[David_M._Kreps]_A_Course_in_Microeconomic_Theory(BookZZ.org).pdf - DAVIDM.KREPS V(~\\~-v Jr A course in microeconomic theory A course in microeconomic

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Unformatted text preview: DAVIDM.KREPS V(~ -\ \~ -·v Jr \, A course in· microeconomic theory A course in microeconomic theory David M. Kreps PRINCETON UNIVERSITY PRESS Copyright © 1990 by David M. Kreps Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 All rights reserved Library of Congress Cataloging-in-Publication Data Kreps, David M. A course in rnicroeconornic theory I David M. Kreps. P· em. Includes bibliographical references. ISBN 0-691-04264-0 (alk. paper) 1. Microeconomics. ·r. Title. HB172.K74 1990 338.5-dc20 89-27619 This book has been composed in Palatino and Computer Modern typefaces. Princeton University Press books are printed on acid-free paper, and meet tlie guidelines for permanence and durability of the Committee on Publication Guidelines for Book Longevity of the Council on Library Resources Printed in the United States of America by Princeton University Press, Princeton, New Jersey 10 9 8 7 6 54 3 2 Figures from Gt;lpter 20 have been adapted with pemuss10n of The Free Press, a C INSTITUTIONS OF CAPITALISM by Division of Macmillan, Inc. fro Oliver E. Williamson. Cop ( for Anat :•.'-'·.· . I "!·. contents preface chapter one: An overview XV 3 1.1. The basic categories: Actors, behavior, institutions, and equilibrium 3 1.2. The purpose of microeconomic theory 7 1.3. Scope, detail, emphasis, and complexity 10 1.4. A precis of the plot 12 part I: Individual and social choice chapter two: The theory of consumer choice and demand 17 Prologue to part I 17 2.1. Preferences and choices 18_ 21 2.2. Marshallian demand without derivatives 37 2.3. Marshallian demand with derivatives 51 2.4. Aggregate demand 62 2.5. Bibliographic notes 63 2.6. Problems 65 chapter three: Choice under uncertainty 3.1. 3.2. 3.3. 3.4. 3.5. 3.6. 3.7. 3.8. Von Neumann-Morgenstem expected utility 72 On utility for money 81 Applications to market demand 87 States of nature and subjective probability 98 Problems with these models 112 Normative applications of the theory 120 Bibliographic notes 122 Problems 124 71 Contents viii chapter four: Dynamic choice 4.1. 4.2. 4.3. 4.4. Optimal dynamic strategies 133 Menus and meals 139 Bibliographic notes and discussion Problems 146 133 143 chapter five: Social choice and efficiency 5.1. 5.2. 5.3. 5.4. 5.5. 5.6. 5.7. 149 The problem 149 Pareto efficiency and optimality: Definitions 153 Benevolent social dictators and social welfare functionals 156 Characterizing efficient social outcomes 164 Social Ch9ice rules and Arrow's possibility theorem 174 Bibliographic notes 181 Problems 182 part II: T}le price mechanism chapter six: Pure exchange and general equilibrium 187 Prologue to part IT 187 6.1. Pure exchange and price equilibrium 187 6.2. Why (not) believe in Walrasian equilibrium? 193 6.3. The efficiency of a general equilibrium 199 6.4. Exis~ce and the number of equilibria 205 6.5. Time, uncertainty, and general equilibrium 216 6.6. Bibliographic notes 223 6.7. Problems 225 chapter seven: The neoclassical firm 7.1. 7.2. 7.3. 7.4. 7.5. Models of the firm's technological capabilities 234 The profit function 239 Conditional factor demands and cost functions 250 From profit or cost functions to technology sets 253 Cost functions and -runs 255 233 Contents 7.6. Bibliographic notes 7.7. Problems 259 ix 259 chapter eight: The competitive firm and perfect competition 8.1. 8.2. 8.3. 8.4. 8.5. 8.6. A perfectly competitive market 264 Perfect competition and -runs 267 What's wrong with partial equilibrium analysis? General equilibrium with firms 283 Bibliographic notes 292 Problems 292 263 279 chapter nine: Monopoly 9.1. 9.2. 9.3. 9.4. 9.5. 9.6. 9.7. 299 The standard theory 299 Maintaining monopoly 302 Multigood monopoly 304 Nonlinear pricing 306 Monopoly power? 314 Bibliographic notes 317 Problems 318 chapter ten: Imperfect competition 325 10.1. The classic models of duopoly 325 10.2. Bibliographic notes and discussion 340 10.3. Problems 347 part III: Noncooperative game theory chapter eleven: Modeling competitive situations Prologue to part ill 355 11.1. Games in extensive form: An example 356 11.2. Games in extensive form: Formalities 363 11.3. Games in normal or stategic form 376 355 x Contents 11.4. Mixed strategies and Kuhn's theorem 11.5. Bibliographic notes 384 11.6. Problems 385 380 chapter twelve: Solution concepts for noncooperative games 387 12.1. Opening remarks 387 12.2. Dominance and iterated dominance for normal form games 12.3. Backwards induction in games of complete and perfect information · 399 12.4. Nash equilibrium 402 12.5. Equilibria in mixed strategies 407 12.6. Why might there be an obvious way to play a given game? 12.7. Refinements of Nash equilibrium 417 393 410 12.7.1. Weak dominance 418 • 12.7.2. Subgame perfection (and iterated weak dominance) 421 • 12.7.3. Sequential equilibrium 425 • 12.7.4. Restrictions on out-of-equilibrium beliefs 432 • 12.7.5. 