N2n port a crate e2

MICROECONOMICS SEVENTH EDITION

THE PEARSON SERIES IN ECONOMICS

Abel/Bernanke/Croushore Macroeconomics*

Bade/Parkin Foundations of Economics*

Berck/Helfand The Economics of the Environment

Bierman/Fernandez Game Theory with Economic Applications

Blanchard Macroeconomics*

Blau/Ferber/Winkler The Economics of Women, Men, and Work

Boardman/Greenberg/Vining/ Weimer Cost-Benefit Analysis

Boyer Principles of Transportation Economics

Branson Macroeconomic Theory and Policy

Bruce Public Finance and the American Economy

Carlton/Perloff Modern Industrial Organization

Case/Fair/Oster Principles of Economics*

Chapman Environmental Economics: Theory, Application, and Policy

Cooter/Ulen Law & Economics

Daniels/VanHoose International Monetary & Financial Economics

Downs An Economic Theory of Democracy

Ehrenberg/Smith Modern Labor Economics

Farnham Economics for Managers

Folland/Goodman/Stano The Economics of Health and Health Care

Fort Sports Economics

Froyen Macroeconomics

Fusfeld The Age of the Economist

Gerber International Economics*

González-Rivera Forecasting for Economics and Business

Gordon Macroeconomics*

Greene Econometric Analysis

Gregory Essentials of Economics

Gregory/Stuart Russian and Soviet Economic Performance and Structure

Hartwick/Olewiler The Economics of Natural Resource Use

Heilbroner/Milberg The Making of the Economic Society

Heyne/Boettke/Prychitko The Economic Way of Thinking

Holt Markets, Games, and Strategic Behavior

Hubbard/O’Brien Economics*

Money, Banking, and the Financial System*

Hubbard/O’Brien/Rafferty Macroeconomics*

Hughes/Cain American Economic History

Husted/Melvin International Economics

Jehle/Reny Advanced Microeconomic Theory

Johnson-Lans A Health Economics Primer

Keat/Young/Erfle Managerial Economics

Klein Mathematical Methods for Economics

Krugman/Obstfeld/Melitz International Economics: Theory & Policy*

Laidler The Demand for Money

Leeds/von Allmen The Economics of Sports

Leeds/von Allmen/Schiming Economics*

Lynn Economic Development: Theory and Practice for a Divided World

Miller Economics Today*

Understanding Modern Economics

Miller/Benjamin The Economics of Macro Issues

Miller/Benjamin/North The Economics of Public Issues

Mills/Hamilton Urban Economics

Mishkin The Economics of Money, Banking, and Financial Markets*

The Economics of Money, Banking, and Financial Markets, Business School Edition*

Macroeconomics: Policy and Practice*

Murray Econometrics: A Modern Introduction

O’Sullivan/Sheffrin/Perez Economics: Principles, Applications, and Tools*

Parkin Economics*

Perloff Microeconomics*

Microeconomics: Theory and Applications with Calculus*

Perloff/Brander Managerial Economics and Strategy*

Phelps Health Economics

Pindyck/Rubinfeld Microeconomics*

Riddell/Shackelford/Stamos/ Schneider Economics: A Tool for Critically Understanding Society

Roberts The Choice: A Fable of Free Trade and Protection

Rohlf Introduction to Economic Reasoning

Roland Development Economics

Scherer Industry Structure, Strategy, and Public Policy

Schiller The Economics of Poverty and Discrimination

Sherman Market Regulation

Stock/Watson Introduction to Econometrics

Studenmund Using Econometrics: A Practical Guide

Tietenberg/Lewis Environmental and Natural Resource Economics

Environmental Economics and Policy

Todaro/Smith Economic Development

Waldman/Jensen Industrial Organization: Theory and Practice

Walters/Walters/Appel/ Callahan/Centanni/Maex/ O’Neill Econversations: Today’s Students Discuss Today’s Issues

Weil Economic Growth

Williamson Macroeconomics

*denotes MyEconLab titles Visit www.myeconlab.com to learn more.

www.myeconlab.com to learn more
iii

MICROECONOMICS SEVENTH EDITION

JEFFREY M. PERLOFF University of California, Berkeley

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Perloff, Jeffrey M. Microeconomics / Jeffrey Perloff.—7th edition. p. cm. Includes bibliographical references and index. ISBN 978-0-13-345691-2 1. Microeconomics. I. Title. HB172.P39 2015 338.5–dc22

2013050602

ISBN-13: 978-0-13-345691-2 ISBN-10: 0-13-345691-9www.pearsonhighered.com

For Alexx, Gregg, Laura, and Spenser

10 9 8 7 6 5 4 3 2 1

www.pearsonhighered.com
v

Brief Contents Preface xiv

Chapter 1 Introduction 1 Chapter 2 Supply and Demand 8 Chapter 3 Applying the Supply-and-Demand Model 42 Chapter 4 Consumer Choice 72 Chapter 5 Applying Consumer Theory 107 Chapter 6 Firms and Production 147 Chapter 7 Costs 179 Chapter 8 Competitive Firms and Markets 220 Chapter 9 Applying the Competitive Model 262 Chapter 10 General Equilibrium and Economic Welfare 308 Chapter 11 Monopoly 344 Chapter 12 Pricing and Advertising 384 Chapter 13 Oligopoly and Monopolistic Competition 424 Chapter 14 Game Theory 468 Chapter 15 Factor Markets 505 Chapter 16 Interest Rates, Investments, and Capital Markets 530 Chapter 17 Uncertainty 561 Chapter 18 Externalities, Open-Access, and Public Goods 595 Chapter 19 Asymmetric Information 623 Chapter 20 Contracts and Moral Hazards 651 Chapter Appendixes A-1 Answers to Selected Questions and Problems A-29

Sources for Challenges and Applications A-46

References A-56

Definitions A-64

Index A-69

Credits A-96

vi

Contents Preface xiv

Chapter 1 Introduction 1

1.1 Microeconomics: The Allocation of Scarce Resources 1 Trade-Offs 2 Who Makes the Decisions 2 Prices Determine Allocations 2

1.2 Models 3 APPLICATION Income Threshold Model

and China 3 Simplifications by Assumption 3 Testing Theories 4 Positive Versus Normative 5

1.3 Uses of Microeconomic Models 6 Summary 7

Chapter 2 Supply and Demand 8 CHALLENGE Quantities and Prices

of Genetically Modified Foods 8 2.1 Demand 9

The Demand Curve 10 APPLICATION Calorie Counting at Starbucks 13 The Demand Function 14 Solved Problem 2.1 15 Summing Demand Curves 16 APPLICATION Aggregating Corn

Demand Curves 16 2.2 Supply 17

The Supply Curve 17 The Supply Function 19 Summing Supply Curves 20 Effects of Government Import

Policies on Supply Curves 20 Solved Problem 2.2 21

2.3 Market Equilibrium 22 Using a Graph to Determine

the Equilibrium 22 Using Math to Determine the Equilibrium 22 Forces That Drive the Market to Equilibrium 23

2.4 Shocking the Equilibrium 24 Effects of a Shift in the Demand Curve 24 Solved Problem 2.3 25 Effects of a Shift in the Supply Curve 26

2.5 Equilibrium Effects of Government Interventions 26 Policies That Shift Supply Curves 27 APPLICATION Occupational Licensing 27 Solved Problem 2.4 28 Policies That Cause Demand to Differ

from Supply 29 APPLICATION Price Controls Kill 31 Solved Problem 2.5 33 Why Supply Need Not Equal Demand 33

2.6 When to Use the Supply-and-Demand Model 34 CHALLENGE SOLUTION Quantities and

Prices of Genetically Modified Foods 35 Summary 36 ■ Questions 37

Chapter 3 Applying the Supply-and-Demand Model 42

CHALLENGE Who Pays the Gasoline Tax? 42 3.1 How Shapes of Supply and Demand

Curves Matter 43 3.2 Sensitivity of the Quantity Demanded to Price 44

Price Elasticity of Demand 45 Solved Problem 3.1 46 Elasticity Along the Demand Curve 46 Demand Elasticity and Revenue 49 Solved Problem 3.2 49 APPLICATION Do Farmers Benefit

from a Major Drought? 50 Demand Elasticities over Time 51 Other Demand Elasticities 51

