown University; Richard Sexton, University ofCalifornia, Davis; Jason Shachat, University of California, San Diego; MaxwellStinchcombe, University of Texas, Austin; Beck Taylor, Baylor University; CurtisTaylor, Texas A & M University; Thomas TenHoeve, Iowa State University; JohnThompson, Louisiana State University; Paul Thistle, Western Michigan University;Guogiang Tian, Texas A & M; Theofanis Tsoulouhas, North Carolina StateUniversity; Geoffrey Turnbull, Louisiana State University; Mich Tvede, University ofPennsylvania; Mark Walbert, Illinois University; Mark Walker, University of Arizona;Larry Westphal, Swarthmore College; Kealoha Widdows, Wabash College;Chiounan Yeh, Alabama State University.

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PART 1 INTRODUCTION TO MICROECONOMICSCHAPTER 1 Analyzing Economic Problems 1CHAPTER 2 Demand and Supply Analysis 26

APPENDIX: Price Elasticity of Demand Along a Constant Elasticity Demand Curve 72

PART 2 CONSUMER THEORYCHAPTER 3 Consumer Preferences and the Concept of Utility 73CHAPTER 4 Consumer Choice 103

APPENDIX 1: The Mathematics of Consumer Choice 143APPENDIX 2: The Time Value of Money 144

CHAPTER 5 The Theory of Demand 150

PART 3 PRODUCTION AND COST THEORYCHAPTER 6 Inputs and Production Functions 200

APPENDIX: The Elasticity of Substitution for a Cobb–Douglas Production Function 243CHAPTER 7 Costs and Cost Minimization 245

APPENDIX: Advanced Topics in Cost Minimization 281CHAPTER 8 Cost Curves 285

APPENDIX: Shephard’s Lemma and Duality 323

PART 4 PERFECT COMPETITIONCHAPTER 9 Perfectly Competitive Markets 327

APPENDIX: Profit Maximization Implies Cost Minimization 384CHAPTER 10 Competitive Markets: Applications 386

PART 5 MARKET POWERCHAPTER 11 Monopoly and Monopsony 438CHAPTER 12 Capturing Surplus 485

PART 6 IMPERFECT COMPETITION AND STRATEGIC BEHAVIORCHAPTER 13 Market Structure and Competition 528

APPENDIX: The Cournot Equilibrium and the Inverse Elasticity Pricing Rule 570CHAPTER 14 Game Theory and Strategic Behavior 571

PART 7 SPECIAL TOPICSCHAPTER 15 Risk and Information 604CHAPTER 16 General Equilibrium Theory 648

APPENDIX: Deriving the Demand and Supply Curves for General Equilibrium 692CHAPTER 17 Externalities and Public Goods 697

Mathematical Appendix 729

Solutions to Selected Problems 749Glossary 771Photo Credits 781Index 783

xvi

B R I E F C O N T E N T S

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CHAPTER 1 Analyzing Economic Problems 1

Microeconomics and Climate Change

1.1 Why Study Microeconomics? 4

1.2 Three Key Analytical Tools 5Constrained Optimization 6Equilibrium Analysis 12Comparative Statics 13

1.3 Positive and Normative Analysis 18

LEARNING-BY-DOING EXERCISES1.1 Constrained Optimization: The Farmer’s Fence 71.2 Constrained Optimization: Consumer Choice 81.3 Comparative Statics with Market Equilibrium in the

U.S. Market for Corn 161.4 Comparative Statics with Constrained

Optimization 18

CHAPTER 2 Demand and Supply Analysis 26

What Gives with the Price of Corn?

2.1 Demand, Supply, and Market Equilibrium 29Demand Curves 30Supply Curves 32Market Equilibrium 33Shifts in Supply and Demand 35

2.2 Price Elasticity of Demand 43Elasticities along Specific Demand Curves 45Price Elasticity of Demand and Total Revenue 47Determinants of the Price Elasticity of Demand 48

xvii

C O N T E N T S

PART 1 INTRODUCTION TO MICROECONOMICS

Market-Level versus Brand-Level Price Elasticities of Demand 49

2.3 Other Elasticities 51Income Elasticity of Demand 51Cross-Price Elasticity of Demand 52Price Elasticity of Supply 54

2.4 Elasticity in the Long Run versus the Short Run 54

Greater Elasticity in the Long Run Than in the Short Run 54

Greater Elasticity in the Short Run Than in the Long Run 56

2.5 Back-of-the-Envelope Calculations 57Fitting Linear Demand Curves Using Quantity, Price,

and Elasticity Information 58Identifying Supply and Demand Curves on the Back of an