'frembling-hand perfectio"~ 437 • 12.7.6. Proper equilibria and stable sets of equilibria 442 12.8. Reprise: Classic duopoly .443 12.9. Bibliographic ~otes 449 12.10. Problems 451 chapter thirteen: Incomplete information and irr~tionality 13.1. 13.2. 13.3. 13.4. 13.5. 13.6. Games of incomplete information 463 An application: Entry deterrence 468 Modeling irrationality 480 More on refinements: Complete theories Bibliographic notes 496 Problems 498 463 489 chapter fourteen: Repeated play: Cooperation and reputation 14.1. The prisoners' dilemma 503 14.2. Repeating games can yield cooperation: The folk theorem 14.3. Noisy observables 515 503 505 Contents 14.4. 14.5. 14.6. 14.7. 14.8. xi Implicit collusion in oligopoly 524 Reputation 531 Reputation redux: Incomplete information Bibliographic notes 543 Problems 546 536 chapter fifteen: Bilateral bargaining 15.1. 15.2. 15.3. 15.4. 15.5. 15.6. 15.7. 551 Simultaneous offers and indetermi:O.ancy 552 Focal equilibria 554 Rubinstein's model 556 The experimental evidence about alternating offers Models with incomplete information 568 Bibliographic notes 570 Problems 571 565 part W: Topics in information economics chapter sixteen: Moral hazard and incentives Prologue to part N 577 16.1. Introduction 578 16.2. Effort incentives: A simple example 579 16.3. Finitely many actions and outcomes 586 16.4. Continuous actions: The first-order approach 16.5. Bibliographic notes and variations 608 16.6. Problems 616 chapter seventeen: Adverse selection and market signaling 17.1. 17.2. 17.3. 17.4. 17.5. Akerlof's model of lemons 625 Signaling quality 629 Signaling and game theory 645 Bibliographic notes and discussion Problems 654 650 577 604 625 Contents xii chapter eighteen: The revelation principle and mechanism design 18.1. 18.2. 18.3. 18.4. 18.5. 18.6. 661 Optimal contracts designed for a single party 661 Optimal contracts for interacting parties 680 The pivot mechanism 704 The Gibbard-Satterthwaite theorem 712 Bibliographic notes 713 Problems 715 part V: Firms and transactions chapter nineteen: Theories of the firm 19.1. 19.2. 19.3. 19.4. 19.5. 19.6. The firm as a profit-maximizing entity The firm as a maximizing entity 729 The firm as a behavioral entity 731 Firms in t;he category of markets 739 Bibliographic notes 740 Problems 740 723 724 chapter twenty: Transaction cost economics and the firm 20.1. Transaction cost economics and firms 743 20.2. Mathematical models of transaction cost economics 20.3. Bibliog:-aphic notes 769 743 756 postscript 771 appendix one: Constrained optimization 775 Al.l. A1.2. A1.3. A1.4. A1.5. A recipe for solving problems 775 The recipe at work: An example 778 Intuition 782 Bibliographic notes 788 Problems 789 xiii Contents appendix two: Dynamic programming A2.1. A2.2. A2.3. A2.4. A2.5. A2.6. 791 An example with a finite horizon 791 Finite horizon dynamic progranurung 796 An example with an infinite horizon 801 Stationary Markov decision problems 806 Bibliographic notes and discussion 813 Problems 814 addendum to the second and subsequent printings 817 index 819 preface This book provides an illtroduction to the content and methods of microeconomic theory. The primary target for this book is a -~~ru:_ gi_aduate student who is lookllg for an illtroduction to microeconomic theory that goes beyond the traditional models of the consumer, the firm, and the market. It could also be used by undergraduate majors who seek an ."advanced theory" course followmg traditional illtermediate micro. And, for relatively mathematically sophisticated students, it could be used as a nontraditional illtermediate micro course. The book presumes, however, that the reader has survived the standard illtermediate microeconomics course, and the student who has not gone through such a course may find it helpful on occasion to consult a traditional illtermediate text. There are many excellent books around; four that I have recommended to students are Friedman, Price Theory (South-Western Publishllg, 1986), Hirshleifer, Price Theory and Applications (4th edition, Prentice Hall, 1988), Nicholson, Microeconomic Theory - Basic Principles and Extensions (3d edition, Dryden Press, 1985), and Pilldyck and Rubinfeld, Microeconomics (Macmillan, 1989). The distinguishllg feature of this book is that although it treats the traditional models (ill parts I and mit emphasizes more recent variations, with special emphases on the use of noncooEerative game theory to mod~l __sQmpetitive ~teracti~ns_ (part_.!!P.L transact!_o.!:IS in_which private informa:tion plays a role (part N), and the theory of :firn:l$__giJ.!