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VIIL CONTENTS Preferences Consumer Preferences 34 Assumptions about Preferences 35 Indif- ference Curves 36 Examples of Preferences 37 Perfect Substitutes e Perfect Complements e Bads «

CONTENTS

The Market

Constructing a Model 1 Optimization and Equilibrium 3 The De- mand Curve 3 The Supply Curve 5 Market Equilibrium 7 Com- parative Statics 9 Other Ways to Allocate Apartments 11 The Dis- criminating Monopolist e The Ordinary Monopolist e Rent Control « Which Way Is Best? 14 Pareto Efficiency 15 Comparing Ways to Al- locate Apartments 16 Equilibrium in the Long Run 17 Summary 18 Review Questions 19

Budget Constraint

The Budget Constraint 20 Two Goods Are Often Enough 21 Prop- erties of the Budget Set 22 How the Budget Line Changes 24 The Numeraire 26 ‘Taxes, Subsidies, and Rationing 26 Example: The Food Stamp Program Budget Line Changes 31 Summary 31 Review Questions 32

VIIL CONTENTS

Preferences

Consumer Preferences 34 Assumptions about Preferences 35 Indif- ference Curves 36 Examples of Preferences 37 Perfect Substitutes

e Perfect Complements e Bads « Neutrals e Satiation e Discrete Goods ¢ Well-Behaved Preferences 44 The Marginal Rate of Substitu- tion 48 Other Interpretations of the MRS 50 Behavior of the MRS

51 Summary 52 Review Questions 52

Utility

Cardinal Utility 57 Constructing a Utility Function 58 Some Exam- ples of Utility Functions 59 Example: Indifference Curves from Utility Perfect Substitutes e Perfect Complements e Quasilinear Preferences

e Cobb-Douglas Preferences e Marginal Utility 65 Marginal Utility

Questions 70 Appendix 70 Example: Cobb-Douglas Preferences

Choice

Perfect Substitutes e Perfect Complements e Neutrals and Bads e Discrete Goods @ Concave Preferences e Cobb-Douglas Preferences ® Estimating Utility Functions 83 Implications of the MRS Condition 85 Choosing Taxes 87 Summary 89 Review Questions 89 Appen- dix 90 Example: Cobb-Douglas Demand Functions

Demand

Normal and Inferior Goods 96 Income Offer Curves and Engel Curves

97 Some Examples 99 Perfect Substitutes e Perfect Complements

e Cobb-Douglas Preferences « Homothetic Preferences se Quasilinear Preferences Ordinary Goods and Giffen Goods 104 The Price Offer Curve and the Demand Curve 106 Some Examples 107 Perfect Substitutes e Perfect Complements e A Discrete Good e¢ Substitutes and Complements 111 The Inverse Demand Function 112 Summary

114 Review Questions 115 Appendix 115

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7 Revealed Preference

The Idea of Revealed Preference 119 From Revealed Preference to Pref- erence 120 Recovering Preferences 122 The Weak Axiom of Re- vealed Preference 124 Checking WARP 125 The Strong Axiom of Revealed Preference 128 How to Check SARP 129 Index Numbers

130 Price Indices 132 Example: Indexing Social Security Payments Summary 135 Review Questions 135

8 Slutsky Equation

The Substitution Effect 137 Example: Calculating the Substitution Ef- fect The Income Effect 141 Example: Calculating the Income Effect Sign of the Substitution Effect 142 The Total Change in Demand 143 Rates of Change 144 The Law of Demand 147 Examples of Income and Substitution Effects 147 Example: Rebating a Tax Example: Voluntary Real Time Pricing Another Substitution Effect 153 Com- pensated Demand Curves 155 Summary 156 Review Questions 157 Appendix 157 Example: Rebating a Small Tax

9 Buying and Selling

Net and Gross Demands 160 The Budget Constraint 161 Changing the Endowment 163 Price Changes 164 Offer Curves and Demand Curves 167 The Shitsky Equation Revisited 168 Use of the Slut- sky Equation 172 Example: Calculating the Endowment Income Effect Labor Supply 173 The Budget Constraint « Comparative Statics of Labor Supply 174 Example: Overtime and the Supply of Labor Sum- mary 178 Review Questions 179 Appendix 179

xX CONTENTS

Intertemporal Choice

The Budget Constraint 182 Preferences for Consumption 185 Com- parative Statics 186 The Slutsky Equation and Intertemporal Choice

187 Inflation 189 Present Value: A Closer Look 191 Analyz- ing Present Value for Several Periods 193 Use of Present Value 194 Example: Valuing a Stream of Payments Example: The True Cost of a Credit Card Bonds 197 Example: Installment Loans Taxes 199 Example: Scholarships and Savings Choice of the Interest Rate 200 Summary 201 Review Questions 201

Asset Markets

Rates of Return 202 Arbitrage and Present Value 204 Adjustments for Differences among Assets 204 Assets with Consumption Returns

205 ‘Taxation of Asset Returns 206 Applications 207 Depletable Resources @ When to Cut a Forest e Example: Gasoline Prices during the Gulf War Financial Institutions 211 Summary 212 Review Questions 213 Appendix 213

