Intermediate microeconomics a modern app

Intermediate Microeconomics A Modern Approach Ninth Edition Intermediate Microeconomics A Modern Approach Ninth Edition Hal R Varian University of California at Berkeley W W Norton Company • New Yor.

Intermediate Microeconomics

A Modern Approach

Ninth Edition

Intermediate Microeconomics

A Modern Approach

Ninth Edition

Hal R Varian

University of California at Berkeley

W W Norton & Company• New York• London

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 NewYork City’s Cooper Union The firm soon expanded its program beyond the In-stitute, publishing books by celebrated academics from America and abroad Bymid-century, the two major pillars of Norton’s publishing program—trade booksand college texts—were firmly established In the 1950s, the Norton family trans-ferred control of the company to its employees, and today—with a staff of fourhundred and a comparable number of trade, college, and professional titles pub-lished each year—W W Norton & Company stands as the largest and oldestpublishing house owned wholly by its employees.

Copyright c 2014, 2010, 2006, 2003, 1999, 1996, 1993, 1990, 1987 by Hal R.Varian

All rights reserved

Printed in the United States of America

NINTH EDITION

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3

To Carol

De-2 Budget Constraint

The Budget Constraint 20 Two Goods Are Often Enough 21 erties of the Budget Set 22 How the Budget Line Changes 24 TheNumeraire 26 Taxes, Subsidies, and Rationing 26 Example: TheFood Stamp Program Budget Line Changes 31 Summary 31 ReviewQuestions 32

51 Summary 52 Review Questions 52

4 Utility

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

Exam-• Cobb-Douglas Preferences Exam-• Marginal Utility 65 Marginal Utilityand MRS 66 Utility for Commuting 67 Summary 69 ReviewQuestions 70 Appendix 70 Example: Cobb-Douglas Preferences

5 Choice

Optimal Choice 73 Consumer Demand 78 Some Examples 78Perfect Substitutes • Perfect Complements • Neutrals and Bads •Discrete Goods • Concave Preferences • Cobb-Douglas Preferences •Estimating Utility Functions 83 Implications of the MRS Condition 85Choosing Taxes 87 Summary 89 Review Questions 89 Appen-dix 90 Example: Cobb-Douglas Demand Functions

6 Demand

Normal and Inferior Goods 96 Income Offer Curves and Engel Curves

97 Some Examples 99 Perfect Substitutes • Perfect Complements

• Cobb-Douglas Preferences • Homothetic Preferences • QuasilinearPreferences • Ordinary Goods and Giffen Goods 104 The Price OfferCurve and the Demand Curve 106 Some Examples 107 PerfectSubstitutes • Perfect Complements • A Discrete Good • Substitutesand Complements 111 The Inverse Demand Function 112 Summary

114 Review Questions 115 Appendix 115

CONTENTS IX

7 Revealed Preference

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

Pref-130 Price Indices 132 Example: Indexing Social Security PaymentsSummary 135 Review Questions 135

8 Slutsky Equation

The Substitution Effect 137 Example: Calculating the Substitution fect The Income Effect 141 Example: Calculating the Income EffectSign of the Substitution Effect 142 The Total Change in Demand 143Rates of Change 144 The Law of Demand 147 Examples of Incomeand 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 157Appendix 157 Example: Rebating a Small Tax

Ef-9 Buying and Selling

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

Analyz-a Credit CAnalyz-ard Example: Extending Copyright Bonds 198 ple: Installment Loans Taxes 200 Example: Scholarships and Sav-ings Choice of the Interest Rate 201 Summary 202 Review Ques-tions 202

Applica-12 Uncertainty

Contingent Consumption 217 Example: Catastrophe Bonds UtilityFunctions and Probabilities 222 Example: Some Examples of UtilityFunctions Expected Utility 223 Why Expected Utility Is Reasonable

224 Risk Aversion 226 Example: The Demand for Insurance versification 230 Risk Spreading 230 Role of the Stock Market 231Summary 232 Review Questions 232 Appendix 233 Example:The Effect of Taxation on Investment in Risky Assets

Di-13 Risky Assets

Mean-Variance Utility 236 Measuring Risk 241 Counterparty Risk

243 Equilibrium in a Market for Risky Assets 243 How ReturnsAdjust 245 Example: Value at Risk Example: Ranking Mutual FundsSummary 249 Review Questions 250

CONTENTS XI

14 Consumer’s Surplus

Demand for a Discrete Good 252 Constructing Utility from Demand

253 Other Interpretations of Consumer’s Surplus 254 From sumer’s Surplus to Consumers’ Surplus 255 Approximating a Continu-ous Demand 255 Quasilinear Utility 255 Interpreting the Change inConsumer’s Surplus 256 Example: The Change in Consumer’s SurplusCompensating and Equivalent Variation 258 Example: Compensatingand Equivalent Variations Example: Compensating and Equivalent Vari-ation for Quasilinear Preferences Producer’s Surplus 262 Benefit-CostAnalysis 264 Rationing • Calculating Gains and Losses 266 Sum-mary 267 Review Questions 267 Appendix 268 Example: AFew Demand Functions Example: CV, EV, and Consumer’s Surplus

Con-15 Market Demand

From Individual to Market Demand 270 The Inverse Demand Function

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

273 The Extensive and the Intensive Margin 273 Elasticity 274Example: The Elasticity of a Linear Demand Curve Elasticity and De-mand 276 Elasticity and Revenue 277 Example: Strikes and ProfitsConstant Elasticity Demands 280 Elasticity and Marginal Revenue 281Example: Setting a Price Marginal Revenue Curves 283 Income Elas-ticity 284 Summary 285 Review Questions 286 Appendix 287Example: The Laffer Curve Example: Another Expression for Elasticity

