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MICROECONOMIC THEORY

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Microeconomic Theory

Basic Principles and Extensions

ELEVENTH EDITION

WALTER NICHOLSON

Amherst College

CHRISTOPHER SNYDER

Dartmouth College

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Microeconomic Theory: Basic Principles

and Extensions, Eleventh Edition

Walter Nicholson, Christopher Snyder

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To Beth, Sarah, David, Sophia, Abby, Nate, and Christopher

To Maura

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About the authors

Walter Nicholson is the Ward H. Patton Professor of Economics at Amherst College.

He received a B.A. in mathematics from Williams College and a Ph.D. in economics

from the Massachusetts Institute of Technology (MIT). Professor Nicholson’s primary

research interests are in the econometric analyses of labor market problems, including

welfare, unemployment, and the impact of international trade. For many years, he has

been Senior Fellow at Mathematica, Inc. and has served as an advisor to the U.S. and

Canadian governments. He and his wife, Susan, live in Naples, Florida, and Amherst,

Massachusetts.

Christopher M. Snyder is a Professor of Economics at Dartmouth College. He received

his B.A. in economics and mathematics from Fordham University and his Ph.D. in economics from MIT. He is Research Associate in the National Bureau of Economic

Research, a member of the Industrial Organization Society board, and Associate Editor of

the International Journal of Industrial Organization and Review of Industrial Organization. His research covers various theoretical and empirical topics in industrial organization, contract theory, and law and economics.

Professor Snyder and his wife Maura Doyle (who also teaches economics at Dartmouth) live within walking distance of campus in Hanover, New Hampshire, with their

three school-aged daughters.

Professors Nicholson and Snyder are also the authors of Intermediate Microeconomics

and Its Application (Cengage Learning, 2010).

vii

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Brief Contents

Preface

PART

ONE

xix

Introduction

CHAPTER 1

CHAPTER 2

PART

TWO

CHAPTER 4

CHAPTER 5

CHAPTER 6

PART

CHAPTER 8

PART

CHAPTER 10

CHAPTER 11

FIVE

CHAPTER 13

SIX

CHAPTER 15

PART

CHAPTER 17

PART

Production Functions 303

Cost Functions 333

Profit Maximization 371

The Partial Equilibrium Competitive Model

General Equilibrium and Welfare 457

Monopoly 501

Imperfect Competition

Pricing in Input Markets

CHAPTER 16

EIGHT

301

409

Market Power 499

CHAPTER 14

SEVEN

Uncertainty 209

Game Theory 251

Competitive Markets 407

CHAPTER 12

PART

Preferences and Utility 89

Utility Maximization and Choice 117

Income and Substitution Effects 145

Demand Relationships among Goods 187

Production and Supply

CHAPTER 9

PART

21

Uncertainty and Strategy 207

CHAPTER 7

FOUR

Economic Models 3

Mathematics for Microeconomics

Choice and Demand 87

CHAPTER 3

THREE

1

CHAPTER 19

579

Labor Markets 581

Capital and Time 607

Market Failure

CHAPTER 18

531

639

Asymmetric Information 641

Externalities and Public Goods

685

Brief Answers to Queries 717

Solutions to Odd-Numbered Problems 727

Glossary of Frequently Used Terms 739

Index 747

ix

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Contents

Preface ................................................................................................................................................ xix

PART

ONE

Introduction

CHAPTER

1

Economic Models .................................................................................................................... 3

Theoretical Models 3

Verification of Economic Models 4

General Features of Economic Models 5

Development of the Economic Theory of Value 9

Modern Developments 17

Summary 18

Suggestions for Further Reading 19

CHAPTER

2

Mathematics for Microeconomics...................................................................................... 21

Maximization of a Function of One Variable 21

Functions of Several Variables 26

Maximization of Functions of Several Variables 33

The Envelope Theorem 35

Constrained Maximization 39

Envelope Theorem in Constrained Maximization Problems 45

Inequality Constraints 46

Second-Order Conditions and Curvature 48

Homogeneous Functions 55

Integration 58

Dynamic Optimization 63

Mathematical Statistics 67

Summary 76

Problems 77

Suggestions for Further Reading 82

Extensions: Second-Order Conditions and Matrix Algebra 83

PART

TWO

Choice and Demand

CHAPTER

3

Preferences and Utility......................................................................................................... 89

