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Intermediate Microeconomics

A Modern Approach

Eighth Edition

W. W. Norton & Company has been independent since its founding in 1923, when William Warder Norton and Mary D. Herter Norton first published lec- tures delivered at the People"s Institute, the adult education division of New York City"s Cooper Union. The firm soon expanded its program beyond the In- stitute, publishing books by celebrated academics from America and abroad. By mid-century, the two major pillars of Norton"s publishing program"trade books and college texts"were firmly established. In the 1950s, the Norton family trans- ferred control of the company to its employees, and today"with a sta of four hundred and a comparable number of trade, college, and professional titles pub- lished each year"W. W. Norton & Company stands as the largest and oldest publishing house owned wholly by its employees.

Copyright

cffi2010, 2006, 2003, 1999, 1996, 1993, 1990, 1987 by Hal R. Varian

All rights reserved

Printed in the United States of America

EIGHTH EDITION

Editor: Jack Repcheck

Production Manager: Eric Pier-Hocking

Editorial Assistant: Jason Spears

T

EXnician: Hal Varian

ISBN 978-0-393-93424-3

W. W. Norton & Company, Inc., 500 Fifth Avenue, New York, N.Y. 10110 W. W. Norton & Company, Ltd., Castle House, 75/76 Wells Street, London W1T 3QT www.wwnorton.com

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Intermediate

Microeconomics

A Modern Approach

Eighth Edition

Hal R. Varian

University of California at Berkeley

W. W. Norton & Company€New York€London

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To Carol

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CONTENTS

Prefacexix

1 The Market

Constructing a Model1Optimization and Equilibrium3The De- mand Curve3The Supply Curve5Market Equilibrium7Com- parative Statics9Other Ways to Allocate Apartments11The Dis- criminating Monopolist€The Ordinary Monopolist€Rent Control€ Which Way Is Best?14Pareto Eτciency15Comparing Ways to Al- locate Apartments16Equilibrium in the Long Run17Summary18

Review Questions19

2 Budget Constraint

The Budget Constraint20Two Goods Are Often Enough21Prop- erties of the Budget Set22How the Budget Line Changes24The Numeraire26Taxes, Subsidies, and Rationing26Example: The Food Stamp ProgramBudget Line Changes31Summary31Review

Questions32

VIIICONTENTS

3 Preferences

Consumer Preferences34Assumptions about Preferences35Indif- ference Curves36Examples of Preferences37Perfect Substitutes €Perfect Complements€Bads€Neutrals€Satiation€Discrete Goods€Well-Behaved Preferences44The Marginal Rate of Substitu- tion48Other Interpretations of the MRS50Behavior of the MRS

51Summary52Review Questions52

4 Utility

Cardinal Utility57Constructing a Utility Function58Some Exam- ples of Utility Functions59Example: Indierence Curves from Utility Perfect Substitutes€Perfect Complements€Quasilinear Preferences €Cobb-Douglas Preferences€Marginal Utility65Marginal Utility and MRS66Utility for Commuting67Summary69Review Questions70Appendix70Example: Cobb-Douglas Preferences

5 Choice

Optimal Choice73Consumer Demand78Some Examples78

Perfect Substitutes€Perfect Complements€Neutrals and Bads€ Discrete Goods€Concave Preferences€Cobb-Douglas Preferences€ Estimating Utility Functions83Implications of the MRS Condition85

Choosing Taxes87Summary89Review Questions89Appen-

dix90Example: Cobb-Douglas Demand Functions

6 Demand

Normal and Inferior Goods96Income Oσer Curves and Engel Curves

97Some Examples99Perfect Substitutes€Perfect Complements

€Cobb-Douglas Preferences€Homothetic Preferences€Quasilinear Preferences€Ordinary Goods and Giσen Goods104The Price Oσer Curve and the Demand Curve106Some Examples107Perfect Substitutes€Perfect Complements€A Discrete Good€Substitutes and Complements111The Inverse Demand Function112Summary