16 Equilibrium

Supply 293 Market Equilibrium 293 Two Special Cases 294 verse Demand and Supply Curves 295 Example: Equilibrium with Lin-ear Curves Comparative Statics 297 Example: Shifting Both CurvesTaxes 298 Example: Taxation with Linear Demand and Supply Pass-ing Along a Tax 302 The Deadweight Loss of a Tax 304 Example:The Market for Loans Example: Food Subsidies Example: Subsidies inIraq Pareto Efficiency 310 Example: Waiting in Line Summary 313Review Questions 313

In-XII CONTENTS

17 Measurement

Summarize data 316 Example: Simpson’s paradox Test 320 mating demand using experimental data 320 Effect of treatment 321Estimating demand using observational data 322 Functional form •Statistical model • Estimation • Identification 324 What can gowrong? 326 Policy evaluation 327 Example: Crime and policeSummary 328 Review Questions 329

Esti-18 Auctions

Classification of Auctions 331 Bidding Rules • Auction Design 332Example: Goethe’s auction Other Auction Forms 336 Example: LateBidding on eBay Position Auctions 338 Two Bidders • More ThanTwo Bidders • Quality Scores • Should you advertise on your brand?

341 Auction revenue and number of bidders 342 Problems with tions 343 Example: Taking Bids Off the Wall The Winner’s Curse

Auc-344 Stable Marriage Problem 345 Mechanism Design 346 mary 348 Review Questions 349

Sum-19 Technology

Inputs and Outputs 350 Describing Technological Constraints 351Examples of Technology 352 Fixed Proportions • Perfect Substi-tutes • Cobb-Douglas • Properties of Technology 354 The MarginalProduct 356 The Technical Rate of Substitution 356 DiminishingMarginal Product 357 Diminishing Technical Rate of Substitution 357The Long Run and the Short Run 358 Returns to Scale 358 Ex-ample: Datacenters Example: Copy Exactly! Summary 361 ReviewQuestions 362

CONTENTS XIII

20 Profit Maximization

Profits 363 The Organization of Firms 365 Profits and Stock MarketValue 365 The Boundaries of the Firm 367 Fixed and Variable Fac-tors 368 Short-Run Profit Maximization 368 Comparative Statics

370 Profit Maximization in the Long Run 371 Inverse Factor DemandCurves 372 Profit Maximization and Returns to Scale 373 RevealedProfitability 374 Example: How Do Farmers React to Price Supports?Cost Minimization 378 Summary 378 Review Questions 379 Ap-pendix 380

21 Cost Minimization

Cost Minimization 382 Example: Minimizing Costs for Specific nologies Revealed Cost Minimization 386 Returns to Scale and theCost Function 387 Long-Run and Short-Run Costs 389 Fixed andQuasi-Fixed Costs 391 Sunk Costs 391 Summary 392 ReviewQuestions 392 Appendix 393

Tech-22 Cost Curves

Average Costs 396 Marginal Costs 398 Marginal Costs and VariableCosts 400 Example: Specific Cost Curves Example: Marginal CostCurves for Two Plants Cost Curves for Online Auctions 404 Long-RunCosts 405 Discrete Levels of Plant Size 407 Long-Run Marginal Costs

408 Summary 409 Review Questions 410 Appendix 411

Func-425 Long-Run Constant Average Costs 427 Summary 428 ReviewQuestions 429 Appendix 429

XIV CONTENTS

24 Industry Supply

Short-Run Industry Supply 431 Industry Equilibrium in the Short Run

432 Industry Equilibrium in the Long Run 433 The Long-Run SupplyCurve 435 Example: Taxation in the Long Run and in the Short RunThe Meaning of Zero Profits 439 Fixed Factors and Economic Rent

440 Example: Taxi Licenses in New York City Economic Rent 442Rental Rates and Prices 444 Example: Liquor Licenses The Politics

of Rent 445 Example: Farming the Government Energy Policy 447Two-Tiered Oil Pricing • Price Controls • The Entitlement Program

• Carbon Tax Versus Cap and Trade 451 Optimal Production of sions • A Carbon Tax • Cap and Trade • Summary 455 ReviewQuestions 455

Emis-25 Monopoly

Maximizing Profits 458 Linear Demand Curve and Monopoly 459Markup Pricing 461 Example: The Impact of Taxes on a Monopo-list Inefficiency of Monopoly 463 Deadweight Loss of Monopoly 465Example: The Optimal Life of a Patent Example: Patent Thickets Ex-ample: Managing the Supply of Potatoes Natural Monopoly 469 WhatCauses Monopolies? 472 Example: Diamonds Are Forever Example:Pooling in Auction Markets Example: Price Fixing in Computer MemoryMarkets Summary 476 Review Questions 476 Appendix 477

26 Monopoly Behavior

Price Discrimination 480 First-Degree Price Discrimination 480 ample: First-degree Price Discrimination in Practice Second-Degree PriceDiscrimination 483 Example: Price Discrimination in Airfares Ex-ample: Prescription Drug Prices Third-Degree Price Discrimination 487Example: Linear Demand Curves Example: Calculating Optimal PriceDiscrimination Example: Price Discrimination in Academic JournalsBundling 492 Example: Software Suites Two-Part Tariffs 493 Mo-nopolistic Competition 494 A Location Model of Product Differentiation

Ex-498 Product Differentiation 500 More Vendors 501 Summary 502Review Questions 502

Lead-525 Simultaneous Quantity Setting 525 An Example of CournotEquilibrium 527 Adjustment to Equilibrium 528 Many Firms inCournot Equilibrium 529 Simultaneous Price Setting 530 Collu-sion 531 Punishment Strategies 533 Example: Price Matching andCompetition Example: Voluntary Export Restraints Comparison of theSolutions 537 Summary 537 Review Questions 538

