MICROECONOMICS NINTH EDITION

Economic Cost versus Accounting Cost 216 Opportunity Cost 216 Sunk Costs 217 Fixed Costs and Variable Costs 219 Fixed versus Sunk Costs 220 Marginal a...

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MICROECONOMICS NINTH EDITION

ROBERT S. PINDYCK

DANIEL L. RUBINFELD

Massachusetts Institute of Technology

University of California, Berkeley

Pearson 330 Hudson Street, NY NY10013

CONTENTS

Preface xv

PART ONE Introduction: Markets and Prices 1 Preliminaries

1

3

1.1 The Themes of Microeconomics 4 Trade-Offs 4 Prices and Markets 5 Theories and Models 5 Positive versus Normative Analysis 6 1.2 What Is a Market? 7 Competitive versus Noncompetitive Markets 8 Market Price 8 Market Definition—The Extent ofa Market 9 1.3 Real versus Nominal Prices 12 1.4 Why Study Microeconomics? 17 Corporate Decision Making: The Toyota Prius 17 Public Policy Design: Fuel Ejficiency Standards for the Twenty-Pirst Century 18 Summary 19 Questions for Review 19 Exercises 20 2 The Basics of Supply and Demand 21 2.1 Supply and Demand 22 The Supply Curve 22 The Demand Curve 23 2.2 The Market Mechanism 25 2.3 Changes in Market Equilibrium 26 2.4 Elasticities of Supply and Demand 33 Point versus Are Elasticities 36 2.5 Short-Run versus Long-Run Elasticities 40 Demand 40 Supply 45 *2.6 Understanding and Predicting the Effects of Changing Market Conditions 49

2.7 Effects of Government Intervention—Price Controls 58 Summary 61 Questions for Review 61 Exercises 62 PART TWO Producers, Consumers, and Competitive Markets 3 Consumer Behavior

65 67

Consumer Behavior 67 3.1 Consumer Preferences 69 Market Baskets 69 Some Basic Assumptions about Preferences 70 Indifference Curves 71 Indifference Maps 71 The Shape of Indifference Curves 73 The Marginal Rate of Substitution 74 Perfect Substitutes and Perfect Complements 76 3.2 Budget Constraints 82 The Budget Line 82 The Effects of Changes in Income and Prices 84 3.3 Consumer Choice 86 Corner Solutions 89 3.4 Revealed Preference 92 3.5 Marginal Utility and Consumer Choice 95 Rationing 98 *3.6 Cost-of-Living Indexes 100 Ideal Cost-of-Living Index 101 Laspeyres Index 102 Paasche Index 103 Price Indexes in the United States: Chain Weighting 104 Summary 105 Questions for Review 106 Exercises 106

' x CONTENTS 4 Individual and Market Demand 109 4.1 Individual Demand 110 Price Changes 110 The Individual Demand Curve 110 Income Changes 112 Normal versus Inferior Goods 113 Engel Curves 114 Substitutes and Complements 116 4.2 Income and Substitution Effects 117 Substitution Effect 118 Income Effect 119 A Special Case: The Gijfen Good 120 4.3 Market Demand 122 From Individual to Market Demand 122 Elasticity of Demand 124 Speculative Demand 127 4.4 Consumer Surplus 130 Consumer Surplus and Demand 130 4.5 Network Externalities 133 Positive Network Externalities 133 Negative Network Externalities 135 *4.6 Empirical Estimation of Demand 137 The Statistical Approach to Demand Estimation 138 The Form of the Demand Relationship 139 Interview and Experimental Approaches to Demand Determination 141 Summary 142 Questions for Review 142 Exercises 143 5 Uncertainty and Consumer Behavior 157 5.1 Describing Risk 158 Probability 158 Expected Value 159 Variability 159 Decision Making 161 5.2 Preferences Toward Risk 163 Different Preferences Toward Risk 164 5.3 Reducing Risk 168 Diversification 168 Insurance 169 The Value of Information 172 *5.4 The Demand for Risky Assets 174 Assets 174 Risky and Riskless Assets 175 AssetReturns 175

The Trade-OffBetween Risk and Return 177 The Investor's Choice Problem 178 Summary 183 Questions for Review 183 Exercises 183 6 Production