3.3 Sensitivity of the Quantity Supplied to Price 53 Elasticity of Supply 53 Elasticity Along the Supply Curve 54 Supply Elasticities over Time 55 APPLICATION Oil Drilling in the Arctic

National Wildlife Refuge 55 Solved Problem 3.3 56

3.4 Effects of a Sales Tax 58 Equilibrium Effects of a Specific Tax 58 The Equilibrium Is the Same No Matter

Who Is Taxed 60 Solved Problem 3.4 60 Firms and Customers Share the Burden

of the Tax 61 APPLICATION Taxes to Prevent Obesity 62

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Solved Problem 3.5 63 Ad Valorem and Specific Taxes Have Similar

Effects 63 Solved Problem 3.6 64 Subsidies 65 APPLICATION The Ethanol Subsidy 66 CHALLENGE SOLUTION Who Pays the

Gasoline Tax? 66 Summary 67 ■ Questions 68

Chapter 4 Consumer Choice 72 CHALLENGE Why Americans Buy

More E-Books Than Do Germans 72 4.1 Preferences 74

Properties of Consumer Preferences 74 APPLICATION You Can’t Have Too

Much Money 75 Preference Maps 76 Solved Problem 4.1 78 APPLICATION Indifference Curves

Between Food and Clothing 82 4.2 Utility 82

Utility Function 82 Ordinal Preferences 83 Utility and Indifference Curves 83 Marginal Utility 85 Utility and Marginal Rates of Substitution 86

4.3 Budget Constraint 86 Slope of the Budget Constraint 88 Solved Problem 4.2 88 Effect of a Change in Price on the

Opportunity Set 89 Effect of a Change in Income on the

Opportunity Set 90 Solved Problem 4.3 90

4.4 Constrained Consumer Choice 90 The Consumer’s Optimal Bundle 91 APPLICATION Substituting Alcohol

for Marijuana 92 Solved Problem 4.4 93

★ Optimal Bundles on Convex Sections of Indifference Curves 94

Buying Where More Is Better 95 Food Stamps 96 APPLICATION Benefiting from Food Stamps 98

4.5 Behavioral Economics 98 Tests of Transitivity 98 Endowment Effect 99 APPLICATION Opt In Versus Opt Out 100 Salience and Bounded Rationality 100 APPLICATION Unaware of Taxes 101 CHALLENGE SOLUTION Why Americans

Buy More E-Books Than Do Germans 101 Summary 102 ■ Questions 103

Chapter 5 Applying Consumer Theory 107 CHALLENGE Per-Hour Versus Lump-Sum

Childcare Subsidies 107 5.1 Deriving Demand Curves 108

Indifference Curves and a Rotating Budget Line 109

Price-Consumption Curve 110 APPLICATION Smoking Versus Eating

and Phoning 111 The Demand Curve Corresponds to the

Price-Consumption Curve 112 Solved Problem 5.1 112

5.2 How Changes in Income Shift Demand Curves 113 Effects of a Rise in Income 113 Solved Problem 5.2 115 Consumer Theory and Income Elasticities 116 APPLICATION Fast-Food Engel Curve 119

5.3 Effects of a Price Change 120 Income and Substitution Effects with a

Normal Good 120 Solved Problem 5.3 122 Solved Problem 5.4 123 APPLICATION Shipping the Good

Stuff Away 124 Income and Substitution Effects with

an Inferior Good 124 Solved Problem 5.5 125

★ Compensating Variation and Equivalent Variation 126

APPLICATION What’s the Value of Using the Internet? 126

5.4 Cost-of-Living Adjustments 126 Inflation Indexes 127 Effects of Inflation Adjustments 129 APPLICATION Paying Employees to Relocate 130

5.5 Deriving Labor Supply Curves 132 Labor-Leisure Choice 132 Income and Substitution Effects 135 Solved Problem 5.6 136

★ Shape of the Labor Supply Curve 137 APPLICATION Working After Winning

the Lottery 138 Income Tax Rates and Labor Supply 139 CHALLENGE SOLUTION Per-Hour Versus

Lump-Sum Childcare Subsidies 141 Summary 142 ■ Questions 143

Chapter 6 Firms and Production 147 CHALLENGE Labor Productivity During

Recessions 147 6.1 The Ownership and Management of Firms 148

Private, Public, and Nonprofit Firms 148

viii Contents

APPLICATION Chinese State-Owned Enterprises 149

The Ownership of For-Profit Firms 149 The Management of Firms 150 What Owners Want 150

6.2 Production Function 151 6.3 Short-Run Production 153

Total Product 153 Marginal Product of Labor 154 Solved Problem 6.1 154 Average Product of Labor 155 Graphing the Product Curves 155 Law of Diminishing Marginal Returns 157 APPLICATION Malthus and the Green

Revolution 158 6.4 Long-Run Production 159

Isoquants 160 APPLICATION A Semiconductor Integrated

Circuit Isoquant 162 Substituting Inputs 163 Solved Problem 6.2 165

6.5 Returns to Scale 166 Constant, Increasing, and Decreasing

Returns to Scale 166 Solved Problem 6.3 167 APPLICATION Returns to Scale in Various

Industries 168 Varying Returns to Scale 169

6.6 Productivity and Technical Change 171 Relative Productivity 171 APPLICATION A Good Boss Raises

Productivity 171 Innovations 171 APPLICATION Tata Nano’s Technical and

Organizational Innovations 173 CHALLENGE SOLUTION Labor Productivity

During Recessions 173 Summary 175 ■ Questions 175

Chapter 7 Costs 179 CHALLENGE Technology Choice

at Home Versus Abroad 179 7.1 The Nature of Costs 180

Opportunity Costs 180 APPLICATION The Opportunity Cost

of an MBA 181 Solved Problem 7.1 181 Costs of Durable Inputs 182 Sunk Costs 183

7.2 Short-Run Costs 183 Short-Run Cost Measures 184 Short-Run Cost Curves 186 Production Functions and the Shape

of Cost Curves 187 APPLICATION Short-Run Cost Curves

for a Beer Manufacturer 190

Effects of Taxes on Costs 191 Solved Problem 7.2 192 Short-Run Cost Summary 193

7.3 Long-Run Costs 193 All Costs Are Avoidable in the Long Run 193 Minimizing Cost 193 Isocost Line 194 Combining Cost and Production Information 196 Solved Problem 7.3 198 Factor Price Changes 199 Solved Problem 7.4 199 The Long-Run Expansion Path and

the Long-Run Cost Function 200 Solved Problem 7.5 202 The Shape of Long-Run Cost Curves 202 APPLICATION Economies of Scale in Nuclear

Power Plants 205 Estimating Cost Curves Versus Introspection 206

7.4 Lower Costs in the Long Run 206 Long-Run Average Cost as the Envelope

of Short-Run Average Cost Curves 207 APPLICATION Long-Run Cost Curves in Beer

Manufacturing 208 APPLICATION Choosing an Inkjet or a Laser

Printer 208 Short-Run and Long-Run Expansion Paths 209 The Learning Curve 209 APPLICATION Learning by Drilling 211

7.5 Cost of Producing Multiple Goods 212 APPLICATION Economies of Scope 213 CHALLENGE SOLUTION Technology Choice

at Home Versus Abroad 214 Summary 215 ■ Questions 216

Chapter 8 Competitive Firms and Markets 220 CHALLENGE The Rising Cost of Keeping

On Truckin’ 220 8.1 Perfect Competition 221

Price Taking 221 Why the Firm’s Demand Curve Is Horizontal 222 Deviations from Perfect Competition 223 Derivation of a Competitive Firm’s

Demand Curve 224 Solved Problem 8.1 225 Why We Study Perfect Competition 226

8.2 Profit Maximization 226 Profit 226 Two Steps to Maximizing Profit 227

8.3 Competition in the Short Run 230 Short-Run Output Decision 231 Solved Problem 8.2 233 Short-Run Shutdown Decision 234 APPLICATION Oil, Oil Sands, and Oil Shale

