A TEXTBOOK OF MICROECONOMIC THEORY Pankaj Tandon Boston University DSAGE j TEXTS www.sagepu bl ications.com London Orth) SlntEpore WMhlnQton DC * Borton
CONTENTS Preface About the Author xiii xv Chapter 1: Introduction to Microeconomic Theory 1 1.1 The Two Central Ideas of Microeconomics 2 1.1.1 Marshall's Demand-Supply Cross 2 1.1.2 The Invisible Hand Theorem 5 1.2 Thinking Likean Economist 6 1.2.1 Think on the Margin 7 1.2.2 Think in Terms of Opportunities 8 1.2.3 Think in Terms of Equilibrium 9 1.3 Plan of This Book 10 Chapter 2: Theory of Consumer Behaviour 12 2.1 The Marshallian Theory of Demand 12 2.2 The Budget Constraint 14 2.2.1 Variations on the Budget Constraint 15 2.3 The Utility Function 19 2.3.1 Basic Properties of Utility Functions 20 2.3.2 Graphical Representation of Utility Functions: Indifference Curves 21 2.3.3 Some Specific Utility Functions 26 2.4 The Consumer's Choice Problem 30 2.4.1 Solving the Consumer's Choice Problem Graphically 31 2.4.2 Solving the Consumer's Choice Problem Algebraically 34 2.5 Comparative Statics on Demand Functions 39 2.5.1 Changes in Budget 40 2.5.2 Changes in Own-Price 45 2.5.3 Changes in Another Good's Price: The Cross-Price Effect 59 2.6 Final Properties of Demand Functions 62 2.6.1 Homogeneity of the Demand Function 62 2.6.2 Cournot Aggregation 63 2.7 Interpretation of the Lagrange Multiplier 64 2.7.1 The Lagrange Multiplier as the Marginal Utility of Money 64 2.7.2 The Lagrange Multiplier in the Consumer's Expenditure Minimisation Problem 65
viii I A TEXTBOOK OF MICROECONOMIC THEORY 2.7.3 The Marshallian Theory Revisited 66 2.8 Revealed Preference Approach to Demand Theory 67 Chapter 3: Applications of Consumer Theory 73 3.1 Taxes and Subsidies 73 3.1.1 The Optimality of Lump-sum Taxation 73 3.1.2 Cash Subsidies versus Food Subsidies 76 3.2 Measuring the Consumer's Weifare Change 79 3.2.1 Marshall's Consumer's Surplus Change 80 3.2.2 The Hicksian Approach: The Compensating and Equivalent Variations in Income 81 3.2.3 An Example to Calculate CV and EV 83 3.2.4 An Alternative Approach to Calculating CV and EV 85 3.2.5 Numerical Example 86 3.2.6 CV, EV and the Change in Consumer's Surplus 87 3.2.7 Weifare Analysis in the Revealed Preference Approach 89 3.3 The Construction of Price Indices 91 3.3.1 Laspeyres and Paasche Price Indices 92 3.3.2 'True' Price Indices 95 Chapter 4: Extensions of Consumer Theory 104 4.1 Demand with Home Production 104 4.2 The Labour Supply Decision 108 4.2.1 The Basic Model 109 4.2.2 Numerical Example: Cobb-Douglas Utility 113 4.2.3 Applications of the Labour Supply Model 114 4.3 Inter-Temporal Choice 117 Chapter 5: Production, Cost and Supply 125 5.1 The Production Function 125 5.1.1 Introduction to the Production Function and the Average and Marginal Products 125 5.1.2 The Elasticity of Substitution 130 5.1.3 Partial Elasticity of Substitution 132 5.1.4 Returns to Scale 132 5.2 Cost Functions 133 5.3 Relationship between the Short- and Long-run Cost Curves 140 5.4 Calculating the Cost Function: Examples 142
CONTENTS ix 5.4.1 Cobb-Douglas Production Function 143 5.4.2 Leontief Production Function 146 5.4.3 Linear Production Function 150 5.5 Profit Maximisation and Firm Supply 154 5.6 Supply in the Long Run 157 Chapter 6: Markets in Partial Equilibrium 164 6.1 The Market Demand Curve 164 6.2 The Market Supply Curve 167 6.2.1 Short versus Long Run 169 6.2.2 External Economies and Diseconomies 170 6.3 Market Equilibrium 172 6.4 Weifare Economics of Market Equilibrium 176 6.5 Analysing Market Interventions 177 6.5.1 Price Supports and Subsidised Sales 178 6.5.2 Price Floors and Price Ceilings 179 6.6 laxes 183 6.6.1 ExciseTaxes 183 6.6.2 Sales Taxes 185 6.6.3 Calculating the Effects of Commodity Taxes 186 6.6.4 Three Basic Results on the Effects of Commodity Taxes in Competitive Markets 190 6.7 Subsidies 194 6.8 Input Markets 195 6.8.1 The Demand for Labour 196 6.8.2 The Capital Market and the Firm's Investment Decision 197 6.8.3 Discounting, Present Value and Inter-temporal Aggregation 197 Chapter 7: General Equilibrium and Weifare Economics 206 7.1 Pareto Efficiency 206 7.2 The Social Allocation Problem 208 7.3 Efficiency in Consumption 211 7.3.1 Efficiency in Consumption and the Consumers' Contract Curve 212 7.3.2 Other Types of Consumers' Contract Curves 214 7.3.3 Competitive Equilibrium and Efficiency in Consumption 216