Envelope 59Identifying the Price Elasticity of Demand from

Shifts in Supply 61

APPENDIX Price Elasticity of Demand along aConstant Elasticity Demand Curve 72

LEARNING-BY-DOING EXERCISES2.1 Sketching a Demand Curve 312.2 Sketching a Supply Curve 332.3 Calculating Equilibrium Price and Quantity 342.4 Comparative Statics on the Market

Equilibrium 372.5 Price Elasticity of Demand 452.6 Elasticities along Special Demand Curves 47

PART 2 CONSUMER THEORY

CHAPTER 3 Consumer Preferences and the Concept of Utility 73

Why Do You Like What You Like?

3.1 Representations of Preferences 75Assumptions about Consumer Preferences 75Ordinal and Cardinal Ranking 76

3.2 Utility Functions 77Preferences with a Single Good: The Concept of

Marginal Utility 77Preferences with Multiple Goods: Marginal Utility, Indifference

Curves, and the Marginal Rate of Substitution 81

3.3 Special Preferences 92Perfect Substitutes 92Perfect Complements 93The Cobb–Douglas Utility Function 94Quasilinear Utility Functions 95

LEARNING-BY-DOING EXERCISES3.1 Marginal Utility 823.2 Marginal Utility That Is Not Diminishing 833.3 Indifference Curves with Diminishing

MRSx,y 903.4 Indifference Curves with Increasing MRSx,y 91

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xviii CONTENTS

CHAPTER 4 Consumer Choice 103

How Much of What You Like Should You Buy?

4.1 The Budget Constraint 105How Does a Change in Income Affect the

Budget Line? 107How Does a Change in Price Affect the

Budget Line? 107

4.2 Optimal Choice 110Using the Tangency Condition to Understand When

a Basket Is Not Optimal 114Finding an Optimal Consumption Basket 115Two Ways of Thinking About Optimality 116Corner Points 118

4.3 Consumer Choice with Composite Goods 121Application: Coupons and Cash Subsidies 121Application: Joining a Club 125Application: Borrowing and Lending 126Application: Quantity Discounts 131

4.4 Revealed Preference 132Are Observed Choices Consistent with Utility

Maximization? 133

APPENDIX 1 The Mathematics of Consumer Choice 143

APPENDIX 2 The Time Value of Money 144

LEARNING-BY-DOING EXERCISES4.1 Good News/Bad News and the Budget Line 1104.2 Finding an Interior Optimum 1154.3 Finding a Corner Point Solution 1194.4 Corner Point Solution with Perfect

Substitutes 1204.5 Consumer Choice That Fails to Maximize Utility 1344.6 Other Uses of Revealed Preference 136

CHAPTER 5 The Theory of Demand 150

Why Understanding the Demand for Cigarettes IsImportant for Public Policy

5.1 Optimal Choice and Demand 152The Effects of a Change in Price 152The Effects of a Change in Income 155

The Effects of a Change in Price or Income: An AlgebraicApproach 160

5.2 Change in the Price of a Good: SubstitutionEffect and Income Effect 162

The Substitution Effect 163The Income Effect 163Income and Substitution Effects When Goods Are Not

Normal 165

5.3 Change in the Price of a Good: The Concept of Consumer Surplus 173

Understanding Consumer Surplus from theDemand Curve 173

Understanding Consumer Surplus from the Optimal Choice Diagram: Compensating Variation and Equivalent Variation 175

5.4 Market Demand 182Network Externalities 184Market Demand with Network Externalities 184

5.5 The Choice of Labor and Leisure 187As Wages Rise, Leisure First Decreases, Then

Increases 187The Backward-Bending Supply of Labor 189

5.6 Consumer Price Indices 192

LEARNING-BY-DOING EXERCISES5.1 A Normal Good Has a Positive Income Elasticity

of Demand 1595.2 Finding a Demand Curve (No Corner Points) 1605.3 Finding a Demand Curve (with a Corner

Point Solution) 1615.4 Finding Income and Substitution Effects

Algebraically 1685.5 Income and Substitution Effects with a

Price Increase 1705.6 Income and Substitution Effects with a Quasilinear

Utility Function 1715.7 Consumer Surplus: Looking at the Demand Curve 1745.8 Compensating and Equivalent Variations with No

Income Effect 1785.9 Compensating and Equivalent Variations with

an Income Effect 1805.10 The Demand for Leisure and the Supply of Labor 191

CHAPTER 6 Inputs and Production Functions 200

Can They Do It Better and Cheaper?