Shutdowns 236 Solved Problem 8.3 237 Short-Run Firm Supply Curve 237

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Short-Run Market Supply Curve 238 Short-Run Competitive Equilibrium 240 Solved Problem 8.4 242

8.4 Competition in the Long Run 243 Long-Run Competitive Profit Maximization 243 Long-Run Firm Supply Curve 243 APPLICATION The Size of Ethanol

Processing Plants 244 Long-Run Market Supply Curve 244 APPLICATION Fast-Food Firms’ Entry

in Russia 245 APPLICATION Upward-Sloping Long-Run

Supply Curve for Cotton 248 APPLICATION Reformulated Gasoline

Supply Curves 252 Solved Problem 8.5 253 Long-Run Competitive Equilibrium 254 CHALLENGE SOLUTION The Rising Cost

of Keeping On Truckin’ 255 Summary 256 ■ Questions 257

Chapter 9 Applying the Competitive Model 262 CHALLENGE “Big Dry” Water Restrictions 262

9.1 Zero Profit for Competitive Firms in the Long Run 263 Zero Long-Run Profit with Free Entry 263 Zero Long-Run Profit When Entry Is Limited 264 APPLICATION Tiger Woods’ Rent 266 The Need to Maximize Profit 266

9.2 Consumer Welfare 267 Measuring Consumer Welfare Using

a Demand Curve 267 APPLICATION Willingness to Pay

and Consumer Surplus on eBay 269 Effect of a Price Change on Consumer

Surplus 270 APPLICATION Goods with a Large Consumer

Surplus Loss from Price Increases 271 Solved Problem 9.1 272

9.3 Producer Welfare 273 Measuring Producer Surplus Using

a Supply Curve 273 Using Producer Surplus 274 Solved Problem 9.2 275 Competition Maximizes Welfare 276 Solved Problem 9.3 278 APPLICATION Deadweight Loss

of Christmas Presents 279 9.5 Policies That Shift Supply and Demand

Curves 280 Restricting the Number of Firms 281 APPLICATION Licensing Cabs 283 Raising Entry and Exit Costs 284

9.6 Policies That Create a Wedge Between Supply and Demand 285 Welfare Effects of a Sales Tax 285

APPLICATION The Deadweight Cost of Raising Gasoline Tax Revenue 286

Solved Problem 9.4 287 Welfare Effects of a Subsidy 288 Solved Problem 9.5 288 Welfare Effects of a Price Floor 289 Solved Problem 9.6 291 APPLICATION How Big Are Farm Subsidies

and Who Gets Them? 292 Welfare Effects of a Price Ceiling 293 Solved Problem 9.7 294 APPLICATION The Social Cost of a

Natural Gas Price Ceiling 295 9.7 Comparing Both Types of Policies: Imports 295

Free Trade Versus a Ban on Imports 296 Free Trade Versus a Tariff 297 Free Trade Versus a Quota 299 APPLICATION The Chicken Tax Trade War 300 Rent Seeking 300 CHALLENGE SOLUTION “Big Dry” Water

Restrictions 301 Summary 303 ■ Questions 303

Chapter 10 General Equilibrium and Economic Welfare 308

CHALLENGE Anti-Price Gouging Laws 308 10.1 General Equilibrium 310

Feedback Between Competitive Markets 311 Solved Problem 10.1 313 Minimum Wages with Incomplete Coverage 314 Solved Problem 10.2 316 APPLICATION Urban Flight 317

10.2 Trading Between Two People 317 Endowments 317 Mutually Beneficial Trades 319 Solved Problem 10.3 321 Bargaining Ability 321

10.3 Competitive Exchange 321 Competitive Equilibrium 322 The Efficiency of Competition 323 Obtaining Any Efficient Allocation Using

Competition 323 10.4 Production and Trading 324

Comparative Advantage 324 Solved Problem 10.4 326 Efficient Product Mix 328 Competition 328

10.5 Efficiency and Equity 330 Role of the Government 330 APPLICATION The Wealth and Income

of the 1% 331 Efficiency 332 Equity 334 APPLICATION How You Vote Matters 336 Efficiency Versus Equity 338

x Contents

CHALLENGE SOLUTION Anti-Price Gouging Laws 339

Summary 340 ■ Questions 341

Chapter 11 Monopoly 344 CHALLENGE Brand-Name and Generic

Drugs 344 11.1 Monopoly Profit Maximization 346

Marginal Revenue 346 Solved Problem 11.1 348 Choosing Price or Quantity 350 Graphical Approach 351 Mathematical Approach 352 APPLICATION Apple’s iPad 353 Solved Problem 11.2 353 Effects of a Shift of the Demand Curve 354

11.2 Market Power 355 Market Power and the Shape of the

Demand Curve 355 APPLICATION Cable Cars and Profit

Maximization 357 Lerner Index 358 Solved Problem 11.3 358 Sources of Market Power 358

11.3 Market Failure Due to Monopoly Pricing 359 Solved Problem 11.4 361

11.4 Causes of Monopoly 362 Cost-Based Monopoly 362 Solved Problem 11.5 364 Government Creation of a Monopoly 364 APPLICATION Botox Patent Monopoly 366

11.5 Government Actions That Reduce Market Power 367 Regulating Monopolies 367 Solved Problem 11.6 370 APPLICATION Natural Gas Regulation 371 Increasing Competition 372 APPLICATION Generic Competition

for Apple’s iPod 373 Solved Problem 11.7 373

11.6 Networks, Dynamics, and Behavioral Economics 374 Network Externalities 375 Network Externalities and Behavioral

Economics 375 Network Externalities as an Explanation for

Monopolies 376 APPLICATION Critical Mass and eBay 376 A Two-Period Monopoly Model 377 CHALLENGE SOLUTION Brand-Name

and Generic Drugs 378 Summary 379 ■ Questions 379

Chapter 12 Pricing and Advertising 384 CHALLENGE Sale Prices 384

12.1 Conditions for Price Discrimination 386

Why Price Discrimination Pays 386 APPLICATION Disneyland Pricing 388 Which Firms Can Price Discriminate 388 Preventing Resale 389 APPLICATION Preventing Resale

of Designer Bags 390 Not All Price Differences Are Price

Discrimination 390 Types of Price Discrimination 390

12.2 Perfect Price Discrimination 391 How a Firm Perfectly Price Discriminates 391 APPLICATION Google Uses Bidding for

Ads to Price Discriminate 392 Perfect Price Discrimination Is Efficient

but Harms Some Consumers 393 APPLICATION Botox Revisited 395 Solved Problem 12.1 396 Transaction Costs and Perfect Price

Discrimination 396 12.3 Group Price Discrimination 396

APPLICATION Warner Brothers Sets Prices for a Harry Potter DVD 397

Group Price Discrimination with Two Groups 397

Solved Problem 12.2 398 APPLICATION Reselling Textbooks 399 Solved Problem 12.3 400 Identifying Groups 402 APPLICATION Buying Discounts 402 Welfare Effects of Group Price Discrimination 403

12.4 Nonlinear Price Discrimination 404 12.5 Two-Part Pricing 406

Two-Part Pricing with Identical Customers 407 Two-Part Pricing with Nonidentical

Consumers 408 APPLICATION iTunes for a Song 410

12.6 Tie-In Sales 410 Requirement Tie-In Sale 410 APPLICATION Ties That Bind 411 Bundling 411 Solved Problem 12.4 413

12.7 Advertising 414 The Decision Whether to Advertise 414 How Much to Advertise 415 APPLICATION Super Bowl Commercials 416 CHALLENGE SOLUTION Sale Prices 417 Summary 418 ■ Questions 419

Chapter 13 Oligopoly and Monopolistic Competition 424

CHALLENGE Government Aircraft Subsidies 424 13.1 Market Structures 426 13.2 Cartels 427

Why Cartels Form 427 Laws Against Cartels 429 APPLICATION Catwalk Cartel 431

xiContents

Why Cartels Fail 432 Maintaining Cartels 432 APPLICATION Casket Entry 433 Mergers 434 APPLICATION Hospital Mergers:

