Chapter 1: Microeconomics: a Working Methodology

Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton

Lecture Suggestions

Chapter 1: Microeconomics: A Working Methodology

For Chapter 1 we suggest you use Experiment 1 in conjunction with end-of-chapter exercise 9 as the basis for a good introductory lecture that illustrates the notions of equilibrium, Pareto-optimality, and comparative statics. In addition, by drawing out the features of some real economic problems that are captured by the experiment and the exercise, the lecture is a nice introduction to model building and experimental economics.

The experiment will take no more than five or ten minutes to conduct, if you ask students to indicate their choices by raising their hands and then record their aggregate response on the blackboard. Each student is asked to imagine that he or she is one of five students playing the following game. The game host gives each of the five students $90, with instructions to either keep the $90 or put it in an envelope. The host promises to collect the five envelopes and to create a common pool of money which will be distributed equally among the five students. For every $90 found in an envelope, the host promises to add $60 and to put it all in the common pool.

The experiment captures the essence of common property problems of the sort that are discussed throughout Chapter 1. (See especially the discussion in Section 1.2.) For example, it mimics a two-period common property fishery in which (i) each individual initially has 90 fish in a private pen; (ii) a fish returned to the open ocean "today" produces 5/3 fish "tomorrow"; (iii) a fish today is a perfect substitute for a fish tomorrow. The experiment highlights the very limited incentive that individual fishers have to permit fish to escape their nets today so they can reproduce and sustain the fishery. And it captures the essential feature of the common pool problem that arises in the extraction of oil from a reservoir by a number of independent producers under the rule of capture. The essence of the common pool problem is that a too rapid rate of extraction diminishes the total amount of oil that can be extracted form the reservoir.

In Experiment 1, a selfish student's dominant strategy is to keep the $90. That is, regardless of what the other four players do, a student maximizes his or her own payoff by keeping the $90: if the student keeps the $90 he or she is richer by $90; if the student puts the $90 in the common pool, he or she is richer by $30 (equal to (90 +

60)/5). This equilibrium is not Pareto-optimal since, if all students put $90 in the common pool instead of keeping it, there would be $750 in the common pool and all students would be richer by $150. Based on past experience with this experiment, you can expect something like 85% of students to choose the dominant strategy.

The following payoff matrix is one way to convey these results. The entries in the body of the matrix are the payoffs of a representative player. Rows correspond to the representative player's strategies—"keep" or "put"—and columns to the number of other players choosing "put".

Payoffs in the Common Property Game

0 I 2 3 4

Keep 90 120 150 180 210

Put 30 60 90 120 150

In Experiment 1 students are also asked to imagine that they are in an environment in which (i) all students must choose the same action (all keep the $90, or all put the $90 in their envelopes), and (ii) the action is determined by a majority vote of the students. In this institutional environment, a selfish student's (weakly) dominant strategy is to cast a vote in favor of forcing all students to put $90 in the envelope (since each student is richer by $150 if all put $90 in the common pool, and each is richer by only $90 if, instead, each keeps $90). This comparative static exercise captures the spirit of the unitization schemes that were devised by most of the oil producing states to solve the common pool problem—these schemes, in effect, allowed a majority of the producers pumping oil form a particular reservoir to devise a unitized extraction plan for the whole reservoir.

The payoffs of a representative player in this majority rules voting game are presented in the following table. Rows correspond to the representative player's strategy—"all keep" or "all put"—and columns correspond to the number of other players who choose "all keep".

Payoffs for Majority Voting Game

0 1 2 3 4

all keep 90 90 90 150 150

all put 90 90 150 150 150

Experiment 2 in conjunction with the appendix to Chapter 1, can be used to produce an additional (or an alternative) introductory lecture that focuses on model building. Experiment 2 is an imaginary game involving two players, and a host. Player One first chooses a 1, 2, 3, 4, or 5. Then, knowing Player One's choice, Player Two then chooses one of the same five integers. The host then randomly chooses one of these five integers (from a uniform probability distribution), and pays $100 to the player whose chosen integer is closest to the one randomly picked by the host. If the two chosen integers are equally close, then the host pays each player $50.

If players are assumed to maximize expected payoff, then it is easy to see that the equilibrium of the game is for both to choose the integer 3. The logic of the exercise is quite interesting because it illustrates how to take a rational approach to sequential decision making. To make a rational choice, Player One must anticipate Player Two's choice. Player One will reason as follows. If I choose 1 (respectively, 5), then Player Two will rationally choose 2 (respectively 4), because by doing so Player Two maximizes his or her expected payoff. Therefore, if I choose 1, my expected payoff is $20. If I choose 2 or 4, then Player Two will rationally choose 3, and my expected payoff will be $40. If I choose 3, then Player Two will rationally choose 3, and my expected payoff will be $50. Therefore, to maximize my expected payoff, I will choose 3. In equilibrium, Player Two also chooses 3.

Chapter 2: A Theory of Preferences

For Chapter 2, we have two suggested lectures: one concerning the rudiments of the economist's theory of preferences and the other concerning the way in which economists use the theory of preferences to attack various problems.

Using experiment 2 in conjunction with the material in Section 2.1 is an effective way to show why economists need a theory of preferences and to introduce the rudiments of the standard theory of preferences. In the experiment, students are asked make a number of binary comparisons regarding a one-week, all-expenses-paid vacation in a

Copyright © 2012 Pearson Canada Inc. 4 variety of cities. For example, would the student prefer Aspen to London, London to Aspen, or are they indifferent between these destinations. The experiment is structured so that students have the opportunity to display preferences that violate both the two- term and three-term consistency assumptions. In a group of 50 students, one usually finds one or two students whose preference statements violate the three-term consistency (transitivity) assumption and once in a while a student's preference statements violate the two-term consistency (reflexivity) assumption. The experiment serves three purposes. (i) It illustrates the need for a theory of preferences—a theory of choice cannot easily be built without a theory of preferences. (ii) With a little massaging, it suggests all three of the fundamental axioms of the standard theory of choice (discussed in detail in Section 2.1). (iii) It alerts the student to the fact that real preferences will sometimes be inconsistent with the theory.

