Frank A. Cowell
STICERD and Department of Economics
London School of Economics
December 2004
Contents iii
List of Tables xiii
List of Figures xv
Preface xxiii
1 Introduction 1
1.1 The rÙle of microeconomic principles 1
1.2 Microeconomic models 2
1.2.1 Purpose 2
1.2.2 The economic actors . 2
1.2.3 Motivation 2
1.2.4 The economic environment . 3
1.2.5 Assumptions and axioms 4
1.2.6 ìTestingîa model 4
1.3 Equilibrium analysis . 5
1.3.1 Equilibrium and economic context . 5
1.3.2 The comparative statics method 5
1.3.3 Dynamics and stability . 6
1.4 Background to this book . 6
1.4.1 Economics . 6
1.4.2 Mathematics . 6
1.5 Using the book 7
1.5.1 A route map . 7
1.5.2 Some tips . 7
The Firm 9
2.1 Basic setting . 9
2.1.1 The Örm: basic ingredients . 10
2.1.2 Properties of the production function . 12
2.2 The optimisation problem 19
2.2.1 Optimisation stage 1: cost minimisation 20
2.2.2 The cost function . 23
2.2.3 Optimisation stage 2: choosing output . 25
2.2.4 Assembling the solution . 26
2.3 The Örm as a ìblack boxî 27
2.3.1 Demand and supply functions of the Örm . 29
2.3.2 Comparative statics: the general case . 31
2.4 The short run . 35
2.5 The multiproduct Örm 39
2.6 Summary . 44
2.7 Reading notes . 44
2.8 Exercises . 44
3 The Firm and the Market 49
3.1 Introduction 49
3.2 The market supply curve 50
3.3 Large numbers and the supply curve 53
3.4 Interaction amongst Örms 55
3.5 The size of the industry . 56
3.6 Price-setting 58
3.6.1 Simple monopoly . 58
3.6.2 Discriminating monopolist 60
3.6.3 Entry fee . 61
3.7 Product variety 62
3.8 Summary . 64
3.9 Reading notes . 64
3.10 Exercises . 64
4 The Consumer 69
4.1 Introduction 69
4.2 The consumerís environment 70
4.3 Revealed preference . 72
4.4 Preferences: axiomatic approach 75
4.5 Consumer optimisation: Öxed income 80
4.5.1 Cost-minimisation 82
4.5.2 Utility-maximisation . 83
4.6 Welfare 87
4.6.1 An application: price indices 92
4.7 Summary . 93
4.8 Reading notes . 93
4.9 Exercises . 94
5 The Consumer and the Market 99
5.1 Introduction 99
5.2 The market and incomes . 100
5.3 Supply by households 100
5.3.1 Labour supply 103
5.4 Household production 107
5.5 Aggregation over goods . 112
5.6 Aggregation of consumers 112
5.7 Summary . 116
5.8 Reading notes . 117
5.9 Exercises . 117
6 A Simple Economy 121
6.1 Introduction 121
6.2 Another look at production . 122
6.2.1 Processes and net outputs 122
6.2.2 The technology 124
6.2.3 The production function again . 128
6.2.4 Externalities and aggregation 128
6.3 The Robinson Crusoe economy . 129
6.4 Decentralisation and trade 132
6.5 Summary . 139
6.6 Reading notes . 139
6.7 Exercises . 139
7 General Equilibrium 143
7.1 Introduction 143
7.2 A more interesting economy . 144
7.2.1 Allocations 145
7.2.2 Incomes 147
7.2.3 An illustration: the exchange economy . 147
7.3 The logic of price-taking . 149
7.3.1 The core of the exchange economy . 151
7.3.2 Competitive equilibrium and the core: small economy 152
7.3.3 Competitive equilibrium and the core: large economy 152
7.4 The excess-demand approach 156
7.4.1 Properties of the excess demand function . 157
7.4.2 Existence . 160
7.4.3 Uniqueness 162
7.4.4 Stability 163
7.5 The rÙle of prices . 166
7.5.1 The equilibrium allocation 167
7.5.2 Decentralisation again 167
7.6 Summary . 171
7.7 Reading notes . 172
7.8 Exercises . 172
8 Uncertainty and Risk 177
8.1 Introduction 177
8.2 Consumption and uncertainty 177
8.2.1 The nature of choice . 179
8.2.2 State-space diagram . 180
8.3 A model of preferences 184
8.3.1 Key axioms 185
8.3.2 Von-Neumann-Morgenstern utility . 188
8.3.3 The ìfelicityîfunction 189
8.4 Risk aversion . 190
8.4.1 Risk premium . 191
8.4.2 Indices of risk aversion 192