Market Power Versus Efficiency 434 13.3 Cournot Oligopoly 435

The Duopoly Nash-Cournot Equilibrium 436 An Airlines Market Example 436 Equilibrium, Elasticity, and the Number

of Firms 440 APPLICATION Mobile Number Portability 442 Nonidentical Firms 442 Solved Problem 13.1 443 Solved Problem 13.2 445 APPLICATION Bottled Water 446

13.4 Stackelberg Oligopoly 447 Graphical Model 447 Solved Problem 13.3 449 Why Moving Sequentially Is Essential 450 Comparison of Competitive, Stackelberg,

Cournot, and Collusive Equilibria 450 13.5 Bertrand Oligopoly 451

Identical Products 452 Differentiated Products 453 APPLICATION Welfare Gain from More

Toilet Paper 455 13.6 Monopolistic Competition 456

APPLICATION Monopolistically Competitive Food Truck Market 456

Equilibrium 457 Solved Problem 13.4 458 Fixed Costs and the Number of Firms 458 Solved Problem 13.5 460 APPLICATION Zoning Laws as a Barrier

to Entry by Hotel Chains 460 CHALLENGE SOLUTION Government Aircraft

Subsidies 461 Summary 462 ■ Questions 463

Chapter 14 Game Theory 468 CHALLENGE Competing E-book Standards 468

14.1 Static Games 470 Normal-Form Games 470 Predicting a Game’s Outcome 471 Multiple Nash Equilibria, No Nash

Equilibrium, and Mixed Strategies 474 APPLICATION Tough Love 477 Solved Problem 14.1 477 Cooperation 478 APPLICATION Strategic Advertising 479

14.2 Repeated Dynamic Games 480 Strategies and Actions in Dynamic Games 481 Cooperation in a Repeated Prisoner’s

Dilemma Game 481 Solved Problem 14.2 483

14.3 Sequential Dynamic Games 483 Game Tree 483 Subgame Perfect Nash Equilibrium 484 Credibility 486 Dynamic Entry Game 487 APPLICATION Dominant Airlines 488 Solved Problem 14.3 489

14.4 Auctions 490 Elements of Auctions 491 Bidding Strategies in Private-Value Auctions 492 Winner’s Curse 493 APPLICATION Bidder’s Curse 494

14.5 Behavioral Game Theory 494 APPLICATION GM’s Ultimatum 495 CHALLENGE SOLUTION Competing E-book

Standards 496 Summary 497 ■ Questions 498

Chapter 15 Factor Markets 505 CHALLENGE Athletes’ Salaries and

Ticket Prices 505 15.1 Competitive Factor Market 506

Short-Run Factor Demand of a Firm 507 Solved Problem 15.1 509 Solved Problem 15.2 510 Long-Run Factor Demand 511 Factor Market Demand 512 Competitive Factor Market Equilibrium 514

15.2 Effects of Monopolies on Factor Markets 515 Market Structure and Factor Demands 515 A Model of Market Power in Input

and Output Markets 516 APPLICATION Unions and Profits 519 Solved Problem 15.3 520

15.3 Monopsony 521 Monopsony Profit Maximization 521 APPLICATION Walmart’s Monopsony

Power 523 Welfare Effects of Monopsony 524 Solved Problem 15.4 525 CHALLENGE SOLUTION Athletes’ Salaries

and Ticket Prices 525 Summary 526 ■ Questions 527

Chapter 16 Interest Rates, Investments, and Capital Markets 530

CHALLENGE Should You Go to College? 530 16.1 Comparing Money Today to Money

in the Future 531 Interest Rates 531 Using Interest Rates to Connect the Present

and Future 534 APPLICATION Power of Compounding 534 Stream of Payments 536 Solved Problem 16.1 537 APPLICATION Saving for Retirement 538

xii Contents

Inflation and Discounting 539 APPLICATION Winning the Lottery 540

16.2 Choices over Time 541 Investing 541 Solved Problem 16.2 543 Solved Problem 16.3 544 Rate of Return on Bonds 544

★ Behavioral Economics: Time-Varying Discounting 545

APPLICATION Falling Discount Rates and Self-Control 546

16.3 Exhaustible Resources 546 When to Sell an Exhaustible Resource 547 Price of a Scarce Exhaustible Resource 547 APPLICATION Redwood Trees 550 Why Price May Be Constant or Fall 551

16.4 Capital Markets, Interest Rates, and Investments 553 Solved Problem 16.4 554 CHALLENGE SOLUTION Should You Go to

College? 555 Summary 557 ■ Questions 557

Chapter 17 Uncertainty 561 CHALLENGE BP and Limited Liability 561

17.1 Assessing Risk 563 Probability 563 Expected Value 565 Solved Problem 17.1 565 Variance and Standard Deviation 566

17.2 Attitudes Toward Risk 567 Expected Utility 567 Risk Aversion 568 Solved Problem 17.2 570 APPLICATION Stocks’ Risk Premium 571 Risk Neutrality 572 Risk Preference 573 APPLICATION Gambling 573

17.3 Reducing Risk 574 Obtain Information 575 Diversify 575 APPLICATION Diversifying Retirement

Funds 577 Buy Insurance 577 Solved Problem 17.3 578 APPLICATION Flight Insurance 580 APPLICATION Limited Insurance

for Natural Disasters 581 17.4 Investing Under Uncertainty 582

Risk-Neutral Investing 582 Risk-Averse Investing 582 Solved Problem 17.4 583

17.5 Behavioral Economics of Uncertainty 584 Biased Assessment of Probabilities 584 APPLICATION Biased Estimates 585

Violations of Expected Utility Theory 586 Prospect Theory 587 CHALLENGE SOLUTION BP and Limited

Liability 589 Summary 590 ■ Questions 591

Chapter 18 Externalities, Open-Access, and Public Goods 595

CHALLENGE Trade and Pollution 595 18.1 Externalities 596

APPLICATION Negative Externalities from Spam 597

18.2 The Inefficiency of Competition with Externalities 597

18.3 Regulating Externalities 600 APPLICATION Pulp and Paper Mill

Pollution and Regulation 602 Solved Problem 18.1 603 APPLICATION Why Tax Drivers 603 Benefits Versus Costs from Controlling

Pollution 604 APPLICATION Protecting Babies 604

18.4 Market Structure and Externalities 605 Monopoly and Externalities 605 Monopoly Versus Competitive Welfare with

Externalities 606 Solved Problem 18.2 606 Taxing Externalities in Noncompetitive

Markets 607 18.5 Allocating Property Rights to Reduce

Externalities 607 Coase Theorem 607 APPLICATION Buying a Town 609 Markets for Pollution 609 APPLICATION Acid Rain Program 610 Markets for Positive Externalities 610

18.6 Rivalry and Exclusion 610 Open-Access Common Property 611 Club Goods 612 APPLICATION Piracy 613 Public Goods 613 Solved Problem 18.3 614 APPLICATION Radiohead’s “Public Good”

Experiment 615 APPLICATION What’s Their Beef? 616 CHALLENGE SOLUTION Trade and Pollution 617 Summary 619 ■ Questions 620

Chapter 19 Asymmetric Information 623 CHALLENGE Dying to Work 623

19.1 Adverse Selection 625 Adverse Selection in Insurance Markets 626 Products of Unknown Quality 626 Solved Problem 19.1 629

xiiiContents

Solved Problem 19.2 629

19.2 Reducing Adverse Selection 630 Restricting Opportunistic Behavior 630 Equalizing Information 631 APPLICATION Changing a Firm’s Name 632 APPLICATION Adverse Selection on eBay

Motors 633 19.3 Price Discrimination Due to False Beliefs

About Quality 634 APPLICATION Reducing Consumers’

Information 635 19.4 Market Power from Price Ignorance 636

Tourist-Trap Model 636 Solved Problem 19.3 638 Advertising and Prices 638

19.5 Problems Arising from Ignorance When Hiring 638 Cheap Talk 639 Education as a Signal 640 Solved Problem 19.4 642 Screening in Hiring 644 CHALLENGE SOLUTION Dying to Work 646 Summary 647 ■ Questions 648