6.1 Introduction to Inputs and Production Functions 202

6.2 Production Functions with a Single Input 204

Total Product Functions 205Marginal and Average Product 206Relationship Between Marginal and Average Product 210

6.3 Production Functions with More Than One Input 210

Total Product and Marginal Product with Two Inputs 210Isoquants 212

PART 3 PRODUCTION AND COST THEORY

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CONTENTS xix

Economic and Uneconomic Regions of Production 216

Marginal Rate of Technical Substitution 217

6.4 Substitutability among Inputs 219Describing a Firm’s Input Substitution Opportunities

Graphically 220Elasticity of Substitution 222Special Production Functions 225

6.5 Returns to Scale 230Definitions 230Returns to Scale versus Diminishing Marginal

Returns 233

6.6 Technological Progress 233

APPENDIX The Elasticity of Substitution for a Cobb–Douglas Production Function 243

LEARNING-BY-DOING EXERCISES6.1 Deriving the Equation of an Isoquant 2166.2 Relating the Marginal Rate of Technical Substitution

to Marginal Products 2196.3 Calculating the Elasticity of Substitution from

a Production Function 2236.4 Returns to Scale for a Cobb–Douglas Production

Function 2326.5 Technological Progress 235

CHAPTER 7 Costs and Cost Minimization 245

What’s Behind the Self-Service Revolution?

7.1 Cost Concepts for Decision Making 247Opportunity Cost 247Economic versus Accounting Costs 250Sunk (Unavoidable) versus Nonsunk (Avoidable)

Costs 251

7.2 The Cost-Minimization Problem 253Long Run versus Short Run 253The Long-Run Cost-Minimization Problem 254Isocost Lines 255Graphical Characterization of the Solution to the

Long-Run Cost-Minimization Problem 256Corner Point Solutions 258

7.3 Comparative Statics Analysis of the Cost-Minimization Problem 260

Comparative Statics Analysis of Changes in Input Prices 260

Comparative Statics Analysis of Changes in Output 264

Summarizing the Comparative Statics Analysis: The Input Demand Curves 265

The Price Elasticity of Demand for Inputs 267

7.4 Short-Run Cost Minimization 269Characterizing Costs in the Short Run 270Cost Minimization in the Short Run 272

Comparative Statics: Short-Run Input Demand versus Long-Run Input Demand 273

More Than One Variable Input in the Short Run 274

APPENDIX Advanced Topics in Cost Minimization 281

LEARNING-BY-DOING EXERCISES7.1 Using the Cost Concepts for a College Campus

Business 2527.2 Finding an Interior Cost-Minimization

Optimum 2587.3 Finding a Corner Point Solution with Perfect

Substitutes 2597.4 Deriving the Input Demand Curves from a Production

Function 2677.5 Short-Run Cost Minimization with One

Fixed Input 2747.6 Short-Run Cost Minimization with Two Variable

Inputs 275

CHAPTER 8 Cost Curves 285

How Can HiSense Get a Handle on Costs?

8.1 Long-Run Cost Curves 287Long-Run Total Cost Curve 287How Does the Long-Run Total Cost Curve Shift When

Input Prices Change? 289Long-Run Average and Marginal Cost Curves 292

8.2 Short-Run Cost Curves 302Short-Run Total Cost Curve 302Relationship Between the Long-Run and the Short-Run

Total Cost Curves 303Short-Run Average and Marginal Cost Curves 305Relationships Between the Long-Run and the Short-Run

Average and Marginal Cost Curves 306When Are Long-Run and Short-Run Average and Marginal

Costs Equal, and When Are They Not? 307

8.3 Special Topics in Cost 310Economies of Scope 310Economies of Experience: The Experience

Curve 313

8.4 Estimating Cost Functions 315Constant Elasticity Cost Function 316Translog Cost Function 316

APPENDIX Shephard’s Lemma and Duality 323

LEARNING-BY-DOING EXERCISES8.1 Finding the Long-Run Total Cost Curve from a

Production Function 2888.2 Deriving Long-Run Average and Marginal Cost

Curves from a Long-Run Total Cost Curve 2948.3 Deriving a Short-Run Total Cost Curve 3038.4 The Relationship between Short-Run and Long-Run

Average Cost Curves 308

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PART 4 PERFECT COMPETITION

CHAPTER 9 Perfectly Competitive Markets 327

A Rose Is a Rose Is a Rose

9.1 What Is Perfect Competition? 330

9.2 Profit Maximization by a Price-Taking Firm 332Economic Profit versus Accounting Profit 333The Profit-Maximizing Output Choice for a