It is very important—but not very easy—to convey to students just how flexible, powerful, and pervasive the theory of preferences is in economics. The chapter contains a number of examples that demonstrate the general applicability of ideas such as maximization, substitution, and diminishing marginal rates of substitution. To motivate the student it is often useful to ask the class “What type of behavior would be inconsistent with, say, substitution.” Students invariably say things like “I would never trade off my life or my friend’s life for anything.” Once this has been stated you can start to probe the student’s behavior. Have the ever sped in a car, consumed too much alcohol, or accepted a dangerous job for more money. Students will usually admit that their own behavior does not conform to their assertions. In the book we look at a number of specific applications that address the basic assumptions of preferences and give students some feeling for the way in which economists use the theory of preferences. Many of the Exercises try to get students more directly into the act as well. A lecture based on theses applications and end-of-chapter exercises will give students an appreciation of the central role of preferences in economics.

Chapter 3: Demand Theory

One of the key ideas in this chapter is that—given an individual's preferences, and the hypothesis that the individual is a utility-maximizer—that individual's behavior can be described by finding his or her demand functions—the functions that tell us what quantities the individual will demand, given any values of the exogenous variables ( p1,

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton p2 , and M). The more general idea is that the endogenous variables in a problem (in this case quantities demanded consumption goods) are determined by the exogenous variables (in this case prices and income). Because this idea occurs in all maximizing (or minimizing) models, it is worth exploring in some detail. In these notes we examine four tractable utility functions: perfect substitutes, perfect complements, hierarchical preferences, and Cobb-Douglas preferences. We first examine the intuition behind the utility functions themselves—what sort of preferences do they capture or approximate? We then derive the associated demand functions, and provide an intuitive understanding of just how the prescribed behavior does, in fact, solve the utility maximizing problem.

Of course, these four utility functions and their associated demand functions can be used in a number of other contexts as well—for example, to illustrate the no-money- illusion properties of demand functions. You can also produce a number of useful problems by looking at variations of these functional forms.

Perfect substitutes: is, perhaps, the easiest case. Here we suggest that you use the example of Anna's preferences for salmon and trout, which is developed in the textbook.

The utility function is U(x1,x2) = x1 + x2, where x1 is pounds of trout and x2 is pounds of salmon. In contrast to the development in the textbook, we suggest that you use a graphic approach. First, draw the indifference map, and then explain that the slope of an indifference curve is -1 (and therefore MRS is 1) because Anna is always willing to swap one more pound of salmon for one less pound of trout. Then suppose p1 is less than p2 and add the budget line to the figure, observing that the budget line is flatter than the indifference curves. Then, solve the utility maximizing problem by picking the bundle on the budget line that lies on the highest indifference curve, and record the result algebraically:

If p1 < p2, then x1* = M/p1 and x2* = 0.

Next, suppose that p2 is less than p1 and repeat the exercise to get the following.

If p2 < p1, then x2* = M/p2 and x1 = 0.

Next, suppose the prices are equal and show that any bundle on the budget line solves the utility maximizing problem because the budget line is coincident with an indifference curve. Finally, provide an intuitive explanation of why the behavior prescribed by these demand functions solves Amy's utility-maximizing problem. Because a pound of salmon

Copyright © 2012 Pearson Canada Inc. 6 is a perfect substitute for a pound of trout, Amy spends all of her budget for fish on (1) trout, if trout is cheaper than salmon, and (2) salmon, if salmon is cheaper than trout. You may want to provide more examples of cases in which this formulation of preferences is appropriate. For example, the fact that some undergraduates always buy the cheapest available brand of beer is consistent with this case of perfect substitutes.

Perfect complements: is perhaps the next-easiest case. In-chapter Problem 3.4 examines this case. We suggest that you interpret x1 and x2 as the number of right and left shoes, and explain why this mathematical formulation is a sensible description of preferences for right and left shoes. Again we suggest that you solve the problem graphically by first drawing a number of indifference curves and then drawing the budget line. Then write out the algebraic description of the solution, and give an intuitive explanation of why the prescribed behavior solves the utility maximizing problem. Finally, you might want to observe that this simple theory answers the question: Why are shoes sold in pairs? Alternatively, why are the two resins used to make epoxy glue packaged together and sold as one unit?

Hierarchical preferences: provide the third, but more difficult case: U(F,T) is F if F 100 and is T if F > 100, where F is pounds of food and T is yards of textiles. It is first useful to give an intuitive explanation of these preferences in terms of a hierarchy of needs. Here, too, we suggest that you develop a graphic solution. First, draw the indifference map. Then assume that 100pF > M (the person does not have enough money to buy 100 pounds of food), draw the budget line, and solve the utility-maximizing problem graphically. It is worthwhile to observe what happens to the solution as pT changes

(nothing), as M decreases or pF increases (the person continues to spend all his or her income if food.. Next, record the result algebraically:

If 100pF > M, then F* = M/pF and T* = O.

Next, assume that 100pF  M, and construct the appropriate graphic solution. Let pF or pT decrease, or M increase and observe that consumption of food does not change, while consumption of textiles increases. Record results algebraically:

If 100pF  M, then F* = 100 and T* = (M - lOOpF)/pF.