Chapter 20 Contracts and Moral Hazards 651 CHALLENGE Changing Bankers’ Incentives 651

20.1 The Principal-Agent Problem 653 Efficiency 654 Symmetric Information 654 Asymmetric Information 655 APPLICATION Selfless or Selfish Doctors? 656 Solved Problem 20.1 657

20.2 Using Contracts to Reduce Moral Hazard 657 Fixed-Fee Contracts 658 Contingent Contracts 659 Solved Problem 20.2 659 Solved Problem 20.3 661 Solved Problem 20.4 663 APPLICATION Contracts and Productivity

in Agriculture 664 Choosing the Best Contract 664 APPLICATION Music Contracts:

Changing Their Tunes 665 20.3 Monitoring to Reduce Moral Hazard 666

Bonding 667 Solved Problem 20.5 668 Deferred Payments 669 Efficiency Wages 669 Monitoring Outcomes 670 APPLICATION Abusing Leased Cars 671

20.4 Checks on Principals 671 APPLICATION Layoffs Versus Pay Cuts 672

20.5 Contract Choice 674

CHALLENGE SOLUTION Changing Bankers’ Incentives 675

Summary 676 ■ Questions 677

Chapter Appendixes A-1 Appendix 2A: Regressions A-1 Appendix 3A: Effects of a Specific Tax on

Equilibrium A-3 Appendix 4A: Utility and Indifference Curves A-4 Appendix 4B: Maximizing Utility A-6 Appendix 5A: The Slutsky Equation A-8 Appendix 5B: Labor-Leisure Model A-9 Appendix 6A: Properties of Marginal and

Average Product Curves A-10 Appendix 6B: The Slope of an Isoquant A-10 Appendix 6C: Cobb-Douglas Production

Function A-10 Appendix 7A: Minimum of the Average

Cost Curve A-11 Appendix 7B: Japanese Beer Manufacturer’s

Short-Run Cost Curves A-11 Appendix 7C: Minimizing Cost A-12 Appendix 8A: The Elasticity of the Residual

Demand Curve A-14 Appendix 8B: Profit Maximization A-15 Appendix 9A: Demand Elasticities

and Surplus A-15 Appendix 11A: Relationship Between

a Linear Demand Curve and Its Marginal Revenue Curve A-16

Appendix 11B: Incidence of a Specific Tax on a Monopoly A-16

Appendix 12A: Perfect Price Discrimination A-17 Appendix 12B: Group Price Discrimination A-18 Appendix 12C: Block Pricing A-18 Appendix 12D: Two-Part Pricing A-19 Appendix 12E: Profit-Maximizing

Advertising and Production A-19 Appendix 13A: Nash-Cournot Equilibrium A-20 Appendix 13B: Nash-Stackelberg

Equilibrium A-22 Appendix 13C: Nash-Bertrand Equilibrium A-23 Appendix 15A: Factor Demands A-24 Appendix 15B: Monopsony A-25 Appendix 16A: Perpetuity A-26 Appendix 18A: Welfare Effects of Pollution

in a Competitive Market A-26 Appendix 20A: Nonshirking Condition A-28

Answers to Selected Questions and Problems A-29 Sources for Challenges and Applications A-46 References A-56 Definitions A-64 Index A-69 Credits A-96

xiv

Preface

When I was a student, I fell in love with microeconomics because it cleared up many mysteries about the world and provided the means to answer new questions. I wrote this book to illustrate that economic theory has practical, problem-solving uses and is not an empty academic exercise.

This book shows how individuals, policy makers, lawyers and judges, and firms can use microeconomic tools to analyze and resolve problems. For example, students learn that

■ individuals can draw on microeconomic theories when deciding about issues such as whether to invest and whether to sign a contract that pegs prices to the government’s measure of inflation;

■ policy makers (and voters) can employ microeconomics to predict the impact of taxes, regulations, and other measures before they are enacted;

■ lawyers and judges use microeconomics in antitrust, discrimination, and con- tract cases; and

■ firms apply microeconomic principles to produce at minimum cost and maxi- mize profit, select strategies, decide whether to buy from a market or to produce internally, and write contracts to provide optimal incentives for employees.

My experience in teaching microeconomics for the departments of economics at MIT; the University of Pennsylvania; and the University of California, Berkeley; the Depart- ment of Agricultural and Resource Economics at Berkeley; and the Wharton Business School has convinced me that students prefer this emphasis on real-world issues.

Features This book differs from other microeconomics texts in three main ways:

■ It places greater emphasis than other texts on modern theories—such as indus- trial organization theories, game theory, transaction cost theory, information theory, contract theory, and behavioral economics—that are useful in analyzing actual markets.

■ It uses real-world economic examples to present the basic theory and offers extensive Applications to a variety of real-world situations.

■ It employs step-by-step problem-based learning to demonstrate how to use microeconomic theory to solve business problems and analyze policy issues.

Modern Theories This book has all of the standard economic theory, of course. However, what sets it apart is its emphasis on modern theories that are particularly useful for understanding how firms behave and the effects of public policy.

xvPreface

Industrial Organization. How do firms differentiate their products to increase their profits? When does market outcome depend on whether firms set prices or quantities? What effects do government price regulations have on firms’ behavior? These and many other questions are addressed by industrial organization theories.

Game Theory. What’s the optimal way to bid in an auction? How do firms set prices to prevent entry of rival firms? What strategy should parents use when their college- graduate child moves back in with them? Game theory provides a way of thinking about strategies and it provides methods to choose optimal strategies.

Contract Theory. What kind of a contract should a firm offer a worker to induce the employee to work hard? How do people avoid being exploited by others who have superior information? Modern contract theory shows how to write contracts to avoid or minimize such problems.

Behavioral Economics. Should a firm allow workers to opt in or opt out of a retirement system? How should people respond to ultimatums? We address questions such as these using behavioral economics—one of the hottest new areas of economic theory—which uses psychological research and theory to explain why people deviate from rational behavior.

Real-World Economics This book demonstrates that economics is practical and provides a useful way to understand actual markets and firms’ and consumers’ decisions in two ways. First, it presents the basic theory using models estimated with real-world data. Second, it uses the theory to analyze hundreds of real-world applications.

Using Estimated Models to Illustrate Theory. The basic theory is presented using estimated demand curves, supply curves, production functions, and cost functions in most chapters. For example, students see how imported oil limits pricing by U.S. oil producers using estimated supply and demand curves, derive a Japanese beer manu- facturer’s cost curve based on an estimated production function, examine regulation of natural gas monopolies using estimated demand and cost curves, and analyze oligopoly firms’ strategies using estimated demand curves and cost and profit data from the real-world rivalries between United Airlines and American Airlines and between Coke and Pepsi.

Applications. Applications use economic theory to predict the price effect of allow- ing drilling in the Arctic National Wildlife Refuge based on estimated demand and supply curves, demonstrate how iTunes price increases affect music downloads using survey data, explain why some top-end designers limit the number of designer bags customers can buy, measure the value of using the Internet, and analyze how a tariff on chickens affects the importation of cars.

Problem-Based Learning People, firms, and policy makers have to solve economic problems daily. This book uses a problem-solving approach to demonstrate how economic theory can help them make good decisions.

Solved Problems. After the introductory chapter, each chapter provides an average of over five Solved Problems. Each Solved Problem poses a qualitative or quantita- tive question and then uses a step-by-step approach to model good problem-solving

xvi Preface

techniques. These issues range from whether Peter Guber and Joe Lacob should have bought the Golden State Warriors, how to determine Intel’s and AMD’s profit- maximizing quantities and prices using their estimated demand curves and marginal costs, and how regulating a monopoly’s price affects consumers and firms.

Challenges. Starting with Chapter 2, each chapter begins with a Challenge that presents information about an important, current real-world issue and concludes with a series of questions about that material. At the end of the chapter, a Challenge Solution answers these questions using methods presented in that chapter. That is, the Challenge combines the approaches of Applications and Solved Problems to motivate the material in the chapter. The issues covered include the effects from introducing genetically modified foods, why Americans buy more e-books than do Germans, com- paring rationing water to raising its price during droughts, whether higher salaries for star athletes raise ticket prices, whether it pays to go to college, and how Heinz can use sales to increase its profit on ketchup.