114Review Questions115Appendix115

CONTENTSIX

7 Revealed Preference

The Idea of Revealed Preference119From Revealed Preference to Pref- erence120Recovering Preferences122The Weak Axiom of Re- vealed Preference124Checking WARP125The Strong Axiom of Revealed Preference128How to Check SARP129Index Numbers

130Price Indices132Example: Indexing Social Security Payments

Summary135Review Questions135

8 Slutsky Equation

The Substitution Eσect137Example: Calculating the Substitution Ef- fectThe Income Eσect141Example: Calculating the Income Eect Sign of the Substitution Eσect142The Total Change in Demand143 Rates of Change144The Law of Demand147Examples of Income and Substitution Eσects147Example: Rebating a Tax Example: Voluntary Real Time PricingAnother Substitution Eσect153Com- pensated Demand Curves155Summary156Review Questions157

Appendix157Example: Rebating a Small Tax

9 Buying and Selling

Net and Gross Demands160The Budget Constraint161Changing the Endowment163Price Changes164Oσer Curves and Demand Curves167The Slutsky Equation Revisited168Use of the Slut- sky Equation172Example: Calculating the Endowment Income Eect Labor Supply173The Budget Constraint€Comparative Statics of Labor Supply174Example: Overtime and the Supply of LaborSum- mary178Review Questions179Appendix179

XCONTENTS

10 Intertemporal Choice

The Budget Constraint182Preferences for Consumption185Com- parative Statics186The Slutsky Equation and Intertemporal Choice

187Inflation189Present Value: A Closer Look191Analyz-

ing Present Value for Several Periods193Use of Present Value194 Example: Valuing a Stream of Payments Example: The True Cost of a Credit Card Example: Extending CopyrightBonds198Exam- ple: Installment LoansTaxes200Example: Scholarships and Sav- ingsChoice of the Interest Rate201Summary202Review Ques- tions202

11 Asset Markets

Rates of Return203Arbitrage and Present Value205Adjustments for Differences among Assets205Assets with Consumption Returns

206Taxation of Asset Returns207Market Bubbles208Applica-

tions209Depletable Resources•When to Cut a Forest•Example: Gasoline Prices during the Gulf WarFinancial Institutions213Sum- mary214Review Questions215Appendix215

12 Uncertainty

Contingent Consumption217Example: Catastrophe BondsUtility Functions and Probabilities222Example: Some Examples of Utility FunctionsExpected Utility223Why Expected Utility Is Reasonable

224Risk Aversion226Example: The Demand for InsuranceDi-

versification230Risk Spreading230Role of the Stock Market231

Summary232Review Questions232Appendix233Example:

The Effect of Taxation on Investment in Risky Assets

13 Risky Assets

Mean-Variance Utility236Measuring Risk241Counterparty Risk

243Equilibrium in a Market for Risky Assets243How Returns

Adjust245Example: Value at Risk Example: Ranking Mutual Funds

Summary249Review Questions250

CONTENTSXI

14 Consumers Surplus

Demand for a Discrete Good252Constructing Utility from Demand

253Other Interpretations of Consumers Surplus254From Con-

sumers Surplus to Consumers Surplus255Approximating a Continu- ous Demand255Quasilinear Utility255Interpreting the Change in Consumers Surplus256Example: The Change in Consumer"s Surplus Compensating and Equivalent Variation258Example: Compensating and Equivalent Variations Example: Compensating and Equivalent Vari- ation for Quasilinear PreferencesProducers Surplus262Bene“t-Cost Analysis264Rationing€Calculating Gains and Losses266Sum- mary267Review Questions267Appendix268Example: A Few Demand Functions Example: CV, EV, and Consumer"s Surplus

