MICROECONOMICS. London School of Economics. University of Western Ontario. Prentice Hall FINANCIAL TIMES

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1 .&*,- *>"> MICROECONOMICS Saul Estrin London School of Economics David Laidler University of Western Ontario Michael Dietrich University of Sheffield Prentice Hall FINANCIAL TIMES An imprint of Pearson Education Harlow, England London New York Boston San Francisco Toronto Sydney Tokyo Singapore Hong Kong Seoul Taipei New Delhi Cape Town Madrid Mexico City Amsterdam Munich Paris Milan

2 List of boxes Preface About the authors Guided tour Acknowledgements xv xvii xxi xxii xxv 1 1 Parti THE THEORY OF CONSUMER BEHAVIOUR 11 2 The basic theory of consumer choice 13 3 Money income and real income 41 4 Utility 70 Part II CONSUMER THEORY: FURTHER TOPICS 89 5 Intertemporal choice 91 6 Intertemporal choice and capital markets Choice in the face of risk 117 Part III PRODUCTION AND COSTS Production functions Cost functions Production functions, cost functions, and the demand for factors of production 184 Part IV BASIC THEORY OF THE FIRM 11 Perfect competition Monopoly Product differentiation and monopolistic competition Alternative theories of the firm 279 PartV OLIGOPOLY AND STRATEGIC INTERACTION Oligopoly: an introduction Oligopoly, and strategic interaction Game theory 340 Part VI FACTOR MARKETS Factor demand Factor supply Labour markets - trade unions and bargaining 416 Part VII GENERAL EQUILIBRIUM AND WELFARE The exchange economy General equilibrium with production Welfare economics 468 Part VIII MISSING MARKETS Taxes, externalities and public goods Economics of information Public choice 523 Further reading 541 Index 545

3 47 u V,1 ' List of boxes Preface About the authors Guided tour Acknowledgements 1 Scarcity and economics The ubiquity of choice The co-ordination of individual choices An outline of the book XV xvii xxi xxii Parti fhe THEORY OF CONSUMER BEHAVIOUR XXV 2 The basic theory of consumer choice The subject matter of this chapter 14 The objects of choice 14 The budget constraint 15 The consumer's tastes 16 More on tastes - ordinal and cardinal utility 19 The solution to the choice problem 20 * An algebraic solution to the choice problem 23 The income consumption curve 25 Price consumption curves 28 The Engel curve 30 The demand curve 32 * A formal derivation of demand functions Notes 40 3 Money income and real income The effect of a change in income 41 The effect of a change in the price of the other good 42 The income effect and substitution effect 43 * An asterisk signifies those sections that make use of calculus and game theory, with a greater degree of difficulty signified by two asterisks Money income and real income 47 Constant real income and the compensating variation in money income 48 Two measures of real income 50 Constant real income and the equivalent variation in money income 53 Income and substitution effects without indifference curves - the idea of revealed preference 56 The 'standard of living' and the 'cost of living' 59 Measuring changes in the cost of living 60 * The Slutsky equation Utility The concept of consumer's surplus 70 An application of consumer's surplus 74 Marshallian consumer theory 75 Marshallian analysis in terms of indifference curves 78 The impossibility of comparing utility between persons 80 * The algebra of Marshallian analysis 81 ** Duality - a more general treatment of equivalent variation, compensating variation and consumer's surplus Part II CONSUMER THEORY: FURTHER TOPICS 5 Intertemporal choice The framework of choice without production 91 Time preference and the solution to the choice problem 94 Saving and the level of the rate of interest 96

