MICROECONOMICS. DAVID A. SESANKO Northwestern University, Kellogg School of Management

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1 MICROECONOMICS DAVID A. SESANKO Northwestern University, Kellogg School of Management RONALD R. BRAEUTIGAM Northwestern University, Department ofeconoiriics with Contributims from Michael J. Gibbs The University of Chicago, Booth School of Business WlLEY

2 BRIEF CONTENTS PART 1 INTRODUCTION TO MICROECONOMICS CHARTER 1 Analyzing Economic Problems 1 CHARTER 2 Demand and Supply Analysis 26 APPENDIX: Price Elasticity of Demand Along a Constant Elasticity Demand Curve 74 PART 2 CONSUMER THEORY CHARTER 3 Consumer Preferences and the Concept of Utility 75 CHARTER 4 Consumer Choice 105 APPENDIX 1: The Mathematics of Consumer Choice 145 APPENDIX 2: The Time Value of Money 146 CHARTER 5 The Theory of Demand 152 PART 3 PRODUCTION AND COST THEORY CHARTER 6 Inputs and Production Functions 204 APPENDIX: The Elasticity of Substitution for a Cobb-Douglas Production Function 247 CHARTER 7 Costs and Cost Minimization 249 APPENDIX: Advanced Topics in Cost Minimization 285 CHARTER 8 Cost Curves 289 APPENDIX: Shephard's Lemma and Duality 327 PART 4 PERFECT COMPETITiON CHARTER 9 Perfectly Competitive Markets 331 APPENDIX: Profit Maximization Implies Cost Minimization 388 CHARTER 10 Competitive Markets: Applications 390 PART 5 MARKET POWER CHARTER 11 Monopoly and Monopsony 442 CHARTER 12 Capturing Surplus 489 PART 6 IMPERFECT COMPETITION AND STRATEGIC BEHAVIOR CHARTER 13 Market Structure and Competition 532 APPENDIX: The Cournot Equilibrium and the Inverse Elasticity Pricing Rule 574 CHARTER 14 Game Theory and Strategie Behavior 575 PART 7 SPECIAL TOPICS CHARTER 15 Risk and Information 608 CHARTER 16 General Equilibrium Theory 654 APPENDIX: Deriving the Demand and Supply Curves for General Equilibrium 698 CHARTER 17 Externalities and Public Goods 703 Mathematical Appendix 739 Solutions to Selected Problems 759 Glossary 781 Index 789 XIII

3 CONTENTS PART 1 INTRODUCTION TO MICROECONOMICS CHARTER 1 Analyzing Economic Problems 1 Microeconomics and Climate Change 1.1 Why Study Microeconomics? Three Key Analytical Tools 5 Constrairied Optimization 6 Equilibrium Analysis 12 Comparative Statics Positive and Normative Analysis Constrained Optimization: The Farmer's Fence Constrained Optimization: Consumer Choice Comparative Statics with Market Equilibrium in the U.S. Market for Com Comparative Statics with Constrained Optimization 18 CHARTER 2 Demand and Supply Analysis 26 What Gives with the Price of Com? 2.1 Demand, Supply, and Market Equilibrium 29 Demand Curves 30 Supply Curves 32 Market Equilibrium 33 Shifts in Supply and Demand Price Elasticity of Demand 45 Elasticities Along Specific Demand Curves 47 Price Elasticity of Demand and Total Revenue 49 Determinants of the Price Elasticity of Demand 50 Market-Level versus Brand-Level Price Elasticities of Demand Other Elasticities 53 Income Elasticity of Demand 53 Cross-Price Elasticity of Demand 54 Price Elasticity of Supply Elasticity in the Long Run versus the Short Run 56 Greater Elasticity in the Long Run Than in the Short Run 56 Greater Elasticity in the Short Run Than in the Long Run Back-of-the-Envelope Calculations 59 Fitting Linear Demand Curves Using Quantity, Price, and Elasticity Information 60 Identifying Supply and Demand Curves on the Back of an Envelope 61 Identifying the Price Elasticity of Demand from Shifts in Supply 63 APPENDIX Price Elasticity of Demand Along a Constant Elasticity Demand Curve 74 LEARNING 8Y DÖING EXERCISES 2.1 Sketching a Demand Curve Sketching a Supply Curve Calculating Equilibrium Price and Quantity Comparative Statics on the Market Equilibrium Price Elasticity of Demand Elasticities along Special Demand Curves 49 PART 2 CONSUMER THEORY CHARTER 3 Consumer Preferences and the Concept of Utility 75 Why Do You Like What You Like? 3.1 Representation of Preferences 77 Assumptions About Consumer Preferences 77 Ordinal and Cardinal Ranking Utility Functions 80 Preferences with a Single Good: The Concept of Marginal Utility 80 Preferences with Multiple Goods: Marginal Utility, Indifference Curves, and the Marginal Rate of Substitution Special Preferences 95 Perfect Substitutes 95 Perfect Complements 96 The Cobb-Douglas Utility Function 97 Quasilinear Utility Functions 98 LEARNING-8Y DÖING EXERCISES 3.1 Marginal Utility Marginal Utility That Is Not Diminishing Indifference Curves with Diminishing MRS Ky Indifference Curves with Increasing MRS Ky 94 xiv