Axioms of Rational Choice 89

xi

xii

Contents

Utility 90

Trades and Substitution 92

The Mathematics of Indifference Curves 99

Utility Functions for Specific Preferences 102

The Many-Good Case 106

Summary 106

Problems 107

Suggestions for Further Reading 110

Extensions: Special Preferences 112

CHAPTER

4

Utility Maximization and Choice....................................................................................... 117

An Initial Survey 118

The Two-Good Case: A Graphical Analysis 119

The n-Good Case 122

Indirect Utility Function 128

The Lump Sum Principle 129

Expenditure Minimization 131

Properties of Expenditure Functions 134

Summary 136

Problems 136

Suggestions for Further Reading 140

Extensions: Budget Shares 141

CHAPTER

5

Income and Substitution Effects ....................................................................................... 145

Demand Functions 145

Changes in Income 147

Changes in a Good’s Price 149

The Individual’s Demand Curve 152

Compensated (Hicksian) Demand Curves and Functions 155

A Mathematical Development of Response to Price Changes 160

Demand Elasticities 163

Consumer Surplus 169

Revealed Preference and the Substitution Effect 174

Summary 176

Problems 177

Suggestions for Further Reading 180

Extensions: Demand Concepts and the Evaluation of Price Indices 181

CHAPTER

6

Demand Relationships among Goods............................................................................... 187

The Two-Good Case 187

Substitutes and Complements 189

Net (Hicksian) Substitutes and Complements 191

Contents

xiii

Substitutability with Many Goods 193

Composite Commodities 193

Home Production, Attributes of Goods, and Implicit Prices 197

Summary 200

Problems 200

Suggestions for Further Reading 203

Extensions: Simplifying Demand and Two-Stage Budgeting 204

PART

THREE

Uncertainty and Strategy

CHAPTER

7

Uncertainty ........................................................................................................................... 209

Mathematical Statistics 209

Fair Gambles and the Expected Utility Hypothesis 210

Expected Utility 211

The von Neumann–Morgenstern Theorem 212

Risk Aversion 214

Measuring Risk Aversion 217

Methods for Reducing Uncertainty and Risk 222

Insurance 222

Diversification 223

Flexibility 224

Information 231

The State-Preference Approach to Choice Under Uncertainty 232

Asymmetry of Information 238

Summary 238

Problems 239

Suggestions for Further Reading 242

Extensions: The Portfolio Problem 244

CHAPTER

8

Game Theory ........................................................................................................................ 251

Basic Concepts 251

Prisoners’ Dilemma 252

Nash Equilibrium 254

Mixed Strategies 260

Existence of Equilibrium 265

Continuum of Actions 265

Sequential Games 268

Repeated Games 274

Incomplete Information 277

Simultaneous Bayesian Games 278

Signaling Games 282

Experimental Games 288

xiv

Contents

Evolutionary Games and Learning 290

Summary 290

Problems 291

Suggestions for Further Reading 295

Extensions: Existence of Nash Equilibrium

PART

FOUR

296

Production and Supply

CHAPTER

9

Production Functions .......................................................................................................... 303

Marginal Productivity 303

Isoquant Maps and the Rate of Technical Substitution 306

Returns to Scale 310

The Elasticity of Substitution 313

Four Simple Production Functions 316

Technical Progress 320

Summary 324

Problems 325

Suggestions for Further Reading 328

Extensions: Many-Input Production Functions 329

CHAPTER

10

Cost Functions...................................................................................................................... 333

Definitions of Costs 333

Cost-Minimizing Input Choices 336

Cost Functions 341

Cost Functions and Shifts in Cost Curves 345

Shephard’s Lemma and the Elasticity of Substitution 355

Short-Run, Long-Run Distinction 355

Summary 362

Problems 363

Suggestions for Further Reading 366

Extensions: The Translog Cost Function 367

CHAPTER

11

Profit Maximization ............................................................................................................. 371