Uncertainty

Contingent Consumption 215 Example: Catastrophe Bonds Utility Functions and Probabilities 220 Example: Some Examples of Utility Functions Expected Utility 221 Why Expected Utility Is Reasonable

222 Risk Aversion 224 Example: The Demand for Insurance Di- versification 228 Risk Spreading 228 Role of the Stock Market 229

The Effect of Taxation on Investment in Risky Assets

Risky Assets

Mean-Variance Utility 234 Measuring Risk 239 Equilibrium in a Market for Risky Assets 241 How Returns Adjust 242 Example: Ranking Mutual Funds Summary 246 Review Questions 246

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CONTENTS XI

Consumer’s Surplus

Demand for a Discrete Good 248 Constructing Utility from Demand

249 Other Interpretations of Consumer’s Surplus 250 From Con- sumer’s Surplus to Consumers’ Surplus 251 Approximating a Continu- ous Demand 251 Quasilinear Utility 251 Interpreting the Change in Consumer’s Surplus 252 Example: The Change in Consumer’s Surplus Compensating and Equivalent Variation 254 Example: Compensating and Equivalent Variations Example: Compensating and Equivalent Vari- ation for Quasilinear Preferences Producer’s Surplus 258 — Benefit-Cost Analysis 260 Rationing « Calculating Gains and Losses 262 Sum-

Few Demand Functions Example: CV, EV, and Consumer’s Surplus

Market Demand

From Individual to Market Demand 266 The Inverse Demand Function

268 Example: Adding Up “Linear” Demand Curves Discrete Goods

269 The Extensive and the Intensive Margin 269 Elasticity 270 Example: The Elasticity of a Linear Demand Curve Elasticity and De- mand 272 Elasticity and Revenue 273 Example: Strikes and Profits Constant Elasticity Demands 276 Elasticity and Marginal Revenue 277 Example: Setting a Price Marginal Revenue Curves 279 Income Elas- ticity 280 Summary 281 Review Questions 282 Appendix 283 Example: The Laffer Curve Example: Another Expression for Elasticity

Equilibrium

Supply 289 Market Equilibrium 289 Two Special Cases 290 In- verse Demand and Supply Curves 291 Example: Equilibrium with Lin- ear Curves Comparative Statics 293 Example: Shifting Both Curves Taxes 294 Example: Taxation with Linear Demand and Supply Pass- ing Along a Tax 298 The Deadweight Loss of a Tax 300 Example: The Market for Loans Example: Food Subsidies Example: Subsidies in Iraq Pareto Efficiency 306 Example: Waiting in Line Summary 309 Review Questions 309

XIE CONTENTS

Auctions

Classification of Auctions 312 Bidding Rules e Auction Design 313 Other Auction Forms 316 Example: Late Bidding on eBay Example: Online Ad Auctions Problems with Auctions 319 The Winner’s Curse

320 Summary 320 Review Questions 321

Technology

Inputs and Outputs 322 Describing Technological Constraints 323 Examples of Technology 324 Fized Proportions « Perfect Substitutes

e Cobb-Douglas ¢ Properties of Technology 326 The Marginal Product

328 The Technical Rate of Substitution 328 Diminishing Marginal Product 329 Diminishing Technical Rate of Substitution 329 The Long Run and the Short Run 330 Returns to Scale 330 Summary

332 Review Questions 333

Profit Maximization

Profits 334 The Organization of Firms 336 Profits and Stock Market Value 336 The Boundaries of the Firm 338 Fixed and Variable Fac- tors 339 Short-Run Profit Maximization 339 Comparative Statics

341 Profit Maximization in the Long Run 342 Inverse Factor Demand Curves 343 Profit Maximization and Returns to Scale 344 Revealed Profitability 345 Example: How Do Farmers React to Price Supports? Cost Minimization 349 Summary 349 Review Questions 350 Ap- pendix 351

Cost Minimization

Cost Minimization 353 Example: Minimizing Costs for Specific Tech- nologies Revealed Cost Minimization 357 Returns to Scale and the Cost Function 358 Long-Run and Short-Run Costs 360 Fixed and Quasi-Fixed Costs 362 Sunk Costs 362 Summary 363 Review Questions 363 Appendix 364

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Cost Curves

Average Costs 367 Marginal Costs 369 Marginal Costs and Variable Costs 371 Example: Specific Cost Curves Example: Marginal Cost Curves for Two Plants Long-Run Costs 375 Discrete Levels of Plant Size 377 Long-Run Marginal Costs 379 Summary 380 Review Questions 381 Appendix 381

Firm Supply

Market Environments 383 Pure Competition 384 The Supply Deci- sion of a Competitive Firm 386 An Exception 388 Another Exception

389 Example: Pricing Operating Systems The Inverse Supply Func- tion 391 Profits and Producer’s Surplus 391 Example: The Supply Curve for a Specific Cost Function The Long-Run Supply Curve of a Firm