End-of-Chapter Questions. Starting with Chapter 2, each chapter ends with an extensive set of questions, many of which are based on real-world problems. Each Solved Problem and Challenge has at least one associated end-of-chapter question that references them and asks students to extend or reapply their analyses. Many of the questions are related to the Applications. Answers to selected end-of-chapter questions appear at the end of the book, and all of the end-of-chapter questions are available in MyEconLab for self-assessment, homework, or testing.

What’s New in the Seventh Edition The Seventh Edition is substantially updated and modified based on the extremely helpful suggestions of faculty and students who used the first six editions. Four major changes run throughout the book:

■ All chapters are revised, and all but two are substantially revised. ■ All the Challenges and almost all the examples and Applications throughout

the book are updated or new. ■ The book has a significant number of new Solved Problems. ■ The end-of-chapter questions are arranged by subject headings, new questions

have been added, and many others updated.

Challenges, Solved Problems, and Questions All of the Challenges are new or updated. Because many users requested more Solved Problems, I increased the number of Solved Problems in this edition to 106 from 94 in the previous edition. In addition, many other Solved Problems are new or substan- tially updated and revised. Starting in this edition, every Solved Problem has at least one associated Question at the end of the chapter.

About 40% of these Solved Problems are tied to real-world events. Many of these are associated with an adjacent Application or examples in the text. In addition to the Challenges, examples of a paired Application and Solved Problem include an inves- tigation into whether farmers benefit from a major drought, the effect of oil drilling in the Arctic National Wildlife Refuge on prices, the opportunity cost of getting an MBA, the social cost of a natural gas price ceiling, Apple’s iPad pricing, and the price effects of reselling textbooks bought abroad in the United States.

xviiPreface

Starting with Chapter 2, the end of each chapter has an average of over 40 verbal, graphical, and mathematical Questions. This edition has 769 Questions, 61 more than in the previous edition. Over 27% of the Questions are new or updated. Many of these Questions are based on recent real-life events and issues drawn from news- papers, journal articles, and other sources.

Applications The Seventh Edition has 131 Applications, 5 more than in the previous edition. Of these, 46% are new and 45% are updated, so that 91% are new or updated. The vast majority of the Applications cover events in 2012 and 2013, a few deal with historical events, and the remaining ones examine timeless material.

To make room for the new Applications, 27 older Applications from the Sixth Edition were moved to MyEconLab. Also, several new ones have been added to the hundreds of Applications and other materials in MyEconLab.

Behavioral Economics The Seventh Edition has a revised treatment of behavioral economics in the chapters on consumer choice, monopoly, interest rates, and uncertainty. It also adds a new behavioral economics section in the game theory chapter.

New and Revised Material in Chapters Every chapter is revised—including most sections. Virtually every chapter has updated examples and statistics. Some of the larger changes include:

■ Chapters 2 and 3 use two new empirical studies (avocados and corn) to illus- trate the basic supply and demand model. They have four new and a number of revised Solved Problems.

■ Chapters 4 and 5 have three new Solved Problems and extensive updating of data. Chapter 5 has a new section on compensating and equivalent variations.

■ Chapter 6 adds many new estimated production functions and a new discussion of returns to scale as a function of firm size.

■ Chapter 7 has substantially revised sections on effects of taxes on costs, long- run costs, and learning by doing. It uses a new Japanese beer empirical example to illustrate the theory, and has a new Solved Problem.

■ Chapter 8 has new statistics and a new Solved Problem. Several sections are substantially revised, including an extended treatment of the shutdown decision.

■ Chapter 9 updates many statistics and has substantially revised sections on rents, price effects on consumer surplus, and trade, and the Challenge Solution. The trade section uses a new empirical oil example.

■ Chapter 10 has a revised Challenge Solution and a new Solved Problem. ■ Chapter 11 is reorganized, revised, and updated, particularly the sections on

market failure and the causes of monopoly. The chapter has three new Solved Problems, two of which now address the iPad.

■ Chapter 12 is completely reorganized and rewritten, particularly the group discrimination section and the nonlinear pricing section, which is expanded. It has a new Challenge.

■ Chapter 13 is reorganized. Revised sections include cartel, antitrust laws, merg- ers, Cournot differentiated products, and Bertrand vs. Cournot.

xviii Preface

■ Chapter 14’s revision removes the discussion of iterative dominance (relying on dominant strategy and best-response approaches), divides the treatment of dynamic games into sections on repeated and sequential games, expands the repeated game material, and adds a new behavioral game theory section.

■ Chapter 17’s major revision includes new section heads and significant revisions to the sections on probability, attitudes toward risk, and behavioral economics. The material on uncertainty and discounting is now on MyEconLab.

■ Chapter 18 updates the pollution data, has a new subsection on the benefits versus costs from controlling pollution, and a new Solved Problem.

■ Chapter 19 is extensively revised and reorganized, with new material on insur- ance markets and a rewritten section on reducing adverse selection.

■ Chapter 20 is fundamentally rewritten and has four new Solved Problems. The first half of the chapter is entirely new.

Alternative Organizations Because instructors differ as to the order in which they cover material, this text has been designed for maximum flexibility. The most common approach to teaching microeconomics is to follow the sequence of the chapters in the first half of this book: supply and demand (Chapters 2 and 3), consumer theory (Chapters 4 and 5), the theory of the firm (Chapters 6 and 7), and the competitive model (Chapters 8 and 9). Many instructors then cover monopoly (Chapter 11), price discrimination (Chapter 12), oligopoly (Chapters 13 and 14), input markets (Chapter 15), uncer- tainty (Chapter 17), and externalities (Chapter 18).

A common variant is to present uncertainty (Sections 17.1 through 17.3) immedi- ately after consumer theory. Many instructors like to take up welfare issues between discussions of the competitive model and noncompetitive models, as Chapter 10, on general equilibrium and economic welfare, does. Alternatively, that chapter may be covered at the end of the course. Faculty can assign material on factor markets earlier (Section 15.1 could follow the chapters on competition, and the remaining sections could follow Chapter 11). The material in Chapters 14–20 can be presented in a variety of orders, though Chapter 20 should follow Chapter 19 if both are covered, and Section 17.4 should follow Chapter 16.

Many business school courses skip consumer theory (and possibly some aspects of supply and demand, such as Chapter 3) to allow more time for consideration of the topics covered in the second half of this book. Business school faculty may want to place particular emphasis on game and theory strategies (Chapter 14), capital markets (Chapter 16), and modern contract theory (Chapters 19 and 20).

Optional, technically demanding sections are marked with a star (★). Subsequent sections and chapters can be understood even if these sections are skipped.

MyEconLab MyEconLab’s powerful assessment and tutorial system works hand-in-hand with this book.

Features for Students MyEconLab puts students in control of their learning through a collection of testing, practice, and study tools. Students can study on their own, or they can complete assignments created by their instructor. In MyEconLab’s structured environment,

xixPreface

students practice what they learn, test their understanding, and pursue a personal- ized study plan generated from their performance on sample tests and quizzes. In Homework or Study Plan mode, students have access to a wealth of tutorial features, including the following:

■ Instant feedback on exercises taken directly from the text helps students under- stand and apply the concepts.

■ Links to the eText version of this textbook allow the student to quickly revisit a concept or an explanation.

■ Enhanced Pearson eText, available within the online course materials and offline via an iPad/Android app, allows instructors and students to highlight, bookmark, and take notes.

■ Learning aids help students analyze a problem in small steps, much the same way an instructor would do during office hours.

■ Temporary Access for students who are awaiting financial aid provides a grace period of temporary access.

Experiments in MyEconLab Experiments are a fun and engaging way to promote active learning and mastery of important economic concepts. Pearson’s Experiment program is flexible and easy for instructors and students to use.

■ Single-player experiments, which can be assigned for homework, allow students to play against virtual players from anywhere at any time they have an Internet connection.