The Nature and Behavior of Firms 371

Profit Maximization 373

Marginal Revenue 375

Short-Run Supply by a Price-Taking Firm 380

Profit Functions 383

Profit Maximization and Input Demand 389

Summary 395

Problems 396

Suggestions for Further Reading 400

Extensions: Boundaries of the Firm 401

Contents

PART

FIVE

xv

Competitive Markets

CHAPTER

12

The Partial Equilibrium Competitive Model .................................................................... 409

Market Demand 409

Timing of the Supply Response 413

Pricing in the Very Short Run 413

Short-Run Price Determination 415

Shifts in Supply and Demand Curves: A Graphical Analysis 419

Mathematical Model of Market Equilibrium 422

Long-Run Analysis 425

Long-Run Equilibrium: Constant Cost Case 426

Shape of the Long-Run Supply Curve 428

Long-Run Elasticity of Supply 431

Comparative Statics Analysis of Long-Run Equilibrium 431

Producer Surplus in the Long Run 435

Economic Efficiency and Welfare Analysis 438

Price Controls and Shortages 441

Tax Incidence Analysis 442

Summary 447

Problems 447

Suggestions for Further Reading 451

Extensions: Demand Aggregation and Estimation 453

CHAPTER

13

General Equilibrium and Welfare ..................................................................................... 457

Perfectly Competitive Price System 457

A Graphical Model of General Equilibrium with Two Goods 458

Comparative Statics Analysis 467

General Equilibrium Modeling and Factor Prices 469

A Mathematical Model of Exchange 471

A Mathematical Model of Production and Exchange 482

Computable General Equilibrium Models 485

Summary 489

Problems 490

Suggestions for Further Reading 494

Extensions: Computable General Equilibrium Models 495

PART

SIX

Market Power

CHAPTER

14

Monopoly .............................................................................................................................. 501

Barriers to Entry 501

xvi

Contents

Profit Maximization and Output Choice 503

Monopoly and Resource Allocation 507

Monopoly, Product Quality, and Durability 510

Price Discrimination 513

Second-Degree Price Discrimination through Price Schedules

Regulation of Monopoly 519

Dynamic Views of Monopoly 523

Summary 523

Problems 524

Suggestions for Further Reading 527

Extensions: Optimal Linear Two-Part Tariffs 528

CHAPTER

517

15

Imperfect Competition ........................................................................................................ 531

Short-Run Decisions: Pricing and Output 531

Bertrand Model 533

Cournot Model 534

Capacity Constraints 540

Product Differentiation 541

Tacit Collusion 547

Longer-Run Decisions: Investment, Entry, and Exit 551

Strategic Entry Deterrence 557

Signaling 559

How Many Firms Enter? 562

Innovation 566

Summary 568

Problems 569

Suggestions for Further Reading 572

Extensions: Strategic Substitutes and Complements 573

PART

SEVEN

Pricing in Input Markets

CHAPTER

16

Labor Markets ...................................................................................................................... 581

Allocation of Time 581

A Mathematical Analysis of Labor Supply 584

Market Supply Curve for Labor 588

Labor Market Equilibrium 589

Wage Variation 591

Monopsony in the Labor Market 595

Labor Unions 598

Summary 601

Problems 601

Suggestions for Further Reading 605

Contents

CHAPTER

xvii

17

Capital and Time ................................................................................................................. 607

Capital and the Rate of Return 607

Determining the Rate of Return 609

The Firm’s Demand for Capital 616

Present Discounted Value Approach to Investment Decisions 618

Natural Resource Pricing 623

Summary 626

Problems 626

Suggestions for Further Reading 630

APPENDIX

The Mathematics of Compound Interest .......................................................................... 631

Present Discounted Value 631

Continuous Time 633

PART

EIGHT

Market Failure

CHAPTER

18

Asymmetric Information ..................................................................................................... 641

