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Microeconomics: Optimization, Experiments, and Behavior
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Microeconomics:
Optimization, Experiments,
and Behavior
John P. Burkett
OXFORD UNIVERSITY PRESS
Microeconomics
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Microeconomics
Optimization, Experiments,
and Behavior
John P. Burkett
2006
Oxford University Press, Inc., publishes works that further
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Copyright © 2006 by Oxford University Press
Published by Oxford University Press, Inc.
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www.oup.com
Oxford is a registered trademark of Oxford University Press
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording, or otherwise,
without the prior permission of Oxford University Press.
Library of Congress Cataloging-in-Publication Data
Burkett, John P.
Microeconomics : optimization, experiments, and behavior / John P. Burkett
p. cm.
ISBN-13 978-0-19-518962-9
ISBN 0-19-518962-0
1. Microeconomics. I. Title.
HB172.B875 2006
338.5—dc22 2005051286
987654321
Printed in the United States of America
on acid-free paper
For Bojana, Keith, and Nicholas.
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Preface
A modern introduction to microeconomics should, in my opinion, (1) convey a sense of
how microeconomics has developed in response to a changing array of practical problems
and anomalies; (2) maintain a clear distinction between normative and positive theories;
(3) integrate findings of behavioral and experimental economics; (4) cover recent, as well
as classic, works; (5) feature clear and concise exposition; (6) move from simple, concrete
applications to more difficult and abstract ones; (7) offer enough quantitative examples
and exercises to show how microeconomic theory is applied and to help students to begin
developing the mathematical skills required for success in advanced economics; and (8)
provide—through footnotes and citations—links to more advanced treatments. With those
goals in mind, I wrote the present text.
The most innovative feature of the book is its extensive coverage of recent research in
behavioral and experimental economics. This research not only documents behavior inconsistent with some elements of traditional theory but also advances positive theories with
superior predictive power. The research I cover includes studies of loss aversion, referencedependent preferences, the context and framing of choice, hyperbolic discounting and
inconsistent intertemporal choice, predictable errors in updating probabilities, nonlinear
weighting of probabilities, and prospect theory. The importance of this material was highlighted by the Swedish Academy of Sciences when it awarded the 2002 Prize in Economic
Sciences to Daniel Kahneman (a psychologist who helped lay the foundations of behavioral economics) and Vernon Smith (an experimental economist). Although the topics are
“advanced” in the sense that they are near the frontier of economic research and seldom covered in textbooks, they are readily comprehended because they center on simple controlled
experiments and relate to everyday concerns.
Covering results from behavioral and experimental economics along with traditional
microeconomic doctrine involves rebalancing three key components of economics: issues,
theory, and data. Traditional introductions emphasize issues, sketch theory, and use data
only to illustrate theory. More advanced texts traditionally focus on theory, relegating
issues and data to asides. Any data in traditional texts are usually from observational
(nonexperimental) studies. The relationship between theory and observational data is likely
to be ambiguous until probed by advanced econometric methods and may remain so even
then. Recognizing that few students have the econometric skills needed for serious analysis
of observational data, some authors focus their texts almost exclusively on theory and issues.
Although widely used, such texts arouse misgivings in students and professors to whom
data-free exposition smells of indoctrination (Leamer 1997). In comparison to traditional
texts, this book places more emphasis on experimental data, both when they support received
theory and when they reveal anomalies. Thus the book covers both feedlot experiments that
viii PREFACE
generate conventionally shaped isoquants and choice experiments that cast doubt on the
predictive value of expected utility theory.
The book presupposes nothing beyond high-school algebra and intellectual curiosity. It
is intended for undergraduate classes and independent reading.
Anyone writing for an audience that includes undergraduates must decide how to handle the growing gap between the rudimentary mathematical skills acquired in secondary
schools, particularly in the United States, and the growing mathematical prerequisites for
reading economists’ professional journals. This gap must somehow be bridged if undergraduates are to be prepared for employment or graduate study in economics and related
fields. To be fully prepared, students need not only classes in mathematics but also practice in formulating and solving quantitative economic problems. Too many texts either omit
such problems or assume that students come fully equipped to handle them. In contrast,
this text offers many opportunities to apply high-school algebra in an economic context and
to develop basic skills in linear programming and risk modeling. Through footnotes and
parenthetical remarks, it also encourages readers to make good use of any calculus they
know. Exercises appear where appropriate in the text; solutions and supplemental problems
are collected at the ends of chapters. When teaching from the book, I usually start each
class by asking students if they had trouble solving any problems in the previous chapter
and end class by helping students tackle the problems in the current chapter. By solving the
problems, students can make appreciable progress toward becoming competent economists.
Acknowledgments
Carole Miller carefully read the entire manuscript, providing scores of helpful suggestions.
