Microeconomics Microeconomics B. Douglas Bernheim Stanford University Michael D. Whinston Northwestern University MICROECONOMICS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publica- tion may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOC/DOC 0 9 8 7 ISBN 978-0-07-290027-9 MHID 0-07-290027-X Editorial director: Brent Gordon Executive editor: Douglas Reiner Developmental editor: Karen Fisher Senior marketing manager: Melissa Larmon Lead project manager: Pat Frederickson Senior production supervisor: Debra R. Sylvester Lead designer: Matthew Baldwin Senior photo research coordinator: Jeremy Cheshareck Photo researcher: Jennifer Blankenship Media project manager: Suresh Babu, Hurix Systems Pvt. Ltd. Cover design: Artemio Ortiz, Jr. Interior design: Artemio Ortiz, Jr. Typeface: 10.5/12.6 Times New Roman Compositor: Lachina Publishing Services Printer: R. R. Donnelley Library of Congress Cataloging-in-Publication Data Bernheim, B. Douglas. Microeconomics / by B. Douglas Bernheim, Michael D. Whinston. p. mc. ISBN-13: 978-0-07-290027-9 (alk. paper) ISBN-10: 0-07-290027-X (alk. paper) 1. Microeconomics. I. Whinston, Michael Dennis. II. Title. HB172.B485 2008 338.5--dc22 2007044523 www.mhhe.com Dedication To our families B. Douglas Bernheim is the Edward Ames Edmonds Professor of Economics at Stan- ford University. He has also taught in the Department of Finance at Northwestern Univer- sity’s J.L. Kellogg Graduate School of Management and the Department of Economics at Princeton University. He received his A.B. from Harvard University in 1979, and Ph.D. from M.I.T. in 1982. Professor Bernheim’s work has spanned a number of fi elds, including public economics, political economy, game theory, contract theory, behavioral economics, industrial organization, and fi nancial economics. He is a Fellow of the American Academy of Arts and Sciences and of the Econometric Society. He has also served as Co-Editor of the American Economic Review, the profession’s most widely read journal. Professor Bernheim’s teaching has included undergraduate courses in microeconomics and public economics, and graduate courses in microeconomics, public economics, political economy, industrial organization, behavioral economics, and insurance and risk management. Michael D. Whinston is the Robert E. and Emily H. King Professor of Business Institutions in the Department of Economics at Northwestern University, where he also holds appointments at the Kellogg Graduate School of Management and the Law School. Prior to moving to Northwestern, he taught at Harvard. Professor Whinston received his B.S. from the Wharton School at the University of Pennsylvania in 1980, his M.B.A. from the Wharton School in 1984, and his Ph.D. from M.I.T. in 1984. His research has covered a variety of topics in microeconomics and industrial organization, including game theory, the design of contracts and organizations, fi rm behavior in oligopolistic markets, antitrust, and law and economics. Professor Whinston is a co-author of the leading graduate textbook in micro- economics,Microeconomic Theory [Oxford University Press, 1995]. He is a Fellow of the Econometric Society and has also served as a Co-Editor of the RAND Journal of Econom- ics, the leading journal in industrial organization. His teaching has included undergraduate microeconomics, as well as graduate courses in microeconomics, industrial organization, and competitive strategy. Professors Bernheim and Whinston met during the early 1980s while in graduate school at M.I.T., where they began a long and productive collaboration, as well as a close friend- ship. Together they have co-authored eight published articles in addition to this book. In the course of their collaboration, they have been known to argue with each other for hours about trivial details, such as whether a sentence should use the word “however” or “nevertheless.” It is a miracle that they managed to complete this book. vii All of us confront an endless variety of economic choices. Some of those choices involve such personal matters as fi nancing the purchase of a new car or saving for retirement. Some involve such business matters as cost-effective production techniques or investment in new product development. Some involve such matters of public policy as whether to vote for a school bond initiative or a candidate who advocates a particular fl avor of health care reform. Sometimes good economic decision making is just a matter of common sense. But in many situations, a command of basic microeconomic principles helps us understand the conse- quences of our choices and make better decisions. Our object in writingthis book is to provide students with a treatment of intermediate micro- economics that stimulates their interest in the fi eld, introduces them to the tools of the dis- cipline, and starts them on the path toward “thinking like an economist.” Most students will not turn out to be economists, but whether they end up making business decisions, helping to design public policies, or simply managing their own money, the tools of microeconomics can prove invaluable. Preface ix Microeconomics a strategy for learning Microeconomics is intended for both business-oriented and policy-oriented courses. It pro- vides students with a basic knowledge of essential