hal varian...................................................................................................................................., Thesis of Economics

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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 staff 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 ©c 2010, 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 TEXnician: Hal Varian

ISBN 978-0-393-93424-

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

1 2 3 4 5 6 7 8 9 0

Intermediate

Microeconomics

A Modern Approach

Eighth Edition

Hal R. Varian

University of California at Berkeley

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

To Carol

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VIII CONTENTS

3 Preferences

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

• Perfect Complements • Bads • Neutrals • Satiation • 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

4 Utility

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

• Cobb-Douglas Preferences • Marginal Utility 65 Marginal Utility and MRS 66 Utility for Commuting 67 Summary 69 Review Questions 70 Appendix 70 Example: Cobb-Douglas Preferences

5 Choice

Optimal Choice 73 Consumer Demand 78 Some Examples 78 Perfect Substitutes • Perfect Complements • Neutrals and Bads • Discrete Goods • Concave Preferences • 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

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 • Quasilinear Preferences • Ordinary Goods and Giffen Goods 104 The Price Offer Curve and the Demand Curve 106 Some Examples 107 Perfect Substitutes • Perfect Complements • A Discrete Good • Substitutes and 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 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 Slutsky 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

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 Con- sumer’s Surplus to Consumers’ Surplus 255 Approximating a Continu- ous Demand 255 Quasilinear Utility 255 Interpreting the Change in Consumer’s Surplus 256 Example: The Change in Consumer’s Surplus Compensating and Equivalent Variation 258 Example: Compensating and Equivalent Variations Example: Compensating and Equivalent Vari- ation for Quasilinear Preferences Producer’s Surplus 262 Benefit-Cost Analysis 264 Rationing • Calculating Gains and Losses 266 Sum- mary 267 Review Questions 267 Appendix 268 Example: A Few Demand Functions Example: CV, EV, and Consumer’s Surplus

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

16 Equilibrium

Supply 293 Market Equilibrium 293 Two Special Cases 294 In- verse Demand and Supply Curves 295 Example: Equilibrium with Lin- ear Curves Comparative Statics 297 Example: Shifting Both Curves Taxes 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 in Iraq Pareto Efficiency 310 Example: Waiting in Line Summary 313 Review Questions 313

XII CONTENTS

17 Auctions

Classification of Auctions 316 Bidding Rules • Auction Design 317 Other Auction Forms 320 Example: Late Bidding on eBay Position Auctions 322 Two Bidders • More Than Two Bidders • Quality Scores • Problems with Auctions 326 Example: Taking Bids Off the Wall The Winner’s Curse 327 Stable Marriage Problem 327 Mech- anism Design 329 Summary 331 Review Questions 331

18 Technology

Inputs and Outputs 332 Describing Technological Constraints 333 Examples of Technology 334 Fixed Proportions • Perfect Substi- tutes • Cobb-Douglas • Properties of Technology 336 The Marginal Product 338 The Technical Rate of Substitution 338 Diminishing Marginal Product 339 Diminishing Technical Rate of Substitution 339 The Long Run and the Short Run 340 Returns to Scale 340 Ex- ample: Datacenters Example: Copy Exactly! Summary 343 Review Questions 344

19 Profit Maximization

Profits 345 The Organization of Firms 347 Profits and Stock Market Value 347 The Boundaries of the Firm 349 Fixed and Variable Fac- tors 350 Short-Run Profit Maximization 350 Comparative Statics 352 Profit Maximization in the Long Run 353 Inverse Factor Demand Curves 354 Profit Maximization and Returns to Scale 355 Revealed Profitability 356 Example: How Do Farmers React to Price Supports? Cost Minimization 360 Summary 360 Review Questions 361 Ap- pendix 362

XIV CONTENTS

23 Industry Supply

Short-Run Industry Supply 413 Industry Equilibrium in the Short Run 414 Industry Equilibrium in the Long Run 415 The Long-Run Supply Curve 417 Example: Taxation in the Long Run and in the Short Run The Meaning of Zero Profits 421 Fixed Factors and Economic Rent 422 Example: Taxi Licenses in New York City Economic Rent 424 Rental Rates and Prices 426 Example: Liquor Licenses The Politics of Rent 427 Example: Farming the Government Energy Policy 429 Two-Tiered Oil Pricing • Price Controls • The Entitlement Program

• Carbon Tax Versus Cap and Trade 433 Optimal Production of Emis- sions • A Carbon Tax • Cap and Trade • Summary 437 Review Questions 437

24 Monopoly

Maximizing Profits 440 Linear Demand Curve and Monopoly 441 Markup Pricing 443 Example: The Impact of Taxes on a Monopo- list Inefficiency of Monopoly 445 Deadweight Loss of Monopoly 447 Example: The Optimal Life of a Patent Example: Patent Thickets Ex- ample: Managing the Supply of Potatoes Natural Monopoly 451 What Causes Monopolies? 454 Example: Diamonds Are Forever Example: Pooling in Auction Markets Example: Price Fixing in Computer Memory Markets Summary 458 Review Questions 458 Appendix 459