8.4.3 Special cases . 195
8.5 Lotteries and preferences . 197
8.5.1 The probability space 198
8.5.2 Axiomatic approach . 199
8.6 Trade . 202
8.6.1 Contingent goods: competitive equilibrium 203
8.6.2 Financial assets 203
8.7 Individual optimisation . 205
8.7.1 The attainable set 205
8.7.2 Components of the optimum 209
8.7.3 The portfolio problem 211
8.7.4 Insurance . 217
8.8 Summary . 219
8.9 Reading notes . 220
8.10 Exercises . 220
9 Welfare 227
9.1 Introduction 227
9.2 The constitution . 228
9.3 Principles for social judgments: e¢ ciency . 234
9.3.1 Private goods and the market 237
9.3.2 Departures from e¢ ciency 242
9.3.3 Externalities . 246
9.3.4 Public goods . 250
9.3.5 Uncertainty 251
9.3.6 Extending the e¢ ciency idea 254
9.4 Principles for social judgments: equity . 257
9.4.1 Fairness 257
9.4.2 Concern for inequality 258
9.5 The social-welfare function . 258
9.5.1 Welfare, national income and expenditure . 259
9.5.2 Inequality and welfare loss 261
9.6 Summary . 264
9.7 Reading notes . 264
9.8 Exercises . 265
10 Strategic Behaviour 271
10.1 Introduction 271
10.2 Games ñbasic concepts . 272
10.2.1 Players, rules and payo§s 272
10.2.2 Information and Beliefs . 273
10.2.3 Strategy 274
10.2.4 Representing a game . 274
10.3 Equilibrium 276
10.3.1 Multiple equilibria 278
10.3.2 E¢ ciency . 279
10.3.3 Existence . 281
10.4 Application: duopoly . 285
10.4.1 Competition in quantities 286
10.4.2 Competition in prices 291
10.5 Time 293
10.5.1 Games and subgames 295
10.5.2 Equilibrium: more on concept and method 297
10.5.3 Repeated interactions 300
10.6 Application: market structure 305
10.6.1 Market leadership 305
10.6.2 Market entry . 306
10.6.3 Another look at duopoly 309
10.7 Uncertainty 310
10.7.1 A basic model 311
10.7.2 An application: entry again . 314
10.7.3 Mixed strategies again 317
10.7.4 A ìdynamicîapproach 317
10.8 Summary . 318
10.9 Reading notes . 319
10.10Exercises . 320
11 Information 327
11.1 Introduction 327
11.2 Hidden characteristics: adverse selection 328
11.2.1 Information and monopoly power 329
11.2.2 One customer type 329
11.2.3 Multiple types: Full information 333
11.2.4 Imperfect information 336
11.2.5 Adverse selection: Competition . 345
11.2.6 Application: Insurance 346
11.3 Hidden characteristics: Signalling 352
11.3.1 Costly signals . 352
11.3.2 Costless signals 360
11.4 Hidden actions 361
11.4.1 The issue . 361
11.4.2 Outline of the problem 362
11.4.3 A simpliÖed model 362
11.4.4 Principal-and-Agent: a richer model 367
11.5 Summary . 373
11.6 Reading notes . 374
11.7 Exercises . 374
2 Design 381
12.1 Introduction 381
12.2 Social choice . 382
12.3 Markets and manipulation 385
12.3.1 Markets: another look 385
12.3.2 Simple trading 386
12.3.3 Manipulation: power and misrepresentation 387
12.3.4 A design issue? 388
12.4 Mechanisms 388
12.4.1 Implementation 390
12.4.2 Direct mechanisms 391
12.4.3 The revelation principle . 392
12.5 The design problem . 393
12.6 Design: applications . 395
12.6.1 Auctions 395
12.6.2 A public project . 403
12.6.3 Contracting again 409
12.6.4 Taxation 415
12.7 Summary . 422
12.8 Reading notes . 424
12.9 Exercises . 424
13 Government and the Individual 431
13.1 Introduction 431
13.2 Market failure? 432
13.3 Nonconvexities 433
13.3.1 Large numbers and convexity 435
13.3.2 Interactions and convexity 435
13.3.3 The infrastructure problem . 436
13.3.4 Regulation 438
13.4 Externalities . 442
13.4.1 Production externalities: the e¢ ciency problem 443
13.4.2 Corrective taxes . 443
13.4.3 Production externalities: Private solutions . 444
13.4.4 Consumption externalities 447
13.4.5 Externalities: assessment 448
13.5 Public consumption . 448