■ Multiplayer experiments allow instructors to assign and manage a real-time experiment with their classes.

■ Pre- and post-questions for each experiment are available for assignment in MyEconLab.

For a complete list of available experiments, visit www.myeconlab.com.

Features for Instructors MyEconLab includes comprehensive homework, quiz, text, and tutorial options, where instructors can manage all assessment needs in one program.

■ All of the end-of-chapter questions are available for assignment and auto-grading. ■ All of the Solved Problems are available for assignment and auto-grading. ■ Test Bank questions are available for assignment or testing. ■ The Custom Exercise Builder allows instructors the flexibility of creating their

own problems for assignments. ■ The powerful Gradebook records each student’s performance and time spent

on the tests, study plan, and homework and can generate reports by student, class, or chapter.

■ Advanced Communication Tools enable students and instructors to communi- cate through email, discussion board, chat, and ClassLive.

■ Customization options provide new and enhanced ways to share documents, add content, and rename menu items.

■ A prebuilt course option provides a turn-key method for instructors to create a MyEconLab course that includes assignments by chapter.

www.myeconlab.com
xx Preface

Supplements A full range of supplementary materials to support teaching and learning accompa- nies this book.

■ The Online Instructor’s Manual revised by Jennifer Steele has many useful and creative teaching ideas. It also offers a chapter outline, additional discussion questions, additional questions and problems, and solutions for all additional questions and problems.

■ The Online Solutions Manual provides solutions for all the end-of-chapter ques- tions in the text.

■ The Online Test Bank by Shana McDermott of the University of New Mexico, James Swanson of the University of Central Missouri, and Lourenço Paz of Syracuse University features problems of varying levels of complexity, suitable for homework assignments and exams. Many of these multiple-choice questions draw on current events.

■ The Computerized Test Bank reproduces the Test Bank material in the TestGen software, which is available for Windows and Macintosh. With TestGen, instructors can easily edit existing questions, add questions, generate tests, and print the tests in a variety of formats.

■ The Online PowerPoint Presentation by Ting Levy of Florida Atlantic University contains text figures and tables, as well as lecture notes. These slides allow instructors to walk through examples from the text during in-class presentations.

These teaching resources are available online for download at the Instructor Resource Center, www.pearsonhighered.com/perloff, and on the catalog page for Microeconomics.

Acknowledgments My greatest debt is to my students. My students at MIT, the University of Pennsyl- vania, and the University of California, Berkeley, patiently dealt with my various approaches to teaching them microeconomics and made useful (and generally polite) suggestions.

The various editions have benefited from the early work by the two best devel- opment editors in the business, Jane Tufts and Sylvia Mallory. Jane Tufts reviewed drafts of the first edition of this book for content and presentation. By showing me how to present the material as clearly, orderly, and thoroughly as possible, she greatly strengthened this text. Sylvia Mallory worked valiantly to improve my writing style and helped to shape and improve every aspect of the book’s contents and appearance in each of the first four editions.

I am extremely grateful to Adrienne D’Ambrosio, Executive Acquisitions Editor, and Sarah Dumouchelle, Editorial Project Manager, at Pearson, who helped me plan this revision and made very valuable suggestions at each stage of the process. Adri- enne, as usual, skillfully handled all aspects of planning, writing, and producing this textbook. In addition, Sarah made sure that the new material in this edition is clear, editing all the chapters, and assisted in arranging the supplements program.

Over the years, many excellent research assistants—Hayley Chouinard, R. Scott Hacker, Guojun He, Nancy McCarthy, Enrico Moretti, Lisa Perloff, Asa Sajise, Hugo Salgado, Gautam Sethi, Edward Shen, Klaas van ’t Veld, and Ximing Wu—worked hard to collect facts, develop examples and figures, and check material.

www.pearsonhighered.com/perloff
xxiPreface

Many people were very generous in providing me with data, models, and exam- ples, including among others: Thomas Bauer (University of Bochum), Peter Berck (University of California, Berkeley), James Brander (University of British Columbia), Leemore Dafny (Northwestern University), Lucas Davis (University of California, Berkeley), James Dearden (Lehigh University), Farid Gasmi (Université des Sci- ences Sociales), Avi Goldfarb (University of Toronto), Claudia Goldin (Harvard University), Rachel Goodhue (University of California, Davis), William Greene (New York University), Nile Hatch (University of Illinois), Larry Karp (Uni- versity of California, Berkeley), Ryan Kellogg (University of Michigan), Arthur Kennickell (Federal Reserve, Washington), Fahad Khalil (University of Washington), Lutz Kilian (University of Michigan), Christopher Knittel (University of California, Davis), Jean-Jacques Laffont (deceased), Ulrike Malmendier (University of California, Berkeley), Karl D. Meilke (University of Guelph), Eric Muehlegger (Harvard Univer- sity), Giancarlo Moschini (Iowa State University), Michael Roberts (North Carolina State University), Wolfram Schlenker (Columbia University), Junichi Suzuki (Uni- versity of Toronto), Catherine Tucker (MIT), Harald Uhlig (University of Chicago), Quang Vuong (Université des Sciences Sociales, Toulouse, and University of Southern California), and Joel Waldfogel (University of Minnesota).

Writing a textbook is hard work for everyone involved. I am grateful to the many teachers of microeconomics who spent untold hours reading and commenting on proposals and chapters. Many of the best ideas in this book are due to them.

I am particularly grateful to Jim Brander of the University of British Columbia who provided material for Chapters 13 and 14, has given me many deep and insightful comments on many editions of this book, and with whom I wrote another, related book. Much of the new material in this edition was jointly written with him. My other biggest debt is to James Dearden, Lehigh University, who has made extremely insightful comments on all prior editions and wrote some of the end-of-chapter questions.

In earlier editions, Peter Berck made major contributions to Chapter 16. Charles F. Mason made particularly helpful comments on many chapters. Larry Karp helped me to develop two of the sections and carefully reviewed the content of several oth- ers. Robert Whaples, Wake Forest University, read many chapters in earlier editions and offered particularly useful comments. He also wrote the first draft of one of my favorite Applications.

I am grateful to the following people who reviewed the book or sent me valuable suggestions at various stages:

M. Shahid Alam, Northeastern University Anne Alexander, University of Wyoming Samson Alva, Boston College Richard K. Anderson, Texas A & M University Niels Anthonisen, University of Western Ontario Wilma Anton, University of Central Florida Emrah Arbak, State University of New York at Albany Scott E. Atkinson, University of Georgia Talia Bar, Cornell University Raymond G. Batina, Washington State University Anthony Becker, St. Olaf College Robert A. Berman, American University Gary Biglaiser, University of North Carolina, Chapel Hill S. Brock Blomberg, Wellesley College Hein Bogaard, George Washington University Vic Brajer, California State University, Fullerton

Jurgen Brauer, Augusta State University Bruce Brown, Cal Polytech Pomona and UCLA Cory S. Capps, University of Illinois, Urbana-Champaign John Cawley, Cornell University Indranil Chakraborty, University of Oklahoma Leo Chan, University of Kansas Joni S. Charles, Southwest Texas State University Kwang Soo Cheong, University of Hawaii at Manoa Joy L. Clark, Auburn University, Montgomery Dean Croushore, Federal Reserve Bank of Philadelphia Douglas Dalenberg, University of Montana Andrew Daughety, Vanderbilt University Carl Davidson, Michigan State University Ronald Deiter, Iowa State University Manfred Dix, Tulane University John Edgren, Eastern Michigan University

