Table of Contents
1 ECONOMICS ................................................................................................................................................... 3
1.1 THE NOTION OF ECONOMICS.............................................................................................................................. 3
1.2 POSITIVE ECONOMICS AND NORMATIVE ECONOMICS ............................................................................................... 3
1.3 RATIONALITY AND EQUILIBRIUM ......................................................................................................................... 3
1.3.1 RATIONALITY (OPTIMISATION) IN THE MARKET ............................................................................................................... 3
1.3.2 RATIONALITY (OPTIMISATION) IN THE GAME THEORY ...................................................................................................... 4
2 DEMAND ....................................................................................................................................................... 5
2.1 THE DEMAND FUNCTION ................................................................................................................................... 5
2.2 DETERMINANTS OF DEMAND ............................................................................................................................. 5
2.3 OPTIMAL CONSUMPTION BUNDLE ....................................................................................................................... 5
2.4 INCOME AND SUBSTITUTION EFFECTS ................................................................................................................... 7
2.5 COMPLEMENTS AND SUBSTITUTES ....................................................................................................................... 7
2.6 DEMAND CURVE AND WELFARE: CONSUMER SURPLUS ............................................................................................. 8
3 MONOPOLY ................................................................................................................................................... 9
3.1 A FIRM’S SUPPLY ............................................................................................................................................ 9
3.2 SIMPLE MONOPOLIST ....................................................................................................................................... 9
3.2.1 PROFIT-MAXIMISATION ............................................................................................................................................10
3.2 DEGREES OF MONOPOLISTIC BEHAVIOUR ............................................................................................................ 10
4 MARKETS, MARKET EQUILIBRIUM, AND MARKET WELFARE .......................................................................... 12
4.1 PERFECT COMPETITION ................................................................................................................................... 12
4.2 EFFICIENCY AND EQUITY .................................................................................................................................. 12
4.3 MARKET IMPERFECTIONS ................................................................................................................................ 13
4.4 PERFECT COMPETITION AND THE TWO WELFARE THEOREMS.................................................................................... 13
5 GOVERNMENT INTERVENTION: TAXES, TAX INCIDENCE, AND WELFARE ......................................................... 15
5.1 UNIT TAXES AND TAX INCIDENCE....................................................................................................................... 15
5.2 EFFICIENCY AND TAXATION .............................................................................................................................. 17
5.3 LUMP-SUM TAXES ......................................................................................................................................... 17
6 GAME THEORY ............................................................................................................................................. 18
6.1 STRATEGIC GAME WITH ORDINAL PREFERENCES.................................................................................................... 18
6.2 NASH EQUILIBRIUM ....................................................................................................................................... 18
6.3 PURE STRATEGY NASH EQUILIBRIA: DOMINATION ................................................................................................. 19
6.4 MIXED STRATEGY NASH EQUILIBRIA .................................................................................................................. 19
© 2020 Joyce Yang
,6.5 CASE STUDIES ............................................................................................................................................... 20
6.5.1 PRISONER’S DILEMMA: STRICT DOMINATION ...............................................................................................................20
6.5.2 BATTLE OF THE SEXES (BACH OR STRAVINSKY): COOPERATION ........................................................................................20
6.5.3 MATCHING PENNIES: STRICTLY COMPETITIVE ...............................................................................................................20
6.6 GAME THEORY AND OLIGOPOLIES ..................................................................................................................... 21
6.6.1 BERTRAND COMPETITION: COMPETING WITH PRICE ......................................................................................................21
6.6.2 COURNOT COMPETITION: COMPETING WITH QUANTITY.................................................................................................22