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The Production Decisions ofa Firm 187 6.1 Firms and Their Production Decisions 188 Why Do Firms Exist? 189 The Technology of Production 190 The Production Function 190 The Short Run versus the Eong Run 191 6.2 Production with One Variable Input (Labor) 192 Average and Marginal Products 192 The Slopes of the Product Curve 193 The Average Product of Labor Curve 195 The Marginal Product of Labor Curve 195 The Law of Diminishing Marginal Returns 196 Labor Productivity 200 6.3 Production with Two Variable Inputs 202 Isoquants 202 Input Flexibility 204 Diminishing Marginal Returns 204 Substitution Among Inputs 204 Production Functions—Two Special Cases 206 6.4 Returns to Scale 209 Describing Returns to Scale 210 Summary 212 Questions for Review 212 Exercises 213 7 The Cost of Production

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7.1 Measuring Cost: Which Costs Matter? 215 Economic Cost versus Accounting Cost 216 Opportunity Cost 216 Sunk Costs 217 Fixed Costs and Variable Costs 219 Fixed versus Sunk Costs 220 Marginal and Average Cost 222 7.2 Cost in the Short Run 223 The Determinants ofShort-Run Cost 223 The Shapes of the Cost Curves 224 7.3 Cost in the Long Run 229 The User Cost of Capital 229 The Cost-Minimizing Input Choice 230 The Isocost Line 231 Choosing Inputs 231 )

CONTENTS xi Cost Minimization with Varying Output Levels 235 The Expansion Path and Long-Run Costs 236 7.4 Long-Run versus Short-Run Cost Curves 239 The Inßexibility of Short-Run Production 239 Long-Run Average Cost 240 Economies and Diseconomies of Scale 241 The Relationship between Short-Run and Long-Run Cost 244 75 Production with Two Outputs—Economies of Scope 245 Product Transformation Curves 245 Economies and Diseconomies of Scope 246 The Degree of Economies of Scope 247 *7.6 Dynamic Changes in Costs— The Learning Curve 248 Graphing the Learning Curve 248 Learning versus Economies of Scale 249 *7.7 Estimating and Predicting Cost 253 Cost Functions and the Measurement of Scale Economies 254 Summary 256 Questions for Review 257 Exercises 258 8 Profit Maximizatiori and Competitive Supply

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8.1 Perfectly Competitive Markets 267 When Is a Market Highly Competitive? 269 8.2 Profit Maximization 270 Do Firms Maximize Profit? 270 Alternative Forms of Organization 271 8.3 Marginal Revenue, Marginal Cost, and Profit Maximization 272 Demand and Marginal Revenue for a Competitive Firm 273 Profit Maximization by a Competitive Firm 275 8.4 Choosing Output in the Short Run 275 Short-Run Profit Maximization by a Competitive Firm 275 When Should the Firm Shut Down? 277 8.5 The Competitive Firm's Short-Run Supply Curve 280 The Firm's Response to an Input Price Change 281 8.6 The Short-Run Market Supply Curve 283 Elasticity of Market Supply 284 Producer Surplus in the Short Run 286 8.7 Choosing Output in the Long Run 288 Long-Run Profit Maximization 288

Long-Run Competitive Equilibrium 289 Economic Rent 292 Producer Surplus in the Long Run 293 8.8 The Industry's Long-Run Supply Curve 294 Constant-Cost Industry 295 Increasing-Cost Industry 296 Decreasing-Cost Industry 297 The Effects ofa Tax 298 Long-Run Elasticity of Supply 299 Summary 302 Questions for Review 302 Exercises 303 9 The Analysis of Competitive Markets

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9.1 Evaluating the Gains and Losses from Government Policies—Consumer and Producer Surplus 305 Review of Consumer and Producer Surplus 306 Application of Consumer and Producer Surplus 307 9.2 The Efficiency of a Competitive Market 311 9.3 Minimum Prices 316 9.4 Price Supports and Production Quotas 320 Price Supports 320 Production Quotas 322 9.5 Import Quotas and Tariffs 329 9.6 The Impact of a Tax or Subsidy 333 The Effects ofa Subsidy 337 Summary 340 Questions for Review 340 Exercises 341

PART THREE Market Structure and Competitive Strategy 345 10 Market Power: Monopoly and Monopsony