4 CONTENTS XV CHARTER 4 Consumer Choice 105 How Much of What You Like Should You Buy? 4.1 The Budget Constraint 107 How Does a Change in lncome Affect the Budget Line? 109 How Does a Change in Price Affect the Budget Line? Optimal Choice 112 Using the Tangency Condition to Understand When a Basket Is Not Optimal 116 Rinding an Optimal Consumption Basket 117 Two Ways of Thinking About Optimality 118 Corner Points Consumer Choice with Composite Goods 123 Application: Coupons and Cash Subsidies 123 Application: Joining a Club 127 Application: Borrowing and Lending 128 Application: Quantity Discounts Revealed Preference 134 Are Observed Choices Consistent with Utility Maximization? 135 APPENDIX 1 The Mathematics of Consumer Choice 145 APPENDIX 2 The Time Value of Money Good News/Bad News and the Budget Line Rinding an Interior Optimum Finding a Corner Point Solution Corner Point Solution with Perfect Substitutes Consumer Choice That Fails to Maximize Utility Other Uses of Revealed Preference 138 CHAPTER 5 The Theory of Demand 152 Why Understanding the Demand for Ogarettes Is Important for Public Policy 5.1 Optimal Choice and Demand 154 The Effects of a Change in Price 154 The Effects of a Change in lncome 157 The Effects of a Change in Price or lncome: An Algebraic Approach Change in the Price of a Good: Substitution Effect and lncome Effect 164 The Substitution Effect 165 The lncome Effect 165 lncome and Substitution Effects When Goods Are Not Normal Change in the Price of a Good: The Concept of Consumer Surplus 175 Understanding Consumer Surplus from the Demand Curve 175 Understanding Consumer Surplus from the Optimal Choice Diagram: Compensating Variation and Equivalent Variation Market Demand 184 Market Demand with Network Externalities The Choice of Labor and Leisure 189 As Wages Rise, Leisure First Decreases, Then Increases 189 The Backward-Bending Supply of Labor Consumer Price Indices 195 LEARNING-BY DÖING EXERCISES 5.1 A Normal Good Has a Positive lncome Elasticity of Demand Finding a Demand Curve (No Corner Points) Finding a Demand Curve (with a Corner Point Solution) Finding lncome and Substitution Effects Algebraically lncome and Substitution Effects with a Price Increase lncome and Substitution Effects with a Quasilinear Utility Function Consumer Surplus: Looking at the Demand Curve Compensating and Equivalent Variations with No lncome Effect Compensating and Equivalent Variations with an lncome Effect The Demand for Leisure and the Supply of Labor 193 PART 3 PRODUCTION AND COST THEORY CHAPTER 6 Inputs and Production Functions 204 Can They Do tt Better and Cheaper? 6.1 Introduction to Inputs and Production Functions Production Functions with a Single Input 208 Total Product Functions 209 Marginal and Average Product 210 Relationship Between Marginal and Average Product Production Functions with More Than One Input 214 Total Product and Marginal Product with Two Inputs 214 Isoquants 216