Finally, provide an intuitive explanation of why this behavior solves the utility maximizing problem.

Cobb-Douglas preferences: are the last case. It is worth developing this case—not so much for its intuitive appeal—but because the solution to the utility-maximizing problem is an interior solution. The problem is, of course, to get an expression for MRS. The following Cobb-Douglas utility function is one case for which MRS can be derived without resorting to calculus:

U(x1,x2) = x1x2

To derive MRS you should use a diagram analogous to Figure 2.5 in conjunction with the following algebraic argument. Suppose the individual initially has bundle (xl,X2) and let u denote the corresponding utility number; that is, u = xlx2. Now ask what increase x in quantity of good 2 will substitute for decrease x1 quantity of good 1. Since the original bundle (x1,x2) is associated with utility number u, so, too, is the bundle

(x1 - x1,x2 + x2); that is,

(x1 - x1(x2 + x2) = u

In other words,

(x1 - x1(x2 +x2) = x1x2

Solving this expression for x2, we get

x2 = x2 x1/(x1 - x)

Now, to get MRS, form the ratio x2/x1 and let x1 approach 0

MRS = x2/x1

Then use this expression for MRS in conjunction with the characterization of an interior solution to get the demand functions:

x* = M/2p1 and x2* = M/2p2

Finally, provide an intuitive interpretation of these demand functions: the individual spends half of his or her income on good 1 and half on good 2. You may also want to, as it were, "wave your hand," to generalize this result. If the utility function is

a( 1 - a U(x1,x2) = (x1) (x1) , then to maximize utility spend a% of income on good 1 and

(1 - a)% on good 2.

Once students have grasped that demand functions are the result of utility maximizing behavior, another lecture can be spent on the subject of elasticity and how to describe various demand curves.

Chapter 4: More Demand Theory

The focus on Chapter 3 was on deriving demand functions from utility functions and showing how each individual assumption made about preferences has implications for demand functions. For example, the application based on advertising, shows how demand functions reflect the cost minimizing choices made by consumers. Chapter 4 considers more advanced topics in demand, and more applications. Several lectures can follow from Chapter 4.

Once students have understood the technique of moving from indifference curves to demand curves, they usually begin to ask questions that they feel are inconsistent with the notion of downward sloping demands. For example, “why do expensive perfumes sell better than cheap perfumes” or “why do people continue to buy stocks when the price increases.” Most of these questions revolve around confusions over relative prices, the nature of the good, and the concept of real income. The first section of the chapter is devoted to dealing with these issues.

Discussing potential objections to the law of demand naturally leads to a discussion of income and substitution effects caused by a price change. The most difficult aspect here is to convince students that there is a change in real income even though nominal income remains constant. A useful exercise is to go through the graphs in the text, and after each one, have the students do the same procedure by in terms of either an opposite movement in price or in terms of good 2. For example, in the text the income and substitution effect are done for a fall in the price of good 1. Simply have the class conduct the thought experiment in terms of a rise in the price of good 1.

Once you have covered the consumer surplus techniques you can use them to draw together three pieces of analysis from Chapter 3 and 4: the pricing problem for a nonprofit dining club, the Polaroid pricing dilemma, and the demonstration that a lump- sum tax is preferred to an excise tax that raises equal revenue. In order to use

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton consumer surplus techniques, we suppose there are no income effects on the demand for the good in question (meals in the club, the number of Polaroid snapshots, the good on which an excise tax is imposed).

Consider Exercise 20 from Chapter 3 where a private, nonprofit dining club (in which all members have the same preferences) that produces meals at a constant marginal cost of $50 per meal, has a fixed overhead cost equal to $1,000 per member per year. We want to show the student that in order to maximize welfare of the representative club member, the club will choose what we can call a membership fee scheme (charge its members an annual membership fee of $1,000 and sell meals at their $50 marginal cost) in preference to what we can call a mark-up scheme (charge a price greater than $50 such that profit per member is $1,000 per year). The representative member's demand curve is the curve CDF in Figure L1. Distance 0A is equal to the $50 marginal cost. By construction, the shaded area is equal to $1,000. Hence, under the mark-up scheme, the club would sell meals at a price equal to distance OB, and each member would buy x' meals. Notice that the annual value of club membership under the mark-up scheme is the area of triangle BCD. In contrast, the value to the club member of the right to buy meals at the $50 marginal cost is the area of triangle ACF. Once the $1,000 annual membership fee is subtracted from this area, we see that the annual value of club membership under the membership fee scheme is the sum of areas BCD and DEF. In other words, relative to the mark-up scheme, the benefit to the club member of the membership fee scheme is the area of triangle DEF.

More generally, the membership fee scheme is the optimal scheme, given that the club must cover its costs. One way to see this result is to think of the member as an owner- manager of an enterprise in which he or she can produce meals at a cost of $50 per meal for his or her private use. Given the opportunity to produce meals at $50, the member will produce and eat x* meals. Of course, the value of the privilege to produce meals for private use at a cost of $50 per meal is triangular area ACF. Since ACF exceeds $1,000, the prospective club member will be more than willing to pay the $1,000 membership fee. (We have not illustrated one interesting wrinkle—the case in which it is impossible to recover the overhead cost under the mark-up scheme, and yet, under the optimal scheme, the prospective member is willing to pay the $1,000 membership fee.)