Price-Taking Firm 334

9.3 How the Market Price Is Determined: Short-Run Equilibrium 337

The Price-Taking Firm’s Short-Run Cost Structure 337Short-Run Supply Curve for a Price-Taking Firm

When All Fixed Costs Are Sunk 339Short-Run Supply Curve for a Price-Taking Firm When

Some Fixed Costs Are Sunk and Some Are Nonsunk 341

Short-Run Market Supply Curve 344Short-Run Perfectly Competitive Equilibrium 348Comparative Statics Analysis of the Short-Run

Equilibrium 349

9.4 How the Market Price Is Determined: Long-Run Equilibrium 352

Long-Run Output and Plant-Size Adjustments byEstablished Firms 352

The Firm’s Long-Run Supply Curve 353Free Entry and Long-Run Perfectly Competitive

Equilibrium 354Long-Run Market Supply Curve 356Constant-Cost, Increasing-Cost, and Decreasing-Cost

Industries 358What Does Perfect Competition Teach Us? 363

9.5 Economic Rent and Producer Surplus 367Economic Rent 367Producer Surplus 370Economic Profit, Producer Surplus, Economic Rent 376

APPENDIX Profit Maximization Implies Cost Minimization 384

LEARNING-BY-DOING EXERCISES9.1 Deriving the Short-Run Supply Curve for a

Price-Taking Firm 3419.2 Deriving the Short-Run Supply Curve for a Price-Taking

Firm with Some Nonsunk Fixed Costs 3439.3 Short-Run Market Equilibrium 3499.4 Calculating a Long-Run Equilibrium 3569.5 Calculating Producer Surplus 375

CHAPTER 10 Competitive Markets:Applications 386

Is Support a Good Thing?

10.1 The Invisible Hand, Excise Taxes and Subsidies 388

The Invisible Hand 389Excise Taxes 390Incidence of a Tax 394Subsidies 397

10.2 Price Ceilings and Floors 400Price Ceilings 400Price Floors 408

10.3 Production Quotas 413

10.4 Price Supports in the Agricultural Sector 417Acreage Limitation Programs 418Government Purchase Programs 418

10.5 Import Quotas and Tariffs 422Quotas 422Tariffs 425

LEARNING-BY-DOING EXERCISES10.1 Impact of an Excise Tax 39310.2 Impact of a Subsidy 40010.3 Impact of a Price Ceiling 40710.4 Impact of a Price Floor 41210.5 Comparing the Impact of an Excise Tax, a Price Floor,

and a Production Quota 41710.6 Effects of an Import Tariff 428

PART 5 MARKET POWER

CHAPTER 11 Monopoly and Monopsony 438

How Do Firms Play Monopoly?

11.1 Profit Maximization by a Monopolist 440The Profit-Maximization Condition 440A Closer Look at Marginal Revenue: Marginal Units and

Inframarginal Units 444Average Revenue and Marginal Revenue 445The Profit-Maximization Condition Shown

Graphically 447A Monopolist Does Not Have a Supply Curve 449

11.2 The Importance of Price Elasticity of Demand 450

Price Elasticity of Demand and the Profit-MaximizingPrice 450

Marginal Revenue and Price Elasticity of Demand 451Marginal Cost and Price Elasticity of Demand: The Inverse

Elasticity Pricing Rule 453The Monopolist Always Produces on the Elastic Region

of the Market Demand Curve 454The IEPR Applies Not Only to Monopolists 456Quantifying Market Power: The Lerner Index 457

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CONTENTS xxi

11.3 Comparative Statics for Monopolists 458Shifts in Market Demand 458Shifts in Marginal Cost 461

11.4 Monopoly with Multiple Plants and Markets 463

Output Choice with Two Plants 463Output Choice with Two Markets 465Profit Maximization by a Cartel 466

11.5 The Welfare Economics of Monopoly 469The Monopoly Equilibrium Differs from the Perfectly

Competitive Equilibrium 469Monopoly Deadweight Loss 471Rent-Seeking Activities 471

11.6 Why Do Monopoly Markets Exist? 471Natural Monopoly 472Barriers to Entry 473

11.7 Monopsony 475The Monopsonist’s Profit-Maximization Condition 475An Inverse Elasticity Pricing Rule for Monopsony 477Monopsony Deadweight Loss 478