15 Market Demand

From Individual to Market Demand270The Inverse Demand Function

272Example: Adding Up "Linear" Demand CurvesDiscrete Goods

273The Extensive and the Intensive Margin273Elasticity274

Example: The Elasticity of a Linear Demand CurveElasticity and De- mand276Elasticity and Revenue277Example: Strikes and Profits Constant Elasticity Demands280Elasticity and Marginal Revenue281 Example: Setting a PriceMarginal Revenue Curves283Income Elas- ticity284Summary285Review Questions286Appendix287 Example: The Laer Curve Example: Another Expression for Elasticity

16 Equilibrium

Supply293Market Equilibrium293Two Special Cases294In- verse Demand and Supply Curves295Example: Equilibrium with Lin- ear CurvesComparative Statics297Example: Shifting Both Curves Taxes298Example: Taxation with Linear Demand and SupplyPass- ing Along a Tax302The Deadweight Loss of a Tax304Example: The Market for Loans Example: Food Subsidies Example: Subsidies in IraqPareto E?ciency310Example: Waiting in LineSummary313

Review Questions313

XIICONTENTS

17 Auctions

Classification of Auctions316Bidding Rules•Auction Design317 Other Auction Forms320Example: Late Bidding on eBayPosition Auctions322Two Bidders•More Than Two Bidders•Quality Scores•Problems with Auctions326Example: Taking Bids Off the WallThe Winner"s Curse327Stable Marriage Problem327Mech- anism Design329Summary331Review Questions331

18 Technology

Inputs and Outputs332Describing Technological Constraints333 Examples of Technology334Fixed Proportions•Perfect Substi- tutes•Cobb-Douglas•Properties of Technology336The Marginal Product338The Technical Rate of Substitution338Diminishing Marginal Product339Diminishing Technical Rate of Substitution339 The Long Run and the Short Run340Returns to Scale340Ex- ample: Datacenters Example: Copy Exactly!Summary343Review

Questions344

19 Profit Maximization

Profits345The Organization of Firms347Profits and Stock Market Value347The Boundaries of the Firm349Fixed and Variable Fac- tors350Short-Run Profit Maximization350Comparative Statics

352Profit Maximization in the Long Run353Inverse Factor Demand

Curves354Profit Maximization and Returns to Scale355Revealed Profitability356Example: How Do Farmers React to Price Supports? Cost Minimization360Summary360Review Questions361Ap- pendix362

CONTENTSXIII

20 Cost Minimization

Cost Minimization364Example: Minimizing Costs for Specific Tech- nologiesRevealed Cost Minimization368Returns to Scale and the Cost Function369Long-Run and Short-Run Costs371Fixed and

Quasi-Fixed Costs373Sunk Costs373Summary374Review

Questions374Appendix375

21 Cost Curves

Average Costs378Marginal Costs380Marginal Costs and Variable Costs382Example: Specific Cost Curves Example: Marginal Cost Curves for Two PlantsCost Curves for Online Auctions386Long-Run Costs387Discrete Levels of Plant Size389Long-Run Marginal Costs

390Summary391Review Questions392Appendix393

22 Firm Supply

Market Environments395Pure Competition396The Supply Deci- sion of a Competitive Firm398An Exception400Another Exception

401Example: Pricing Operating SystemsThe Inverse Supply Func-

tion403Profits and Producer"s Surplus403Example: The Supply Curve for a Specific Cost FunctionThe Long-Run Supply Curve of a Firm

407Long-Run Constant Average Costs409Summary410Review

Questions411Appendix411

XIVCONTENTS

23 Industry Supply

Short-Run Industry Supply413Industry Equilibrium in the Short Run

414Industry Equilibrium in the Long Run415The Long-Run Supply

Curve417Example: Taxation in the Long Run and in the Short Run The Meaning of Zero Profits421Fixed Factors and Economic Rent

