THIRD EDITION THE STRUCTU Of ECONOMICSTHIRD EDITION THE STRUCTURE Of ECONOMICS A MATHEMATICAL ANALYSIS Eugene Silberberg University of Washington Wing Suen University of Hong Kong ! Irwin = tim! McGraw-Hill Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St.Louis Bangkok Bogoté Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei TorontoMcGraw-Hill Higher Education 82 A Division of The McGraw-Hill Companies THE STRUCTURE OF ECONOMICS A Mathematical Analysis International Edition 2001 Exclusive rights by McGraw-Hill Book Co ~ Singapore, for manufacture and export. This book cannot be re-exported from the country to which it is sold by McGraw-Hill. The International Edition is not available in North America, Published by McGraw-Hill, an imprint of The McGraw-Hill Companies, Inc. 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2001, 1990, 1978, by The McGraw-Hill Companies, Inc, All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher. Some ancillaries, including electronic and print components, may not be available to customers outside the United States, 10 09 08 07 06 05 04 162U58 20 09 08 07 06 05 04 03 02 CTP SLP Library of Congress Cataloging-in-Publication Data Silberberg, Eugene. The structure of economics: a mathematical analysis / Eugene Silberberg, Wing Suen.—3" ed Pom. Includes bibliographical references and indexes. ISBN 0-07-234352-4 1. _ Economics, Mathematical. I. Suen, Wing Chuen, Il. Title HB135.854 2000 330°-01°51—de21 00-037220 www.mhhe.com When ordering this title, use ISBN 0-07-118136-9 Printed in Singapore14 1s 31 32 33 CONTENTS Comparative Statics and the Paradigm of Economics Introduction The Marginalist Paradigm Theories and Refutable Prop. The Structure of Theories Refutable Propositions Theories Versus Models; Comparative Statics Examples of Comparative Statics Problems Selected References Bibliography jons Review of Calculus (One Variable) Functions, Slopes, and Elasticity Maxima and Minima Continuous Compounding The Mean Value Theorem Taylor's Series Applications of Taylor’s Series: Derivation of the First- and Second- Order Conditions for a Maximum; Coneavity and Convexity Functions of Several Variables Functions of Several Variables Level Curves: I Partial Derivatives 25 25 27 28 31 32 34 37 37 37 39 vii3.6 4.1 43 44 45 46 47 6.1 62 CONTENTS ‘The Chain Rule Second Deriv. Level Curves: IT Convexity of the Level Curves cs by the Chain Rule Monotonic Transformations and Diminishing Marginal Utility Problems Homogeneous Functions and Euler's Theorem Problems Selected References Profit Maximization Unconstrained Maxima and Minima: First-Order Necessary Conditions Sufficient Conditions for Maxima and Minima: Two Variables Problems An Extended Footnote An Application of Maximizing Behavior: The Profit-Maximizing Firm ‘The Supply Function Homogeneity of the Demand and Supply Functions; Elasticities Elasticities ‘The Long Run and the Short Run; An Example of the Le Chatelier Principle ‘A More Fundamental Look at the Le Chatelier Principle Problems Analysis of Finite Changes: A Digression for Functions of Several Variables, ity and the Maximum Conditions Selected References Matrices and Determinants Matrices Determinants, Cramer’s Rule The Implicit Function Theorem Problems Appendix Simple Matrix Operations The Rank of a Matrix The Inverse of a Matrix Orthogonality Problems Selected References Comparative Statics: The Traditional Methodology Introduction; Profit Maximization Once More Generalization to n Variables First-Order Necessary Conditions Second-Order Sufficient Conditions Profit Maximization: n Factors 47 49 51 53 55 56 65 65 66 66 68 n2 13 74 81 82 83 84 86 87 1 92 92 93 95 96 96 98 105 109 110 110 12 U3 us 116 116 7 17 121 121 121 12464 65 66 a 12 eps 14 8.1 8.2 83 84 85 8.6 8.9 contents ix ‘The Theory of Constrained Maxima and Minima: First-Order Necessary Conditions Constrained Maximization with More than One Constraint: A Digression Second-Order Conditions The Geometry of Constrained Maxi General Methodology Problems Selected References ization The Envelope Theorem and Duality History of the Problem The Profit Function General Comparative Statics Analysi Models with Constraints Comparative Statics: Primal-Dual Analysis An Important Special Case Interpretation of the Lagrange Multiplier Le Chitelier Effects Problems Bibliography : Unconstrained Models The Derivation of Cost Functions The Cost Funetion Marginal Cost