& REES GRAVELLE HUGH GRAVELLE & RAY REES Dr Sanjit Dhami .

MIC3e prelim.qxd 1/9/08 1:51 AM Page ixPreface to the third editionWe seem to be able to produce a new edition of this book every eleven years or so.This is undoubtedly not an optimal interval from the point of view of maximizingsales revenue, but it is an interesting one over which to observe the changes inmicroeconomic theory and in the way it is taught. In the time that elapsed betweenthe first and second editions, the increasing emphasis on game theory and theeconomics of uncertainty and asymmetric information, at the expense of the moretraditional topics in consumption, production and general equilibrium theory, wasquite marked. That tendency has strengthened over the period since the secondedition appeared, and this is reflected in the content and organization of this thirdedition. We have added a new chapter on game theory, and have considerablyextended and restructured the chapters on uncertainty and asymmetric information. In order to keep the length of the book within reasonable bounds, we havedeleted some material that we thought was unlikely these days to be covered in anadvanced microeconomics course, and replaced the chapter on the mathematics ofoptimization by a number of shorter appendices. In addition, the discussions of theliterature and suggestions for further reading previously at the end of each chapterhave been gathered into a set of notes at the end of the book, which has not onlysaved space but, we hope, has allowed us to improve them.The aims and approach of the book have remained the same. We have tried toprovide a comprehensive exposition of modern microeconomic theory, beginningat the intermediate level and ending at an appropriate level for graduate students.We aim to cover the ground between the standard intermediate micro course, taughtlargely in two dimensions with little explicit use of mathematics, and the advanceddoctoral course. This book is meant to fit between, say, Hal Varian’s excellentIntermediate Microeconomics, and Mas-Colell, Whinston and Green’s magisterialMicroeconomic Theory. We have again placed major emphasis on trying to give thestudent an intuitive understanding of the economic content of the models, and oftheir purpose and nature, as well as a clear account of their mathematics.We are very grateful to the many users of this book, students as well as teachers,who have over the years sent us corrections and suggestions for improvement.We would like particularly to thank Patricia Apps and Klaus Schmidt, who havecommented in depth on some of the new material we have prepared for this edition.We are also grateful to Paula Harris of Pearson Education for her good-naturedstoicism in the face of missed deadlines, and for her encouragement finally to finishthis book.H.S.E.G.R.R.

MIC3e prelim.qxd 1/9/08 1:51 AM Page x.

MIC3e C01.qxd 1/9/08 3:29 AM Page 1CHAPTER1The nature and scope ofmicroeconomicsA. Concepts and methodsMicroeconomics is a set of models constructed with the aim of helping us understand the process by which scarce resources are allocated among alternative uses,and of the role of prices and markets in this process. In its purest form, it is a philosophical inquiry into the processes of resource allocation. However, with understanding usually comes the ability to predict and to control, and this has certainlybeen the case in microeconomics. The concepts and models economists havedeveloped, in conjunction with the necessary empirical data, provide the basis for theanalysis of policies by governments wishing to influence the allocation of resources.Through the development of ‘operations research’, ‘management science’ and‘business economics’, concepts from microeconomics have also been applied toassist decision-taking in business.A good way of providing an introductory overview of microeconomics is to set outits basic elements.1. Goods and services or commoditiesThese are the central objects of economic activity, since ‘economic activity’ consistsof the production and exchange of commodities. We distinguish commodities fromeach other by one or more of three characteristics: their attributes, which determinethe way they meet the needs of consumers and producers; the location at which theyare made available; and the date at which they are made available. For example, coaland crude oil have different attributes, as do the services of a hairdresser and thoseof an accountant (though in each case the broad category of resource from whichthe commodities derive – ‘land’ in one case and ‘labour’ in the other – is the same).Equally important is the fact that crude oil in Dubai available tomorrow is a different commodity from crude oil available tomorrow at a refinery in western Europe;while coal in London today is a different commodity from coal in London this timenext year. The basis of the distinction between commodities is that they cannot beregarded as perfect substitutes in production or consumption – a businessman whogoes along to his accountant for advice on a tax problem would not be just as happyto be offered a haircut instead.Commodities are not necessarily physical objects or labour services. For example,Chapters 19 and 21 are concerned with markets for insurance and for financialcapital. The purchase of a share in a company quoted on the stock exchangeentitles the purchaser to a future stream of dividend payments. The purchaser ofcar insurance buys a promise from the insurer to reimburse her for any costs incurred if she has an accident. As the insurance example suggests, and as we will see inChapter 19, the definition of such commodities requires an extension of the set of.