30 Game Applications

Best Response Curves 556 Mixed Strategies 558 Games of nation 560 Battle of the Sexes • Prisoner’s Dilemma • AssuranceGames • Chicken • How to Coordinate • Games of Competition 564Games of Coexistence 569 Games of Commitment 571 The Frogand the Scorpion • The Kindly Kidnapper • When Strength Is Weak-ness • Savings and Social Security • Example: Dynamic inefficiency

Coordi-of price discrimination Hold Up • Bargaining 580 The UltimatumGame • Summary 583 Review Questions 583

XVI CONTENTS

31 Behavioral Economics

Framing Effects in Consumer Choice 586 The Disease Dilemma •Anchoring Effects • Bracketing • Too Much Choice • ConstructedPreferences • Uncertainty 590 Law of Small Numbers • Asset In-tegration and Loss Aversion • Time 593 Discounting • Self-control

• Example: Overconfidence Strategic Interaction and Social Norms 595Ultimatum Game • Fairness • Assessment of Behavioral Economics

597 Summary 599 Review Questions 599

32 Exchange

The Edgeworth Box 602 Trade 604 Pareto Efficient Allocations

605 Market Trade 607 The Algebra of Equilibrium 609 Walras’Law 611 Relative Prices 612 Example: An Algebraic Example ofEquilibrium The Existence of Equilibrium 614 Equilibrium and Effi-ciency 615 The Algebra of Efficiency 616 Example: Monopoly inthe Edgeworth Box Efficiency and Equilibrium 619 Implications of theFirst Welfare Theorem 621 Implications of the Second Welfare Theorem

623 Summary 625 Review Questions 626 Appendix 626

33 Production

The Robinson Crusoe Economy 628 Crusoe, Inc 630 The Firm 631Robinson’s Problem 632 Putting Them Together 632 Different Tech-nologies 634 Production and the First Welfare Theorem 636 Produc-tion and the Second Welfare Theorem 637 Production Possibilities 637Comparative Advantage 639 Pareto Efficiency 641 Castaways, Inc

643 Robinson and Friday as Consumers 645 Decentralized ResourceAllocation 646 Summary 647 Review Questions 647 Appen-dix 648

CONTENTS XVII

34 Welfare

Aggregation of Preferences 651 Social Welfare Functions 653 WelfareMaximization 655 Individualistic Social Welfare Functions 657 FairAllocations 658 Envy and Equity 659 Summary 661 ReviewQuestions 661 Appendix 662

35 Externalities

Smokers and Nonsmokers 664 Quasilinear Preferences and the CoaseTheorem 667 Production Externalities 669 Example: PollutionVouchers Interpretation of the Conditions 674 Market Signals 677Example: Bees and Almonds The Tragedy of the Commons 678 Ex-ample: Overfishing Example: New England Lobsters Automobile Pollu-tion 682 Summary 684 Review Questions 684

36 Information Technology

Systems Competition 687 The Problem of Complements 687 lationships among Complementors • Example: Apple’s iPod and iTunesExample: Who Makes an iPod? Example: AdWords and AdSense Lock-

Re-In 693 A Model of Competition with Switching Costs • Example:Online Bill Payment Example: Number Portability on Cell Phones Net-work Externalities 697 Markets with Network Externalities 697 Mar-ket Dynamics 699 Example: Network Externalities in Computer Soft-ware Implications of Network Externalities 703 Example: The YellowPages Example: Radio Ads Two-sided Markets 705 A Model ofTwo-sided Markets • Rights Management 706 Example: Video RentalSharing Intellectual Property 708 Example: Online Two-sided MarketsSummary 711 Review Questions 712

XVIII CONTENTS

37 Public Goods

When to Provide a Public Good? 714 Private Provision of the PublicGood 718 Free Riding 718 Different Levels of the Public Good 720Quasilinear Preferences and Public Goods 722 Example: PollutionRevisited The Free Rider Problem 724 Comparison to Private Goods

726 Voting 727 Example: Agenda Manipulation The Clarke-Groves Mechanism 730 Groves Mechanism • The VCG Mech-anism • Examples of VCG 732 Vickrey Auction • Clarke-GrovesMechanism • Problems with the VCG 733 Summary 734 ReviewQuestions 735 Appendix 735

Vickrey-38 Asymmetric Information

The Market for Lemons 738 Quality Choice 739 Choosing the ity • Adverse Selection 741 Moral Hazard 743 Moral Hazard andAdverse Selection 744 Signaling 745 Example: The Sheepskin EffectIncentives 749 Example: Voting Rights in the Corporation Example:Chinese Economic Reforms Asymmetric Information 754 Example:Monitoring Costs Example: The Grameen Bank Summary 757 Re-view Questions 758

Qual-Mathematical Appendix

Functions A1 Graphs A2 Properties of Functions A2 InverseFunctions A3 Equations and Identities A3 Linear Functions A4Changes and Rates of Change A4 Slopes and Intercepts A5 AbsoluteValues and Logarithms A6 Derivatives A6 Second Derivatives A7The Product Rule and the Chain Rule A8 Partial Derivatives A8Optimization A9 Constrained Optimization A10

The success of the first eight editions of Intermediate Microeconomics haspleased me very much It has confirmed my belief that the market wouldwelcome an analytic approach to microeconomics at the undergraduatelevel

My aim in writing the original text was to present a treatment of themethods 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 emphasizethe fundamental conceptual foundations of microeconomics and to provideconcrete 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 ical prerequisites for economics courses at many colleges and universities.The lack of calculus and problem-solving experience in general makes itdifficult to present some of the analytical methods of economics However,

mathemat-it is not impossible One can go a long way wmathemat-ith a few simple facts aboutlinear demand and supply functions, and some elementary algebra It isperfectly 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 beappropriate for all students