6.6.3 BERTRAND VS COURNOT COMPETITION .......................................................................................................................22
7 ASYMMETRIC INFORMATION: MORAL HAZARD ............................................................................................ 23
7.1 MORAL HAZARD: INSURANCE ........................................................................................................................... 23
7.2 MORAL HAZARD: PERFORMANCE-BASED CONTRACTS ............................................................................................ 24
7.2.1 GENERAL ................................................................................................................................................................24
7.2.2 PARTNERSHIP PROBLEM ............................................................................................................................................24
7.2.3 PRINCIPLE-AGENT PROBLEM ......................................................................................................................................25
8 ASYMMETRIC INFORMATION: ADVERSE SELECTION ...................................................................................... 26
8.1 ADVERSE SELECTION: MARKET FOR LEMONS ........................................................................................................ 26
8.2 ADVERSE SELECTION: INSURANCE MARKETS......................................................................................................... 27
8.3 GOVERNMENT POLICIES THAT COMBAT ADVERSE SELECTION ................................................................................... 27
9 BEHAVIOURAL ECONOMICS AND SOCIAL PREFERENCES ................................................................................ 28
9.1 BEHAVIOURAL ECONOMICS AND SOCIAL PREFERENCES ........................................................................................... 28
9.2 ALTRUISM ................................................................................................................................................... 28
9.2.1 ALTRUISM: MARKET TRADE (NO EFFECT) ....................................................................................................................28
9.2.2 ALTRUISM: PARTNERSHIP PROBLEM (POSITIVE EFFECT) .................................................................................................29
9.2.2 ALTRUISM: SIMULTANEOUS PRISONER’S DILEMMA .......................................................................................................29
9.2.3 ALTRUISM: CHARITY .................................................................................................................................................30
9.2.4 ULTIMATUM AND DICTATOR GAMES ...........................................................................................................................30
9.3 HAPPINESS AND STATUS.................................................................................................................................. 31
9.3.1 MEASURING HAPPINESS............................................................................................................................................31
9.3.2 THE EASTERLIN PARADOX: HAPPINESS AND INCOME ......................................................................................................31
10 ECONOMICS OF DISCRIMINATION .............................................................................................................. 32
10.1 RACIAL BELIEF-BASED DISCRIMINATION IN POLICE VEHICLE SEARCHES...................................................................... 32
10.1.1 BELIEF-BASED DISCRIMINATION (NOT RACIST) ...........................................................................................................33
10.1.1 BELIEF-BASED AND TASTE-BASED DISCRIMINATION (RACIST) ........................................................................................33
2
,1 Economics
1.1 The Notion of Economics
Economics: is the study of how economic agents choose to allocate scarce resources and how those
choices affect society.
Economic agent: an individual or a group that makes choices.
Allocation of scarce resources
o Scarce resources: things that people want, where the quantity that people want exceeds the
quantity that is available.
o Scarcity: the situation of having unlimited wants in a world of limited resources.
1.2 Positive Economics and Normative Economics
Microeconomics: the study of how individuals, households, firms, and governments make choices, and
how those choices affect prices, the allocation of resources, and the wellbeing of other economic agents.
Economic analysis aims to understand people’s choices and consists of:
1. Positive economics: describes what people actually do.
o Objective and fact-based
o Makes predictions about what we can see and measure from data
2. Normative economics: advises what people, including society, ought to do.
o Subjective and value-based
o Evaluates different policies and situations with respect to a particular notion of welfare.
1.3 Rationality and Equilibrium
Rationality (optimisation): people decide what to do by analysing all known costs and benefits of the
different options and pick the best option.
Equilibrium: a situation in which everyone is simultaneously optimising, i.e. when no individual thinks s/he
has a better available option.
1.3.1 Rationality (Optimisation) in the Market
Demand function, D:
results from the
Equilibrium point: QD = QS optimising behaviour of
consumers.
1. No consumer would
want to buy more. Supply function, S:
2. No supplier would want results from the
to produce more. optimising behaviour of
firms.
3
, 1.3.2 Rationality (Optimisation) in the Game Theory
1. Rationality: each player has a belief about the behaviour of other players and each player best
responds to this belief.
2. Beliefs are correct: each player actually behave in line with the others’ beliefs about them
The Kitty Genovese Case of the Bystander Effect
Bystander effect: as the number of bystanders (N) increases, the probability (P) that someone calls the
police decreases.