Average Cost A General Relationship Between Average and Marginal Costs The Cost Minimization Problem The Factor Demand Curves Interpretation of the Lagrange Multiplier arative Statics Relations: The Traditional Methodology ‘Comparative Statics Relations Using Duality Theory Reciprocity Conditions Cost Curves in the Short and Long Run Factor Demands in the Short and Long Run Relation to Profit Maximization Elasticities; Further Properties of the Factor Demand Curves Homogeneity Output Elasticities 8.10 The Average Cost Curve 8.11 Analysis of Firms in Long-Run Competitive Equilibrium 91 9.2 Analysis of Factor Demands in the Long Run Problems Selected References Cost and Production Functions: Special Topics Homogeneous and Homothetic Production Functions ‘The Cost Function: Further Properties Homothetic Functions 128 132 134 138 141 148, 150 151 151 152 156 159 161 165 166 169 172 174 175 175 179 180 181 183 189 189 193 202 202 205 207 209 2u1 212 216 216 218 220 222 ~224 225 225 228 232X CONTENTS 9.3 The Duality of Cost and Production Functions 234 The Importance of Duality 237 9.4. Elasticity of Substitution; the Constant-Elasticity-of-Substitution (CES) Production Function 238 Generalizations to n Factors 248 The Generalized Leontief Cost Function 249 Problems 250 Bibliography 250 10 The Derivation of Consumer Demand Functions * 252 10.1 Introductory Remarks: The Behavioral Postulates 252 10.2. Utility Maximization 261 Interpretation of the Lagrange Multiplier 266 Roy’s Identity 268 10,3. The Relationship Between the Utility Maximization Model and the Cost Minimization Model 22 10.4 The Comparative Statics of the Utility Maximization Model; the Traditional Derivation of the Slutsky Equation 276 10.5 The Modern Derivation of the Slutsky Equation 282 Conditional Demands 286 ‘The Addition of a New Commodity 288 10.6 Elasticity Formulas for Money-Income-Held-Constant and Real-Income-Held-Constant Demand Curves 291 The Slutsky Equation in Elasticity Form 291 Compensated Demand Curves 294 10.7 Special Topics 297 Separable Utility Functions 297 The Labor-Leisure Choice 299 Slutsky Versus Hicks Compensations 304 The Division of Labor Is Limited by the Extent of the Market 306 Problems 310 Selected References 313 11 Special Topics in Consumer Theory 1 Revealed Preference and Exchange 1.2. The Strong Axiom of Revealed Preference and Integrability Integrability 11.3 The Composite Commodity Theorem Shipping the Good Apples Out 11.4 Houschold Production Functions Comparative Statics 11.5 Consumer's Surplus Example Empirical Approximations 11.6 Empirical Estimation and Functional Forms Linear Expenditure System CES Utility Function Indirect Addilog Utility Function12 12.1 12.2 12.3 13 1B 13.3 13.4 14 14.1 142 143 144 14.5 Almost Ideal Demand System Problems References on Theory References on Functional Forms Intertemporal Choice n-Period Utility Maximization Time Preference Fisherian Investment ‘The Fisher Separation Theorem Real Versus Nominal Interest Rates The Determination of the Interest Rate Stocks and Flows Problems Selected References Behavior Under Uncertainty Uncertainty and Probability Random Variables and Probability Distributions Mean and Variance Specification of Preferences State Preference Approach ‘The Expected Utility Hypothesis Cardinal and Ordinal Utility Risk Aversion Measures of Risk Aversion Mean- Variance Utility Function Gambling, Insurance, and Diversification Comparative Statics Allocation of Wealth to Risky Assets Output Decisions Under Price Uncertainty Increases in Riskiness Problems Selected References Maximization with Inequality and Nonnegativity Constraints Nonnegativity Functions of Two or More Variables Inequality Constraints ‘The Saddle Point Theorem Nonlinear Programming ‘An “Adding-Up” Theorem Problems Appendix Bibliography CONTENTS. xi 361 362 363 366 366 368 368 371 378 380 382 384 387 391 392 394 304 305 396, 399 399 401 403 405 406 409 4il 4 412 413 416 416 418 418 423 427 432 437 440 442 443xii 15 15.1 15.2 15.3 15.4 15.5 15.6 16 16.1 16.2 16.3 16.4 16.5 17 1 17.2 173 174 17.5 176 18 18.1 18.2 18.3 CONTENTS Contracts and Incentives The Organization of Production Principal-Agent Models Comparative Statics Multitask Agency Performance Measurement Choosing the Performance Measure Costly Monitoring and Efficiency Wages Team Production Incomplete Contracts Factors Affecting Ownership Structure Problems Selected References Markets with