xxii Preface

Patrick Emerson, University of Colorado, Denver Xin Fang, Hawai’i Pacific University Bernard Fortin, Université Laval Tom Friedland, Rutgers University Roy Gardner, Indiana University Rod Garratt, University of California, Santa Barbara Wei Ge, Bucknell University Lisa Giddings, University of Wisconsin, La Crosse J. Fred Giertz, University of Illinois, Urbana-Champaign Haynes Goddard, University of Cincinnati Steven Goldman, University of California, Berkeley Julie Gonzalez, University of California, Santa Cruz Rachel Goodhue, University of California, Davis Srihari Govindan, University of Western Ontario Gareth Green, Seattle University Thomas A. Gresik, Pennsylvania State University Jonathan Gruber, MIT Steffan Habermalz, University of Nebraska, Kearney Claire Hammond, Wake Forest University John A. Hansen, State University of New York, Fredonia Philip S. Heap, James Madison University L. Dean Hiebert, Illinois State University Kathryn Ierulli, University of Illinois, Chicago Mike Ingham, University of Salford, U.K. Samia Islam, Boise State University D. Gale Johnson, University of Chicago Erik Jonasson, Lund University, Sweden Charles Kahn, University of Illinois, Urbana-Champaign Vibha Kapuria-Foreman, Colorado College Paula M. Kazi, Bucknell University Carrie Kerekes, Florida Gulf Coast University Alan Kessler, Providence College Kristin Kiesel, California State University, Sacramento Kate Krause, University of New Mexico Robert Lemke, Lake Forest College Jing Li, University of Pennsylvania Qihong Liu, University of Oklahoma Zhou Lu, City College of New York Fred Luk, University of California, Los Angeles Robert Main, Butler University David Malueg, Tulane University Steve Margolis, North Carolina State University Kate Matraves, Michigan State University James Meehan, Colby College Claudio Mezzetti, University of North Carolina,

Chapel Hill Chun-Hui Miao, University of South Carolina Janet Mitchell, Cornell University Felix Munoz-Garcia, Washington State University Babu Nahata, University of Louisville Kathryn Nantz, Fairfield University Jawwad Noor, Boston University Yuka Ohno, Rice University Patrick B. O’Neil, University of North Dakota John Palmer, University of Western Ontario Christos Papahristodoulou, Uppsala University

Silve Parviainen, University of Illinois, Urbana-Champaign Sharon Pearson, University of Alberta Anita Alves Pena, Colorado State University Ingrid Peters-Fransen, Wilfrid Laurier University Jaishankar Raman, Valparaiso University Sunder Ramaswamy, Middlebury College Lee Redding, University of Michigan, Dearborn David Reitman, Department of Justice Luca Rigotti, Tillburg University S. Abu Turab Rizvi, University of Vermont Bee Yan Aw Roberts, Pennsylvania State University Richard Rogers, Ashland University Nancy Rose, Sloan School of Business, MIT Joshua Rosenbloom, University of Kansas Roy Ruffin, University of Houston Matthew Rutledge, Boston College Alfonso Sanchez-Penalver, University of Massachusetts,

Boston George Santopietro, Radford College David Sappington, University of Florida Rich Sexton, University of California, Davis Quazi Shahriar, San Diego State University Jacques Siegers, Utrecht University, The Netherlands Alasdair Smith, University of Sussex William Doyle Smith, University of Texas at El Paso Philip Sorenson, Florida State University Peter Soule, Park College Robert Stearns, University of Maryland Jennifer Lynn Steele, Washington State University Shankar Subramanian, Cornell University Albert J. Sumell, Youngstown State University Beck A. Taylor, Baylor University Scott Templeton, Clemson University Mark L. Tendall, Stanford University Justin Tevie, University of New Mexico Wade Thomas, State University of New York, Oneonta Judith Thornton, University of Washington Vitor Trindade, Syracuse University Nora Underwood, University of California, Davis Burcin Unel, University of Florida Kay Unger, University of Montana Alan van der Hilst, University of Washington Bas van der Klaauw, Free University Amsterdam and

Tinbergen Institute Andrew Vassallo, Rutgers University Jacob L. Vigdor, Duke University Peter von Allmen, Moravian College Eleanor T. von Ende, Texas Tech University Curt Wells, Lund University Lawrence J. White, New York University John Whitehead, East Carolina University Colin Wright, Claremont McKenna College Bruce Wydick, University of San Francisco Peter Zaleski, Villanova University Artie Zillante, Florida State University Mark Zupan, University of Arizona

xxiiiPreface

In addition, I thank Bob Solow, the world’s finest economics teacher, who showed me how to simplify models without losing their essence. I’ve also learned a great deal over the years about economics and writing from my coauthors on other projects, especially Dennis Carlton (my coauthor on Modern Industrial Organization), Jackie Persons, Steve Salop, Michael Wachter, Larry Karp, Peter Berck, Amos Golan, and Dan Rubinfeld (whom I thank for still talking to me despite my decision to write this book).

It was a pleasure to work with the good people at Pearson, who were incredibly helpful in producing this book. Marjorie Williams and Barbara Rifkin signed me to write it. I would like to thank Donna Battista, Editor-in-Chief for Business Publishing, and Denise Clinton, Publisher for MyEconLab, who were instrumental in making the entire process work. Meredith Gertz did her usual outstanding job of supervising the production process, assembling the extended publishing team, and managing the design of the handsome interior. She makes the entire process as smooth as possible.

I thank Jonathan Boylan for the cover design. I also want to acknowledge, with appreciation, the efforts of Melissa Honig, Noel Lotz, and Courtney Kamauf in developing MyEconLab, the online assessment and tutorial system for the book.

Gillian Hall and the rest of the team at The Aardvark Group Publishing Services have my sincere gratitude for designing the book and keeping the project on track and on schedule. As always, I’m particularly thankful to work with Gillian, who is wonderfully flexible and committed to producing the best book possible. Rebecca Greenberg did a superior copyediting for this edition—and made many important contributions to the content.

Finally, and most importantly, I thank my wife, Jackie Persons, and daughter, Lisa Perloff, for their great patience and support during the nearly endless writing process. And I apologize for misusing their names—and those of my other relatives and friends—in the book!

J. M. P.

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1

An Economist’s Theory of Reincarnation: If you’re good, you come back on a higher level. Cats come back as dogs, dogs come back as horses, and people— if they’ve been really good like George Washington—come back as money.

Introduction 11 If each of us could get all the food, clothing, and toys we wanted without work- ing, no one would study economics. Unfortunately, most of the good things in life are scarce—we can’t all have as much as we want. Thus, scarcity is the mother of economics.

Microeconomics is the study of how individuals and firms make themselves as well off as possible in a world of scarcity and the consequences of those individual deci- sions for markets and the entire economy. In studying microeconomics, we examine how individual consumers and firms make decisions and how the interaction of many individual decisions affects markets and the entire economy.

Microeconomics is often called price theory to emphasize the important role that prices play. Microeconomics explains how the actions of all buyers and sellers deter- mine prices and how prices influence the decisions and actions of individual buyers and sellers.

microeconomics the study of how indi- viduals and firms make themselves as well off as possible in a world of scarcity and the conse- quences of those individ- ual decisions for markets and the entire economy

In this chapter, we examine three main topics

1. Microeconomics: The Allocation of Scarce Resources. Microeconomics is the study of the allocation of scarce resources.

2. Models. Economists use models to make testable predictions.

3. Uses of Microeconomic Models. Individuals, governments, and firms use microeconomic models and predictions in decision making.

1.1 Microeconomics: The Allocation of Scarce Resources

Individuals and firms allocate their limited resources to make themselves as well off as possible. Consumers pick the mix of goods and services that makes them as happy as possible given their limited wealth. Firms decide which goods to produce, where to produce them, how much to produce to maximize their profits, and how to produce those levels of output at the lowest cost by using more or less of vari- ous inputs such as labor, capital, materials, and energy. The owners of a depletable natural resource such as oil decide when to use it. Government decision makers—to

CHAPTER 1 Introduction2

benefit consumers, firms, or government bureaucrats—decide which goods and ser- vices the government produces and whether to subsidize, tax, or regulate industries and consumers.

Trade-Offs People make trade-offs because they can’t have everything. A society faces three key trade-offs:

■ Which goods and services to produce: If a society produces more cars, it must produce fewer of other goods and services, because there are only so many resources—workers, raw materials, capital, and energy—available to produce goods.

■ How to produce: To produce a given level of output, a firm must use more of one input if it uses less of another input. For example, cracker and cookie manufacturers switch between palm oil and coconut oil, depending on which is less expensive.