Outline Economic Theory, Michaelmass Term 2003



Economic Theory (ec4010), 2007 – 2008

Module 2: Microeconomics

Dr. Jacco Thijssen

Office:

Ext:

Email: Jacco.Thijssen@tcd.ie

http: tcd.ie/Economics/staff/thijssej

Introduction

This module will introduce two cornerstones of modern microeconomics: game theory and information economics. The central premise of both fields are incentives and their influence on economic behaviour.

Game theory (a branch of applied mathematics) has become a powerful tool of economic analysis for situations where a small number of economic agents (firms, governments, individuals) behave interdependently (anticipate how their decisions affect others and how these others will then react). This course will introduce the equilibrium concepts commonly used, develop techniques for solving simple games, and focus on applications of these techniques in a variety of economic settings. Applications here could include oligopoly theory, labour markets, international trade, monetary policy, auctions, public goods, and corporate finance.

Information economics deals explicitly with the analysis of information asymmetries between different market participants. Standard neo-classical economics assumes that every agent possesses the same information. In real (economic) settings this is often not the case. For example, the seller of a used car typically has more information about the quality of the car than a (potential) buyer. Or think of an insurance company offering you a policy, knowing that you know more about your risk profile than they do. What effects do these information asymmetries have on the resulting contracts? We will analyse these issues using the tools of game theory.

Preliminaries

The course should be seen as essential for anybody intending to do graduate work (here or abroad), but is designed to be accessible to both single and joint honors students, especially if they enjoy logic and reasoning. The mathematical preliminaries go no further than basic calculus, optimization under constraints, and basic probability theory; material that has been covered in previous years. I have neither the time nor the inclination to repeat all this and will assume that you are up to speed with this material. If you are rusty on (some of) the mathematics mentioned, you can use the mathematical appendix in Rasmusen (or any of the other texts) to brush up your knowledge. The hurdles in game theory are really conceptual rather than mathematical!

Learning Outcomes

After this module you should understand:

• The structure of games in strategic and extensive form

• The role of information in game theory

• The four main equilibrium concepts of non-cooperative game theory

• The main forms of asymmetric information

• The game theoretic analysis of asymmetric information

• The game theoretic analysis of mechanisms

• The game theoretic analysis of auctions

• The game theoretic analysis of bargaining

After this module you should be able to:

• Represent strategic situations between two (groups of) agents as strategic or extensive form games

• Compute equilibria of simple strategic or extensive form games

• Formalize and analyse simple situations of asymmetric information as games

• Discuss at least one form of asymmetric information in detail, referring to the relevant academic literature and by using relevant examples.

After this module you should have a critical attitude to:

• The main postulates of game theory

• The use of game theory to analyse information asymmetries

• The presence of asymmetric information in economic situations

Course Structure and Assessment

There is one weekly two-hours lecture and a bi-weekly seminar during which the theory is discussed and exercises and examples are demonstrated. The course will be assessed by a hand-in exercise and by a final examination.

The term test consists of an exercise sheet, which has to be handed in at a date to be specified in due course. The term test counts for 10% towards your final grade. Half of the final exam consists of questions related to this module. (NB Unlike some courses, both modules count 50% towards your exam grade. Within each part you will have some choice options.) Do not hesitate to contact me if you have any problems with the course whatsoever.

A Word of Caution

Please, be not fooled by the clarity of the textbook. Game theory is not a spectator sports. You will not master it unless you keep up the reading and do the exercises throughout the module. Rote learning will get you absolutely nowhere. Do not expect a good result if you leave studying to two weeks before the exam!

Literature

The text used throughout is:

• Rasmusen, E. (2007), “Games and Information”, 4th ed., Blackwell.

Alternatively you can consult the following texts:

• Gibbons, R. (1992), “A Primer in Game Theory”, Pearson. (a slightly more compact text)

• Osborne, M.J. (2004), “An Introduction to Game Theory”, Oxford UP. (for the more mathematically inclined)

• Binmore, K.J. (2007), “Playing for Real”, Oxford UP. (for the more philosophically interested).

• Campbell, D.E. (2006), “Incentives; Motivation and the Economics of Information”, Cambridge UP. (very accessible and nice text)

If you are interested in pursuing the topics covered in this course at the postgraduate level, you might want to take a look at the following, more advanced, texts:

• Mas-Colell, A., M.D. Whinston and J.R. Green (1995), “Microeconomic Theory”, Oxford University Press (Part II of this standard post-graduate textbook deals with game theory).

• Fudenberg, D. and J. Tirole (1991), “Game Theory”, MIT Press (aimed primarily at economists, very thorough and popular; personally, I don’t like the writing style too much).

• Osborne, M.J. and A. Rubinstein (1994), “A Course in Game Theory”, MIT Press (what a beauty! Great book, aimed at mathematicians and economists; limited choice of topics, but very rigorous indeed.)

Detailed Outline

Part I: Game Theory

Games and Information (1.1-3; 2.1-3)

• Strategies and games

• Dominance

• Information sets

1. Nash equilibrium (1.4-5; 2.4-5; 3.1,2,5,6)

• Nash Equilibrium in pure and mixed strategies

• Bayesian games and equilibrium

• Continuous strategies

2. Dynamic Games with Symmetric Information (ch 4; 5.1-4)

• Subgame Perfect Equilibrium and credible threats

• Finitely vs. infinitely repeated games and the Folk theorem

• Reputation

3. Dynamic Games with Incomplete Information (6.1-4)

• Perfect Bayesian Equilibrium

• Common knowledge

Part II: Information Economics

4. Moral Hazard (7.1-4; 8.1-2)

• Principal-agent models

• Incentive compatibility

• Applications

5. Adverse Selection (ch 9)

• Market breakdown

• Lemons

• Insurance

6. Mechanism Design (ch 10)

• Mechanisms

• Revelation principle

• Applications

7. Signalling (ch 11)

• Signalling and screening

• Education as a signaling device

8. Auctions (ch 13)

• Types of auctions

• Revenue equivalence in private value auctions

• Common value auctions and the Winner’s curse

9. Bargaining

• Nash bargaining solution

• Alternating offers

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