XX PREFACE

Many undergraduate majors in economics are students who should knowcalculus, 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 completecalculus appendices to many of the chapters This means that the calculusmethods are there for the students who can handle them, but they do notpose a barrier to understanding for the others

I think that this approach manages to convey the idea that calculus isnot just a footnote to the argument of the text, but is instead a deeperway to examine the same issues that one can also explore verbally andgraphically Many arguments are much simpler with a little mathematics,and all economics students should learn that In many cases I’ve foundthat with a little motivation, and a few nice economic examples, studentsbecome quite enthusiastic about looking at things from an analytic per-spective

For students who are comfortable with calculus, I also offer a version ofthe text that incorporates the material in the chapter appendices into thebody of chapters

There are several other innovations in this text First, the chapters aregenerally very short I’ve tried to make most of them roughly “lecturesize,” so that they can be read in one sitting I have followed the standardorder of discussing first consumer theory and then producer theory, butI’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 mostimportant part of microeconomics; rather, I have found that this is thematerial that students find the most mysterious, so I wanted to provide amore detailed treatment of it

Second, I’ve tried to put in a lot of examples of how to use the theoriesdescribed here In most books, students look at a lot of diagrams of shiftingcurves, but they don’t see much algebra, or much calculation of any sort forthat 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 economicsstudent should be able to translate an economic story into an equation or

a numerical example, but all too often the development of this skill isneglected 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 effort intogenerating 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 moreaccurate than is usually the case in intermediate micro texts It is truethat I’ve sometimes chosen special cases to analyze when the general case

is too difficult, but I’ve tried to be honest about that when I did it Ingeneral, I’ve tried to spell out every step of each argument in detail Ibelieve that the discussion I’ve provided is not only more complete and more

PREFACE XXI

accurate than usual, but this attention to detail also makes the argumentseasier to understand than the loose discussion presented in many otherbooks

There Are Many Paths to Economic Enlightenment

There is more material in this book than can comfortably be taught in onesemester, so it is worthwhile picking and choosing carefully the materialthat you want to study If you start on page 1 and proceed through thechapters 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 agreat deal of freedom in choosing how to present the material, and I hopethat more people will take advantage of this freedom The following chartillustrates the chapter dependencies

Consumer's Surplus Market Demand

Production Welfare

Oligopoly Game Theory Game Applications

Monopoly Behavior Factor Markets

Technology Cost Minimization Cost Curves Firm Supply Industry Supply Monopoly Externalities Public Goods Asymmetric Information Profit Maximization

The Market Budget Preferences Utility Choice Demand

Equilibrium Auctions Information Technology

The darker colored chapters are “core” chapters—they should probably becovered in every intermediate microeconomics course The lighter-coloredchapters are “optional” chapters: I cover some but not all of these everysemester The gray chapters are chapters I usually don’t cover in my course,but they could easily be covered in other courses A solid line going fromChapter A to Chapter B means that Chapter A should be read before

XXII PREFACE

chapter B A broken line means that Chapter B requires knowing somematerial in Chapter A, but doesn’t depend on it in a significant way

I generally cover consumer theory and markets and then proceed directly

to producer theory Another popular path is to do exchange right afterconsumer theory; many instructors prefer this route and I have gone tosome trouble to make sure that this path is possible

Some people like to do producer theory before consumer theory This ispossible with this text, but if you choose this path, you will need to sup-plement the textbook treatment The material on isoquants, for example,assumes that the students have already seen indifference curves

Much of the material on public goods, externalities, law, and informationcan be introduced earlier in the course I’ve arranged the material so that

it is quite easy to put it pretty much wherever you desire

Similarly, the material on public goods can be introduced as an tration of Edgeworth box analysis Externalities can be introduced rightafter the discussion of cost curves, and topics from the information chaptercan be introduced almost anywhere after students are familiar with theapproach of economic analysis

illus-Changes for the Ninth Edition

I have added a new chapter on measurement which describes some of theissues involved in estimating economic relationships The idea is to in-troduce the student to some basic concepts from econometrics and try tobridge the theoretical treatment in the book with the practical problemsencountered in practice

I have offered some new examples drawn from Silicon Valley firms such

as Apple, eBay, Google, Yahoo, and others I discuss topics such as thecomplementarity between the iPod and iTunes, the positive feedback asso-ciated with companies such as Facebook, and the ad auction models used

by Google, Microsoft, and Yahoo I believe that these are fresh and esting examples of economics in action

inter-I’ve also added an extended discussion of mechanism design issues, cluding two-sided matching markets and the Vickrey-Clarke-Groves mech-anisms This field, which was once primarily theoretical in nature, has nowtaken on considerable practical importance

in-The Test Bank and Workbook

The workbook, Workouts in Intermediate Microeconomics, is an integralpart of the course It contains hundreds of fill-in-the-blank exercises thatlead the students through the steps of actually applying the tools they havelearned in the textbook In addition to the exercises, Workouts contains acollection of short multiple-choice quizzes based on the workbook problems

in each chapter Answers to the quizzes are also included in Workouts

PREFACE XXIII

These quizzes give a quick way for the student to review the material he

or she has learned by working the problems in the workbook

But there is more instructors who have adopted Workouts for theircourse can make use of the Test Bank offered with the textbook The TestBank contains several alternative versions of each Workouts quiz Thequestions in these quizzes use different numerical values but the same in-ternal logic They can be used to provide additional problems for students

to work on, or to give quizzes to be taken in class Grading is quick andreliable because the quizzes are multiple choice and can be graded electron-ically

In our course, we tell the students to work through all the quiz questionsfor each chapter, either by themselves or with a study group Then duringthe term we have a short in-class quiz every other week or so, using thealternative versions from the Test Bank These are essentially the Work-outs quizzes with different numbers Hence, students who have done theirhomework find it easy to do well on the quizzes