Imperfect Information The Value of Information in Decision Making Search Sequential Search Equilibrium Price Dispersion Adverse Selection Favorable Selection Signaling ‘A More General Analysis Monopolistic Screening Problems Selected References General Equilibrium I: Linear Models Introduction: Fixed-Coefficient Technology The Linear Activity Analysis Model: A Specific Example ‘The Rybezynski Theorem ‘The Stolper-Samuelson Theorem ‘The Dual Problem ‘The Simplex Algorithm Mathematical Prereq The Simplex Algorithm: Example Problems: Bibliography es General Equilibrium II: Nonlinear Models Tangency Conditions General Comparative Statics Results The Factor Price Equalization and Related Theorems The Four-Equation Model The Factor Price Equalization Theorem The Stolper-Samuelson Theorems The Rybezynski Theorem 448 448 449 452 454 457 460 461 463 466 469 471 471 473 473 474 476 478 482 485 487 490 491 496 497 498 498 507 513 515 517 526 526 530 534 536 537 537 545 550 556 558 559 56618.4 18.5 19 19.1 19.2 19.3 19.4 19.5 19.6 19.7 19.8 20 20.1 20.2 20.3 20.4 CONTENTS Applications of the Two-Good, Two-Factor Model ‘Summary and Conclusions Problems Bibliography Welfare Economics Social Welfare Functions The Pareto Conditions Pure Exchange Production The Classical “Theorems” of Welfare Economics A “Nontheorem” About Taxation The Theory of the Second Best Public Goods Consumer's Surplus as a Measure of Welfare Gains and Losses Property Rights and Transactions Costs The Coase Theorem The Theory of Share Tenancy: An Application of the Coase Theorem Problems Bibliography Resource Allocation over Time: Optimal Control Theory The Meaning of Dynamics Brief History Solution to the Problem The Calculus of Variations Endpoint (Transversality) Conditions Autonomous Problems Sufficient Conditions Solutions to Differential Equations Simultaneous Differential Equations Interpretations and Solutions Intertemporal Choice Harvesting a Renewable Resource Capital Utilization Problems Selected References Hints and Answers Index xiii 568 572 574 576 3877 577 581 581 584 591 594 595 597 600 604 608 611 615 616 617 617 621 621 627 629 630 632 633 636 637 637 640 644 649 650 652 661PREFACE It’s safe to say that the most interesting and important developments in microeco- nomic theory since the publication of the second edition of this work in 1990 are in the area of choice under imperfect information. With uncertainty, the choices individuals make may reflect the problems of moral hazard and adverse selection, and the operation of the market changes as well to reflect these actions. In the third edition, therefore, we expand the scope of the text to include these new developments in economic theory. In particular, the new Chapter 15, “Contracts and Incentives,” covers the recent developments in contract theory, and the new Chapter 16, “Markets with Imperfect Information,” covers recent developments in information economics. Wing Suen, of the University of Hong Kong, penned these chapters. Wing was also the secret author in the second edition of Chapter 13, “Behavior Under Uncertainty,” to which we have added a few examples. To accommodate this new material, we discarded the old Chapter 19 on stabil- ity of equilibrium. We fee! that this material is now less relevant to today’s economics courses, both absolutely and relative to the new material. Also, since today’s stu- dents are much better prepared mathematically than students were when the first edition was first published, we discarded most of the material in Chapter 2, “Review of Calculus (One Variable),” assuming that students have rudimentary knowledge of the calculus of one variable, We maintained the discussion of calculus of sev- eral variables but deleted some of the formalisms, in order to make the material accessible to students whose knowledge of that material is less than in working order. Various other changes in the traditional parts of the book include a discussion of discriminating monopoly in Chapter 4, “Profit Maximization”; a theorem and application related to complementary factors of production in Chapter 6, “Compar- ative Statics: The Traditional Methodology”; an extended but easier discussion of xvXvi PREFACE the LeChatelier effects in Chapter 7, “The Envelope Theorem and Duality”; and a variety of extensions and emendations throughout the text. Although all the analysis contained herein derives from topics in microeco- nomics, the