The analysis of the club problem in the previous paragraph reveals a deep similarity between that problem and the Polaroid pricing dilemma. If we interpret Figure LI as a

Polaroid pricing dilemma, then distance 0A is the marginal cost of film, and the price at which Polaroid will sell its film. It will sell its camera at a price equal to the triangular area ACF. In both problems there is a constant marginal cost and, in the solution to both problems, the optimal price per unit is set equal to the constant marginal cost. In effect, this price maximizes the benefit to the consumer of the ability to produce the good in question at the constant marginal cost. The major difference between the two problems concerns the distribution of the maximized benefit. In the not-for-profit dining club, the club member gets the benefit as consumer's surplus, while in the Polaroid pricing dilemma the monopolist gets the benefit as profit.

To tackle the comparison of an excise tax with a lump sum tax which raises equal revenue, interpret distance 0A in Figure L1 as the price of the good in question, distance AB as the magnitude of the excise tax, and the shaded area as the amount of excise tax paid. Then triangular area DEF can be interpreted as a measure of the benefit to the consumer of switching from the excise tax to a $1,000 lump-sum tax.

One final lecture that follows from chapter 4 is the difference between total value and marginal value. Going over these notions provides a chance to review concepts like marginal rates of substitution, optimization, and consumer’s surplus. More importantly, though, the ideas of TV and MV are very intuitive for students and they easily find examples of their inverse relationship in their own life.

Chapter 5: Intertemporal Decision Making and Capital Values

Exercise 2 at the end of Chapter 5, in conjunction with the material in Section 5.1, can be used to produce a very good lecture on the separation theorem. In exercise 2, Sarah has been given a choice between two inheritance packages—Package B is front- loaded, and Package A is back-loaded. Begin with part c of the exercise where the deposit rate of interest is 0% and the borrowing rate is 100%. First, construct the budget lines associated with these two packages. Then use the diagram to observe that the future value of Package A exceeds the future value of Package B, while the present value of Package B exceeds the present value of Package A. Now introduce preferences in which Sarah has a constant MRS of future consumption for present consumption, and show that if Sarah's MRS is "large," she will choose Package A, while if her MRS is "small," she will choose Package B. In short, her choice of an inheritance

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton package cannot be separated from her preferences. Now turn to part a, where the deposit and borrowing rates of interest are identical, and show that her choice of an inheritance bundle can be separated from her preferences. This leads naturally to a statement of the separation theorem.

This way of approaching the separation theorem shows clearly the tremendous simplification that arises when the borrowing and deposit rates are identical. Of course, students will recognize that, as a matter of fact, the borrowing rate exceeds the lending rate. So this lecture provides a good opportunity to discuss the role of simplifying assumptions in economic theory.

Chapter 6: Production and Cost: One Variable Input

In Section 6.1, we derive a Cobb-Douglas production function that is used throughout Chapters 6 and 7 to illustrate almost all of the concepts that arise in the two chapters. We look at a production function for a courier firm that owns one truck. The variable inputs are gas and a driver's time, and output is measured in kilometers. We suppose that kilometers per litre is inversely proportional to the speed at which the truck is driven. As we show in Section 6.1, this assumption gives rise to a constant-returns-to- scale Cobb-Douglas production function. It is worthwhile to look through the chapters to see how this production function can be used to illustrate key concepts that arise in the two chapters. Further, this production function illustrates a trade-off that is universal in transportation economics, the trade-off between labor and energy. In effect, more speed allows one to substitute energy for labor (and to some extent for capital as well).

If you enjoy talking about rent dissipation in common property situations, you can discuss the following problem and then relate it to the complementary model of traffic congestion discussed in the chapter. In the exercise, there are two fisheries—an ocean fishery in which there is a constant catch per unit of effort (equal to 100 fish per fisherman per day) and a lake fishery in which there is a diminishing marginal catch. The total catch function for the lake fishery is y = lO00zl/2 where z is number of fisherman and y is total number offish caught. Unfortunately, there is no simple non-calculus argument that we have found to derive the marginal catch

At the end of the day, each fisher on the lake has caught the average product of fish, and the harvest of fish from the lake is therefore equitably distributed among the fishers. Suppose there are 150 fishers on the island. From here you can discuss how calculate the marginal and average products; what happens if everyone fishes in the ocean, if everyone fishes in the lake; what level of fishing maximizes the total take; what the outcome is if no one owns the lake, if it is owned collectively, or privately. Etc.

This exercise is designed to illustrate (i) the total dissipation of the potential value of the lake when fishermen have common access to the two fisheries, (ii) the optimal allocation of fishers to the two fisheries, and (iii) how the optimal allocation can be achieved under alternative institutional arrangements, including private property and a tax on fish caught. The point of doing something like this is to show the student that there is some potential value in deriving marginal products beyond simply finding cost curves.

Chapter 7: Production and Cost: Many Variable Inputs

Problem 7.4 can used as the basis for a good lecture on the physical basis and cost implications of increasing returns. In these problems, fenced pasture land, measured in square feet, is the output being produced. For simplicity, all fenced pastures are squares. The inputs are land, also measured in square feet, and barbed wire, measured in linear feet. Given z1 square feet of land, one can produce a fenced pasture no larger than z1 square feet. And given z2 linear feet of barbed wire, one can fence a pasture no 2 larger than (z2/4) square feet. (Here we are assuming that a foot of barbed wire will produce a foot of fence.) Hence, the production function is

2 y = min[z1, (z2/4) )

Problem 7.4 examines returns to scale for this production function. There are, of course, constant returns to scale when there is excess barbed wire and increasing returns to scale when there is excess land.

