Intermediate

Microeconomics

With Calculus

First Edition

Hai R. Varian

Google and University of California at Berkeley

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

 CONTENTS

Preface xix

1 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 • The Ordinary Monopolist • 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

2 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
 VIII CONTENTS

3 Preferences

Consumer Preferences 34 Assumptions about Preferences 35 Indif-

ference Curves 36 Examples of Preferences 37 Perfect Substitutes
• Perfect Complements • Bads • Neutrais • 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 Example: Cobb-Douglas Preferences Utility for Com-
muting 69 Summary 71 Review Questions 71

5 Choice

Optimal Choice 73 Consumer Demand 78 Some Examples 78

Perfect Substitutes • Perfect Complements • Neutrais and Bads •
Discrete Goods • Concave Preferences » Solving the Preference Max-
imization Problem • Cobb-Douglas Preferences • Estimating Utility
Functions 88 Implications of the MRS Condition 90 Choosing Taxes
91 Summary 94 Review Questions 94

6 Demand

Normal and Inferior Goods 97 Income Offer Curves and Engel Curves
98 Some Examples 100 Perfect Substitutes • Perfect Complements
• Cobb-Douglas Preferences • Homothetic Preferences • Quasilinear
Preferences • Ordinary Goods and Giffen Goods 106 The Price Offer
Curve and the Demand Curve 108 Some Examples 109 Perfect
Substitutes • Perfect Complements • A Discrete Good « Substitutes
and Complements 114 The Inverse Demand Function 115 Summary
117 Review Questions 117
 CONTENTS IX

7 Revealed Preference

The Idea of Revealed Preference 120 From Revealed Preference to Pref­

erence 121 Recovering Preferences 123 The Weak Axiom of Re­
vealed Preference 125 Checking WARP 126 The Strong Axiom of
Revealed Preference 129 How to Check SARP 130 Index Numbers
131 Price Indices 133 Example: Indexing Social Security Payrrients
Summary 136 Review Questions 136

8 Slutsky Equation

The Substitution Effect 138 Example: Calculating the Substitution Ef­

fect The Income Effect 142 Example: Calculating the Income Effect
Sign of the Substitution Effect 143 The Total Change in Demand 144
Rates of Change 145 The Law of Demand 148 Examples of Income
and Substitution Effects 148 Example: Rebating a Tax Example:
Voluntary Real Time Pricing Another Substitution Effect 155 Com-
pensated Demand Curves 157 Summary 157 Review Questions 158
Appendix 158 Example: Rebating a Small Tax

9 Buying and Selling

Net and Gross Demands 161 The Budget Constraint 162 Changing
the Endowment 164 Price Changes 165 Offer Curves and Demand
Curves 168 The Slutsky Equation Revisited 169 Use of the Slut­
sky Equation 174 Example: Calculating the Endowment Income Effect
Labor Supply 176 The Budget Constraint • Comparative Statics of
Labor Supply 178 Example: Overtime and the Supply of Labor Sum­
mary 181 Review Questions 182
 X CONTENTS

10 Intertemporal Choice

The Budget Constraint 183 Preferences for Consumption 186 Com-

parative Statics 187 The Slutsky Equation and Intertemporal Choice
188 Inflation 190 Present Value: A Closer Look 192 Analyz-
ing Present Value for Several Periods 194 Present Value in Continuous
Time 195 Use of Present Value 195 Example: Valuing a Stream
of Payments Example: The True Cost of a Credit Card Example: Ex-
tending Copyright Bonds 199 Example: Installment Loans Taxes
201 Example: Scholarships and Savings Choice of the Interest Rate
203 Summary 203 Review Questions 203

11 Asset Markets

Rates of Return 205 Arbitrage and Present Value 207 Adjustments

for Differences among Assets 207 Assets with Consumption Returns
208 Taxation of Asset Returns 209 Market Bubbles 210 Applica­
tions 211 Depletable Resources • When to Cut a Forest # Example:
Gasoline Prices during the Gulf War Financial Institutions 215 Sum­
mary 216 Review Questions 217 Appendix 217

12 Uncertainty

Contingent Consumption 219 Example: Catastrophe Bonds Utility

Functions and Probabilities 224 Example: Some Examples of Utility
Functions Expected Utility 225 Why Expected Utility Is Reasonable
226 Risk Aversion 228 Example: The Demand for Insurance Ex­
ample: The Effect of Taxation on Investment in Risky Assets Diversi-
fication 235 Risk Spreading 235 Role of the Stock Market 236
Summary 237 Review Questions 237