We firmly believe that you can’t learn economics without working someproblems The quizzes provided in Workouts and in the Test Bank makethe learning process much easier for both the student and the teacher

A hard copy of the Test Bank is available from the publisher, as is thetextbook’s Instructor’s Manual, which includes my teaching suggestionsand lecture notes for each chapter of the textbook, and solutions to theexercises in Workouts

A number of other useful ancillaries are also available with this book These include a comprehensive set of PowerPoint slides, as well

text-as the Norton Economic News Service, which alerts students to economicnews related to specific material in the textbook For information onthese and other ancillaries, please visit the homepage for the book athttp://www.wwnorton.com/varian

The Production of the Book

The entire book was typeset by the author using TEX, the wonderful setting system designed by Donald Knuth I worked on a Linux systemand using GNU emacs for editing, rcs for version control and the TEXLive system for processing I used makeindex for the index, and TrevorDarrell’s psfig software for inserting the diagrams

type-The book design was by Nancy Dale Muldoon, with some modifications

by Roy Tedoff and the author Jack Repchek coordinated the whole effort

in his capacity as editor

Acknowledgments

Several people contributed to this project First, I must thank my editorialassistants for the first edition, John Miller and Debra Holt John provided

XXIV PREFACE

many comments, suggestions, and exercises based on early drafts of thistext and made a significant contribution to the coherence of the final prod-uct Debra did a careful proofreading and consistency check during thefinal stages and helped in preparing the index

The following individuals provided me with many useful suggestions andcomments during the preparation of the first edition: Ken Binmore (Univer-sity of Michigan), Mark Bagnoli (Indiana University), Larry Chenault (Mi-ami University), Jonathan Hoag (Bowling Green State University), AllenJacobs (M.I.T.), John McMillan (University of California at San Diego),Hal White (University of California at San Diego), and Gary Yohe (Wes-leyan University) In particular, I would like to thank Dr Reiner Bucheg-ger, who prepared the German translation, for his close reading of the firstedition and for providing me with a detailed list of corrections Other in-dividuals to whom I owe thanks for suggestions prior to the first editionare Theodore Bergstrom, Jan Gerson, Oliver Landmann, Alasdair Smith,Barry Smith, and David Winch

My editorial assistants for the second edition were Sharon Parrott andAngela Bills They provided much useful assistance with the writing andediting Robert M Costrell (University of Massachusetts at Amherst), Ash-ley Lyman (University of Idaho), Daniel Schwallie (Case-Western Reserve),

A D Slivinskie (Western Ontario), and Charles Plourde (York University)provided me with detailed comments and suggestions about how to improvethe second edition

In preparing the third edition I received useful comments from the ing individuals: Doris Cheng (San Jose), Imre Csek´o (Budapest), GregoryHildebrandt (UCLA), Jamie Brown Kruse (Colorado), Richard Manning(Brigham Young), Janet Mitchell (Cornell), Charles Plourde (York Uni-versity), Yeung-Nan Shieh (San Jose), and John Winder (Toronto) I espe-cially want to thank Roger F Miller (University of Wisconsin), and DavidWildasin (Indiana) for their detailed comments, suggestions, and correc-tions

follow-The fifth edition benefited from the comments by Kealoah Widdows(Wabash College), William Sims (Concordia University), Jennifer R Rein-ganum (Vanderbilt University), and Paul D Thistle (Western MichiganUniversity)

I received comments that helped in preparation of the sixth edition fromJames S Jordon (Pennsylvania State University), Brad Kamp (Univer-sity of South Florida), Sten Nyberg (Stockholm University), Matthew R.Roelofs (Western Washington University), Maarten-Pieter Schinkel (Uni-versity of Maastricht), and Arthur Walker (University of Northumbria).The seventh edition received reviews by Irina Khindanova (ColoradoSchool of Mines), Istvan Konya (Boston College), Shomu Banerjee (GeorgiaTech), Andrew Helms (University of Georgia), Marc Melitz (Harvard Uni-versity), Andrew Chatterjea (Cornell University), and Cheng-Zhong Qin(UC Santa Barbara)

PREFACE XXV

Finally, I received helpful comments on the eighth edition from KevinBalsam (Hunter College), Clive Belfield (Queens College, CUNY), ReinerBuchegger (Johannes Kepler University), Lars Metzger (Technische Uni-versitaet Dortmund), Jeffrey Miron (Harvard University), Babu Nahata(University of Louisville), and Scott J Savage (University of Colorado)

Berkeley, CaliforniaDecember 2013

CHAPTER 1

THE MARKET

The conventional first chapter of a microeconomics book is a discussion ofthe “scope and methods” of economics Although this material can be veryinteresting, it hardly seems appropriate to begin your study of economicswith such material It is hard to appreciate such a discussion until youhave seen some examples of economic analysis in action

So instead, we will begin this book with an example of economic analysis

In this chapter we will examine a model of a particular market, the marketfor apartments Along the way we will introduce several new ideas and tools

of economics Don’t worry if it all goes by rather quickly This chapter

is meant only to provide a quick overview of how these ideas can be used.Later on we will study them in substantially more detail

we want to have a simplified description of the apartment market There

is a certain art to choosing the right simplifications in building a model Ingeneral we want to adopt the simplest model that is capable of describingthe economic situation we are examining We can then add complicationsone at a time, allowing the model to become more complex and, we hope,more realistic

The particular example we want to consider is the market for apartments

in a medium-size midwestern college town In this town there are twosorts of apartments There are some that are adjacent to the university,and others that are farther away The adjacent apartments are generallyconsidered to be more desirable by students, since they allow easier access

to the university The apartments that are farther away necessitate taking

a bus, or a long, cold bicycle ride, so most students would prefer a nearbyapartment if they can afford one