5 xvi CONTENTS Economic and Uneconomic Regions of Production 220 Marginal Rate of Technical Substitution Substitutability Among Inputs 223 Describing a Firm's In put Substitution Opportunities Graphically 224 Elasticity of Substitution 226 Special Production Functions Returns to Scale 234 Definitions 234 Returns to Scale versus Diminishing Marginal Returns Technological Progress 237 APPENDIX The Elasticity of Substitution for a Cobb-Douglas Production Function Deriving the Equation of an Isoquant Relating the Marginal Rate of Technical Substitution to Marginal Products Calculating the Elasticity of Substitution from a Production Function Returns to Scale for a Cobb-Douglas Production Function Technological Progress 239 CHARTER 7 Costs and Cost Minimization 249 Whafs Behind the Self-Service Revolution? 7.1 Cost Concepts for Decision Making 251 Opportunity Cost 251 Economic versus Accounting Costs 254 Sunk (Unavoidable) versus Nonsunk (Avoidable) Costs The Cost-Minimization Problem 257 Long Run versus Short Run 257 The Long-Run Cost-Minimization Problem 258 Isocost Lines 259 Graphical Characterization of the Solution to the Long-Run Cost-Minimization Problem 260 Corner Point Solutions Comparative Statics Analysis of the Cost-Minimization Problem 264 Comparative Statics Analysis of Changes in Input Prices 264 Comparative Statics Analysis of Changes in Output 268 Summarizing the Comparative Statics Analysis: The Input Demand Curves 269 The Price Elasticity of Demand for Inputs Short-Run Cost Minimization 273 Characterizing Costs in the Short Run 274 Cost Minimization in the Short Run 276 Comparative Statics: Short-Run Input Demand versus Long-Run Input Demand 277 More Than One Variable Input in the Short Run 278 APPENDIX Advanced Topics in Cost Minimization Using the Cost Concepts for a College Campus Business Finding an Interior Cost-Minimization Optimum Finding a Corner Point Solution with Perfect Substitutes Deriving the Input Demand Curves from a Production Function Short-Run Cost Minimization with One Fixed Input Short-Run Cost Minimization with Two Variable Inputs 279 CHARTER 8 Cost Curves 289 How Can HiSense Get a Handle on Costs? 8.1 Long-Run Cost Curves 291 Long-Run Total Cost Curve 291 How Does the Long-Run Total Cost Curve Shift When Input Prices Change? 293 Long-Run Average and Marginal Cost Curves Short-Run Cost Curves 306 Short-Run Total Cost Curve 306 Relationship ßetween the Long-Run and the Short-Run Total Cost Curves 307 Short-Run Average and Marginal Cost Curves 309 Relationships ßetween the Long-Run and the Short-Run Average and Marginal Cost Curves 310 When Are Long-Run and Short-Run Average and Marginal Costs Equal, and When Are They Not? Special Topics in Cost 314 Economies of Scope 314 Economies of Experience: The Experience Curve Estimating Cost Functions 319 Constant Elasticity Cost Function 320 Translog Cost Function 320 APPENDIX Shephard's Lemma and Duality Finding the Long-Run Total Cost Curve from a Production Function Deriving Long-Run Average and Marginal Cost Curves from a Long-Run Total Cost Curve Deriving a Short-Run Total Cost Curve The Relationship Between Short-Run and Long-Run Average Cost Curves 312

6 CONTENTS xvii PART 4 PERFECT COMPETITION CHAPTER 9 Perfectly Competitive Markets 331 A Rose Is a Rose Is a Rose 9.1 What Is Perfect Competition? Profit Maximization by a Price-Taking Firm 336 Economic Profit versus Accounting Profit 336 The Profit-Maximizing Output Choice for a Price-Taking Firm How the Market Price Is Determined: Short-Run Equilibrium 341 The Price-Taking Firm's Short-Run Cost Structure 341 Short-Run Supply Curve for a Price-Taking Firm When All Fixed Costs Are Sunk 343 Short-Run Supply Curve for a Price-Taking Firm When Some Fixed Costs Are Sunk and Some Are Nonsunk 345 Short-Run Market Supply Curve 349 Short-Run Perfectly Competitive Equilibrium 352 Comparative Statics Analysis of the Short-Run Equilibrium How the Market Price Is Determined: Long-Run Equilibrium 356 Long-Run Output and Plant-Size Adjustments by Established Firms 356 The Firm's Long-Run Supply Curve 357 Free Entry and Long-Run Perfectly Competitive Equilibrium 358 Long-Run Market Supply Curve 360 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries 362 What Does Perfect Competition Teach Us? Economic Rent and Producer Surplus 371 Economic Rent 371 Producer Surplus 374 Economic Profit, Producer Surplus, Economic Rent 380 APPENDIX Profit Maximization Implies Cost Minimization Deriving the Short-Run Supply Curve for a Price-Taking Firm Deriving the Short-Run Supply Curve for a Price-Taking Firm with Some Nonsunk Fixed Costs Short-Run Market Equilibrium Cakulating a Long-Run Equilibrium Calculating Producer Surplus 379 CHAPTER 10 Competitive Markets: Applications 390 Is Support a Good Thing? 10.1 The Invisible Hand, Excise Taxes and Subsidies 392 The Invisible Hand 393 Excise Taxes 394 Incidence of a Tax 398 Subsidies Price Ceilings and Floors 404 Price Ceilings 405 Price Floors Production Quotas Price Supports in the Agricultural Sector 421 Acreage Limitation Programs 422 Government Purchase Programs Import Quotas and Tariffs 426 Quotas 426 Tariffs Impact of an Excise Tax Impact of a Subsidy Impact of a Price Ceiling Impact of a Price Floor Comparing the Impact of an Excise Tax, a Price Floor. and a Production Quota Effects of an Import Tariff 432 PART 5 MARKET POWER CHAPTER 11 Monopoly and Monopsony 442 Why Do Firms Play Monopoly? 11.1 Profit Maximization by a Monopolist 444 The Profit-Maximization Condition 444 A Closer Look at Marginal Revenue: Marginal Units and Inframarginal Units 448 Average Revenue and Marginal Revenue 449 The Profit-Maximization Condition Shown Graphically 451 A Monopolist Does Not Have a Supply Curve The Importanee of Price Elasticity of Demand 454 Price Elasticity of Demand and the Profit-Maximizing Price 454 Marginal Revenue and Price Elasticity of Demand 455 Marginal Cost and Price Elasticity of Demand: The Inverse Elasticity Pricing Rule 457 The Monopolist Always Produces on the Elastic Region of the Market Demand Curve 458 The IEPR Applies Not Only to Monopolist* 460 Quantifying Market Power: The Lerner Index 461