This simple example is illustrative of a large class of problems where there are increasing returns to scale for essentially physical reasons. Another interesting example is the pipeline. The following is a simplified version of the problem that captures the relationship between oil transported and two inputs, land and the steel used to produce the pipe. (We are ignoring a number of other inputs) We will think of producing a pipeline that is one mile long. A pipeline typically has an access road used for construction and maintenance which we will take to be 16 feet wide. And, of course, there must be land on which to build the pipeline. A pipeline of diameter D will then require a strip of land of width 16 + D feet. To produce a pipe of diameter D, we need a sheet of steel of width D (the circumference of a circle of diameter D). The quantity of oil that will flow through the pipeline is approximately proportional to the area of a cross section of the pipe. If we choose units correctly, then output—that is, quantity of oil transported—for a pipeline of diameter D is equal to (D/2)2, the area of a cross section of a pipe of diameter D. Now suppose we have a strip of land that is one mile long and L feet wide, and a sheet of steel that is one mile long and S feet wide. Given the strip of land, the maximum amount of oil that can be transported is 0 if L is less than 16, and is ((L-16)/2)2 if L is greater than 16. Given the sheet of steel, the maximum amount of oil that can be transported is (S/2)2. We can then write the production function as y = 0 if L < 16 y = min[((L - 16)/2)2, (S/2)2] if L  16

The associated cost function is

C(y, wL, wS) = 0 if y = 0

1/2 C(y, wL, wS) = 16wL + 2(y/) (wL + wS) if y > 0 where the unit of land is a strip one mile long and a foot wide, and the unit of steel is a strip one mile long and a foot wide.

Chapter 8: The Theory of Perfect Competition

Sections 8.1 and 8.2 of the text in combination with either Experiment 3 or Experiment 4 can be used to provide a good introduction to the theory of competitive markets and to the robustness of the theory. Sections 8.1 and 8.2 focus a partial equilibrium exchange

Copyright © 2012 Pearson Canada Inc. 14 economy in which students buy and sell tickets to a concert. In Experiments 3 and 4, students buy and sell "magic paper clips". As the experimenter, you can choose students' reservation demand and supply prices for the magic paper clips, and compute the associated competitive equilibrium. You can then compare quantity actually exchanged and the average price received in the experiment with the predictions of the competitive model.

Experiment 4 employs a double-oral auction to effect trades. There are a large number of experiments using this institution, some of which are discussed in Section 8.2. In a typical class, this institution produces results that are remarkably similar to the predictions of the competitive model.

Experiment 3 uses a casual trading mechanism—students simply circulate around the classroom trying to buy and sell magic paper clips. The casual trading institution is perhaps more interesting. None of the assumptions of the competitive model are satisfied and yet, in a typical class, the results of this experiment are also remarkably similar to the predictions of the competitive model.

These experiments are more time-consuming than the others in this manual. You will need perhaps an hour to prepare for the experiments and to conduct them you will need up to half an hour of class time. Nevertheless, they are worthwhile, since they give the student the chance to see at first hand the surprising power of an abstract and apparently unrealistic theory.

Chapter 9: Applications of the Competitive Model

The most basic tool in an economist’s tool kit is the competitive model. It is always worthwhile devoting at least one lecture to discussing applications of this model. Students are often impressed if you bring in a copy of the current local newspaper and reveal how the model is alive in many of the stories reported.

One suggestion for a lecture is to take the cold climate warm houses example, and convert it to an air conditioning question. Or you could assume that you are a landlord who owns two apartments, and must decide how warm to keep them. Let’s discuss the latter.

The first issue is to recognize that the amount of rent paid for the apartment will depend on the temperature inside. Suppose at a temperature of 23 degrees you can get $600/month for the apartment. How much is the tenant willing to pay to increase the heat in the apartment to 25 degrees? The area under his demand curve between 23 and 25 degrees. Now ask your students, should you offer better heated apartments and charge a higher rent, or should you offer cooler homes with a lower rent? At this point you can remind the student of the Polaroid camera example and the general principle of two part tariffs. You can make the issue more interesting by assuming the tenants are different in their tastes for heat or that the apartments are different in the cost of heating.

Another fun application of the competitive model is to use some of the Gary Becker applications to the family. Assume that you have a model in which men demand one wife and women demand one husband. In such a model the supply of one spouse is the inverse of the demand for the other. Depending on the relative demand and supply curves you either get a positive, negative, or zero price for a husband (wife). Once an equilibrium has been found, introduce the custom of (voluntary) polygamy, and ask if the students think this would make women better or worse off. Then show how polygamy causes the demand for wives to increase and results in an increased transfer to women, making them better off. You might point out that the opposition to polygamy in the US came from males living outside of Utah! Depending on how far you want to go with this type of analysis you can discuss other things that might alter the male to female ratio in the marriage market, and discuss how these transfers might take place in a country like Canada where there are no official prices for spouses. For example, wars tend to have a drastic effect on the number of men relative to women of marrying age, causing a rise in the transfer to men. Changes in the birth rate over the 20th century and the fact that women tend to marry older men has caused other changes in this ratio. Using an example like this allows an opportunity to discuss the nature of economics and its potential limits.

Chapter 10: Monopoly

The suggested lecture uses the patent model in Section 10.10 to develop an understanding of the need for trading off one policy objective against another when the number of instruments available to a policy maker is less than the number of objectives the policy maker would like to achieve. (This is, of course, a well known problem in

Copyright © 2012 Pearson Canada Inc. 16 macroeconomics and in regulatory economics. We discuss some of these regulatory problems in the context of the environment in Chapter 18.) In our model of patents, there are a number of ideas for valuable new products lodged in the minds of developers. Associated with each product is a development cost and what we call an imitation lag—the period of time it would take other firms to imitate the product. We use this model to illustrate the appropriability problem and to show the way how a patent can solve the appropriability problem by providing a period of monopoly that is long enough for the developer to recover his or her development cost. Most importantly, we develop in some detail the nasty trade-off between the deadweight loss from monopoly pricing and the need to solve different developers' appropriability problems when only one instrument—the length of the patent period—is available to the policy maker.