13 Risky Assets

Mean-Variance Utility 239 Measuring Risk 244 Counterparty Risk

246 Equilibrium in a Market for Risky Assets 246 How Returns
Adjust 248 Example: Value at Risk Example: Ranking Mutual Funds
Summary 252 Review Questions 253
 CONTENTS XI

14 Consumer's Surplus

Demand for a Discrete Good 255 Constructing Utility from Demand

256 Other Interpretation of Consumer's Surplus 257 From Con­
sumer's Surplus to Consumers' Surplus 258 Approximating a Continu-
ous Demand 258 Quasilinear Utility 258 Interpreting the Change in
Consumer's Surplus 259 Example: The Change in Consumer's Surplus
Compensating and Equivalent Variation 261 Example: Compensating
and Equivalent Variations Example: Compensating and Equivalent Vari­
ation for Quasilinear Preferences Producer's Surplus 265 Benefit-Cost
Analysis 267 Rationing • Calculating Gains and Losses 269 Sum­
mary 270 Review Questions 270 Appendix 271 Example: A
Few Demand Functions Example: CV, EV, and Consumer's Surplus

15 Market Demand

From Individual to Market Demand 273 The Inverse Demand Function

275 Example: Adding Up "Linear" Demand Curves Discrete Goods
276 The Extensive and the Intensive Margin 276 Elasticity 277
Example: The Elasticity of a Linear Demand Curve Elasticity and De­
mand 279 Elasticity and Revenue 280 Example: Strikes and Profits
Constant Elasticity Demands 283 Elasticity and Marginal Revenue 284
Example: Setting a Price Marginal Revenue Curves 286 Income Elas­
ticity 287 Summary 288 Review Questions 289 Appendix 290
Example: The Laffer Curve Example: Another Expression for Elasticity

16 Equilibrium

Supply 296 Market Equilibrium 296 Two Special Cases 297 In­
verse Demand and Supply Curves 298 Example: Equilibrium with Lin­
ear Curves Comparative Statics 300 Example: Shifting Both Curves
Taxes 301 Example: Taxation with Linear Demand and Supply Pass­
ing Along a Tax 305 The Deadweight Loss of a Tax 307 Example:
The Market for Loans Example: Food Subsidies Example: Subsidies in
Iraq Pareto Efficiency 313 Example: Waiting in Line Summary 316
Review Questions 316
 XII CONTENTS

17 Measurement

Summarize data 319 Example: Simpson's paradox Test 323 Esti-

mating demand using experimental data 323 Effect of treatment 324
Estimating demand using observational data 325 Functional form •
Statistical model • Estimation • Identification 327 What can go
wrong? 329 Policy evaluation 330 Example: Crime and police
Summary 331 Review Questions 332

18 Auctions

Classification of Auctions 334 Bidding Rules • Auction Design 335

Example: Goethe's auction Other Auction Forms 339 Example: Late
Bidding on eBay Position Auctions 341 Two Bidders • More Than
Two Bidders • Quality Scores • Should you advertise on your brand?
344 Auction revenue and number of bidders 345 Problems with Auc­
tions 346 Example: Taking Bids Off the Wall The Winner's Curse
347 Stable Marriage Problem 348 Mechanism Design 349 Sum­
mary 351 Review Questions 352

19 Technology

Inputs and Outputs 353 Describing Technological Constraints 354

Examples of Technology 355 Fixed Proportions • Perfect Substi­
tutes • Cobb-Douglas • Properties of Technology 357 The Marginal
Product 359 The Technical Rate of Substitution 359 Diminishing
Marginal Product 360 Diminishing Technical Rate of Substitution 360
The Long Run and the Short Run 361 Returns to Scale 361 Ex­
ample: Datacenters Example: Copy Exactly! Summary 364 Review
Questions 365
 CONTENTS XIII

20 Profit Maximization

Profits 366 The Organization of Firnis 368 Profits and Stock Market
Value 368 The Boundaries of the Firm 370 Fixed and Variable Fac­
tors 371 Short-Run Profit Maximization 371 Comparative Statics
373 Profit Maximization in the Long Run 375 Example: Profit Max­
imization with Cobb-Douglas Production Inverse Factor Demand Curves
377 Profit Maximization and Returns to Scale 378 Revealed Prof-
itability 379 Example: How Do Farmers React to Price Supports?
Cost Minimization 384 Summary 384 Review Questions 384

21 Cost Minimization

Cost Minimization 386 Example: Minimizing Costs for Specific Tech­

nologies Revealed Cost Minimization 392 Returns to Scale and the
Cost Function 393 Long-Run and Short-Run Costs 395 Fixed and
Quasi-Fixed Costs 397 Sunk Costs 397 Summary 398 Review
Questions 398