25 Monopoly Behavior

Price Discrimination 462 First-Degree Price Discrimination 462 Ex- ample: First-degree Price Discrimination in Practice Second-Degree Price Discrimination 465 Example: Price Discrimination in Airfares Ex- ample: Prescription Drug Prices Third-Degree Price Discrimination 469 Example: Linear Demand Curves Example: Calculating Optimal Price Discrimination Example: Price Discrimination in Academic Journals Bundling 474 Example: Software Suites Two-Part Tariffs 475 Mo- nopolistic Competition 476 A Location Model of Product Differentiation 480 Product Differentiation 482 More Vendors 483 Summary 484 Review Questions 484

CONTENTS XV

26 Factor Markets

Monopoly in the Output Market 485 Monopsony 488 Example: The Minimum Wage Upstream and Downstream Monopolies 492 Summary 494 Review Questions 495 Appendix 495

27 Oligopoly

Choosing a Strategy 498 Example: Pricing Matching Quantity Lead- ership 499 The Follower’s Problem • The Leader’s Problem • Price Leadership 504 Comparing Price Leadership and Quantity Leadership 507 Simultaneous Quantity Setting 507 An Example of Cournot Equilibrium 509 Adjustment to Equilibrium 510 Many Firms in Cournot Equilibrium 511 Simultaneous Price Setting 512 Collu- sion 513 Punishment Strategies 515 Example: Price Matching and Competition Example: Voluntary Export Restraints Comparison of the Solutions 519 Summary 519 Review Questions 520

28 Game Theory

The Payoff Matrix of a Game 522 Nash Equilibrium 524 Mixed Strategies 525 Example: Rock Paper Scissors The Prisoner’s Dilemma 527 Repeated Games 529 Enforcing a Cartel 530 Example: Tit for Tat in Airline Pricing Sequential Games 532 A Game of Entry Deterrence 534 Summary 536 Review Questions 537

29 Game Applications

Best Response Curves 538 Mixed Strategies 540 Games of Coordi- nation 542 Battle of the Sexes • Prisoner’s Dilemma • Assurance Games • Chicken • How to Coordinate • Games of Competition 546 Games of Coexistence 551 Games of Commitment 553 The Frog and the Scorpion • The Kindly Kidnapper • When Strength Is Weakness

• Savings and Social Security • Hold Up • Bargaining 561 The Ultimatum Game • Summary 564 Review Questions 565

CONTENTS XVII

33 Welfare

Aggregation of Preferences 632 Social Welfare Functions 634 Welfare Maximization 636 Individualistic Social Welfare Functions 638 Fair Allocations 639 Envy and Equity 640 Summary 642 Review Questions 642 Appendix 643

34 Externalities

Smokers and Nonsmokers 645 Quasilinear Preferences and the Coase Theorem 648 Production Externalities 650 Example: Pollution Vouchers Interpretation of the Conditions 655 Market Signals 658 Example: Bees and Almonds The Tragedy of the Commons 659 Ex- ample: Overfishing Example: New England Lobsters Automobile Pollu- tion 663 Summary 665 Review Questions 665

35 Information Technology

Systems Competition 668 The Problem of Complements 668 Re- lationships among Complementors • Example: Apple’s iPod and iTunes Example: Who Makes an iPod? Example: AdWords and AdSense Lock- In 674 A Model of Competition with Switching Costs • Example: Online Bill Payment Example: Number Portability on Cell Phones Net- work Externalities 678 Markets with Network Externalities 678 Mar- ket Dynamics 680 Example: Network Externalities in Computer Soft- ware Implications of Network Externalities 684 Example: The Yellow Pages Example: Radio Ads Two-sided Markets 686 A Model of Two-sided Markets • Rights Management 687 Example: Video Rental Sharing Intellectual Property 689 Example: Online Two-sided Markets Summary 692 Review Questions 693

XVIII CONTENTS

36 Public Goods

When to Provide a Public Good? 695 Private Provision of the Public Good 699 Free Riding 699 Different Levels of the Public Good 701 Quasilinear Preferences and Public Goods 703 Example: Pollution Revisited The Free Rider Problem 705 Comparison to Private Goods 707 Voting 708 Example: Agenda Manipulation The Vickrey- Clarke-Groves Mechanism 711 Groves Mechanism • The VCG Mech- anism • Examples of VCG 713 Vickrey Auction • Clarke-Groves Mechanism • Problems with the VCG 714 Summary 715 Review Questions 716 Appendix 716

37 Asymmetric Information

The Market for Lemons 719 Quality Choice 720 Choosing the Qual- ity • Adverse Selection 722 Moral Hazard 724 Moral Hazard and Adverse Selection 725 Signaling 726 Example: The Sheepskin Effect Incentives 730 Example: Voting Rights in the Corporation Example: Chinese Economic Reforms Asymmetric Information 735 Example: Monitoring Costs Example: The Grameen Bank Summary 738 Re- view Questions 739

Mathematical Appendix

Functions A1 Graphs A2 Properties of Functions A2 Inverse Functions A3 Equations and Identities A3 Linear Functions A Changes and Rates of Change A4 Slopes and Intercepts A5 Absolute Values and Logarithms A6 Derivatives A6 Second Derivatives A The Product Rule and the Chain Rule A8 Partial Derivatives A Optimization A9 Constrained Optimization A

Answers A

Index A