Chapter 11: Input Markets and the Allocation of Resources

Here we have two suggestions for your lectures. Problems 11.13 and 11.14 can be used to draw out all of the important points regarding monopsony. Both draw on the same set-up in which coal suppliers, all of whom have a common reservation price, are spread out along a 1000-mile-long railroad line. Differential transportation costs associated with different distances from coal demanders give rise to monopsony power for demanders. In Problems 11.13 and 11.14, a single coal demander is located at one end of the line. Problem 11.13 concerns the standard monopsony equilibrium. It can used to illustrate not only the equilibrium, but also the fact that the equilibrium is not efficient and that the monopsonist fails to extract maximum profit form this market. Problem 11.14, which is concerned with a perfectly-discriminating monopsonist, addresses both of these issues.

In addition, exercises 5 and 6 can be used to produce a good lecture on bilateral monopoly. Exercise 5 introduces the topic in an abstract framework, and exercise 6 is concerned with the application of the topic to a particular market for agricultural labor.

Chapter 13: Competitive General Equilibrium

Problems 13.9 and 13.10 in conjunction with exercises 1, 2 and 3 can be used to put the first theorem of welfare economics in perspective and to introduce the student to

Pigovian taxes and subsidies. Attention is naturally drawn to the "then" portion of the first theorem—"then the competitive general equilibrium is Pareto-optimal." These problems and exercises draw attention to the "if' portion of the theorem—"if no awkward problems arise." Focusing on the "if' portion of the theorem helps to put the theorem itself in perspective, and it raises the policy problems that concerned Pigou. Problem 13.9 and exercise 1 focus on the standard monopoly distortion, while Problem 13.10 and exercise 2 looks at distortionary taxes, exercise 3 looks at monopsony.

Chapter 14: Price Discrimination and Monopoly Practices

You can use the following problem to illustrate and integrate the fundamental points of price discrimination in a simple and penetrating way. Suppose that some book vendor can produce a book at a constant marginal cost of $8 and that 11 potential buyers have the following reservation prices: $55, $50, $45, … $5. Each will buy the book at any price less than or equal to his or her reservation price.

1. If the book vendor must announce a take it-or-leave it price, what price maximizes profit? What quantity will be sold, and what are the book vendor’s profits? Are there unrealized gains from trade?

2. Suppose that the book vendor knows what each potential buyer’s reservation price actually is and that those buyers are completely isolated from each other. The vendor can then set an individual price for each buyer. How many books will it sell? At what price will it sell each book? What are its profits?

The problem specifies reservation prices for 11 potential buyers for a certain book. The publisher can produce the book at a constant marginal cost. Using this set-up, you can easily illustrate the following points: (i) Marginal revenues is less than price. (ii) The ordinary monopoly equilibrium is inefficient, since the gains form trade are not exhausted. (iii) To achieve efficiency, books must be sold up to the point where price is equal to marginal cost. (iv) The fact that the gains form trade are not exhausted in the ordinary monopoly equilibrium means that there are unrealized opportunities for profit. (v) Hence, a sophisticated monopolist will look for ways to increase profit via price discrimination. (To illustrate this possibility, it would be useful to divide the group of 11 buyers into two subgroups and then compute the discriminatory prices for these subgroups.) (vi) Finally, the set-up can be used to illustrate the efficient regulatory

Price discrimination is often quite foreign to students, but other forms of compound pricing are not. In this chapter the two-part tariff is analyzed once again, and students are quick to point out that drinks at local night clubs that charge an entry fee do not appear to be sold at marginal cost. This naturally leads to the discussion of tie-in sales and the role different types of consumers play. Finally, students love the section on the exploitation of affection. By using economics to explain something so basic seems to leave a great impression on students.

Chapter 15: Introduction to Game Theory

Students find it hard to switch gears with game theory. They don’t understand why a different set of tools are necessary. Part of the job of the instructor then is to teach the fundamental differences in the problems, and to show how many concepts are not that new. Thus spending time on daily issues convinces students the relevance of game theory in their own lives, and showing how a competitive equilibrium is also a Nash equilibrium also helps ease their minds. Problems 5, 6, and 9 in the back of the book have extensive solutions in this manual. They can easily be used to motivate the lectures.

In addition, experiment 5 can be used in conjunction with Section 15.1 to provide a good introductory lecture on game theory. The experiment nicely illustrates the basic concepts of game theory—strategy, strategy combination, payoff, best response function, and Nash equilibrium strategy combination. In addition, the results from this experiment provide an empirical test of Nash equilibrium (and of dominant strategy equilibrium).

The experiment entails two versions of the Prisoners' Dilemma game. In both versions, the Nash equilibrium payoffs are $100 per player, whereas they are $200 per player if both players choose what amounts to the cooperative strategy. The difference between the two versions lies in the incentive in each version to play the non-cooperative strategy as opposed to the cooperative strategy. In Version 1, regardless of which strategy the other player chooses, a player's payoff is $80 larger if that player chooses the non-cooperative strategy. In contrast, in Version 2, the incentive to play the non-

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton cooperative strategy in preference to the cooperative strategy is just $10. Corresponding to these differences, in Version 1 the vast majority of players choose the non-cooperative strategy, while in Version 2 a significant number of players choose the cooperative strategy.