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10.1 Monopoly 348 Average Revenue and Marginal Revenue 348 The Monopolist's Output Decision 349 An Example 351 A Rule of Thumbfor Pricing 353 Shifts in Demand 355 The Effect ofa Tax 356 *The Multiplant Firm 357

xii CONTENTS 10.2 Monopoly Power 358 Production, Price, and Monopoly Power 361 Measuring Monopoly Power 361 The Rule of Thumbfor Pricing 362 10.3 Sources of Monopoly Power 365 The Elasticity of Market Demand 366 The Number ofFirms 366 The Interaction Among Firms 367 10.4 The Social Costs of Monopoly Power 367 Rent Seeking 368 Price Regulation 369 Natural Monopoly 370 Regulation in Practice 371 10.5 Monopsony 372 Monopsony and Monopoly Compared 375 10.6 Monopsony Power 376 Sources of Monopsony Power 376 The Social Costs of Monopsony Power 377 Bilateral Monopoly 378 10.7 Limiting Market Power: The Antitrust Laws 379 Restricting What Firms Can Do 380 Enforcement of the Antitrust Laws 382 Antitrust in Europe 382 Summary 386 Questions for Review 387 Exercises 387 11 Pricing with Market Power 11.1 Capturing Consumer Surplus 392 11.2 Price Discrimination 393 First-Degree Price Discrimination 393 Second-Degree Price Discrimination 396 Third-Degree Price Discrimination 396 11.3 Intertemporal Price Discrimination and Peak-Load Pricing 402 Intertemporal Price Discrimination 403 Peak-Load Pricing 404 11.4 The Two-Part Tariff 406 *11.5 Bundling 411 Relative Valuations 412 Mixed Bundling 414 Bundling in Practice 418 Tying 421 *11.6 Advertising 421 A Rule of Thumbfor Advertising 423 Summary 426 Questions for Review 426 Exercises 427

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12 Monopolistic Competition and Oligopoly

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12.1 Monopolistic Competition 444 The Makings of Monopolistic Competition 444 Ecjuilibrium in the Short Run and the Long Run 445 Monopolistic Competition and Economic Efficiency 446 12.2 Oligopoly 448 Equilibrium in an Oligopolistic Market 449 The Cournot Model 450 The Linear Demand Curve—An Example 453 First Mover Advantage—The Stackelberg Model 455 12.3 Price Competition 456 Price Competition with Homogeneous Products— The Bertrand Model 456 Price Competition with Differentiated Products 457 12.4 Competition versus Collusion: The Prisoners' Dilemma 461 12.5 Implications of the Prisoners' Dilemma for Oligopolistic Pricing 464 Price Rigidity 464 Price Signaling and Price Leadership 465 The Dominant Firm Model 468 12.6 Cartels 469 Analysis ofCartel Pricing 470 Summary 474 Questions for Review 475 Exercises 475 13 Game Theory and Competitive Strategy 479 13.1 Gaming and Strategie Decisions 479 Noncooperative versus Cooperative Games 480 13.2 Dominant Strategies 482 13.3 The Nash Equilibrium Revisited 484 Maximin Strategies 486 *Mixed Strategies 488 13.4 Repeated Games 490 13.5 Sequential Games 495 The Extensive Form ofa Game 495 The Advantage of Moving First 496 13.6 Threats, Commitments, and Credibility 497 Empty Threats 498 Commitment and Credibility 498 Bargaining Strategy 500 13.7 Entry Deterrence 502 Strategie Trade Policy and International Competition 505 )

CONTENTS xiii *13.8 Auctions 508 Auction Formats 509 Valuation and Information 509 Private-Value Auctions 510 Common-Value Auctions 511 Maximizing Auction Revenue 513 Bidding and Collusion 513 Summary 516 Questions for Review 516 Exercises 517 14 Markets for Factor Inputs

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14.1 Competitive Factor Markets 521 Demandfor a Factor Input Wien Only One Input Is Variable 522 Demandfor a Factor Input When Several Inputs Are Variable 525 The Market Demand Curve 526 The Supply of Inputs to a Firm 529 The Market Supply of Inputs 531 14.2 Equilibrium in a Competitive Factor Market 534 Economic Rent 534 14.3 Factor Markets with Monopsony power 538 Monopsony Power: Marginal and Average Expenditure 538 Purchasing Decisions with Monopsony Power 539 Bargaining Power 540 14.4 Factor Markets with Monopoly Power 542 Monopoly Power over the Wage Rate 542 Unionized and Nonunionized Workers 544 Summary 547 Questions for Review 547 Exercises 548 15 Investment, Time, and Capital Markets