7 xviii CONTENTS 11.3 Comparative Statics for Monopolists 462 Shifts in Market Demand 462 Shifts in Marginal Cost Monopolywith Multiple Plants and Markets 467 Output Choice with Two Plants 467 Output Choice with Two Markets 469 Profit Maximization by a Cartel The Weifare Economics of Monopoly 473 The Monopoly Equilibrium Differs from the Perfectly Competitive Equilibrium 473 Monopoly Deadweight Loss 475 Rent-Seeking Activities Why Do Monopoly Markets Exist? 475 Natural Monopoly 476 Barriers to Entry Monopsony 479 The Monopsonist's Profit-Maximization Condition 479 An Inverse Elasticity Pricing Rule for Monopsony 481 Monopsony Deadweight Loss Marginal and Average Revenue for a Linear Demand Curve Applying the Monopol ist's Profit-Maximization Condition Computing the Optimal Monopoly Price for a Constant Elasticity Demand Curve Computing the Optimal Monopoly Price for a Linear Demand Curve Computing the Optimal Price Using the Monopoly Midpoint Rule Determining the Optimal Output, Price, and Division of Production for a Multiplant Monopolist Determining the Optimal Output and Price for a Monopolist Serving Two Markets Applying the Monopsonist's Profit-Maximization Condition Applying the Inverse Elasticity Rule for a Monopsonist 482 CHAPTER 12 Capturing Surplus 489 Why Did Your Carpet or Your Airline Ticket Cost So Much Less Than Mine? 12.1 Capturing Surplus First-Degree Price Discrimination: Making the Most from Each Consumer Second-Degree Price Discrimination: Quantity Discounts 499 Block Pricing 499 Subscription and Usage Charges Third-Degree Price Discrimination: Different Prices for Different Market Segments 505 Two Different Segments, Two Different Prices 505 Screening 508 Third-Degree Price Discrimination with Capacity Constraints 510 Implementing the Scheme of Price Discrimination: Building "Fences" Tying (Tie-In Sales) 516 Bundling 517 Mixed Bundling Advertising Capturing Surplus: Uniform Pricing versus First-Degree Price Discrimination Where Is the Marginal Revenue Curve with First-Degree Price Discrimination? Increasing Profits with a Block Tariff Third-Degree Price Discrimination in Railroad Transport Third-Degree Price Discrimination for Airline Tickets Price Discrimination Subject to Capacity Constraints Markup and Advertising-to-Sales Ratio 524 PART 6 IMPERFECT COMPETITION AND STRATEGIC BEHAVIOR CHAPTER 13 Market Structure and Competition 532 Is Competition Always the Same? If Not, Why Not? 13.1 Describing and Measuring Market Structure Oligopoly with Homogeneous Products 537 The Cournot Model of Oligopoly 537 The Bertrand Model of Oligopoly 545 Why Are the Cournot and Bertrand Equilibria Different? 547 The Stackelberg Model of Oligopoly Dominant Firm Markets Oligopoly with Horizontally Differentiated Products 553 What Is Product Differentiation? 553 Bertrand Price Competition with Horizontally Differentiated Products Monopolistic Competition 562 Short-Run and Long-Run Equilibrium in Monopolistically Competitive Markets 562 Price Elasticity of Demand, Margins, and Number of Firms in the Market 564 Do Prices Fall When More Firms Enter? 564