4 Saving and changes in the rate of interest Notes Intertemporal choice and capital markets The production opportunity curve and the internal rate of return 103 Access to a perfect capital market 106 The separation of investment and consumption decisions 107 Rules for selecting the optimal investment-production plan Interdependent production opportunities Capital market imperfection Note 7 Choice in the face of risk The idea of expected utility Probability and cardinal utility Diminishing marginal utility and expected utility Insurance and gambling Insurance and gambling: further analysis Further analysis of risk Equilibrium demand for insurance A note on moral hazard and adverse selection 'art III PRODUCTION AND COSTS 8 Production functions Ownership, control and the entrepreneur Production Activities and the isoquant The production function 145 Long-run and short-run analysis 146 The long-run production function: some preliminaries 146 Returns to scale 147 Factors leading to variable returns to scale 151 Substitutability 152 The elasticity of substitution 153 The short-run production function and returns to a factor 156 More on diminishing returns 158 The general Cobb-Douglas function Note Cost functions Expenditure on inputs and the cost function 166 Long-run cost minimisation 166 Long-run total cost and the expansion path 170 Average and marginal costs in the long run 172 Long-run costs with varying returns to scale The short run Short-run cost functions Short- and long-run average cost - the 'envelope' Fixed and variable costs * From production to cost functions in the short run - a formal treatment 10 Production functions, cost functions, and the demand for factors of production From production to cost functions in the long run Fixed proportions technology Perfect substitutability Cobb-Douglas technology Conditional factor demand functions Costs when input prices change The cost function and conditional factor demand functions

5 Some properties of conditional factor demand functions 196 The effect of changes in input prices on average and marginal costs Demand elasticity and price discrimination 250 Perfect price discrimination 252 Multipart tariffs 253 Classifying types of price discrimination J artlv 3ASIC THEORY OF THE FIRM 11 Perfect competition The profit-maximisation hypothesis 206 The perfectly competitive firm's demand function 206 Total, average and marginal revenue 207 The firm's short-run supply curve 210 * A formal treatment 212 Price determination in the short run 214 The firm and the industry in the long run 215 The properties of the competitive industry 218 The U-shaped average cost curve and managerial inputs 221 Inter-firm differences in efficiency 222 Variations in factor prices in the short run 224 Factor price variations in the long run 226 Perfect competition and the supply curve 227 * Appendix - returns to scale and profitability in the Cobb-Douglas case Note Monopoly The demand curve, total revenue, and marginal revenue 233 * A formal treatment of the relationship between demand and marginal revenue - some examples 237 Profit-maximising price and output 238 * A formal treatment of monopoly equilibrium 241 Natural monopoly 242 Producer's surplus and the cost of monopoly 245 Price discrimination Product differentiation and monopolistic competition Goods, attributes and choice 260 The basic framework 260 A simple application - brand loyalty 263 An elaboration - combining brands 264 Product differentiation and market research 265 Advertising 267 Differentiated products and monopolistic competition 268 The firm in monopolistic competition 269 Monopolistic competition and efficiency 270 * A more formal analysis 272 Mark-up pricing 273 Criticisms of monopolistic competition Alternative theories of the firm Corporate governance 280 Revenue maximisation in a competitive market 282 The revenue-maximising hypothesis under monopoly 283 The effects of lump-sum taxes 284 The competitive labour-managed firm - an introduction 286 Maximising income per worker 286 Enterprise choices in the short run 288 * A more formal treatment 289 A comparison of income-per-workermaximising and profit-maximising firms 290 The short-run supply curve 291 The labour-managed firm in the long run 295 Labour-managed and profit-maximising firms with free entry