422Example: Taxi Licenses in New York CityEconomic Rent424

Rental Rates and Prices426Example: Liquor LicensesThe Politics of Rent427Example: Farming the GovernmentEnergy Policy429 Two-Tiered Oil Pricing€Price Controls€The Entitlement Program €Carbon Tax Versus Cap and Trade433Optimal Production of Emis- sions€A Carbon Tax€Cap and Trade€Summary437Review

Questions437

24 Monopoly

Maximizing Profits440Linear Demand Curve and Monopoly441 Markup Pricing443Example: The Impact of Taxes on a Monopo- listIneciency of Monopoly445Deadweight Loss of Monopoly447 Example: The Optimal Life of a Patent Example: Patent Thickets Ex- ample: Managing the Supply of PotatoesNatural Monopoly451What Causes Monopolies?454Example: Diamonds Are Forever Example: Pooling in Auction Markets Example: Price Fixing in Computer Memory

MarketsSummary458Review Questions458Appendix459

25 Monopoly Behavior

Price Discrimination462First-Degree Price Discrimination462Ex- ample: First-degree Price Discrimination in PracticeSecond-Degree Price Discrimination465Example: Price Discrimination in Airfares Ex- ample: Prescription Drug PricesThird-Degree Price Discrimination469 Example: Linear Demand Curves Example: Calculating Optimal Price Discrimination Example: Price Discrimination in Academic Journals Bundling474Example: Software SuitesTwo-Part Taris475Mo- nopolistic Competition476A Location Model of Product Dierentiation

480Product Dierentiation482More Vendors483Summary484

Review Questions484

CONTENTSXV

26 Factor Markets

Monopoly in the Output Market485Monopsony488Example: The Minimum WageUpstream and Downstream Monopolies492Summary

494Review Questions495Appendix495

27 Oligopoly

Choosing a Strategy498Example: Pricing MatchingQuantity Lead- ership499The Follower"s Problem€The Leader"s Problem€Price Leadership504Comparing Price Leadership and Quantity Leadership

507Simultaneous Quantity Setting507An Example of Cournot

Equilibrium509Adjustment to Equilibrium510Many Firms in Cournot Equilibrium511Simultaneous Price Setting512Collu- sion513Punishment Strategies515Example: Price Matching and Competition Example: Voluntary Export RestraintsComparison of the

Solutions519Summary519Review Questions520

28 Game Theory

The Payo Matrix of a Game522Nash Equilibrium524Mixed Strategies525Example: Rock Paper ScissorsThe Prisoner"s Dilemma

527Repeated Games529Enforcing a Cartel530Example: Tit

for Tat in Airline PricingSequential Games532AGameofEntry

Deterrence534Summary536Review Questions537

29 Game Applications

Best Response Curves538Mixed Strategies540Games of Coordi- nation542Battle of the Sexes€Prisoner"s Dilemma€Assurance Games€Chicken€How to Coordinate€Games of Competition546 Games of Coexistence551Games of Commitment553The Frog and the Scorpion€The Kindly Kidnapper€When Strength Is Weakness €Savings and Social Security€Hold Up€Bargaining561The

Ultimatum Game€Summary564Review Questions565

XVICONTENTS

30 Behavioral Economics

Framing Eects in Consumer Choice567The Disease Dilemma€ Anchoring Eects€Bracketing€TooMuchChoice€Constructed Preferences€Uncertainty571Law of Small Numbers€Asset In- tegration and Loss Aversion€Time574Discounting€Self-control €Example: OverconfidenceStrategic Interaction and Social Norms576 Ultimatum Game€Fairness€Assessment of Behavioral Economics

578Summary579Review Questions581

31 Exchange

The Edgeworth Box583Trade585Pareto Ecient Allocations

586Market Trade588The Algebra of Equilibrium590Walras"

Law592Relative Prices593Example: An Algebraic Example of EquilibriumThe Existence of Equilibrium595Equilibrium and E- ciency596The Algebra of Eciency597Example: Monopoly in the Edgeworth BoxEciency and Equilibrium600Implications of the First Welfare Theorem602Implications of the Second Welfare Theorem

604Summary606Review Questions607Appendix607

32 Production

The Robinson Crusoe Economy609Crusoe, Inc.611The Firm612 Robinson"s Problem613Putting Them Together613Dierent Tech- nologies615Production and the First Welfare Theorem617Produc- tion and the Second Welfare Theorem618Production Possibilities618 Comparative Advantage620Pareto Eciency622Castaways, Inc.

