Instructor’s Manual Intermediate Microeconomics Ninth Edition Instructor’s Manual Intermediate Microeconomics Ninth Edition Instructor’s Manual by Hal R. Varian Answers to Workouts by Hal R. Varian and Theodore C. Bergstrom W. W. Norton & Company • New York • London c 2014, 2010, 2002, 1999, 1996, 1993, 1990, 1988 by W. W. Norton & Company Copyright All rights reserved Printed in the United States of America Typeset in TEX by Hal R. Varian NINTH EDITION ISBN 978-0-393-93676-6 W. W. Norton & Company, Inc., 500 Fifth Avenue, New York, N.Y. 10110 W. W. Norton & Company, Ltd., Castle House, 75/76 Wells Street, London W1T 3QT www.wwnorton.com 1234567890 CONTENTS Part I Chapter Highlights 1. The Market 1 2. Budget Constraint 4 3. Preferences 7 4. Utility 10 5. Choice 13 6. Demand 16 7. Revealed Preference 18 8. Slutsky Equation 21 9. Buying and Selling 23 10. Intertemporal Choice 26 11. Asset Markets 29 12. Uncertainty 31 13. Risky Assets 33 14. Consumer’s Surplus 35 15. Market Demand 37 16. Equilibrium 39 17. Measurement 42 18. Auctions 44 19. Technology 46 20. Proﬁt Maximization 48 21. Cost Minimization 50 22. Cost Curves 52 23. Firm Supply 54 24. Industry Supply 56 25. Monopoly 59 26. Monopoly Behavior 61 27. Factor Markets 63 28. Oligopoly 65 29. Game Theory 68 30. Game Applications 71 31. Behavioral Economics 75 32. Exchange 78 33. Production 81 34. Welfare 83 35. Externalities 85 36. Information Technology 88 37. Public Goods 92 38. Information 95 Part II Answers to Workouts 1. The Market 1 2. Budget Constraint 5 3. Preferences 17 4. Utility 33 5. Choice 49 6. Demand 67 7. Revealed Preference 81 8. Slutsky Equation 97 9. Buying and Selling 111 10. Intertemporal Choice 131 11. Asset Markets 147 12. Uncertainty 161 13. Risky Assets 175 14. Consumer’s Surplus 181 15. Market Demand 191 16. Equilibrium 201 17. Measurement 219 18. Auctions 221 19. Technology 239 20. Proﬁt Maximization 251 21. Cost Minimization 267 22. Cost Curves 279 23. Firm Supply 285 24. Industry Supply 295 25. Monopoly 311 26. Monopoly Behavior 317 27. Factor Markets 331 28. Oligopoly 335 29. Game Theory 351 30. Game Applications 365 31. Behavioral Economics 381 32. Exchange 391 33. Production 407 34. Welfare 417 35. Externalities 427 36. Information Technology 439 37. Public Goods 455 38. Asymmetric Information 469 Chapter 1 1 Chapter 1 The Market This chapter was written so I would have something to talk about on the ﬁrst day of class. I wanted to give students an idea of what economics was all about, and what my lectures would be like, and yet not have anything that was really critical for the course. (At Michigan, students are still shopping around on the ﬁrst day, and a good number of them won’t necessarily be at the lecture.) I chose to discuss a housing market since it gives a way to describe a number of economic ideas in very simple language and gives a good guide to what lies ahead. In this chapter I was deliberately looking for surprising results—analytic insights that wouldn’t arise from “just thinking” about a problem. The two most surprising results that I presented are the condominium example and the tax example in Section 1.6. It is worth emphasizing in class just why these results are true, and how they illustrate the power of economic modeling. It also makes sense to describe their limitations. Suppose that every condominium conversion involved knocking out the walls and creating two apartments. Then what would happen to the price of apartments? Suppose that the condominiums attracted suburbanites who wouldn’t otherwise consider renting an apartment. In each of these cases, the price of remaining apartments would rise when condominium conversion took place. The point of a simple economic model of the sort considered here is to focus our thoughts on what the relevant eﬀects are, not to come to a once-and-for-all conclusion about the urban housing market. The real insight that is oﬀered by these examples is that you have to consider both the supply and the demand side of the apartment market when you analyze the impact of this particular policy. The only concept that the students seem to have trouble with in this chapter is the idea of Pareto eﬃciency. I usually talk about the idea a little more than is in the book and rephrase it a few times. But then I tell them not to worry about it too much, since we’ll look at it in great detail later in the course. The workbook problems here are pretty straightforward. The biggest problem is getting the students to draw the true (discontinuous) demand curve, as in Figure 1.1, rather than just to sketch in a downward-sloping curve as in Figure 1.2. This is a good time to emphasize to the students that when they are given numbers describing a curve, they have to use the numbers—they can’t just sketch in any old shape. 2 Chapter Highlights The Market A. Example of an economic model — the market for apartments 1. models are simpliﬁcations of reality 2. for example, assume all apartments are identical 3. some are close to the university, others are far away 4. price of outer-ring apartments is exogenous — determined outside the model 5. price of inner-ring apartments is endogenous — determined within the model B. Two principles of economics 1. optimization principle — people choose actions that are in their interest 2. equilibrium principle — people’s actions must eventually be consistent with each other C. Constructing the demand curve 1. line up the people by willingness-to-pay. See Figure 1.1. 2. for large numbers of people, this is essentially a smooth curve as in Figure 1.2. D. Supply curve 1. depends on time frame 2. but we’ll look at the short run — when supply of apartments is ﬁxed. E. Equilibrium 1. when demand equals supply 2. price that clears the market F. Comparative statics 1. how does equilibrium adjust when economic conditions change? 2. “comparative” — compare two equilibria 3. “statics” — only look at equilibria, not at adjustment 4. example — increase in supply lowers price; see Figure 1.5. 