Complex Contracts as a Response to Asymmetric Information 641

Principal-Agent Model 642

Hidden Actions 645

Owner-Manager Relationship 646

Moral Hazard in Insurance 650

Hidden Types 655

Nonlinear Pricing 656

Adverse Selection in Insurance 663

Market Signaling 670

Auctions 672

Summary 676

Problems 676

Suggestions for Further Reading 679

Extensions: Nonlinear Pricing with a Continuum of Types 680

CHAPTER

19

Externalities and Public Goods......................................................................................... 685

Defining Externalities 685

Externalities and Allocative Inefficiency 687

Solutions to the Externality Problem 691

Attributes of Public Goods 694

Public Goods and Resource Allocation 696

Lindahl Pricing of Public Goods 700

Voting and Resource Allocation 703

A Simple Political Model 705

xviii

Contents

Voting Mechanisms 708

Summary 710

Problems 710

Suggestions for Further Reading 713

Extensions: Pollution Abatement 714

Brief Answers to Queries...............................................................................................................717

Solutions to Odd-Numbered Problems .......................................................................................727

Glossary of Frequently Used Terms ............................................................................................. 739

Index ................................................................................................................................................... 747

Preface

The 11th edition of Microeconomic Theory: Basic Principles and Extensions continues

a successful collaboration between the authors starting with the 10th edition. This edition

represents a significant effort to continue refining and modernizing our treatment of

microeconomics. Despite the significant changes appearing in virtually every chapter, the

text retains all of the elements that have made it successful for so many editions. The basic approach is to focus on building intuition about economic models while providing

students with the mathematical tools needed to go further in their studies. The text also

seeks to facilitate that linkage by providing many numerical examples, advanced problems, and extended discussions of empirical implementation—all of which are intended

to show students how microeconomic theory is used today. New developments continue

to keep the field exciting, and we hope this edition manages to capture that excitement.

New to the Eleventh Edition

We took a fresh look at every chapter to make sure that they continue to provide clear

and up-to-date coverage of all of the topics examined. The major revisions include the

following.

•

•

•

•

•

•

•

•

•

•

Many of the topics in our introductory chapter on mathematics have been revised to

conform more closely to methods usually encountered in the recent economics literature.

The chapters on uncertainty and game theory have been broken out into their own

separate part. This shrinks the part of the book on choice and demand to a more

manageable size and emphasizes the unique nature of the strategy and uncertainty

topics.

The chapter on uncertainty (Chapter 7) has been extensively revised. The sections on

real options and the value of information have been expanded. Applications to financial economics and the portfolio problem have been streamlined and collected in the

Extensions.

The treatment of game theory (Chapter 8) has been substantially streamlined, providing the same level of rigor in a third less space.

A modern treatment of the literature on firms’ boundaries and objectives (The

Theory of the Firm) has been added to the body of Chapter 9 and expanded on further in the Extensions.

Our general equilibrium chapter (Chapter 13) has been thoroughly revised. Most

notably we now use this chapter to provide students with an elementary introduction

to vector notation.

We have added a number of new topics to our discussion of labor markets focusing

mainly on issues related to human capital and job search.

Coverage of behavioral economics has been expanded, sprinkled throughout various

relevant chapters. A handful of behavioral economics problems have been included.

The public-good problem is rigorously analyzed using game theory (Chapter 19).

Dozens of new problems have been added.

xix

xx

Preface

Supplements to the Text

The thoroughly revised ancillaries for this edition include the following.

•

•

The Solutions Manual and Test Bank (by the text authors). The Solutions Manual

contains comments and solutions to all problems, and the test bank has been revised

to include additional questions. Both are available to all adopting instructors in electronic version on the text Web site (www.cengage.com/economics/nicholson) and on

the Instructor Resources CD (IRCD).

PowerPoint Lecture Presentation Slides. PowerPoint slides for each chapter of the

text provide a thorough set of outlines for classroom use or for students as a study

aid. The slides are available from the book’s Web site (www.cengage.com/economics/

nicholson) and on the IRCD.

Online Resources

South-Western, a part of Cengage Learning, provides students and instructors with a set

of valuable online resources that are an effective complement to this text. Each new copy

of the book comes with a registration card that provides access to Economic Applications

and InfoTrac College Edition.