395 Long-Run Constant Average Costs 397 Summary 398 Review Questions 399 Appendix 399

Industry Supply

Short-Run Industry Supply 401 Industry Equilibrium in the Short Run

402 Industry Equilibrium in the Long Run 403 The Long-Run Supply Curve 405 Example: Taxation in the Long Run and in the Short Run The Meaning of Zero Profits 409 Fixed Factors and Economic Rent

410 Example: Taai Licenses in New York City Economic Rent 412 Rental Rates and Prices 414 Example: Liquor Licenses The Politics

of Rent 415 Example: Farming the Government Energy Policy 417 Two-Tiered Oil Pricing @ Price Controls e The Entitlement Program

e Summary 421 Review Questions 422

XIV.) CONTENTS

Monopoly

Maximizing Profits 424 Linear Demand Curve and Monopoly 425 Markup Pricing 427 Example: The Impact of Taxes on a Monopo- list Inefficiency of Monopoly 429 Deadweight Loss of Monopoly 431 Example: The Optimal Life of a Patent Example: Patent Thickets Nat- ural Monopoly 435 What Causes Monopolies? 437 Example: Di- amonds Are Forever Example: Pooling in Auction Markets Example: Price Fizing in Computer Memory Markets Summary 441 Review Questions 442 Appendix 443

Monopoly Behavior

Price Discrimination 445 First-Degree Price Discrimination 445 Ex- ample: First-degree Price Discrimination in Practice Second-Degree Price Discrimination 448 Example: Price Discrimination in Airfares — Ex- ample: Prescription Drug Prices Third-Degree Price Discrimination 452 Example: Linear Demand Curves Example: Calculating Optimal Price Discrimination Example: Price Discrimination in Academic Journals Bundling 457 Example: Software Suites Two-Part Tariffs 458 Mo- nopolistic Competition 459 A Location Model of Product Differentiation

463 Product Differentiation 465 More Vendors 466 Summary 467 Review Questions 467

Factor Markets

Monopoly in the Output Market 468 Monopsony 471 Example: The Minimum Wage Upstream and Downstream Monopolies 475 Summary

477 Review Questions 478 Appendix 478

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CONTENTS XV

Oligopoly

Choosing a Strategy 481 Quantity Leadership 481 The Follower’s Problem e The Leader’s Problem « Price Leadership 487 Comparing Price Leadership and Quantity Leadership 489 Simultaneous Quantity Setting 489 An Example of Cournot Equilibrium 491 Adjustment to Equilibrium 493 Many Firms in Cournot Equilibrium 493 5imulta- neous Price Setting 494 Collusion 495 Punishment Strategies 498 Example: Price Matching and Competition Example: Voluntary Export Restraints Comparison of the Solutions 501 Summary 502 Review Questions 503

Game Theory

The Payoff Matrix of a Game 504 Nash Equilibrium 506 Mixed Strategies 507 Example: Rock Paper Scissors The Prisoner’s Dilemma

509 Repeated Games 511 Enforcing a Cartel 512 Example: Tit for [at in Airline Pricing Sequential Games 514 A Game of Entry Deterrence 516 Summary 518 Review Questions 519

Game Applications

Best Response Curves 520 Mixed Strategies 522 Games of Coordi- nation 524 Battle of the Sexes e@ Prisoner’s Dilemma e Assurance Games e Chicken ® How to Coordinate e Games of Competition 528 Games of Coexistence 533 Gamesof Commitment 535 The Frog and the Scorpion s® The Kindly Kidnapper e When Strength Is Weakness

e Savings and Social Security s® Hold Up e Bargaining 543 The Ultimatum Game e Summary 546 Review Questions 547

XVI CONTENTS

Behavioral Economics

Framing Effects in Consumer Choice 549 The Disease Dilemma e Anchoring Effects Bracketing e Too Much Choice © Constructed Preferences e Uncertainty 553 Law of Small Numbers e Asset In- tegration and Loss Aversion e Time 556 Discounting ® Self-control

e Example: Overconfidence Strategic Interaction and Social Norms 558 Ultimatum Game e Fairness e Assessment of Behavioral Economics

560 Summary 561 Review Questions 563

Exchange

The Edgeworth Box 565 ‘Trade 567 Pareto Efficient Allocations

568 Market Trade 570 The Algebra of Equilibrium 572 Walras’ Law 574 _ Relative Prices 575 Example: An Algebraic Example of Equilibrium The Existence of Equilibrium 577 Equilibrium and Effi- ciency 578 The Algebra of Efficiency 579 Example: Monopoly in the Edgeworth Box Efficiency and Equilibrium 582 Implications of the First Welfare Theorem 584 Implications of the Second Welfare Theorem

Production

The Robinson Crusoe Economy 591 Crusoe, Inc 593 The Firm 594 Robinson’s Problem 595 Putting Them Together 595 Different Tech- nologies 597 Production and the First Welfare Theorem 599 Produc- tion and the Second Welfare Theorem 600 Production Possibilities 600 Comparative Advantage 602 Pareto Efficiency 604 Castaways, Inc

606 Robinson and Friday as Consumers 608 Decentralized Resource

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