6 >artv )LIGOPOLY AND STRATEGIC INTERACTION Oligopoly - an introduction Collusive and non-collusive behaviour 303 The oligopoly problem 304 An illustration of the oligopoly problem: the kinked demand curve 305 Collusive behaviour - cartels 307 Cheating and retaliation Notes Oligopoly and strategic interaction The Cournot model 314 Isoprofit curves and reaction functions 315 * A more formal treatment of the Cournot model 321 More on the non-collusive approach 323 The Bertrand model 324 Price leadership 328 Stackelberg equilibrium 330 * A formal treatment of the Stackelberg model 332 Collusive and non-collusive behaviour compared - the contract curve * Conjectural variations 17 Game theory Dominant strategies Nash equilibrium The prisoners' dilemma Optimal cartel bargaining Repeated games Credibility and punishment in cartels Tit-for-tat 352 Sequential games 354 Entry deterrence and predatory pricing 355 Credibility and commitment 357 Mixed strategies 'artvr : ACTOR MARKETS 18 Factor demand Physical products and revenue products 365 Factor demand in the short run 368 * The firm's factor demand in the long run 371 Industry demand for labour 372 Influences on the elasticity of factor demand 373 Factor payments, the value of output and the Euler theorem 374 * The firm's factor demand in the long run - a formal analysis 378 Factor demand under monopoly 382 The monopolist's factor demand curves 382 * A formal treatment 386 Monopsony 387 Discriminating monopsony Factor supply Flows, stocks and their relationship 397 Supply to the firm and the industry 398 Transfer price and rent 399 Quasi-rent 401 The individual's supply of labour 402 The nature of the choice problem 402 Variations in the wage rate 404 Overtime payments 406 The effect of fixing the length of the working week 407 Household production - the simple case 408 Household production and the labour market 409

7 Household production and the labour supply function Factor prices and the distribution of income 20 Labour markets - trade unions and bargaining An overview of union behaviour Basic analysis of the monopoly union model Wage bill maximisation * Maximising expected utility of the representative worker The monopoly union model - a final comment s Bargaining between unions and firms Efficient bargaining * Bargaining theory Different union objectives and efficient bargaining Part VII GENERAL EQUILIBRIUM AND WELFARE 21 The exchange economy A simple exchange economy - the box diagram The contract curve, trade and the core Competitive prices and the auctioneer Properties of competitive equilibrium Blocking coalitions and the core The existence, uniqueness and stability of equilibrium Market mechanisms and planning General equilibrium with production The production sector 454 Production possibilities and the transformation curve 456 Simultaneous equilibrium in consumption and production Welfare economics The Pareto criterion and Pareto optimality 469 The Pareto criterion and competitive equilibrium in an exchange economy 470 Pareto optimality in production 471 The Pareto optimality of competitive equilibrium in a production economy 472 The two fundamental theorems of welfare economics 475 The Pareto criterion and distributional questions 475 Some illustrations 477 Compensation criteria 477 The compensation criteria in an ambiguous case 480 The utility frontier 480 The distribution of welfare Note 485 Part VIII MISSING MARKETS 24 Taxes, externalities and public goods Taxation and Pareto optimality 490 The second-best principle 491 Externalities and absence of markets 491 Property rights and the Coase theorem 494 Public goods 497 The free rider problem 498 Public goods and government intervention

8 25 Economics of information The idea of asymmetric information 502 The market for lemons 503 Adverse selection, quality choice and informed consumers 506 Adverse selection and moral hazard 509 Solutions to adverse selection - signals 513 Signalling in the labour market 514 Hidden action and managerial incentives Note Public choice Why vote at all? 525 The voting paradox The median voter The median voter and income redistribution The influence of the tax rate on mean income and tax revenue The median voter's problem Redistribution through the provision of public goods Variations in productivity and the extent of redistribution The significance and limitations of the median voter theorem Costly information Interest group politics Rent seeking Further reading Index Supporting resources Visit to find valuable online resources Companion Website for students Extra practice and self-assessment problems linked to the boxes in the text Solutions to selected problems in the text An online glossary of key terms Flashcards to test your understanding of key terms Annotated links to relevant economics sites on the web For instructors Complete, downloadable Instructor's Manual Detailed solutions to end-of-chapter problems in the text e New to this edition, testbank of customisabie questions for formative or summative assessment PowerPoints of ail figures and captions in the book Also: The Companion Website provides the following features: Search tool to help locate specific items of content results and profile tools to send results of quizzes to instructors Online help and support to assist with website usage and troubleshooting For more information please contact your local Pearson Education sales representative or visit