LEARNING-BY-DOING EXERCISES11.1 Marginal and Average Revenue for a Linear Demand

Curve 44711.2 Applying the Monopolist’s Profit-Maximization

Condition 44911.3 Computing the Optimal Monopoly Price for a

Constant Elasticity Demand Curve 45311.4 Computing the Optimal Monopoly Price for a Linear

Demand Curve 45411.5 Computing the Optimal Price Using the Monopoly

Midpoint Rule 46011.6 Determining the Optimal Output, Price, and Division

of Production for a Multiplant Monopolist 46511.7 Determining the Optimal Output and Price for a

Monopolist Serving Two Markets 46611.8 Applying the Monopsonist’s Profit-Maximization

Condition 476

11.9 Applying the Inverse Elasticity Rule for a Monopsonist 478

CHAPTER 12 Capturing Surplus 485

Why Did Your Ticket Cost So Much Less Than Mine?

12.1 Capturing Surplus 487

12.2 First-Degree Price Discrimination: Making theMost from Each Consumer 490

12.3 Second-Degree Price Discrimination: Quantity Discounts 495

Block Pricing 495Subscription and Usage Charges 498

12.4 Third-Degree Price Discrimination: DifferentPrices for Different Market Segments 501

Two Different Segments, Two Different Prices 501Screening 504Third-Degree Price Discrimination with Capacity

Constraints 506Implementing the Scheme of Price Discrimination:

Building “Fences” 508

12.5 Tying (Tie-In Sales) 512Bundling 513Mixed Bundling 515

12.6 Advertising 518

LEARNING-BY-DOING EXERCISES12.1 Capturing Surplus: Uniform Pricing versus

First-Degree Price Discrimination 49212.2 Where Is the Marginal Revenue Curve with

First-Degree Price Discrimination? 49312.3 Increasing Profits with a Block Tariff 49712.4 Third-Degree Price Discrimination in Railroad

Transport 50312.5 Third-Degree Price Discrimination for Airline Tickets 50512.6 Price Discrimination Subject to Capacity Constraints 50712.7 Markup and Advertising-to-Sales Ratio 520

PART 6 IMPERFECT COMPETITION AND STRATEGIC BEHAVIOR

CHAPTER 13 Market Structure andCompetition 528

Is Competition Always the Same? If Not, Why Not?

13.1 Describing and Measuring Market Structure 530

13.2 Oligopoly with Homogeneous Products 533The Cournot Model of Oligopoly 533The Bertrand Model of Oligopoly 541Why Are the Cournot and Bertrand Equilibria

Different? 543The Stackelberg Model of Oligopoly 544

13.3 Dominant Firm Markets 546

13.4 Oligopoly with Horizontally DifferentiatedProducts 549

What Is Product Differentiation? 549Bertrand Price Competition with Horizontally

Differentiated Products 553

13.5 Monopolistic Competition 558Short-Run and Long-Run Equilibrium in Monopolistically

Competitive Markets 558Price Elasticity of Demand, Margins, and Number of Firms

in the Market 560Do Prices Fall When More Firms Enter? 560

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APPENDIX The Cournot Equilibrium and the Inverse Elasticity Pricing Rule 570

LEARNING-BY-DOING EXERCISES13.1 Computing a Cournot Equilibrium 53613.2 Computing the Cournot Equilibrium for Two or

More Firms with Linear Demand 54013.3 Computing the Equilibrium in the Dominant Firm

Model 54813.4 Computing a Bertrand Equilibrium with Horizontally

Differentiated Products 556

CHAPTER 14 Game Theory and StrategicBehavior 571

What’s in a Game?

14.1 The Concept of Nash Equilibrium 573A Simple Game 573

The Nash Equilibrium 574The Prisoners’ Dilemma 574Dominant and Dominated Strategies 575Games with More Than One Nash Equilibrium 579Mixed Strategies 583Summary: How to Find All the Nash Equilibria in a

Simultaneous-Move Game with Two Players 584

14.2 The Repeated Prisoners’ Dilemma 584

14.3 Sequential-Move Games and Strategic Moves 590Analyzing Sequential-Move Games 590The Strategic Value of Limiting One’s Options 593

LEARNING-BY-DOING EXERCISES14.1 Finding the Nash Equilibrium: Coke versus Pepsi 57814.2 Finding All of the Nash Equilibria in a Game 58214.3 An Entry Game 592

PART 7 SPECIAL TOPICS

CHAPTER 15 Risk and Information 604

What Are My Chances of Winning?