624Robinson and Friday as Consumers626Decentralized Resource

Allocation627Summary628Review Questions628Appen-

dix629

CONTENTSXVII

33 Welfare

Aggregation of Preferences632Social Welfare Functions634Welfare Maximization636Individualistic Social Welfare Functions638Fair

Allocations639Envy and Equity640Summary642Review

Questions642Appendix643

34 Externalities

Smokers and Nonsmokers645Quasilinear Preferences and the Coase Theorem648Production Externalities650Example: Pollution VouchersInterpretation of the Conditions655Market Signals658 Example: Bees and AlmondsThe Tragedy of the Commons659Ex- ample: Overfishing Example: New England LobstersAutomobile Pollu- tion663Summary665Review Questions665

35 Information Technology

Systems Competition668The Problem of Complements668Re- lationships among Complementors€Example: Apple"s iPod and iTunes Example: Who Makes an iPod? Example: AdWords and AdSenseLock- In674A Model of Competition with Switching Costs€Example: Online Bill Payment Example: Number Portability on Cell PhonesNet- work Externalities678Markets with Network Externalities678Mar- ket Dynamics680Example: Network Externalities in Computer Soft- wareImplications of Network Externalities684Example: The Yellow Pages Example: Radio AdsTwo-sided Markets686AModelof Two-sided Markets€Rights Management687Example: Video Rental Sharing Intellectual Property689Example: Online Two-sided Markets

Summary692Review Questions693

XVIIICONTENTS

36 Public Goods

When to Provide a Public Good?695Private Provision of the Public Good699Free Riding699Dierent Levels of the Public Good701 Quasilinear Preferences and Public Goods703Example: Pollution RevisitedThe Free Rider Problem705Comparison to Private Goods

707Voting708Example: Agenda ManipulationThe Vickrey-

Clarke-Groves Mechanism711Groves Mechanism€The VCG Mech- anism€Examples of VCG713Vickrey Auction€Clarke-Groves Mechanism€Problems with the VCG714Summary715Review

Questions716Appendix716

37 Asymmetric Information

The Market for Lemons719Quality Choice720Choosing the Qual- ity€Adverse Selection722Moral Hazard724Moral Hazard and Adverse Selection725Signaling726Example: The Sheepskin Eect Incentives730Example: Voting Rights in the Corporation Example: ChineseEconomicReformsAsymmetric Information735Example: Monitoring Costs Example: The Grameen BankSummary738Re- view Questions739

Mathematical Appendix

FunctionsA1GraphsA2Properties of FunctionsA2Inverse FunctionsA3Equations and IdentitiesA3Linear FunctionsA4 Changes and Rates of ChangeA4Slopes and InterceptsA5Absolute Values and LogarithmsA6DerivativesA6Second DerivativesA7 The Product Rule and the Chain RuleA8Partial DerivativesA8