Players: 𝑛 neighbours
Actions: “call” or “not call”
Payoffs (preferences):
• Cost of calling: 1
• Payoff if someone calls: 𝑥 > 1
Someone else calls 𝒙 Best
You call 𝑥−1 Second best
No one calls 0 Worse
Solutions:
• 𝒑: probability of each individual neighbour calling
o If neighbours preferred to call, they would call for sure: 𝑝 = 1.
o If neighbours preferred not to call, they would not call for sure: 𝑝 = 0.
o 0 < 𝑝 < 1, then the neighbours are indifferent between calling and not calling the police.
• Therefore:
o Payoff from calling: 1(𝑥 − 1) = 𝑥 − 1
o Payoff from not calling: 𝑝(someone else calls)𝑥 = [1 − (1 − 𝑝)𝑛−1 ]𝑥
o Probability each person calls: 𝑝
o Probability no one calls: (1 − 𝑝)𝑛
o Probability at least one person calls: 1 − (1 − 𝑝)𝑛
o Probability someone else calls: 1 − (1 − 𝑝)𝑛−1
• Equilibrium condition: 𝑥 − 1 = [1 − (1 − 𝑝)𝑛−1 ]𝑥
𝟏
𝟏 𝒏−𝟏
• 𝒑=𝟏 − (𝒙) so that neighbours are indifferent about calling
o Psychologists’ Bystander Effect: a decreasing function, i.e., probability that each neighbour
calls the police decreases as 𝑛 increases.
𝐧
𝟏 𝐧−𝟏
• 𝒑(𝐚𝐭 𝐥𝐞𝐚𝐬𝐭 𝐨𝐧𝐞 𝐜𝐚𝐥𝐥𝐬) = 𝟏 − (𝐱)
o Economists’ Bystander Effect: a decreasing function, i.e., probability that someone calls the
police decreases as 𝑛 increases.
4
1 ECONOMICS ................................................................................................................................................... 3
1.1 THE NOTION OF ECONOMICS.............................................................................................................................. 3
1.2 POSITIVE ECONOMICS AND NORMATIVE ECONOMICS ............................................................................................... 3
1.3 RATIONALITY AND EQUILIBRIUM ......................................................................................................................... 3
1.3.1 RATIONALITY (OPTIMISATION) IN THE MARKET ............................................................................................................... 3
1.3.2 RATIONALITY (OPTIMISATION) IN THE GAME THEORY ...................................................................................................... 4
2 DEMAND ....................................................................................................................................................... 5
2.1 THE DEMAND FUNCTION ................................................................................................................................... 5
2.2 DETERMINANTS OF DEMAND ............................................................................................................................. 5
2.3 OPTIMAL CONSUMPTION BUNDLE ....................................................................................................................... 5
2.4 INCOME AND SUBSTITUTION EFFECTS ................................................................................................................... 7
2.5 COMPLEMENTS AND SUBSTITUTES ....................................................................................................................... 7
2.6 DEMAND CURVE AND WELFARE: CONSUMER SURPLUS ............................................................................................. 8
3 MONOPOLY ................................................................................................................................................... 9
3.1 A FIRM’S SUPPLY ............................................................................................................................................ 9
3.2 SIMPLE MONOPOLIST ....................................................................................................................................... 9
3.2.1 PROFIT-MAXIMISATION ............................................................................................................................................10
3.2 DEGREES OF MONOPOLISTIC BEHAVIOUR ............................................................................................................ 10
4 MARKETS, MARKET EQUILIBRIUM, AND MARKET WELFARE .......................................................................... 12
4.1 PERFECT COMPETITION ................................................................................................................................... 12
4.2 EFFICIENCY AND EQUITY .................................................................................................................................. 12
4.3 MARKET IMPERFECTIONS ................................................................................................................................ 13
4.4 PERFECT COMPETITION AND THE TWO WELFARE THEOREMS.................................................................................... 13
5 GOVERNMENT INTERVENTION: TAXES, TAX INCIDENCE, AND WELFARE ......................................................... 15
5.1 UNIT TAXES AND TAX INCIDENCE....................................................................................................................... 15
5.2 EFFICIENCY AND TAXATION .............................................................................................................................. 17
5.3 LUMP-SUM TAXES ......................................................................................................................................... 17
6 GAME THEORY ............................................................................................................................................. 18
6.1 STRATEGIC GAME WITH ORDINAL PREFERENCES.................................................................................................... 18