15.1 Describing Risky Outcomes 606Lotteries and Probabilities 606Expected Value 608Variance 608

15.2 Evaluating Risky Outcomes 611Utility Functions and Risk Preferences 611Risk-Neutral and Risk-Loving Preferences 614

15.3 Bearing and Eliminating Risk 617Risk Premium 617When Would a Risk-Averse Person Choose to Eliminate

Risk? The Demand for Insurance 620Asymmetric Information in Insurance Markets: Moral

Hazard and Adverse Selection 622

15.4 Analyzing Risky Decisions 627Decision Tree Basics 627Decision Trees with a Sequence of Decisions 629The Value of Information 631

15.5 Auctions 633Types of Auctions and Bidding Environments 634Auctions When Bidders Have Private Values 635Auctions When Bidders Have Common Values:

The Winner’s Curse 639

LEARNING-BY-DOING EXERCISES15.1 Computing the Expected Utility for Two Lotteries

for a Risk-Averse Decision Maker 61415.2 Computing the Expected Utility for Two Lotteries:

Risk-Neutral and Risk-Loving Decision Makers 61615.3 Computing the Risk Premium from a Utility

Function 620

15.4 The Willingness to Pay for Insurance 62115.5 Verifying the Nash Equilibrium in a First-Price

Sealed-Bid Auction with Private Values 636

CHAPTER 16 General Equilibrium Theory 648

How Do Gasoline Taxes Affect the Economy?

16.1 General Equilibrium Analysis: Two Markets 650

16.2 General Equilibrium Analysis: Many Markets 654

The Origins of Supply and Demand in a Simple Economy 654

The General Equilibrium in Our Simple Economy 660Walras’ Law 664

16.3 General Equilibrium Analysis: ComparativeStatics 665

16.4 The Efficiency of Competitive Markets 669What Is Economic Efficiency? 669Exchange Efficiency 670Input Efficiency 676Substitution Efficiency 678Pulling the Analysis Together: The Fundamental Theorems

of Welfare Economics 681

16.5 Gains from Free Trade 682Free Trade Is Mutually Beneficial 682Comparative Advantage 686

APPENDIX Deriving the Demand and Supply Curvesfor General Equilibrium in Figure 16.9 and Learning-by-Doing Exercise 16.2 692

LEARNING-BY-DOING EXERCISES16.1 Finding the Prices at a General Equilibrium with

Two Markets 654

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CONTENTS xxiii

16.2 Finding the Conditions for a General Equilibrium with Four Markets 663

16.3 Checking the Conditions for Exchange Efficiency 674

CHAPTER 17 Externalities and Public Goods 697

When Does the Invisible Hand Fail?

17.1 Introduction 699

17.2 Externalities 700Negative Externalities and Economic Efficiency 702Positive Externalities and Economic Efficiency 711Property Rights and the Coase Theorem 716

17.3 Public Goods 719

Efficient Provision of a Public Good 720The Free Rider Problem 722

LEARNING-BY-DOING EXERCISES17.1 The Efficient Amount of Pollution 70417.2 Emissions Fee 70717.3 The Coase Theorem 71717.4 Optimal Provision of a Public Good 721

Mathematical Appendix 729

Solutions to Selected Problems 749

Glossary 771

Photo Credits 781

Index 783

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1

1.1WHY STUDY MICROECONOMICS?

1.2THREE KEY ANALYTICAL TOOLS

1.3POSITIVE AND NORMATIVE ANALYSIS

APPLICATION 1.1 Generating Electricity: 8,760Decisions per Year

APPLICATION 1.2 The Toughest Ticket in Sports

ANALYZING ECONOMICPROBLEMS1.1 WHY STUDY MICROECONOMICS?

1APPLICATION 1.3 Positive and Normative

Analyses of the Minimum Wage

Microeconomics and Climate Change

By the late 2000s, the scientific consensus had formed: climate change is for real, and it cannot be

explained entirely by natural forces:

• There is compelling scientific evidence that concentrations of greenhouse gasses—compounds such as

carbon dioxide and methane whose properties work to warm surface temperatures on the Earth—

have accumulated to levels substantially higher than those that prevailed at any time during the last

500,000 years.