microeconomic principles. While many fi ne microeconomics texts are already available, Microeconomics offers instructors and students some distinct advantages: Accessibility. Microeconomics does not require calculus. While knowledge of calculus is certainly useful, we believe that students can develop a solid understanding of microeco- nomic principles, as well as an ability to solve practical quantitative problems, without it. Clarity. Students face enough challenges while learning microeconomics without having to slog through opaque explanations. We have worked hard to make sure that the writing in Microeconomics is transparent, the explanations are clear and intuitive, and the graphs lead students naturally through the key ideas. Up-to-date coverage. The book covers exciting recent developments in microeconomics, drawing on game theory, information economics, and behavioral economics. Equally impor- tant, it offers cutting-edge coverage of traditional core topics, including marginal analysis, consumer theory, producer theory, monopoly, and oligopoly. Applications of theory include discussions of current events and issues. Accuracy. Sometimes textbooks stretch the truth a bit to make a point seem more obvious to students. We believe that such stretches are rarely desirable. Nor are they necessary, provided adequate attention is given to the development of clear explanations. Microeconomics strives to “tell no lies” while ensuring that its explanations are understandable. Usefulness.Many students who use books that don’t require calculus often learn to do little more than draw pictures to illustrate solutions (for example, of a consumer’s choice from a budget constraint). This does a disservice to students with less mathematical training. In fact, if students are given the right starting points, they can solve a wide range of quantitative problems using only simple algebra. By combining this innovative approach with worked- out problems and in-text exercises, Microeconomics allows students of varying mathematical backgrounds to solve problems using microeconomic tools. Relevance.Students should always understand why they are studying topics. Other texts sometimes assure students that new concepts will be useful in contexts where their useful- ness is not at all obvious to the average person. We believe that students learn better if they have immediate answers to the questions “Why should I care?” and “What do I gain from learning this?” We also underscore the relevance of the material by featuring fact-based applications (as opposed to hypothetical discussions), which relate directly to one or more of the central aspects of the theory being discussed. x Preface a strategy for teaching Calculus and Noncalculus Flexibility Microeconomics requires no knowledge of calculus. However, an instructor who wishes to teach a calculus-based course using this book can easily do so. For the most important points, explanations involving calculus appear in footnotes, appendices, and certain Add- Ons. In addition, the book includes a large number of quantitative worked-out problems and exercises. Where calculus would ordinarily be required, we simply supply the student with a derivative—for example, a formula for the marginal rate of substitution between goods, or for the marginal product of an input. In the context of consumer theory, the marginal rate of substitution is actually a more natural starting point for analysis than the utility function; after all, the marginal rate of substitution is observable, whereas a utility function is not. For a calculus-based course, an instructor can ask students to verify the derivatives. Supplying the derivatives cleanly separates the calculus portion of problem-solving from the “eco- nomic” portion, and prevents the calculus from interfering with students’ understanding of the economics. True-to-Discipline Organization The organization of Microeconomics is slightly unconventional for an undergraduate micro- economics text. As a discipline, microeconomic theory begins by examining the behavior of individuals in their roles as either consumers or managers of fi rms. On this foundation, it builds a theory of aggregate economic outcomes, with an emphasis on market equilibria. Logically, it therefore makes sense to study the theory of decision making before diving into an analysis of how markets operate. Microeconomics follows the logical structure of the discipline more closely than other texts by clearly distinguishing the study of individual decision making from the analysis of markets. • Part I contains three introductory chapters. The fi rst introduces the fi eld of micro- economics. The second reviews the basic principles of supply and demand. The third elaborates on a central theme of microeconomic reasoning: how to fi nd a decision that maximizes the difference between total benefi ts and total costs by equating marginal benefi ts to marginal costs. We invoke that principle repeatedly throughout the rest of the book. • Part II focuses on individuals’ economic decisions. Three chapters on consumer theory and three on producer theory are followed by three chapters covering decisions involving time, uncertainty, and strategy/game theory. An additional chapter examines behavioral perspectives on economic decision making.