6.2 NASH EQUILIBRIUM ....................................................................................................................................... 18
6.3 PURE STRATEGY NASH EQUILIBRIA: DOMINATION ................................................................................................. 19
6.4 MIXED STRATEGY NASH EQUILIBRIA .................................................................................................................. 19
© 2020 Joyce Yang
,6.5 CASE STUDIES ............................................................................................................................................... 20
6.5.1 PRISONER’S DILEMMA: STRICT DOMINATION ...............................................................................................................20
6.5.2 BATTLE OF THE SEXES (BACH OR STRAVINSKY): COOPERATION ........................................................................................20
6.5.3 MATCHING PENNIES: STRICTLY COMPETITIVE ...............................................................................................................20
6.6 GAME THEORY AND OLIGOPOLIES ..................................................................................................................... 21
6.6.1 BERTRAND COMPETITION: COMPETING WITH PRICE ......................................................................................................21
6.6.2 COURNOT COMPETITION: COMPETING WITH QUANTITY.................................................................................................22
6.6.3 BERTRAND VS COURNOT COMPETITION .......................................................................................................................22
7 ASYMMETRIC INFORMATION: MORAL HAZARD ............................................................................................ 23
7.1 MORAL HAZARD: INSURANCE ........................................................................................................................... 23
7.2 MORAL HAZARD: PERFORMANCE-BASED CONTRACTS ............................................................................................ 24
7.2.1 GENERAL ................................................................................................................................................................24
7.2.2 PARTNERSHIP PROBLEM ............................................................................................................................................24
7.2.3 PRINCIPLE-AGENT PROBLEM ......................................................................................................................................25
8 ASYMMETRIC INFORMATION: ADVERSE SELECTION ...................................................................................... 26
8.1 ADVERSE SELECTION: MARKET FOR LEMONS ........................................................................................................ 26
8.2 ADVERSE SELECTION: INSURANCE MARKETS......................................................................................................... 27
8.3 GOVERNMENT POLICIES THAT COMBAT ADVERSE SELECTION ................................................................................... 27
9 BEHAVIOURAL ECONOMICS AND SOCIAL PREFERENCES ................................................................................ 28
9.1 BEHAVIOURAL ECONOMICS AND SOCIAL PREFERENCES ........................................................................................... 28
9.2 ALTRUISM ................................................................................................................................................... 28
9.2.1 ALTRUISM: MARKET TRADE (NO EFFECT) ....................................................................................................................28
9.2.2 ALTRUISM: PARTNERSHIP PROBLEM (POSITIVE EFFECT) .................................................................................................29
9.2.2 ALTRUISM: SIMULTANEOUS PRISONER’S DILEMMA .......................................................................................................29
9.2.3 ALTRUISM: CHARITY .................................................................................................................................................30
9.2.4 ULTIMATUM AND DICTATOR GAMES ...........................................................................................................................30
9.3 HAPPINESS AND STATUS.................................................................................................................................. 31
9.3.1 MEASURING HAPPINESS............................................................................................................................................31
9.3.2 THE EASTERLIN PARADOX: HAPPINESS AND INCOME ......................................................................................................31
10 ECONOMICS OF DISCRIMINATION .............................................................................................................. 32
10.1 RACIAL BELIEF-BASED DISCRIMINATION IN POLICE VEHICLE SEARCHES...................................................................... 32
10.1.1 BELIEF-BASED DISCRIMINATION (NOT RACIST) ...........................................................................................................33
10.1.1 BELIEF-BASED AND TASTE-BASED DISCRIMINATION (RACIST) ........................................................................................33
2
,1 Economics
1.1 The Notion of Economics
Economics: is the study of how economic agents choose to allocate scarce resources and how those
choices affect society.