13.5.1 Nonrivalness and e¢ ciency conditions . 449
13.5.2 Club goods 449
13.6 Public goods . 451
13.6.1 The issue . 451
13.6.2 Voluntary provision . 452
13.6.3 Personalised prices? . 454
13.6.4 Public goods: market failure and the design problem . 457
13.6.5 Public goods: alternative mechanisms . 458
13.7 Optimal allocations? . 460
13.7.1 Optimum with lump-sum transfers . 461
13.7.2 Second-best approaches . 464
13.8 Conclusion: Economic Prescriptions 467
13.9 Reading notes . 468
13.10Exercises . 468
Bibliography 473
A Mathematics Background 485
A.1 Introduction 485
A.2 Sets 486
A.2.1 Sets in Rn . 486
A.3 Functions . 487
A.3.1 Linear and a¢ ne functions . 487
A.3.2 Continuity . 488
A.3.3 Homogeneous functions . 490
A.3.4 Homothetic functions 491
A.4 Di§erentiation 492
A.4.1 Function of one variable . 492
A.4.2 Function of several variables . 493
A.4.3 Function-of-a-Function Rule . 493
A.4.4 The Jacobian derivative . 494
A.4.5 The Taylor expansion 494
A.4.6 Elasticities 494
A.5 Mappings and systems of equations . 496
A.5.1 Fixed-point results 496
A.5.2 Implicit functions . 497
A.6 Convexity and Concavity 499
A.6.1 Convex sets 499
A.6.2 Hyperplanes 500
A.6.3 Separation results 500
A.6.4 Convex and concave functions 503
A.6.5 quasiconcave functions 505
A.6.6 The Hessian property 507
A.7 Maximisation . 507
A.7.1 The basic technique . 508
A.7.2 Constrained maximisation 510
A.7.3 More on constrained maximisation . 511
A.7.4 Envelope theorem 514
A.7.5 A point on notation . 515
A.8 Probability 515
A.8.1 Statistics . 516
A.8.2 Bayesírule 518
A.8.3 Probability distributions: examples . 518
A.9 Reading notes . 519
B Answers to Footnote Questions 521
B.1 Introduction 521
B.2 The Örm 521
B.3 The Örm and the market . 528
B.4 The consumer . 529
B.5 The consumer and the market 535
B.6 A simple economy 539
B.7 General equilibrium . 542
B.8 Uncertainty and risk . 548
B.9 Welfare 556
B.10 Strategic behaviour 561
B.11 Information 570
B.12 Design . 583
B.13 Government and individual . 598
C Selected Proofs 607
C.1 The Örm 607
C.1.1 Marginal cost and the Lagrange multiplier . 607
C.1.2 Properties of the cost function (Theorem 2.2) . 608
C.1.3 Firmís demand and supply functions (Theorem 2.4) . 611
C.1.4 Firmís demand and supply functions (continued) . 612
C.1.5 Properties of proÖt function (Theorem 2.7) 613
C.2 The consumer . 614
C.2.1 The representation theorem (Theorem 4.1) 614
C.2.2 Existence of ordinary demand functions (Theorem 4.5) 615
C.2.3 Quasiconvexity of the indirect utility function . 615
C.3 The consumer and the market 616
C.3.1 Composite commodity (Theorem 5.1): . 616
C.3.2 The representative consumer (Theorem 5.2): . 616
C.4 A simple economy 617
C.4.1 Decentralisation (Theorem 6.2) . 617
C.5 General equilibrium . 617
C.5.1 Competitive equilibrium and the core (Theorem 7.1) . 617
C.5.2 Existence of competitive equilibrium (Theorem 7.4) . 618
C.5.3 Uniqueness of competitive equilibrium (Theorem 7.5) 619
C.5.4 Valuation in general equilibrium (Theorem 7.6) 619
C.6 Uncertainty and risk . 620
C.6.1 Risk-taking and wealth (Theorem 8.7) . 620
C.7 Welfare 620
C.7.1 Arrowís theorem (Theorem 9.1) . 620
C.7.2 Blackís theorem (Theorem 9.2) . 622
C.7.3 The support theorem (Theorem 9.5) 623
C.7.4 Potential superiority (Theorem 9.10) 625
C.8 Strategic behaviour 626
C.8.1 Nash equilibrium in pure strategies with inÖnite strategy
sets (Theorem 10.2) . 626
C.8.2 Existence of Nash equilibrium (Theorem 10.1) 627
C.8.3 The Folk theorem 627
C.9 Design . 628
C.9.1 Revenue equivalence (Theorem 12.6) 628
C.9.2 The Clark-Groves mechanism (Theorem 12.7) 630
Index 632
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