OptimizationA9Constrained OptimizationA10

AnswersA11

IndexA31

PREFACE

The success of the first seven editions ofIntermediate Microeconomicshas pleased me very much. It has confirmed my belief that the market would welcome an analytic approach to microeconomics at the undergraduate level. My aim in writing the first edition was to present a treatment of the methods of microeconomics that would allow students to apply these tools on their own and not just passively absorb the predigested cases described in the text. I have found that the best way to do this is to emphasize the fundamental conceptual foundations of microeconomics and to provide concrete examples of their application rather than to attempt to provide an encyclopedia of terminology and anecdote. A challenge in pursuing this approach arises from the lack of mathemat- ical prerequisites for economics courses at many colleges and universities. The lack of calculus and problem-solving experience in general makes it difficult to present some of the analytical methods of economics. How- ever, it is not impossible. One can go a long way with a few simple facts about linear demand functions and supply functions and some elementary algebra. It is perfectly possible to be analytical without being excessively mathematical. The distinction is worth emphasizing. An analytical approach to eco- nomics is one that uses rigorous, logical reasoning. This does not neces- sarily require the use of advanced mathematical methods. The language of mathematics certainly helps to ensure a rigorous analysis and using it is undoubtedly the best way to proceed when possible, but it may not be appropriate for all students.

XXPREFACE

Many undergraduate majors in economics are students whoshouldknow calculus, but dont"at least, not very well. For this reason I have kept cal- culus out of the main body of the text. However, I have provided complete calculus appendices to many of the chapters. This means that the calculus methods are there for the students who can handle them, but they do not pose a barrier to understanding for the others. I think that this approach manages to convey the idea that calculus is not just a footnote to the argument of the text, but is instead a deeper way to examine the same issues that one can also explore verbally and graphically. Many arguments are much simpler with a little mathematics, and all economics students should learn that. In many cases Ive found that with a little motivation, and a few nice economic examples, students become quite enthusiastic about looking at things from an analytic per- spective. There are several other innovations in this text. First, the chapters are generally very short. Ive tried to make most of them roughly lecture size,Ž so that they can be read at one sitting. I have followed the standard order of discussing “rst consumer theory and then producer theory, but Ive spent a bit more time on consumer theory than is normally the case. This is not because I think that consumer theory is necessarily the most important part of microeconomics; rather, I have found that this is the material that students “nd the most mysterious, so I wanted to provide a more detailed treatment of it. Second, Ive tried to put in a lot of examples of how to use the theory described here. In most books, students look at a lot of diagrams of shifting curves, but they dont see much algebra, or much calculation of any sort for that matter. But it is the algebra that is used to solve problems in practice. Graphs can provide insight, but the real power of economic analysis comes in calculating quantitative answers to economic problems. Every economics student should be able to translate an economic story into an equation or a numerical example, but all too often the development of this skill is neglected. For this reason I have also provided a workbook that I feel is an integral accompaniment to this book. The workbook was written with my colleague Theodore Bergstrom, and we have put a lot of eσort into generating interesting and instructive problems. We think that it provides an important aid to the student of microeconomics. Third, I believe that the treatment of the topics in this book is more accurate than is usually the case in intermediate micro texts. It is true that Ive sometimes chosen special cases to analyze when the general case is too diτcult, but Ive tried to be honest about that when I did it. In general, Ive tried to spell out every step of each argument in detail. I believe that the discussion Ive provided is not only more complete and more accurate than usual, but this attention to detail also makes the arguments easier to understand than the loose discussion presented in many other books.

PREFACEXXI

There Are Many Paths to Economic Enlightenment

There is more material in this book than can comfortably be taught in one semester, so it is worthwhile picking and choosing carefully the material that you want to study. If you start on page 1 and proceed through the chapters in order, you will run out of time long before you reach the end of the book. The modular structure of the book allows the instructor a great deal of freedom in choosing how to present the material, and I hope that more people will take advantage of this freedom. The following chart illustrates the chapter dependencies.

Consumer's SurplusMarket Demand

Production Welfare

Oligopoly

Game Theory

Game ApplicationsMonopoly Behavior

Factor Markets

Uncertainty

Intertemporal Choice

Asset Markets

Risky AssetsRevealed Preference

Slutsky Equation

Buying and Selling

Exchange

Technology

Cost Minimization

Cost Curves

Firm Supply

Industry Supply

Monopoly

Externalities

Public Goods

Asymmetric InformationProfit Maximization

The Market

Budget

Preferences

Utility

Choice

Demand

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