x I A TEXTBOOK OF MICROECONOMIC THEORY 7.4 Walras's Law 221 7.5 Efficiency in Production 223 7.6 Efficiency in Product-Mix 225 7.7 The Optimality Theorems of Weifare Economics 229 Chapter 8: Uncertainty and Information 237 8.1 Basics 237 8.2 Risk Aversion 239 8.3 The Expected Utility Hypothesis 240 8.3.1 Risk aversion and Insurance 242 8.3.2 Graphical Representation Using the Utility Function 245 8.3.3 Graphical Representation Using State-Contingent Utility 247 8.3.4 Decision Trees 252 8.4 Market Solutions to the Problems of Uncertainty 255 8.4.1 A Formula for the Cost of Risk 255 8.4.2 Risk-Pooling 257 8.4.3 Risk-Spreading 259 8.5 Barriers to Efficiency in Risk Markets 261 8.5.1 Correlated Risks 261 8.5.2 Asymmetrie Information 262 8.6 Methods to Overcome Inefficiencies in Risk Markets 271 8.6.1 Screening 272 8.6.2 Signalling 273 Chapter 9: Monopoly and Market Power 280 9.1 Basic Monopoly Model 282 9.1.1 Multi-Plant Monopoly 287 9.1.2 Multiple Plants in the Long Run 289 9.1.3 Comparing Monopoly to Perfect Competition 291 9.1.4 Cartels: A Digression 294 9.2 Variations to the Basic Model: Alternative Pricing Strategies 296 9.2.1 Two-Part Pricing 297 9.2.2 First-Degree Price Discrimination 300 9.2.3 Third-Degree Price Discrimination 302 9.2.4 Second-Degree Price Discrimination 304 9.3 Limit (Entry-Deterring) Pricing 310 9.3.1 Contestable Markets 310 9.3.2 The Price Leadership Model 311 9.3.3 Price Leadership in the Long Run 316
CONTENTS xi 9.4 Natural Monopoly and Regulation 317 9.4.1 The Fundamental Pricing Problem in Natural Monopoly 319 9.4.2 Marginal Cost Pricing and the Deficit Problem 320 9.4.3 Average Cost Pricing 320 9.4.4 Two-Part Pricing 320 9.4.5 The Multi-Product Firm and Ramsey Pricing 323 9.4.6 Peak-Load Pricing 325 9.4.7 Rate-of-Return Regulation and the Averch-Johnson Effect 326 9.4.8 The Problem of X-Inefficiency in Regulated and State-Owned Monopolies 327 9.4.9 Price-Cap Regulation and Other Trends in Regulatory Policy 328 9.5 Monopsony 331 9.5.1 Basic Monopsony Model 331 9.5.2 Alternative Pricing Strategies 334 9.6 Bilateral Monopoly 335 Chapter 10: The Theory of Games 345 10.1 Basics 345 10.2 Static Games of Complete Information 347 10.2.1 The Prisoners'Dilemma 347 10.2.2 Battie of the Sexes 350 10.2.3 Matching Pennies and Mixed Strategies 352 10.2.4 Mixed Strategies in the Battie of the Sexes Game 354 10.3 Sequential Games 355 10.4 Repeated Games 359 Chapter 11: Market Structures between Competition and Monopoly 363 11.1 Monopolistic Competition 363 11.2 The Cournot Model 367 11.2.1 The Basic Model 368 11.2.2 Graphical Exposition of the Duopoly Gase 369 11.2.3 Reaching the Cournot Equilibrium: A Dynamic Process 370 11.2.4 An Example: The Gase of Linear Demand and Constant Costs 371 11.2.5 Free Entry in Long-Run Cournot Equilibrium 374 11.3 The Stackelberg Model and Strategie Behaviour 376 11.3.1 The Best-Response Function Revisited 377 11.3.2 The Stackelberg Model 379 11.3.3 Entry Deterrence in the Stackelberg Model 382
xii I A TEXTBOOK OF MICROECONOMIC THEORY 11.4 Price Competition 384 11.4.1 The Bertrand Model 385 11.4.2 Capacity Constraints in the Bertrand Model 386 11.4.3 Bertrand Competition with Increasing Marginal Cost 388 11.4.4 Bertrand Competition with Differentiated Products 389 11.4.5 Strategie Behaviour in the Bertrand Model 392 Chapter 12: Externalities and Public Goods 402 12.1 Externalities 402 12.1.1 The Allocation Problem under Externalities 404 12.1.2 The Pigouvian Tax 405 12.1.3 The Possibility of Abatement and Effluent Fees 406 12.1.4 Relationship between Effluent Fees and Pigouvian laxes 410 12.1.5 Positive Externalities 417 12.1.6 The Coase Theorem 417 12.1.7 Common Property Externalities 421 12.2 Public Goods 424 12.2.1 The Allocation Problem with Public Goods 425 12.2.2 The Free Rider Problem and Demand Revelation 429 12.2.3 Voting 432 Answers to Chapter-end Exercises Index A-1 1-1