Chapter 17: Choice Making Under Uncertainty

This lecture, which draws on the Exercise A of this manual and either (or both) experiment 6 or experiment 7, is designed to develop the student's understanding of the expected utility approach, to illustrate the strong predictions that come out of the model, and to generate some experimental data that can be used to put the approach in perspective. You may want to conduct the experiment(s) at the end of one lecture, and discuss exercise 5 and the results of the experiment in the next. It is useful either to assign exercise A for the following lecture or to alert students to look at exercise A before the following lecture.

Exercise A concerns preference orderings for risky prospects in which there are three possible prizes—$10, $5, and $1. It is useful for a several purposes. First, it illustrates how the expected utility approach is used. In the context of this exercise, one von Neumann-Morgenstern utility function for an individual is U(10) = 1, U(5) e*, and U(1) = 0, where e* is a person-specific utility number that is less than 1 and greater than 0. The expected utilities of prospects A, B, and C in exercise 6 are, respectively, 1/3 + e*/3, 1/2, and 3e*/4. Under the expected utility approach, the preference ordering "C is preferred to A is preferred to B", requires (i) that 3e*/4 > 1/3 + e*/3, or that e* > 4/5, and (ii) that 1/3 + e*/3 > 1/2, or that e* > 1/2. Therefore, any expected-utility-maximizer for whom e* > 4/5 would express this preference ordering.

Exercise A also illustrates the strong, testable predictions that come out of the theory. For example, the preference ordering "C preferred to B preferred to A" requires (i) that 3e* > 1/2, or that e* > 2/3, and (ii) that 1/2 > 1/3 + e*/3, or that e* < 1/2. Since it is impossible to satisfy both inequalities, this preference ordering is inconsistent with expected utility theory.

Finally, the exercise also provides a concrete illustration of the meaning of risk neutrality, risk aversion, and risk inclination. Prospect (p,0,1 - p: 10,5,0) has an expected value of 5 when p = 4/9. Then, by definition, an individual is risk neutral if he

Copyright © 2012 Pearson Canada Inc. 20 or she is indifferent between (4/9,0,5/9:10,5,1) and (0,1,0:10,5,1). Since the expected utility of the first of these prospects is 4/9 and the expected utility of the second is e*, we see that for a risk-neutral person, e* is 4/9. Values ore* greater than 4/9 are consistent with risk aversion, and values less than 4/9 are consistent with risk inclination.

Experiment 6 is designed to illustrate the extent to which expected utility theory is consistent with real choice behavior. It asks students to write down their preference ordering for four risky prospects that involve just three possible prizes. The techniques used to answer exercise A can then be used to sort out results for this experiment. There are 49 possible preference orderings over the four prospects, 11 of which are consistent with expected utility theory, and 38 of which are inconsistent. If' preference orderings were uniformly distributed over the 49 possibilities, one would expect roughly a fifth (22.5%) to be consistent with expected utility theory. In discussing the results, begin by picking one of the preference orderings that is consistent with expected utility and then calculating the range of implied e* values. Then pick one of the preference orderings that is inconsistent with expected utility and show why it is inconsistent.

Report the number of preference orderings from the experiment that are and are not consistent with the theory. In a typical experiment, roughly 85% of the responses are consistent with the theory—a success rate that is far larger that the 22.5% figure that would arise if preferences were uniformly distributed over the 49 possibilities, indicating that the theory seems to capture important aspects of behavior under uncertainty. Yet, the theory is revealed to be far from perfect since a significant number of reported preference orderings are inconsistent with the theory.

Finally, it is useful to calculate the value of e* for a risk-neutral person—5/9 in Experiment 2. For the preference orderings that are consistent with the theory, it is informative to calculate the fractions that are consistent with risk aversion, risk neutrality, and risk inclination. In a typical class, very few of the preference orderings exhibit risk inclination.

Experiment 7 is more subversive of the theory of excepted utility. Because it is designed to illustrate one of the circumstances in which the theory of expected utility is clearly inconsistent with typical behavior, you can expect most of the data you generate from this experiment to be inconsistent with the theory. If you choose to conduct this experiment, you may want to follow up with a lecture on non-expected utility. Mark Machina's entry in The New Palgrave, titled "the expected-utility hypothesis," is a useful

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton resource for such a lecture (see the bibliography for Chapter 17 for a complete reference.)

Exercise A

Consider the following prospects that offer prizes $10, $5, and $1.

Prospect A (1/3, 1/3, 1/3: 10, 5, 1)

Prospect B (1/2, 0, 1/2: 10, 5, 1)

Prospect C (0, ¾, ¼,:10, 5, 1) a. Let U(10) = and U(1) = 0, and then find U (5) for a risk-neutral person. b. Show that the ordering “C preferred to B preferred to A” is consistent with expected-utility theory. Is this preference ordering associated with risk aversion, risk inclination, or risk neutrality? c. Show that the ordering “B preferred to A preferred to C” is consistent with expected-utility theory. Is this preference ordering associated with risk aversion, risk inclination, or risk neutrality? d. Show that ordering “A preferred to B preferred to C” is inconsistent with expected-utility theory.

Solutions a) U(5) = 4/9 b) “C preferred to A” requires that U(5) > 4/5, and “A preferred to B” requires that U(5) . ½. Hence, for any person with U(5) > 4/5, C is preferred to A which is preferred to B. Such a person is risk-averse since 4/5 exceeds 4/9. c) “B preferred to A” requires that U(5) < ½, and “A preferred to C” requires that U(5) < 4/5. Hence, for any person with U(5) < ½, B is preferred to A which is preferred to C. Such a person could be risk-averse (if 4/9 < U(5) < ½), risk- neutral (if U(5) = 4/9), or risk-inclined (if U(5) < 4/9).