Economic agent: an individual or a group that makes choices.
Allocation of scarce resources
o Scarce resources: things that people want, where the quantity that people want exceeds the
quantity that is available.
o Scarcity: the situation of having unlimited wants in a world of limited resources.
1.2 Positive Economics and Normative Economics
Microeconomics: the study of how individuals, households, firms, and governments make choices, and
how those choices affect prices, the allocation of resources, and the wellbeing of other economic agents.
Economic analysis aims to understand people’s choices and consists of:
1. Positive economics: describes what people actually do.
o Objective and fact-based
o Makes predictions about what we can see and measure from data
2. Normative economics: advises what people, including society, ought to do.
o Subjective and value-based
o Evaluates different policies and situations with respect to a particular notion of welfare.
1.3 Rationality and Equilibrium
Rationality (optimisation): people decide what to do by analysing all known costs and benefits of the
different options and pick the best option.
Equilibrium: a situation in which everyone is simultaneously optimising, i.e. when no individual thinks s/he
has a better available option.
1.3.1 Rationality (Optimisation) in the Market
Demand function, D:
results from the
Equilibrium point: QD = QS optimising behaviour of
consumers.
1. No consumer would
want to buy more. Supply function, S:
2. No supplier would want results from the
to produce more. optimising behaviour of
firms.
3
, 1.3.2 Rationality (Optimisation) in the Game Theory
1. Rationality: each player has a belief about the behaviour of other players and each player best
responds to this belief.
2. Beliefs are correct: each player actually behave in line with the others’ beliefs about them
The Kitty Genovese Case of the Bystander Effect
Bystander effect: as the number of bystanders (N) increases, the probability (P) that someone calls the
police decreases.
Players: 𝑛 neighbours
Actions: “call” or “not call”
Payoffs (preferences):
• Cost of calling: 1
• Payoff if someone calls: 𝑥 > 1
Someone else calls 𝒙 Best
You call 𝑥−1 Second best
No one calls 0 Worse
Solutions:
• 𝒑: probability of each individual neighbour calling
o If neighbours preferred to call, they would call for sure: 𝑝 = 1.
o If neighbours preferred not to call, they would not call for sure: 𝑝 = 0.
o 0 < 𝑝 < 1, then the neighbours are indifferent between calling and not calling the police.
• Therefore:
o Payoff from calling: 1(𝑥 − 1) = 𝑥 − 1
o Payoff from not calling: 𝑝(someone else calls)𝑥 = [1 − (1 − 𝑝)𝑛−1 ]𝑥
o Probability each person calls: 𝑝
o Probability no one calls: (1 − 𝑝)𝑛
o Probability at least one person calls: 1 − (1 − 𝑝)𝑛
o Probability someone else calls: 1 − (1 − 𝑝)𝑛−1
• Equilibrium condition: 𝑥 − 1 = [1 − (1 − 𝑝)𝑛−1 ]𝑥
𝟏
𝟏 𝒏−𝟏
• 𝒑=𝟏 − (𝒙) so that neighbours are indifferent about calling
o Psychologists’ Bystander Effect: a decreasing function, i.e., probability that each neighbour
calls the police decreases as 𝑛 increases.
𝐧
𝟏 𝐧−𝟏
• 𝒑(𝐚𝐭 𝐥𝐞𝐚𝐬𝐭 𝐨𝐧𝐞 𝐜𝐚𝐥𝐥𝐬) = 𝟏 − (𝐱)
o Economists’ Bystander Effect: a decreasing function, i.e., probability that someone calls the
police decreases as 𝑛 increases.
4