Others who contributed useful comments include Christopher Anderson, Calvin Blackwell,
Wentworth Boynton, Keith Burkett, Bruce Cater, Joel Dirlam, Glenn Erickson, Phillip
Fanchon, John Gates, Ernesto Lucas, Charles Plott, Yngve Ramstad, Bojana Ristich,
Mohammed Sharif, Jon Sutinen, Kathryn Zeiler, and many former students.
While a graduate student at the University of California (Berkeley), I benefited from
contact with many excellent professors, among whom six are particularly relevant to this
work: From George Akerlof and Roy Radner I learned to appreciate rigorous theoretical
analysis of both optimizing and nonoptimizing behavior. From Daniel McFadden and
Thomas Rothenberg I learned how much economics can benefit from careful linkage of
theory and data. From Laura D’Andrea Tyson and Benjamin Ward I learned the value of
close attention to interactions between economic institutions and behavior.
Like most textbook authors, I am indebted to my predecessors. Microeconomic texts and
treatises that I have used with pleasure as a student or a teacher include A. Asimakopulos’s
An Introduction to Economic Theory: Microeconomics, Theodore C. Bergstrom and John
H. Miller’s Experiments with Economic Principles, William J. Baumol’s Economic Theory and Operations Analysis, Samuel Bowles and David Kendrick’s Notes and Problems in
Microeconomic Theory, Jae Wan Chung’s Utility and Production Functions, Richard M.
Cyert and James G. March’s A Behavioral Theory of the Firm, Gerard Debreu’s Theory
of Value, A. K. Dixit’s Optimization in Economic Theory, Robert H. Frank’s Microeconomics and Behavior, C. E. Ferguson’s Microeconomic Theory, James M. Henderson and
Richard E. Quandt’s Microeconomic Theory: A Mathematical Approach, Michael D. Intriligator’s Mathematical Optimization and Economic Theory, Geoffrey A. Jehle and Philip
J. Reny’s Advanced Microeconomic Theory, David M. Kreps’s Notes on the Theory of
Choice, Heinz D. Kurz and Neri Salvadori’s Theory of Production, Edmond Malinvaud’s
Lectures on Microeconomic Theory, Andreu Mas-Colell, Michael D. Whinston, and Jerry
R. Green’s Microeconomic Theory, Richard R. Nelson and Sidney G. Winter’s An Evolutionary Theory of Economic Change, Walter Nicholson’s Microeconomic Theory: Basic
Principles and Extensions, Edmund S. Phelps’s Political Economy, Robert S. Pindyck and
Daniel L. Rubinfeld’s Microeconomics, Dominick Salvatore’s Microeconomics: Theory
and Applications, Paul A. Samuelson’s Foundations of Economic Analysis, Andrew Schotter’s Microeconomics: A Modern Approach, Oz Shy’s Industrial Organization, Joseph E.
Stiglitz’s Principles of Microeconomics, Henri Theil’s Optimal Decision Rules for Government and Industry and The System-Wide Approach to Microeconomics, Hal R. Varian’s
Microeconomic Analysis, and W. Kip Viscusi, John M Vernon, and Joseph E. Harrington
Jr.’s Economics of Regulation and Antitrust.
x ACKNOWLEDGMENTS
The staff of Oxford University Press has been very helpful. Special thanks for thoughtful
and expeditious work are due to the acquiring editor, Terry Vaughn; the editorial assistant,
Catherine Rae; the production editor, Keith Faivre; and the copyeditor, Barbara Conner.
Production of the book was greatly facilitated by Donald Knuth’s TEX and Leslie
Lamport’s LaTEX.
Contents
1 The Origins and Scope of Microeconomics 1
1.1 Definitions of Economics 1
1.2 Ancient Origins 1
1.3 Classical Concepts 3
1.4 Mathematical Methods 10
1.5 Interdisciplinary Inquiries 12
1.6 Predictive Problems 13
1.7 Empirical Endeavors 14
1.8 Micro and Macro 15
1.9 Summary 15
1.10 Solutions to Exercises 16
1.11 Problems 17
2 Inputs, Outputs, and Costs 19
2.1 Basic Concepts 19
2.2 Input Substitution 19
2.3 Cost Minimization Problem 22
2.4 Summary 25
2.5 Solutions to Exercises 25
2.6 Problems 26
2.7 Appendix: Review of Exponents and Logarithms 27
3 Cost Minimization Using Linear Programming 28
3.1 Limitations of Production Experiments 28
3.2 Reformulation of the Least-cost Diet Problem in Terms of Nutrients 28
3.3 Linear Programming Techniques 37
3.4 Summary 38
3.5 Solutions to Exercises 38
3.6 Problems: Something to Chew On 40