Copyright © 2012 Pearson Canada Inc. 22 d) “B preferred to A” requires that U(5) < ½, and “C preferred to B: requires that U(5) > 2/3. Hence, this preference ordering is inconsistent with expected-utility theory.

Chapter 18: Asymmetric Information, the Rules of the Game, and Externalities

Chapters 18–20 are based on a fundamental difference in assumptions than are the earlier chapters. It is important, when teaching this material, to stress that to assume asymmetric information is not a minor alteration. Asymmetric information allows for the possibility of transaction costs, and an understanding of transaction costs allows the economist to address an entire spectrum of questions that simply do not arise out of the neoclassical model. In introducing this material it is just as important to stress that the neoclassical model is useful, even though it does not explain everything. An analogy to frictionless physics is perhaps useful.

The chapter begins with the classic externality problem articulated by Ronald Coase. It is critical to get across to the student that Coase was making two important points: first in a model of zero transaction costs (the neoclassical, symmetric information case) property rights (the rules of the game) do not matter; however, when transaction costs are positive, then the distribution of property rights does matter.

You might try using Experiment 8 to produce an introductory lecture that raises the important issues of negotiation in a simple context and provides a test of the important hypothesis that when transaction costs are low, individuals bargain to the optimal outcome.

Experiment 8 involves two players, one of whom is randomly given the opportunity to choose one of three integers—1, 2, or 3. That choice determines a payoff for both players. Payoffs are structured so that the players' joint payoff is maximized by a choice of 2, while the private payoff to player A is maximized by a choice of 3 and the private payoff to player B by a choice of 1. Then, in circumstances where the players have no opportunity to negotiate a deal, if given the opportunity to choose the integer, Player A would choose 3 and Player B would choose 1. However, in this experiment, the players do have a chance to negotiate a contract that specifies which integer will be chosen and a side-payment. In the context of this game, the players should agree to a choice of 2

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton and to a side payment that makes both of them at least as well off as they would have been in the absence of a contract.

This set-up can be used to illustrate in a very transparent way the concept of externality, and the property fights solution to the externality problem.

In addition to the experiment, the example of no-fault divorce also provides a useful in class example of the issues brought up by the Coase theorem. Most of the students in class will understand trends in divorce and will recognize the transaction costs that can arise in bargaining over children and other marital assets. A discussion of these issues naturally leads to the definition of transaction costs and to a broader discussion of the general applications.

Chapter 19: The Theory of the Firm

The primary message of this chapter is that different organizational forms are appropriate for different situations. That message is clearest in Figure 19.7 of Chapter 19, where different situations are described by different points in the space of monitoring costs (M) and team productivity (B), and where the parameter space is partitioned into three subsets, such that in each subset, one of the three organizational forms considered in Sections 19.2 through 19.4 Pareto-dominates the other two.

Our suggested lecture is to use exercise 1 to illustrate all of the arguments in Sections 19.2 through 19.4 for a particular utility function, and in particular to accurately develop a figure analogous to Figure 19.7. (You may want to alert students to the fact that you are going to use this lecture to develop the theory of organizational form.) The utility function is the following:

U(e,y) = 8(y - e2/2)

You can begin by using a noncalculus argument to show that MRS of income for leisure is equal to e for this particular utility function. Suppose the individual initially has bundle (e,y) and let u denote the corresponding utility number; that is, u = 8(y - e2/2). Now ask what increase in income y will substitute for an increase in quantity of effort e. Since the original bundle (e,y) is associated with utility number u, so, too, is the bundle (e+e, y+y); that is,

8(y + y - (e + e)2/2) = u

In other words,

8(y + y - (e +e)2/2) = 8(y - e2/2)

Solving this expression for y, we get

y = ee + (e)2/2

Now to get MRS, form the ratio y/e and let e approach 0

MRS = e

Given this result (which is simply asserted in exercise 19.1), just follow the approach outlined in the exercise to produce the relevant diagram. The diagram itself accompanies the answer to exercise 1 of Chapter 19 in the Solutions section of this Instructor's Solutions Manual.

Chapter 20: Asymmetric Information and Market Behaviour

This final chapter provides more examples that follow from the theory developed in chapter 18namely that the method of exchange is determined in light of mitigating transaction costs.

The example of the role of sunk costs and reputation can be used for an entire lecture. Many examples of this type of behavior exit, and students should be encouraged to participate fully in thinking up examples. One can make the model more difficult by asking what would happen if the firms were monopolists, if interest rates went down, or if consumers could not verify the sunk investments.

A separate lecture should be devoted to adverse selection and moral hazard. Two moral hazard applications are easily done in class. The first is the classic Marshallian treatment of share tenancy. Those familiar with this literature know that with just one margin contracted for (labor), too little labor is supplied and the share contract produces too little output. One can easily imagine another margin (say land or capital) that can experience moral hazard as well. Ignoring risk aversion, this allows an opening to

Copyright © 2012 Pearson Canada Inc. Full file at http://TestbankCollege.eu/Solution-Manual-Microeconomics-8th-Edition-Eaton discuss multi-task agency (if the class is up to it). Another fun application of moral hazard is sharing in marriage.

Assume that both spouses contribute to the marriage in terms of time and share in the output of the marriage. Assume also that each spouse has some outside opportunity that provides private consumption. The outcome is that each one will shirk some of their marital duties, depending on what the share is. This model easily allows for a discussion of what the optimal share should be, and can lead to a discussion of what type of spouse (in terms of marginal productivity) would be the bet match for a given individual (in terms of their marginal productivity).