=l_o_tb.e:cnoruncu:}sgt_ institu!lons (part V). For the most part, the formal mathematical requirements of this book are mild. The reader will have to be able to do constramed optimization problems with inequality constramts, using Lagrange multipliers and the complementary slackness conditions. A cookbook recipe for this technique and an example are presented ill an appendix. The reader can trust that for any problem ill this book, with exceptions as noted, any solution to the first-order conditions and the complementary slackness conditions is a global optimum. That is, with a few exceptions, only "convex" problems are considered. The reader is expected to know basic probability theory. For the sake of completeness, I sometimes delve illto "optional" topics that either require a significant amount of mathematics or deal with somewhat advanced and/ or esoteric topics. This material is presented both ill footnotes and ill slightly smaller typesize ill the text. For the most part, it XVl Preface is up to the reader to supply the necessary mathematical background. The one exception concerns dynamic programming; a second appendix gives just enough background :in the techniques of d.p. to get through its uses :in this book I apologize for any frustration the more technical material may cause. I have tried to make the book comprehensible even if the reader skips all this material The level of mathematical sophistication required (as opposed to the number of mathematical tools) rises as the book progresses. I have written this book with a first-year graduate student :in mind, and I expect that the tolerence of such students for abstract arguments will rise as their first year of study unfolds. The general style of the book is informal, and the number of theorems and proofs is relatively low. This book is meant to be a skeleton survey of microeconorl:tic theory or, more precisely, of some of the topics and techniques of microeconomic theory; students and instructors will wish to supplement what is here accord:ing to their own tastes and :interests. I try at the end of each chapter to :indicate where the reader should go for more advanced and complete coverage of the topics under discussion. 1 The text is relatively more complete and formal :in part ill, the :introduction to noncooperative game theory, because there are fewer good advanced treatments of that material other than the original papers. Two caveats are called for by ·the style I employ. Despite the very impressive number of pages in this book, the number of ideas per page is low relative to a standard text. I prefer, and I think students prefer, books that are relatively chatty. Be that as it may, this book is relatively chatty. (This is my excuse for calling this A Course in . . . . Perhaps it would have been better to have called this Lectures in .... ) I hope that readers who know some of the material aren't put off by this but can get to what they don't know without much delay. Second, fve tried to write a good textbook, which is not to my mind the same thing as a good reference book The reader who goes back to this book to find something specific may find the exercise somewhat trying. In particular, many important concepts are discussed only in the context of specific problems, with the reader left to think through the general structure. I think this makes for a good textbook; but it doesn't make for a good reference book Besides not always giv:ing general formulations of concepts, I never give exhaustive surveys of the 1 These reading lists are products of convenience, which means that they emphasize my own work and the work of close colleagues; there is certainly a Stanford and then American bias to these lists. They are not intended to be exhaustive; they certainly are not intended to establish precedence. It is inevitable that I have omitted many excellent and important citations, and apologies are hereby tendered to anyone offended. Preface xvii range of applications that can be found in the literature; I hope that the reader, having digested my one example in one context, will be prepared to study other examples and contexts encountered outside this book. And I have not tried to diversify among topics. Some economy is achieved by using related examples (many of which I draw from the literature on industrial organization), and a book this long should economize whenever and wherever possible. Owing to the limitations of time (and, less importantly, space), I didn't get to a few topics that I would have liked to have included. These fall primarily in the areas of parts IV and V and include: rational expectations with differential information; search; coordination failures; micromodels of market institutions, including auctions; models of political institutions. If ever there is a second edition, perhaps it will be longer still! Insofar as a textbook can have a plot or a story or a message, I believe that this book does; this is not simply a compendium of many interesting and somewhat connected models. It is traditional, I believe, to give a precis of the "message" in the preface. But I have instead moved this to the end of chapter 1 in the hope that more readers will see it there than would see it here. Concerning the ordering of topics, I am greatly undecided on one point (and instructors using this book may wish to undo the decision I settled on). To show applications of game theory as the techniques are developed, it may