8 CONTENTS xix APPENDIX The Cournot Equilibrium and the Inverse Elasticity Pricing Rule Computing a Cournot Equilibrium Computing the Cournot Equilibrium for Two or More Firms with Linear Demand Computing the Equilibrium in the Dominant Firm Model Computing a Bertrand Equilibrium with Horizontally Differentiated Products 560 CHAPTER 14 Game Theory and Strategie Behavior 575 Whafs In a Game? 14.1 The Concept of Nash Equilibrium 577 A Simple Game 577 The Nash Equilibrium 578 The Prisoners' Dilemma 578 Dominant and Dominated Strategies 579 Games with More Than One Nash Equilibrium 583 Mixed Strategies 586 Summary: How to Find All the Nash Equilibria in a Simultaneous-Move Game with Two Players The Repeated Prisoners' Dilemma Sequential-Move Games and Strategie Moves 594 Analyzing Sequential-Move Games 594 The Strategie Value of Limiting One's Options Finding the Nash Equilibrium: Coke versus Pepsi Finding All of the Nash Equilibria in a Game An Entry Game 596 PART 7 SPECIAL TOPICS CHAPTER 15 Risk and Information 608 Risky Business 15.1 Describing Risky Outcomes 610 Lotteries and Probabilities 610 " Expected Value 612 Variance Evaluating Risky Outcomes 615 Utility Functions and Risk Preferences 615 Risk-Neutral and Risk-Loving Preferences Bearing and Eliminating Risk 621 Risk Premium 621 When Would a Risk-Averse Person Choose to Eliminate Risk? The Demand for Insurance 624 Asymmetrie Information in Insurance Markets: Moral Hazard and Adverse Selection Analyzing Risky Decisions 633 Decision Tree Basics 633 Decision Trees with a Sequence of Decisions 635 The Value of Information Auctions 639 Types of Auctions and Bidding Environments 640 Auctions When Bidders Have Private Values 641 Auctions When Bidders Have Common Values: The Winner's Curse Computing the Expected Utility for Two Lotteries for a Risk-Averse Decision Maker Computing the Expected Utility for Two Lotteries: Risk-Neutral and Risk-Loving Decision Makers Computing the Risk Premium from a Utility Function The Willingness to Pay for Insurance Verifying the Nash Equilibrium in a First-Price Sealed-Bid Auction with Private Values 642 CHAPTER 16 General Equilibrium Theory 654 How Do Gasoline Taxes Affect the Economy? 16.1 General Equilibrium Analysis: Two Markets General Equilibrium Analysis: Many Markets 660 The Origins of Supply and Demand in a Simple Economy 660 The General Equilibrium in Our Simple Economy 666 Walras' Law General Equilibrium Analysis: Comparative Statics The Efficiency of Competitive Markets 675 What Is Economic Efficiency? 675 Exchange Efficiency 676 Input Efficiency 682 Substitution Efficiency 684 Pulling the Analysis Together: The Fundamental Theorems of Weifare Economics Gains from Free Trade 688 Free Trade Is Mutually Beneficial 688 Comparative Advantage 692 APPENDIX Deriving the Demand and Supply Curves for General Equilibrium in Figure 16.9 and Learningby-Doing Exercise Finding the Prices at a General Equilibrium with Two Markets 660

9 XX CONTENTS 16.2 Finding the Conditions for a General Equilibrium with Four Markets Checking the Conditions for Exchange Efficiency 680 CHAPTER 17 Externalities and Public Goods 703 When Does the Invisible Hand Fall? 17.1 Introduction Externalities 706 Negative Externalities and Economic Efficiency 708 Positive Externalities and Economic Efficiency 722 Property Rights and the Coase Theorem Public Goods 728 Efficient Provision of a Public Good 729 The Free-Rider Problem The Efficient Amount of Pollution Emissions Fee The Coase Theorem Optimal Provision of a Public Good 731 Mathematical Appendix 739 Solutions to Selected Problems 759 Glossary 781 Index 789

Preface. Chapter 1 Basic Tools Used in Understanding Microeconomics. 1.1 Economic Models

Preface. Chapter 1 Basic Tools Used in Understanding Microeconomics. 1.1 Economic Models Preface Chapter 1 Basic Tools Used in Understanding Microeconomics 1.1 Economic Models 1.1.1 Positive and Normative Analysis 1.1.2 The Market Economy Model 1.1.3 Types of Economic Problems 1.2 Mathematics