• There is strong evidence that the climate is warming. According to the Fourth Assessment of the

Intergovernmental Panel on Climate Change (IPCC) issued in 2007—the best representation of the

scientific consensus on climate change—“Warming of the climate system is unequivocal, as is now

evident from observations of increases in global average air and ocean temperatures, widespread

melting of snow and ice, and rising global average sea level.”1

1“Summary for Policymakers” in Climate Change 2007: The Physical Science Basis. Contributions of WorkingGroup I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, S. Soloman, D. Qin, M. Manning, Z. Chen, M. Marquis, K. B. Avery, M. Tignor, and H. L. Mikllers (eds.) (Cambridge:Cambridge University Press 2007), p. 5. http://www.ipcc.ch/ipccreports/ar4-wg1.htm (accessed April 3,2009).

c01analyzingeconomicproblems.qxd 7/14/10 10:54 AM Page 1

2

• There is persuasive evidence that climate change

has been induced, in part, by humans. According

to the IPCC: “The common conclusion of a wide

range of fingerprint studies conducted over the

last 15 years is that observed climate changes cannot

be explained by natural factors alone.”2

But if the diagnosis of climate change is un-

equivocal, what to do about it is less obvious.

Greenhouse gas emissions come from power plants,

factories, and automobiles all over the world. The

number of pollution sources that potentially need to

be controlled is mind-boggling. And large countries such as China and the United States, the two coun-

tries accounting for the largest share of greenhouse gas emissions, might balk at the enormous price

tag associated with curtailing their emissions. In light of these issues, the challenge of combating

global climate change would appear to be insurmountable.

Microeconomics offers powerful insights into why climate change is such a difficult problem and

what to do about it. Climate change is a tough problem to deal with because the parties that cause

greenhouse gas emissions are unlikely to take into account the environmental harm that their deci-

sions cause for others. For example, economists estimate that in the mid-2000s, the typical American

household caused about $150 annually in environmental damage by consuming products or services

that caused greenhouse gas emissions.3 Did you or your family take this into account when you

made decisions about how much electricity to use or how much to drive? Probably not. After all, you

did not have to pay this cost, either directly (because no one directly charged you for this cost) or

indirectly (because it was not reflected in the price of the products you consumed because the

producers of those products were not charged for this cost). New York Times columnist Tom

Friedman puts it this way:

[I]f I had my wish, the leaders of the world’s 20 top economies would commit themselves to a newstandard of accounting—call it “Market to Mother Nature” accounting. Why? Becouse it’s now obvi-ous that the reason we’re experiencing a simultaneous meltdown in the financial system and the climate system is because we have been mispricing risk in both arenas—producing a huge excess ofboth toxic assets and toxic air that now threatens the stability of the whole planet.

Just as A.I.G. sold insurance derivatives at prices that did not reflect the real costs and the real risksof massive defaults (for which we the taxpayers ended up paying the difference), oil companies, coalcompanies and electric utilities today are selling energy products at prices that do not reflect thereal costs to the environment and real risks of disruptive climate change (so future taxpayers willend up paying the difference).4

2H. R. Le Treut, R. Somerville, U. Cubasch, Y. Ding, C. Mauritzen, A. Mokssit, T. Peterson, and M. Prather,“Historical Overview of Climate Change,” in Climate Change 2007: The Physical Science Basis, p. 103.3The estimate of the social cost of electricity usage comes from W. Nordhaus, A Question of Balance:Weighing the Options on Global Warming Policies (New Haven, CT: Yale University Press, 2008), p. 11.4“The Price Is Not Right,” New York Times (March 31, 2009).

c01analyzingeconomicproblems.qxd 7/14/10 10:55 AM Page 2

But Friedman’s diagnosis of the problem is also suggestive of a solution: to induce parties to make

decisions that reflect the real costs of climate change, find a way to put a price on the harm that

greenhouse gas emissions cause to the climate and the economy. Basic ideas from microeconomics are

being applied today to help do this. Consider, for example, the European Union (EU) Emissions Trading

System. Under the provisions of the Kyoto Treaty, the countries of the EU must reduce their emissions

of greenhouse gases 8 percent below their emissions in 1990. To do so, the EU has adopted what is

called a cap-and-trade system.5

A cap-and-trade system applies microeconomics to achieve a given amount of pollution reduction at

a cost as low as possible. Here’s how it works. Caps are placed on how much of a greenhouse gas, say

carbon dioxide (CO2), can be emitted from specific sources (e.g., power plants or factories). At the same

time, CO2 permits are granted to the firms that own those sources of CO2 pollution, allowing them to

emit a given amount of CO2 within a given period of time. Firms are then free to trade these permits in

an open market. The idea behind this scheme is that a firm that can cheaply reduce its CO2 emissions

below its cap (e.g., by installing pollution control equipment) can sell its allowances to other firms for

whom pollution control would be more expensive. The beauty of this system—which follows directly

from the fact that it is market-based—is that reductions in emissions of a given amount are achieved as

cheaply as possible. Moreover, a government (or group of governments as in the case of the EU) does

not need to know which firms can reduce pollution more cheaply. The free market identifies those firms

through the purchase and sale of permits: firms with low costs of compliance sell permits; firms with

high costs of compliance buy them. And by reducing the supply of allowances over time, the govern-

ment can reduce pollution, all the while being assured that the reduction is done at as low a cost as is

possible.