22 Cost Curves

Average Costs 400 Marginal Costs 402 Marginal Costs and Variable
Costs 405 Example: Specific Cost Curves Example: Marginal Cost
Curves for Two Plants Cost Curves for Online Auctions 408 Long-Run
Costs 410 Discrete Levels of Plant Size 412 Long-Run Marginal Costs
414 Summary 415 Review Questions 416

23 Firm Supply

Market Environments 417 Pure Competition 418 The Supply Deci-

sion of a Competitive Firm 420 An Exception 421 Another Exception
422 Example: Pricing Operating Systems The Inverse Supply Func­
tion 424 Profits and Producer's Surplus 425 Example: The Supply
Curve for a Specific Cost Function The Long-Run Supply Curve of a Firm
429 Long-Run Constant Average Costs 431 Summary 432 Review
Questions 433
 XIV CONTENTS

24 Industry Supply

Short-Run Industry Supply 434 Industry Equilibrium in the Short Run

435 Industry Equilibrium in the Long Run 436 The Long-Run Supply
Curve 438 Example: Taxation in the Long Run and in the Short Run
The Meaning of Zero Profits 442 Fixed Factors and Economic Rent
443 Example: Taxi Licenses in New York City Economic Rent 446
Rental Rates and Prices 447 Example: Liquor Licenses The Politics
of Rent 448 Example: Farming the Government Energy Policy 450
Two-Tiered Oil Pricing • Price Controls • The Entitlement Program
• Carbon Tax Versus Cap and Trade 454 Optimal Production of Emis­
sions • A Carbon Tax • Cap and Trade • Summary 458 Review
Questions 458

25 Monopoly

Maximizing Profits 461 Linear Demand Curve and Monopoly 463

Markup Pricing 463 Example: The Impact of Taxes on a Monopo­
list InefBciency of Monopoly 467 Deadweight Loss of Monopoly 468
Example: The Optimal Life of a Patent Example: Patent Thickets Ex­
ample: Managing the Supply of Potatoes Natural Monopoly 473 What
Causes Monopolies? 475 Example: Diamonds Are Forever Exam­
ple: Pooling in Auction Markets Example: Price Fixing in Computer
Memory Markets Summary 479 Review Questions 479

26 Monopoly Behavior

Price Discrimination 482 First-Degree Price Discrimination 482 Ex­

ample: First-degree Price Discrimination in Practice Second-Degree Price
Discrimination 485 Example: Price Discrimination in Airfares Ex­
ample: Prescription Drug Prices Third-Degree Price Discrimination 489
Example: Linear Demand Curves Example: Calculating Optimal Price
Discrimination Example: Price Discrimination in Academic Journals
Rundling 494 Example: Software Suites Two-Part Tariffs 495 Mo-
nopolistic Competition 496 A Location Model of Product Differentiation
500 Product Differentiation 502 More Vendors 503 Summary 503
Review Questions 504
 CONTENTS XV

27 Factor Markets

Monopoly in the Output Market 505 Monopsony 508 Example: The

Minimum Wage Upstream and Downstream Monopolies 512 Summary
514 Review Questions 515

28 Oligopoly

Choosing a Strategy 517 Example: Pricing Matching Quantity Lead-

ership 518 The Follower's Problem • The Leader's Problem • Price
Leadership 523 Comparing Price Leadership and Quantity Leadership
526 Simultaneous Quantity Setting 526 An Example of Cournot
Equilibrium 528 Adjustment to Equilibrium 529 Many Firms in
Cournot Equilibrium 530 Simultaneous Price Setting 531 Collu-
sion 532 Punishment Strategies 534 Example: Price Matching and
Competition Example: Voluntary Export Restraints Comparison of the
Solutions 538 Summary 538 Review Questions 539

29 Game Theory

The Payoff Matrix of a Game 541 Nash Equilibrium 543 Mixed

Strategies 544 Example: Rock Paper Scissors The Prisoner's Dilemma
546 Repeated Games 548 Enforcing a Carte] 549 Example: Tit
for Tat in Airline Pricing Sequential Games 551 A Game of Entry
Deterrence 553 Summary 555 Review Questions 556

30 Game Applications

Best Response Curves 557 Mixed Strategies 559 Games of Coordi-

nation 561 Battie of the Sexes • Prisoner's Dilemma • Assurance
Games • Chicken • How to Coordinate • Games of Competition 565
Games of Coexistence 570 Games of Commitment 572 The Frog
and the Scorpion • The Kindly Kidnapper • When Strength Is Weak-
ness • Savings and Social Security • Example: Dynamic inefficiency
of price discrimination Hold Up • Bargaining 581 The Ultimatum
Game • Summary 584 Review Questions 584
 XVI CONTENTS