MIC3e C01.qxd 1/9/08 3:29 AM Page 22CHAPTER 1 THE NATURE AND SCOPE OF MICROECONOMICSrelevant characteristics defining commodities to include the ‘state of the world’ inwhich the commodity will be delivered. For the first half of the book we deal withmarkets where there is no uncertainty and the characterization of commodities bytheir attributes, location and date is sufficient.In most of microeconomics we usually assume a finite set of possible bundles ofattributes, a finite set of possible locations – we do not regard geographical space ascontinuous, but rather divided up into small areas – and a finite set of dates. We donot regard calendar time as continuous, but rather divided up into equal discretetime intervals, and moreover not as extending indefinitely far into the future, butinstead we assume some definite, though possibly very distant, time horizon. Theseassumptions ensure that there is a finite number of commodities. Alternatively,we could assume a continuum of commodities: given any one commodity, we couldalways define another which is as close as we like to the first in attributes, locationor time. Moreover, this commodity continuum need not be bounded – we couldpicture commodities as points in a space which stretches to infinity, since we couldalways define commodities available later in time. Since the assumptions required toestablish a finite set of commodities do not seem to do serious injustice to reality,while considerably simplifying the analysis, we usually adopt them.2. PricesAssociated with each commodity is a price, which may be expressed in one of twoways. First, we may choose one commodity in the economy as a numeraire, i.e. as thecommodity in terms of which all prices are to be expressed. For example, supposewe choose gold. Then the price of each commodity is the number of units of goldwhich exchange for one unit of that commodity. The price of gold is 1. In general,we are free to choose any commodity as numeraire, so that prices could just aswell be expressed in terms of the number of units of some kind of labour service,or the number of bottles of beer, or Armani suits, which exchange for one unitof each other commodity. It might be argued that in reality different commodities may have different degrees of suitability for use in market transactions.Commodities which are not easily divisible, and which are bulky and subject tophysical decay, will tend not to be used as a means of payment. However, it is important to note that a numeraire is not intended to represent a means of exchange,or ‘money’, in this sense. We are simply using it as a unit of account, or a unitof measurement for prices in the economy, and nothing need be implied about themechanism by which transactions actually take place. Given the choice of numeraire,prices are effectively commodity rates of exchange – they express the rate at which thenumeraire exchanges for each other commodity. They have the dimension (unitsof the numeraire/units of the commodity). They are therefore not independent ofthe units in which we measure commodities. For example, if we double the unitin which we measure each commodity except for the numeraire we would have todouble prices.The second way in which prices might be expressed does not involve a numeraire.Instead, we suppose there to be some unit of account which is not a quantity ofsome commodity, but an abstract unit used in making bookkeeping entries. If oneunit of a commodity is sold, the account is credited with a certain number of unitsof account, whereas, if the commodity is bought, the same number of units isdebited from the account. The price of the commodity is then the number of units.

MIC3e C01.qxd 1/9/08 3:29 AM Page 3A. CONCEPTS AND METHODS3debited or credited per unit of the commodity. We find it useful to give this unit ofaccount a name, and so we could call it the pound sterling, or the US dollar, forexample. If different accounts are kept in different units, then rates of exchangebetween units of account must be established before transfers from one account toanother can be made. Clearly, there is no actual commodity corresponding to theunit of account, say the pound sterling. A cheque made out for x is an instructionto credit one account and debit another, i.e. to transfer x units of account betweenaccounts. Notes and coin have no intrinsic worth (until perhaps they cease to beused in exchange and acquire intrinsic worth – become commodities themselves –to numismatists), but are simply tokens representing numbers of units of accountwhich are passed around directly and form part (usually a relatively small part) ofthe credit side of one’s accounts.The seemingly abstract definition of prices in terms of units of account is the wayprices are usually expressed, and has come ab

We aim to cover the ground between the standard intermediate micro course, taught largely in two dimensions with little explicit use of mathematics, and the advanced doctoral course. This book is meant to fit between, say, Hal Varian’s excellent Intermediate Microeconomics, and Mas-Colell, Whinston and Green’s magisterial Microeconomic .