real subject of this book is metaeconomics rather than economics itself, That is, we concer ourselves principally with the methodology of positive eco- nomics, in particular, the way meaningful theorems are derived in economics. Paul Samuelson explained in his monumental Foundations of Economic Analysis (Har- vard University Press, 1947) that the meaningful theorems in economics consist not in laying out various equilibrium conditions, which are rarely observable and therefore empirically sterile, but in deriving predictions that the direction of change of some decision variable in response to a change in some observable parameter must be in some particular direction. The statement that consumers equate their marginal rates of substitution to relative prices is not testable unless we can measure indifference curves. By contrast, the law of demand, which merely requires us to be able to measure the direction of change of an observable price and quantity, is a meaningful, i.e. refutable theorem. Thus in this book, in both the new chapters as well as the old, we devote ourselves almost exclusively to exploring the conditions under which models with a maximization hypothesis generate propositions that are at least in principle refutable. Although the mathematics we use is elementary, itis extremely useful. The late G. H. Hardy wrote in his delightful essay A Mathematician’s Apology (Cambridge University Press, 1940) that Itis the dull and elementary parts of applied mathematics, as itis the dull and elementary parts of pure mathematics, that work for good or ill. Time may change all this. No one foresaw the applications of matrices and groups and other purely mathematical theories to modern physics, and it may be that some of the “highbrow” applied mathematics will become useful in as unexpected a way; but the evidence so far points to the conclusion that, in one subject as in the other, it is what is commonplace and dull that counts for practical life. Moreover, The general conclusion, surely, stands out plainly enough. If useful knowledge is, as we agreed provisionally to say, knowledge which is likely now or in the comparatively near future, to contribute to the material comfort of mankind, so that mere intellectual satisfaction is irrelevant, then the great bulk of mathematics is useless. But this is precisely what an economist would expect! Hardy was observing the law of diminishing marginal product in the application of mathematical tools to science. A large gain in clarity and economy of exposition can be had from the incorporation of elementary algebra and calculus. The gain from adding real analysis and topology, however, is apt to be less. And perhaps, when such arcane fields as complex analysis and algebraic topology are brought to bear on scientific analysis, their marginal product will be found to be approximately zero, fitting Hardy's definition of “useless.” (It is amusing to note, though, that number theory,PREFACE XVii long considered one of the most useless of all mathematical inquiries, has recently found important application in modern cryptography.) In this book we explore the insights that elementary mathematics affords the study of positive economics. We do not explore these issues to their fullest generality or mathematical rigor. Although generality and rigor are important economic goods, their production, because of the above-mentioned law of diminishing returns, entails, increasing marginal costs. Thus we are usually content with intuitive, heuristic proofs of many mathematical propositions. We refer students to standard mathematics texts for rigorous discussions of various theorems we use in this book. We aimed for that unobservable margin where for the bulk of our readers, the marginal benefits of greater rigor and generality equal their respective marginal costs. By example after example we hope to convince the reader that these elementary tools yield interesting and sometimes profound insights into modern economics A note to students and instructors: Long experience teaching this material, and the authors’ own experiences in learning it, have made it abundantly clear that mastering this material is impossible without doing the problems. So do the problems! The only true indicator of understanding is that you can explain the solution to someone else. An Instructor's Manual is available from McGraw-Hill. Eugene Silberberg Wing Suen