be sensible to interleave parts m and rv. After finishing chapter 12, go on to the earlier sections of chapter 16. Then take up chapter 17 and, when the game theoretic treatment of signaling is encountered, return to chapter 13. The disadvantage is that this breaks up the "oligopoly story" that runs through part ill; my own experience is that the oligopoly story generates sufficient interest for a first pass through the techniques, and then parts IV and V provide good opport:unities to review the techniques of part ill. More generally, the book is filled with material that various instructors may find peripheral or too detailed for a first course; the course that I have taught, which formed the basis for this book, went from the first page to the last in ten weeks, but covered perhaps a third to a half of what fits between. Most of the chapters come with a set of problems at the end. The serious student should do as many as possible. There are fewer problems per topic than one normally finds in textbooks, and the problems tend to be longer than most textbook problems because they often develop variations on the basic themes that the text doesn't cover. Variations are left to the problems on the principle that "doing" a model is a much better way to learn than reading about the model. A few of these problems require xviii Preface mathematical skills substantially beyond those needed to read the text of the book; the student who completes all the problems will have done extraordinarily well. In teaching a course based on this book, I've supplemented the material here with reading in other, more traditional, texts, and (as importantly) with discussion of a few case studies from the Harvard Business School. I have found particularly valuable: The Oil Tanker Shipping Industry in 1983 (Case #9-384-034) for discussion of perfect competition; GE vs. Westinghouse in Large Thrbine Generators (A), (B), and (C) (#9-380-128,129,130) for discussion of implicit collusion in a noisy environment; The Lincoln Electric Company (#376-028) for discussion of incentives, screening, and nonneoclassical models of the firm; and The Washington Post (A) and (B) (#667-076,077) for discussion of internal organization, implicit contracts, transaction cost economics, and so forth. I am gratefUl to a number of colleagues (some of whom were anonymous reviewers) and students who made helpful comments and suggestions on drafts of this book. 2 It would be impossible to give a comprehensive list, but Dilip Abreu, Anat Admati, David Baron, Elchanan Ben Porath, Ken Binmore, Don Brown, Drew Fudenberg, Oliver Hart, Bengt Holmstrom, David Levine, Nachum Melumad, Andrew McLennan, Paul Milgrom, Barry Nalebuff, John Pencavel, Stefan Reichelstein, Peter Reiss, John Roberts, Ariel Rubinstein, Jos·e Scheinkman, Jean Trrole, Guy Weyns, Jin Whang, Bob Wilson, Mark Wolfson, and especially Alex Benos, Marco Li Calzi, and Janet Spitz deserve special mention. I am also grateful to Vrrginia Barker, who copy-edited the book with skill and grace, and to Jack Repcheck of the Princeton University Press for his unflagging efforts in the preparation of this book and for his confidence in it, even when confronted with the possibility of yet another unexpected hundred pages. It goes without saying that most of what is contained here I learned from and with many teachers, colleagues, and students. The list of such individuals is much too long to give here, so I will refrain except to note my obvious debt to Robert Wilson and to thank him and all of the rest of you. Note: For the addendum to the second and subsequent printings, see pages 817-18. 2 Many of the reviewers will be unhappy that I didn't more directly address their criticisms. But let me take this opportunity to assure them that I took those criticisms to heart, and I think they all helped make this a far better book. A course in microeconomic theory chapter one An overview This opening chapter sets out some basic concepts and philosophy for the rest of the book. In particular, we address four questions: What are the basic categories :in microeconomic theory? What are the purposes of microeconomic theory? How does one's purpose influence the levels of scope, detail, and emphasis :in one's model? How will the development of the theory proceed :in this book? 1.1. The basic categories: Actors, behavior, institutions, and equilibrium Microeconomic theory: concerns t:l:!_eQ;>ehavior of~dividual economic\ I.(act9rs_and the·~gregati~__9f ~eh.:_~ction5 ~ diff~r_~i}ns_t!futional fraffiE;. works. This one-sentence description :introduces four categories: The :in-· , dividual(qctor~ traditionally either a_£~~1Eller_CQP_~~~ theCJ!!Jz_apjor 9j_ 1 the actor, traditionally(1J.tilitv(:naximization by consum~rs and_~rofit(m'!X-. i ~ation by firms; a!! in~Jj~JjE_nal fiame'U!_~rk, which describes what( options t!"te_!n<:!J.Y!dl.lal act()~_~ye and -~hat<putC_()_!!l~? they(receiv~ as i\..~!!on \ 1 ·of the actions of others, traditionall...
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