Economic Applications

The purchase of this new textbook includes complimentary access to South-Western’s

InfoApps (InfoTrac and Economic Applications) Web site. The Web site includes a suite

of regularly updated Web features for economics students and instructors: EconNews,

EconDebates, and EconData. These resources can help students deepen their understanding of economic concepts by analyzing current news stories, policy debates, and economic data. EconApps can also help instructors develop assignments, case studies, and

examples based on real-world issues.

EconDebates provides current coverage of economics policy debates; it includes a

primer on the issues, links to background information, and commentaries.

EconNews summarizes recent economics news stories and offers questions for further

discussion.

EconData presents current and historical economic data with accompanying commentary, analysis, and exercises.

Students buying a used book can purchase access to InfoApps at www.cengagebrain.com.

InfoTrac College Edition

The purchase of this new textbook also comes with four months of access to InfoTrac.

This powerful and searchable online database provides access to full text articles from

more than a thousand different publications ranging from the popular press to scholarly

journals. Instructors can search topics and select readings for students, and students can

search articles and readings for homework assignments and projects. The publications

cover a variety of topics and include articles that range from current events to theoretical

developments. InfoTrac College Edition offers instructors and students the ability to integrate scholarship and applications of economics into the learning process.

Preface

xxi

Acknowledgments

We are indebted to the team at Cengage and especially to Susan Smart for once again

bringing her organizing and cajoling skills to this edition. The copyeditors at Cenveo

Publisher Services did a great job of making sense of our messy manuscripts. Juli Cook’s

text design succeeded in achieving two seemingly irreconcilable goals—making the text

both compact and easy to read. Cliff Kallemeyn did a fine job of keeping the production

on track; we especially appreciated the way he coordinated the copyediting and page production processes. Devanand Srinivasan supervised the actual production of pages, dealing expertly with the super-abundance of equations.

We thank our colleagues at Amherst and Dartmouth College for valuable conversations and understanding. Several colleagues who used the book for their courses offered

us detailed suggestions for revision. We have also benefitted from the reactions of generations of students to the use of the book in our own microeconomics classes. Over the

years, Amherst students Mark Bruni, Eric Budish, Adrian Dillon, David Macoy, Tatyana

Mamut, Anoop Menon, Katie Merrill, Jordan Milev, Doug Norton, and Jeff Rodman and

Dartmouth students Wills Begor and Glynnis Kearny worked with us revising various

chapters.

Walter gives special thanks to his wife Susan; after providing much-needed support

through twenty-two editions of his microeconomics texts, she is happy for the success, but

wonders about his sanity. Walter’s children (Kate, David, Tory, and Paul) still seem to be

living happy and productive lives despite a severe lack of microeconomic education. Perhaps this can be remedied as the next generation (Beth, Sarah, David, Sophia, Abby, Nate,

and Christopher) grows older. At least he hopes they will wonder what the books dedicated

to them are all about. The texts sit on a convenient shelf, awaiting this curiosity.

Chris gives special thanks to his family—his wife, Maura Doyle, and their daughters,

Clare, Tess, and Meg—for their patience during the revision process. Maura has extensive

experience using the book in her popular microeconomics courses at Dartmouth College,

and was a rich source of suggestions reflected in this revision.

Perhaps our greatest debt is to instructors who adopt the text, who share a similar

view of how microeconomics should be taught. We are grateful for the suggestions that

teachers and students have shared with us over the years and encourage teachers and students to continue to e-mail us with any comments on the text (wenicholson@amherst.edu

or Christopher.M.Snyder@dartmouth.edu).

Walter Nicholson Amherst, Massachusetts

Christopher Snyder Hanover New Hampshire

July 2011

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Introduction

PART

ONE

Chapter 1

Economic Models

Chapter 2

Mathematics for Microeconomics

This part contains two chapters. Chapter 1 examines the general philosophy of how economists build models

of economic behavior. Chapter 2 then reviews some of the mathematical tools used in the construction of

these models. The mathematical tools from Chapter 2 will be used throughout the remainder of this book.

1

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