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15.1 Stocks versus Flows 552 15.2 Present Discounted Value 553 Valuing Payment Streams 554 15.3 The Value of a Bond 556 Perpetuities 557 The Effective Yield on a Bond 558 15.4 The Net Present Value Criterion for Capital Investment Decisions 561 The Electric Motor Factory 562 Real versus Nominal Discount Rates 563 Negative Future Cash Flows 564 15.5 Adjustments for Risk 565

Diversifiable versus Nondiversifiable Risk 566 The Capital Asset Pricing Model 567 15.6 Investment Decisions by Consumers 570 15.7 Investments in Human Capital 572 *15.8 Intertemporal Production Decisions—Depletable Resources 576 The Production Decision ofan Individual Resource Producer 576 The Behavior of Market Price 577 User Cost 577 Resource Production by a Monopolist 578 15.9 How Are Interest Rates Determined? 580 A Variety of Interest Rates 581 Summary 582 Questions for Review 583 Exercises 583 PART FOUR Information, Market Failure, and the Role of Government

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16 General Equilibrium and Economic Efficiency 587 16.1 General Equilibrium Analysis 587 Two Interdependent Markets—Moving to General Equilibrium 588 Reaching General Equilibrium 589 Economic Efficiency 593 16.2 Efficiency in Exchange 594 The Advantages of Trade 595 The Edgeworth Box Diagram 595 Efficient Allocations 596 The Contract Curve 598 Consumer Equilibrium in a Competitive Market 599 The Economic Efficiency of Competitive Markets 601 16.3 Equity and Efficiency 602 The Utility Possibilities Frontier 602 Equity and Perfect Competition 604 16.4 Efficiency in Production 605 Input Efficiency 605 The Production Possibilities Frontier 606 Output Efficiency 607 Efficiency in Output Markets 609 16.5 The Gains from Free Trade 610 Comparative Advantage 610 An Expanded Production Possibilities Frontier 611 16.6 An Overview—The Efficiency of Competitive Markets 615

xiv CONTENTS 16.7 Why Markets Fail 616 Market Power 617 Incomplete Information 617 Externalities 617 Public Goods 618 Summary 619 Questions for Review 619 Exercises 620 17 Markets with Asymmetrie Information 623 17.1 Quality Uncertainty and the Market for Lemons 624 The Market for Used Cars 624 Implications of Asymmetrie Information 626 The Importance of Reputation and Standardization 627 17.2 Market Signaling 631 A Simple Model of Job Market Signaling 632 Guarantees and Warranties 634 17.3 Moral Hazard 636 17.4 The Principal-Agent Problem 638 The Principal-Agent Problem in Private Enterprises 638 The Principal-Agent Problem in Public Enterprises 641 Incentives in the Principal-Agent Framework 642 *17.5 Managerial Incentives in an Integrated Firm 644 Asymmetrie Information and Incentive Design in the Integrated Firm 644 Applications 646 17.6 Asymmetrie Information in Labor Markets: Efficiency Wage Theory 647 Summary 649 Questions for Review 650 Exercises 650

An Emissions Standard 660 An Emissions Fee 660 Standards versus Fees 661 Tradeable Emissions Permits 664 Recycling 667 18.3 Stock Externalities 671 Stock Buildup and Its Impact 672 18.4 Externalities and Property Rights 677 Property Rights 677 Bargaining and Economic Efficiency 678 Costly Bargaining—The Role of Strategie Behavior 679 A Legal Solution—Suing for Damages 679 18.5 Common Property Resources 681 18.6 Public Goods 683 Efficiency and Public Goods 684 Public Goods and Market Failure 686 Summary 687 Questions for Review 688 Exercises 689 19 Behavioral Economics

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19.1 Reference Points and Consumer Preferences 692 19.2 Fairness 696 19.3 Rules of Thumb and Biases in Decision Making 697 19.4 Bubbles 704 Informational Cascades 706 19.5 Behavioral Economics and Public Policy 709 Summing Up 711 Summary 711 Questions for Review 712 Exercises 712 Appendix: The Basics of Regression

18 Externalities and Public Goods 653

Glossary

18.1 Externalities 653 Negative Externalities and Inefficiency 654 Positive Externalities and Inefficiency 656 18.2 Ways of Correcting Market Failure 659

Answers to Selected Exercises

721

Photo Credits Index

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