We will think of the apartments as being located in two large rings rounding the university The adjacent apartments are in the inner ring,while the rest are located in the outer ring We will focus exclusively onthe market for apartments in the inner ring The outer ring should be inter-preted as where people can go who don’t find one of the closer apartments.We’ll suppose that there are many apartments available in the outer ring,and their price is fixed at some known level We’ll be concerned solely withthe determination of the price of the inner-ring apartments and who gets

sur-to live there

An economist would describe the distinction between the prices of the twokinds of apartments in this model by saying that the price of the outer-ringapartments is an exogenous variable, while the price of the inner-ringapartments is an endogenous variable This means that the price ofthe outer-ring apartments is taken as determined by factors not discussed

in this particular model, while the price of the inner-ring apartments isdetermined by forces described in the model

The first simplification that we’ll make in our model is that all ments are identical in every respect except for location Thus it willmake sense to speak of “the price” of apartments, without worrying aboutwhether the apartments have one bedroom, or two bedrooms, or whatever.But what determines this price? What determines who will live inthe inner-ring apartments and who will live farther out? What can besaid about the desirability of different economic mechanisms for allocatingapartments? What concepts can we use to judge the merit of differentassignments of apartments to individuals? These are all questions that wewant our model to address

apart-THE DEMAND CURVE 3

1.2 Optimization and Equilibrium

Whenever we try to explain the behavior of human beings we need to have

a framework on which our analysis can be based In much of economics weuse a framework built on the following two simple principles

The optimization principle: People try to choose the best patterns ofconsumption that they can afford

The equilibrium principle: Prices adjust until the amount that peopledemand of something is equal to the amount that is supplied

Let us consider these two principles The first is almost tautological Ifpeople are free to choose their actions, it is reasonable to assume that theytry to choose things they want rather than things they don’t want Ofcourse there are exceptions to this general principle, but they typically lieoutside the domain of economic behavior

The second notion is a bit more problematic It is at least conceivablethat at any given time peoples’ demands and supplies are not compati-ble, and hence something must be changing These changes may take along time to work themselves out, and, even worse, they may induce otherchanges that might “destabilize” the whole system

This kind of thing can happen but it usually doesn’t In the case

of apartments, we typically see a fairly stable rental price from month tomonth It is this equilibrium price that we are interested in, not in how themarket gets to this equilibrium or how it might change over long periods

of time

It is worth observing that the definition used for equilibrium may bedifferent in different models In the case of the simple market we willexamine in this chapter, the demand and supply equilibrium idea will beadequate for our needs But in more general models we will need moregeneral definitions of equilibrium Typically, equilibrium will require thatthe economic agents’ actions must be consistent with each other

How do we use these two principles to determine the answers to thequestions we raised above? It is time to introduce some economic concepts

1.3 The Demand Curve

Suppose that we consider all of the possible renters of the apartments andask each of them the maximum amount that he or she would be willing topay to rent one of the apartments

Let’s start at the top There must be someone who is willing to paythe highest price Perhaps this person has a lot of money, perhaps he is

4 THE MARKET (Ch 1)

very lazy and doesn’t want to walk far or whatever Suppose that thisperson is willing to pay $500 a month for an apartment

If there is only one person who is willing to pay $500 a month to rent

an apartment, then if the price for apartments were $500 a month, exactlyone apartment would be rented—to the one person who was willing to paythat price

Suppose that the next highest price that anyone is willing to pay is $490.Then if the market price were $499, there would still be only one apartmentrented: the person who was willing to pay $500 would rent an apartment,but the person who was willing to pay $490 wouldn’t And so it goes Onlyone apartment would be rented if the price were $498, $497, $496, and so

on until we reach a price of $490 At that price, exactly two apartmentswould be rented: one to the $500 person and one to the $490 person.Similarly, two apartments would be rented until we reach the maximumprice that the person with the third highest price would be willing to pay,and so on

Economists call a person’s maximum willingness to pay for somethingthat person’s reservation price The reservation price is the highestprice that a given person will accept and still purchase the good In otherwords, a person’s reservation price is the price at which he or she is justindifferent between purchasing or not purchasing the good In our example,

if a person has a reservation price p it means that he or she would be justindifferent between living in the inner ring and paying a price p and living

in the outer ring

Thus the number of apartments that will be rented at a given price p∗

will just be the number of people who have a reservation price greater than

or equal to p∗ For if the market price is p∗, then everyone who is willing

to pay at least p∗ for an apartment will want an apartment in the innerring, and everyone who is not willing to pay p∗ will choose to live in theouter ring

We can plot these reservation prices in a diagram as in Figure 1.1 Herethe price is depicted on the vertical axis and the number of people who arewilling to pay that price or more is depicted on the horizontal axis.Another way to view Figure 1.1 is to think of it as measuring how manypeople would want to rent apartments at any particular price Such a curve

is an example of a demand curve—a curve that relates the quantitydemanded to price When the market price is above $500, zero apart-ments will be rented When the price is between $500 and $490, oneapartment will be rented When it is between $490 and the third high-est reservation price, two apartments will be rented, and so on Thedemand curve describes the quantity demanded at each of the possibleprices