5. example — create condos which are purchased by renters; no eﬀect on price; see Figure 1.6. G. Other ways to allocate apartments 1. discriminating monopolist 2. ordinary monopolist 3. rent control H. Comparing diﬀerent institutions 1. need a criterion to compare how eﬃcient these diﬀerent allocation methods are. 2. an allocation is Pareto eﬃcient if there is no way to make some group of people better oﬀ without making someone else worse oﬀ. 3. if something is not Pareto eﬃcient, then there is some way to make some people better oﬀ without making someone else worse oﬀ. 4. if something is not Pareto eﬃcient, then there is some kind of “waste” in the system. I. Checking eﬃciency of diﬀerent methods 1. free market — eﬃcient 2. discriminating monopolist — eﬃcient 3. ordinary monopolist — not eﬃcient 4. rent control — not eﬃcient Chapter 1 3 J. Equilibrium in long run 1. supply will change 2. can examine eﬃciency in this context as well Chapter 1 NAME The Market Introduction. The problems in this chapter examine some variations on the apartment market described in the text. In most of the problems we work with the true demand curve constructed from the reservation prices of the consumers rather than the “smoothed” demand curve that we used in the text. Remember that the reservation price of a consumer is that price where he is just indiﬀerent between renting or not renting the apartment. At any price below the reservation price the consumer will demand one apartment, at any price above the reservation price the consumer will demand zero apartments, and exactly at the reservation price the consumer will be indiﬀerent between having zero or one apartment. You should also observe that when demand curves have the “staircase” shape used here, there will typically be a range of prices where supply equals demand. Thus we will ask for the the highest and lowest price in the range. 1.1 (3) Suppose that we have 8 people who want to rent an apartment. Their reservation prices are given below. (To keep the numbers small, think of these numbers as being daily rent payments.) Person Price = A = 40 B 25 C 30 D 35 E 10 F 18 G 15 H 5 (a) Plot the market demand curve in the following graph. (Hint: When the market price is equal to some consumer i’s reservation price, there will be two diﬀerent quantities of apartments demanded, since consumer i will be indiﬀerent between having or not having an apartment.) 2 THE MARKET (Ch. 1) Price 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 Apartments (b) Suppose the supply of apartments is ﬁxed at 5 units. In this case there is a whole range of prices that will be equilibrium prices. What is the highest price that would make the demand for apartments equal to 5 units? $18. (c) What is the lowest price that would make the market demand equal to 5 units? $15. (d) With a supply of 4 apartments, which of the people A–H end up getting apartments? A, B, C, D. (e) What if the supply of apartments increases to 6 units. What is the range of equilibrium prices? $10 to $15. 1.2 (3) Suppose that there are originally 5 units in the market and that 1 of them is turned into a condominium. (a) Suppose that person A decides to buy the condominium. What will be the highest price at which the demand for apartments will equal the supply of apartments? What will be the lowest price? Enter your answers in column A, in the table. Then calculate the equilibrium prices of apartments if B, C, . . . , decide to buy the condominium. NAME 3 Person A B C D E F G H High price 18 18 18 18 25 25 25 25 Low price 15 15 15 15 18 15 18 18 (b) Suppose that there were two people at each reservation price and 10 apartments. What is the highest price at which demand equals supply? 18. Suppose that one of the apartments was turned into a condo- minium. Is that price still an equilibrium price? Yes. 1.3 (2) Suppose now that a monopolist owns all the apartments and that he is trying to determine which price and quantity maximize his revenues. (a) Fill in the box with the maximum price and revenue that the monopolist can make if he rents 1, 2, . . ., 8 apartments. (Assume that he must charge one price for all apartments.) Number 1 2 3 4 5 6 7 8 Price 40 35 30 25 18 15 10 5 Revenue 40 70 90 100 90 90 70 40 (b) Which of the people A–F would get apartments? A, B, C, D. (c) If the monopolist were required by law to rent exactly 5 apartments, what price would he charge to maximize his revenue? (d) Who would get apartments? $18. A, B, C, D, F. (e) If this landlord could charge each individual a diﬀerent price, and he knew the reservation prices of all the individuals, what is the maximum revenue he could make if he rented all 5 apartments? $148. (f ) If 5 apartments were rented, which individuals would get the apartments? A, B, C, D, F. 1.4 (2) Suppose that there are 5 apartments to be rented and that the city rent-control board sets a maximum rent of $9. Further suppose that people A, B, C, D, and E manage to get an apartment, while F, G, and H are frozen out. 4 THE MARKET (Ch. 1) (a) If subletting is legal—or, at least, practiced—who will sublet to whom in equilibrium? (Assume that people who sublet can evade the city rentcontrol restrictions.) E, who is willing to pay only $10 for an apartment would sublet to F, who is willing to pay $18. (b) What will be the maximum amount that can be charged for the sublet payment? $18. (c) If you have rent control with unlimited subletting allowed, which of the consumers described above will end up in the 5 apartments? A, B, C, D, F. (d) How does this compare to the market outcome? It’s the same. 1.5 (2) In the text we argued that a tax on landlords would not get passed along to the renters. What would happen if instead the tax was imposed on renters? (a) To answer this question, consider the group of people in Problem 1.1. What is the maximum that they would be willing to pay to the landlord if they each had to pay a $5 tax on apartments to the city? Fill in the box below with these reservation prices. Person A B C D E F G H Reservation Price 35 20 25 30 5 13 10 0 (b) Using this information determine the maximum equilibrium price if there are 5 apartments to be rented. $13. (c) Of course, the total price a renter pays consists of his or her rent plus the tax. This amount is $18. (d) How does this compare to what happens if the tax is levied on the landlords? It’s the same.