3.7 Appendix: Software for Linear Programming 41
4 Production and Costs 44
4.1 Inputs and Outputs 44
4.2 Production Functions 44
4.3 Expansion Paths 46
4.4 Returns to Scale 47
4.5 Cost Curves 50
4.6 Summary 52
xi
xii CONTENTS
4.7 Solutions to Exercises 52
4.8 Problems 53
4.9 Appendix: An Experiment with Economies of Scale and Learning
by Doing 54
5 The Production Decisions of Competitive Firms 60
5.1 Revenue and Profit 60
5.2 Perfect Competition 60
5.3 Supply Curves 61
5.4 Summary 67
5.5 Solutions to Exercises 67
5.6 Problems 67
6 Marginal Products and Factor Proportions 69
6.1 Marginal Products 69
6.2 Factor Demand 71
6.3 Factor Prices and Proportions 71
6.4 Summary 73
6.5 Solutions to Exercises 73
6.6 Problems 73
7 Comparative Advantage and Gains from Trade 75
7.1 Production and Comparative Advantage 75
7.2 Revenue Maximization 80
7.3 International Trade 82
7.4 Summary 84
7.5 Solutions to Exercises 85
7.6 Problems 86
7.7 Appendix: A Linear Programming Solution to a Space Allocation
Problem 88
8 Allocation of Factors in Competitive Markets 90
8.1 Introduction to General Equilibrium 90
8.2 General Equilibrium in Factor Markets 90
8.3 Applications 95
8.4 Summary 97
8.5 Solutions to Exercises 97
8.6 Problems 98
9 Consumer Choice and Demand 99
9.1 Introduction 99
9.2 Budget Constraints 99
9.3 Consumer Preferences 101
9.4 Constrained Optimization 106
9.5 Demand 107
9.6 Consumer Surplus 111
9.7 Summary 112
9.8 Solutions to Exercises 113
9.9 Problems 113
CONTENTS xiii
10 Exchange and Product Assortment 116
10.1 Exchange 116
10.2 Product Assortment 118
10.3 Summary 120
10.4 Solutions to Exercises 120
10.5 Problems 121
11 Loss Aversion and Reference-dependent Preferences 122
11.1 Evidence That Assets Can Affect Preferences 122
11.2 A Theory of Reference Dependence 127
11.3 Boundaries of Loss Aversion, the Endowment Effect, and the
WTA-WTP Gap 128
11.4 Economic Implications of Loss Aversion 132
11.5 Summary 134
11.6 Solutions to Exercises 135
11.7 Problems: Economics Gets Kinky 135
12 The Context and Framing of Choice 137
12.1 Context 137
12.2 Invariance and Framing 140
12.3 Value Comparison 142
12.4 Summary 144
12.5 Solutions to Exercises 144
12.6 Problems 145
13 Labor Supply 146
13.1 Consumption vs. Leisure 146
13.2 Labor Supply Curve 147
13.3 Nonlinear Budget Constraints 148
13.4 Pace and Motivation 151
13.5 Human Capital and Education 151
13.6 Summary 152
13.7 Solutions to Exercises 153
13.8 Problems 154
14 Monopoly and Monopsony Power 155
14.1 Monopoly 155
14.2 Varieties of Imperfect Competition 169
14.3 Monopolistic Competition 169
14.4 Monopsony 172
14.5 Monopsonistic Competition 175
14.6 Summary 175
14.7 Solutions to Exercises 176
14.8 Problems 178
15 Oligopoly and Oligopsony: Classic Models 180
15.1 Oligopoly 180
15.2 Oligopsony 188
15.3 Summary 189
15.4 Solutions to Exercises 190
xiv CONTENTS
15.5 Problems 190
15.6 Appendix: An Experiment with Duopoly 191
16 Economics of Time 194
16.1 Interest 194
16.2 Present and Future Value 195
16.3 Implications for Schooling and Work 197
16.4 Summary 198
16.5 Solutions to Exercises 198
16.6 Problems 198
17 Saving Behavior 200
17.1 Intertemporal Choice 200
17.2 Budget Constraints 200
17.3 Causes of Low Saving Rates 202
17.4 Policies to Stimulate Saving 204
17.5 Summary 204
17.6 Solutions to Exercises 205
17.7 Problems 205
18 Inconsistent Intertemporal Choice 207
18.1 Preferences 207
18.2 Additivity, Consistency, and Exponential Discounting 207
18.3 Hyperbolic Discounting and Inconsistent Preferences 208
18.4 Other Anomalies 208
18.5 Policy Implications 211
18.6 Summary 211
18.7 Solutions to Exercises 212
18.8 Problems 213
18.9 Appendix: Additivity, Consistency, and Discounting 213
19 Economics of Risk 214
19.1 Risk and Probability 214
19.2 Expected Value 218
19.3 Attitudes Toward Risk 219
19.4 Insurance 219
19.5 Summary 223
19.6 Solutions to Exercises 224
19.7 Problems 224
20 Behavior in the Face of Risk 225
20.1 Normative Theories 225
20.2 Positive Theories 229
20.3 Judging Probabilities 232
20.4 Summary 235
20.5 Solutions to Exercises 236
20.6 Problems 236
20.7 Appendix: Shapes of Utility Functions and Attitudes Toward Risk 238