Microeconomics is a field of study that has broad applicability. It can help public policy makers deal

with difficult issues such as climate change, and it can help those same public officials anticipate the

unintended consequences of the policies they adopt. For example, microeconomic analyses of cap-and-

trade systems reveal that while a cap-and-trade system offers the potential to correctly price greenhouse

gas emissions, there are circumstances under which this system can result in significant underpricing

or overpricing of those emissions if policy makers make even small mistakes in setting the cap.6

Microeconomics can also help business firms better understand their competitive environments, and it can

give them concrete tools that can be used to unlock additional profitability through pricing strategies. It

can help us understand how households’ consumption decisions are shaped by the fundamentals (e.g.,

tastes and price levels) they face, and it can shed light on why prices in competitive markets fluctuate as

they do. Microeconomics can even help us understand social phenomena such as crime and marriage

(yes, economists have even studied these). What’s remarkable is that nearly all phenomena studied by

3

5The Kyoto Treaty was adopted in the late 1990s, and it called for industrialized countries to scale backthe amount of greenhouse gases. The treaty was ratified by EU counties, but not by the United States.6See, for example, W. J. McKibbin and P. J. Wilcoxen, “The Role of Economics in Climate ChangePolicy,” Journal of Economic Perspectives, 16, no. 2 (Spring 2002): 107–129.

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4 CHAPTER 1 ANALYZING ECONOMIC PROBLEMS

economists rely on three powerful analytical tools: constrained optimization, equilibrium analysis, and

comparative statics.

CHAPTER PREVIEW After reading and studying this chapter, you will be able to:

• Contrast the two main branches of economics—microeconomics and macroeconomics.

• Describe the three main analytical tools of microeconomics—constrained optimization, equilibrium

analysis, and comparative statics—and recognize examples of each of these tools.

• Explain the difference between positive and normative analysis.

Economics is the science that deals with the allocation of limited resources to sat-isfy unlimited human wants. Think of human wants as being all the goods andservices that individuals desire, including food, clothing, shelter, and anything elsethat enhances the quality of life. Since we can always think of ways to improve ourwell-being with more or better goods and services, our wants are unlimited.However, to produce goods and services, we need resources, including labor, mana-gerial talent, capital, and raw materials. Resources are said to be scarce because theirsupply is limited. The scarcity of resources means that we are constrained in thechoices we can make about the goods and services we produce, and thus also aboutwhich human wants we will ultimately satisfy. That is why economics is oftendescribed as the science of constrained choice.

Broadly speaking, economics is composed of two branches, microeconomics andmacroeconomics. The prefix micro is derived from the Greek word mikros, whichmeans “small.” Microeconomics therefore studies the economic behavior of individ-ual economic decision makers, such as a consumer, a worker, a firm, or a manager. Italso analyzes the behavior of individual households, industries, markets, labor unions,or trade associations. By contrast, the prefix macro comes from the Greek wordmakros, which means “large.” Macroeconomics thus analyzes how an entire nationaleconomy performs. A course in macroeconomics would examine aggregate levels ofincome and employment, the levels of interest rates and prices, the rate of inflation,and the nature of business cycles in a national economy.

Constrained choice is important in both macroeconomics and microeconomics.For example, in macroeconomics we would see that a society with full employmentcould produce more goods for national defense, but it would then have to producefewer civilian goods. It might use more of its depletable natural resources, such asnatural gas, coal, and oil, to manufacture goods today, in which case it would con-serve less of these resources for the future. In a microeconomic setting, a consumermight decide to allocate more time to work, but would then have less time availablefor leisure activities. The consumer could spend more income on consumptiontoday, but would then save less for tomorrow. A manager might decide to spend moreof a firm’s resources on advertising, but this might leave less available for researchand development.

Every society has its own way of deciding how to allocate its scarce resources.Some resort to a highly centralized organization. For example, during the Cold War,governmental bureaucracies heavily controlled the allocation of resources in the

1.1WHY STUDYMICRO-ECONOMICS?

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