31 Behavioral Economics

Framing Effects in Consumer Choice 587 The Disease Dilemma •

Anchoring Effects • Bracketing • Too Much Choice • Constructed
Preferences « Uncertainty 591 Law of Small Numbers • Asset In­
tegration and Loss Aversion • Time 594 Discounting • Self-control
• Example: Overconfidence Strategie Interaction and Social Nor ms 596
Ultimatum Game • Fairness • Assessment of Behavioral Economics
598 Summary 600 Review Questions 600

32 Exchange

The Edgeworth Box 602 Trade 604 Pareto Efficient Allocations

605 Market Trade 609 The Algebra of Equilibrium 612 Walras'
Law 613 Relative Prices 614 Example: An Algebraic Example of
Equilibrium The Existence of Equilibrium 616 Equilibrium and Effi-
ciency 617 The Algebra of Efficiency 617 Example: Monopoly in
the Edgeworth Box Efficiency and Equilibrium 621 Implications of the
First Weifare Theorem 623 Implications of the Second Weifare Theorem
624 Summary 627 Review Questions 627

33 Produktion

The Robinson Crusoe Economy 629 Crusoe, Inc. 631 The Firm 632
Robinson's Problem 633 Putting Them Together 633 Different Tech­
nologies 635 Production and the First Weifare Theorem 637 Produc-
tion and the Second Weifare Theorem 638 Production Possibilities 638
Comparative Advantage 640 Pareto Efficiency 642 Castaways, Inc.
646 Robinson and Friday as Consumers 648 Decentralized Resource
Allocation 648 Summary 650 Review Questions 650

34 Weifare

Aggregation of Preferences 653 Social Weifare Functions 655 Weifare

Maximization 657 Individualistic Social Weifare Functions 659 Fair
Allocations 661 Envy and Equity 662 Summary 664 Review
Questions 664
 CONTENTS XVII

35 Externalities

Smokers and Nonsmokers 667 Quasilinear Preferences and the Coase

Theorem 670 Production Externalities 672 Example: Pollution
Vouchers Interpretation of the Conditions 677 Market Signals 680
Example: Bees and Almonds The Tragedy of the Commons 681 Ex­
ample: Overfishing Example: New England Lobsters Automobile Pollu­
tion 685 Summary 687 Review Questions 687

36 Information Technology

Systems Competition 690 The Problem of Complements 690 Re-

lationships among Complementors • Example: Apple's iPod and iTunes
Example: Who Makes an iPod? Example: AdWords and AdSense Lock-
In 696 A Model of Competition with Switching Costs • Example:
Online Bill Payment Example: Number Portability on Cell Phones Net­
work Externalities 700 Markets with Network Externalities 700 Mar­
ket Dynamics 702 Example: Network Externalities in Computer Soft­
ware Implications of Network Externalities 706 Example: The Yellow
Pages Example: Radio Ads Two-sided Markets 708 A Model of
Two-sided Markets • Rights Management 709 Example: Video Rental
Sharing Intellectual Property 711 Example: Online Two-sided Markets
Summary 714 Review Questions 715

37 Public Goods

When to Provide a Public Good? 717 Private Provision of the Public

Good 721 Free Riding 721 Different Levels of the Public Good 723
Quasilinear Preferences and Public Goods 725 Example: Pollution
Revisited The Free Rider Problem 728 Comparison to Private Goods
729 Voting 730 Example: Agenda Manipulation The Vickrey-
Clarke-Groves Mechanism 733 Groves Mechanism • The VCG Mech-
anism • Examples of VCG 736 Vickrey Auction • Clarke-Groves
Mechanism • Problems with the VCG 737 Summary 738 Review
Questions 739
 XVIII CONTENTS

38 Asymmetrie Information

The Market for Lemons 741 Quality Choice 742 Choosing the Qual-
ity • Adverse Selection 744 Moral Hazard 746 Moral Hazard and
Adverse Selection 747 Signaling 748 Example: The Sheepskin Effect
Incentives 752 Example: Voting Rights in the Corporation Example:
Chinese Economic Reforms Asymmetrie Information 757 Example:
Monitoring Costs Example: The Grameen Bank Summary 760 Re­
view Questions 761

Mathematical Appendix

Functions AI Graphs A2 Properties of Functions A2 Inverse

Functions A3 Equations and Identities A3 Linear Functions A4
Changes and Rates of Change A4 Slopes and Intercepts A5 Absolute
Values and Logarithms A6 Derivatives A6 Second Derivatives A7
The Product Rule and the Chain Rule A8 Partial Derivatives A8
Optimization A9 Constrained Optimization A10

Answers AH

Index A31