The demand curve for apartments slopes down: as the price of ments decreases more people will be willing to rent apartments If there aremany people and their reservation prices differ only slightly from person to

apart-THE SUPPLY CURVE 5

sures the market price and the horizontal axis measures how

many apartments will be rented at each price

Figure1.1

person, it is reasonable to think of the demand curve as sloping smoothly

downward, as in Figure 1.2 The curve in Figure 1.2 is what the demand

curve in Figure 1.1 would look like if there were many people who want to

rent the apartments The “jumps” shown in Figure 1.1 are now so small

relative to the size of the market that we can safely ignore them in drawing

the market demand curve

1.4 The Supply Curve

We now have a nice graphical representation of demand behavior, so let us

turn to supply behavior Here we have to think about the nature of the

market we are examining The situation we will consider is where there are

many independent landlords who are each out to rent their apartments for

the highest price the market will bear We will refer to this as the case of a

competitive market Other sorts of market arrangements are certainly

possible, and we will examine a few later

For now, let’s consider the case where there are many landlords who all

operate independently It is clear that if all landlords are trying to do the

best they can and if the renters are fully informed about the prices the

landlords charge, then the equilibrium price of all apartments in the inner

ring must be the same The argument is not difficult Suppose instead

that there is some high price, p , and some low price, p, being charged

for apartments The people who are renting their apartments for a highprice could go to a landlord renting for a low price and offer to pay a rentsomewhere between ph and pl A transaction at such a price would makeboth the renter and the landlord better off To the extent that all partiesare seeking to further their own interests and are aware of the alternativeprices being charged, a situation with different prices being charged for thesame good cannot persist in equilibrium.

But what will this single equilibrium price be? Let us try the methodthat we used in our construction of the demand curve: we will pick a priceand ask how many apartments will be supplied at that price

The answer depends to some degree on the time frame in which we areexamining the market If we are considering a time frame of several years,

so that new construction can take place, the number of apartments willcertainly respond to the price that is charged But in the “short run”—within a given year, say—the number of apartments is more or less fixed

If we consider only this short-run case, the supply of apartments will beconstant at some predetermined level

The supply curve in this market is depicted in Figure 1.3 as a verticalline Whatever price is being charged, the same number of apartments will

be rented, namely, all the apartments that are available at that time

Short-run supply curve The supply of apartments is fixed

in the short run

Figure1.3

1.5 Market Equilibrium

We now have a way of representing the demand and the supply side of the

apartment market Let us put them together and ask what the equilibrium

behavior of the market is We do this by drawing both the demand and

the supply curve on the same graph in Figure 1.4

In this graph we have used p∗ to denote the price where the quantity

of apartments demanded equals the quantity supplied This is the

equi-librium price of apartments At this price, each consumer who is willing

to pay at least p∗ is able to find an apartment to rent, and each landlord

will be able to rent apartments at the going market price Neither the

con-sumers nor the landlords have any reason to change their behavior This

is why we refer to this as an equilibrium: no change in behavior will be

observed

To better understand this point, let us consider what would happen at

a price other than p∗ For example, consider some price p < p∗ where

demand is greater than supply Can this price persist? At this price at

least some of the landlords will have more renters than they can handle

There will be lines of people hoping to get an apartment at that price;

there are more people who are willing to pay the price p than there are

apartments Certainly some of the landlords would find it in their interest

to raise the price of the apartments they are offering

Similarly, suppose that the price of apartments is some p greater than p∗

Then some of the apartments will be vacant: there are fewer people whoare willing to pay p than there are apartments Some of the landlords arenow in danger of getting no rent at all for their apartments Thus they willhave an incentive to lower their price in order to attract more renters.

If the price is above p∗there are too few renters; if it is below p∗there aretoo many renters Only at the price of p∗ is the number of people who arewilling to rent at that price equal to the number of apartments availablefor rent Only at that price does demand equal supply

At the price p∗ the landlords’ and the renters’ behaviors are compatible

in the sense that the number of apartments demanded by the renters at p∗

is equal to the number of apartments supplied by the landlords This isthe equilibrium price in the market for apartments

Once we’ve determined the market price for the inner-ring apartments,

we can ask who ends up getting these apartments and who is exiled to thefarther-away apartments In our model there is a very simple answer tothis question: in the market equilibrium everyone who is willing to pay p∗

or more gets an apartment in the inner ring, and everyone who is willing

to pay less than p∗gets one in the outer ring The person who has a vation price of p∗ is just indifferent between taking an apartment in theinner ring and taking one in the outer ring The other people in the innerring are getting their apartments at less than the maximum they would bewilling to pay for them Thus the assignment of apartments to renters isdetermined by how much they are willing to pay

reser-COMPARATIVE STATICS 9

1.6 Comparative Statics

Now that we have an economic model of the apartment market, we can

begin to use it to analyze the behavior of the equilibrium price For

exam-ple, we can ask how the price of apartments changes when various aspects

of the market change This kind of an exercise is known as

compara-tive statics, because it involves comparing two “static” equilibria without

worrying about how the market moves from one equilibrium to another

The movement from one equilibrium to another can take a substantial

amount of time, and questions about how such movement takes place can

be very interesting and important But we must walk before we can run,

so we will ignore such dynamic questions for now Comparative statics

analysis is only concerned with comparing equilibria, and there will be

enough questions to answer in this framework for the present

Let’s start with a simple case Suppose that the supply of apartments is

Old p*

New p*

Increasing the supply of apartments As the supply of

apartments increases, the equilibrium price decreases

Figure1.5

It is easy to see in this diagram that the equilibrium price of apartments

will fall Similarly, if the supply of apartments were reduced the equilibrium

price would rise

10 THE MARKET (Ch 1)

Let’s try a more complicated—and more interesting—example Supposethat a developer decides to turn several of the apartments into condomini-ums What will happen to the price of the remaining apartments?Your first guess is probably that the price of apartments will go up,since the supply has been reduced But this isn’t necessarily right It istrue that the supply of apartments to rent has been reduced But the de-mand for apartments has been reduced as well, since some of the peoplewho were renting apartments may decide to purchase the new condomini-ums

It is natural to assume that the condominium purchasers come fromthose who already live in the inner-ring apartments—those people whoare willing to pay more than p∗ for an apartment Suppose, for example,that the demanders with the 10 highest reservation prices decide to buycondos rather than rent apartments Then the new demand curve is justthe old demand curve with 10 fewer demanders at each price Since thereare also 10 fewer apartments to rent, the new equilibrium price is justwhat it was before, and exactly the same people end up living in the inner-ring apartments This situation is depicted in Figure 1.6 Both the demandcurve and the supply curve shift left by 10 apartments, and the equilibriumprice remains unchanged

RESERVATION

PRICE

NUMBER OF APARTMENTS

Old supply

New supply

Old demand

New demand

OTHER WAYS TO ALLOCATE APARTMENTS 11

Most people find this result surprising They tend to see just the tion in the supply of apartments and don’t think about the reduction indemand The case we’ve considered is an extreme one: all of the condo pur-chasers were former apartment dwellers But the other case—where none

reduc-of the condo purchasers were apartment dwellers—is even more extreme.The model, simple though it is, has led us to an important insight If wewant to determine how conversion to condominiums will affect the apart-ment market, we have to consider not only the effect on the supply ofapartments but also the effect on the demand for apartments

Let’s consider another example of a surprising comparative statics ysis: the effect of an apartment tax Suppose that the city council decidesthat there should be a tax on apartments of $50 a year Thus each landlordwill have to pay $50 a year to the city for each apartment that he owns.What will this do to the price of apartments?

anal-Most people would think that at least some of the tax would get passedalong to apartment renters But, rather surprisingly, that is not the case

In fact, the equilibrium price of apartments will remain unchanged!

In order to verify this, we have to ask what happens to the demand curveand the supply curve The supply curve doesn’t change—there are just asmany apartments after the tax as before the tax And the demand curvedoesn’t change either, since the number of apartments that will be rented

at each different price will be the same as well If neither the demand curvenor the supply curve shifts, the price can’t change as a result of the tax.Here is a way to think about the effect of this tax Before the tax isimposed, each landlord is charging the highest price that he can get thatwill keep his apartments occupied The equilibrium price p∗ is the highestprice that can be charged that is compatible with all of the apartmentsbeing rented After the tax is imposed can the landlords raise their prices tocompensate for the tax? The answer is no: if they could raise the price andkeep their apartments occupied, they would have already done so If theywere charging the maximum price that the market could bear, the landlordscouldn’t raise their prices any more: none of the tax can get passed along

to the renters The landlords have to pay the entire amount of the tax.This analysis depends on the assumption that the supply of apartmentsremains fixed If the number of apartments can vary as the tax changes,then the price paid by the renters will typically change We’ll examine thiskind of behavior later on, after we’ve built up some more powerful toolsfor analyzing such problems

1.7 Other Ways to Allocate Apartments

In the previous section we described the equilibrium for apartments in

a competitive market But this is only one of many ways to allocate a

12 THE MARKET (Ch 1)

resource; in this section we describe a few other ways Some of these maysound rather strange, but each will illustrate an important economic point

The Discriminating Monopolist

First, let us consider a situation where there is one dominant landlord whoowns all of the apartments Or, alternatively, we could think of a number

of individual landlords getting together and coordinating their actions toact as one A situation where a market is dominated by a single seller of aproduct is known as a monopoly

In renting the apartments the landlord could decide to auction them offone by one to the highest bidders Since this means that different peoplewould end up paying different prices for apartments, we will call this thecase of the discriminating monopolist Let us suppose for simplicitythat the discriminating monopolist knows each person’s reservation pricefor apartments (This is not terribly realistic, but it will serve to illustrate

an important point.)

This means that he would rent the first apartment to the fellow whowould pay the most for it, in this case $500 The next apartment would gofor $490 and so on as we moved down the demand curve Each apartmentwould be rented to the person who was willing to pay the most for it.Here is the interesting feature of the discriminating monopolist: exactlythe same people will get the apartments as in the case of the market solution,namely, everyone who valued an apartment at more than p∗ The lastperson to rent an apartment pays the price p∗—the same as the equilibriumprice in a competitive market The discriminating monopolist’s attempt tomaximize his own profits leads to the same allocation of apartments as thesupply and demand mechanism of the competitive market The amount thepeople pay is different, but who gets the apartments is the same It turnsout that this is no accident, but we’ll have to wait until later to explainthe reason

The Ordinary Monopolist

We assumed that the discriminating monopolist was able to rent each ment at a different price But what if he were forced to rent all apartments

apart-at the same price? In this case the monopolist faces a tradeoff: if he chooses

a low price he will rent more apartments, but he may end up making lessmoney than if he sets a higher price

Let us use D(p) to represent the demand function—the number of ments demanded at price p Then if the monopolist sets a price p, he willrent D(p) apartments and thus receive a revenue of pD(p) The revenuethat the monopolist receives can be thought of as the area of a box: the

apart-OTHER WAYS TO ALLOCATE APARTMENTS 13

height of the box is the price p and the width of the box is the number of

apartments D(p) The product of the height and the width—the area of

the box—is the revenue the monopolist receives This is the box depicted

Revenue box The revenue received by the monopolist is just

the price times the quantity, which can be interpreted as the

area of the box illustrated

Figure1.7

If the monopolist has no costs associated with renting an apartment, he

would want to choose a price that has the largest associated revenue box

The largest revenue box in Figure 1.7 occurs at the price ˆp In this case

the monopolist will find it in his interest not to rent all of the apartments

In fact this will generally be the case for a monopolist The monopolist

will want to restrict the output available in order to maximize his profit

This means that the monopolist will generally want to charge a price that

is higher than the equilibrium price in a competitive market, p∗ In the

case of the ordinary monopolist, fewer apartments will be rented, and each

apartment will be rented at a higher price than in the competitive market

Rent Control

A third and final case that we will discuss will be the case of rent control

Suppose that the city decides to impose a maximum rent that can be