# Outline and description of module

## Briefly

• Introduction, the meaning of models/theory (about 5% of module)

• Preferences and ‘choices subject to constraints’…. basic Economic (and behavioural) models (about 20% of module)

• Decision-making under uncertainty, and its implications for Finance. ($\approx$ 10%)

• Consumer and market demand and its properties (preferences and optimization leads to this) ($\approx$ 10%) <

• Profit maximising price-setting firms … How (esp. monopoly) firms consider demand in making (esp. pricing & market segmentation) decisions to maximise profit. … evidence on this. ($\approx$ 15%)

• Mid-term examination about here

• Game theory : ‘Choices and outcomes in strategic settings’, using the tools and language of Game Theory (and, time-permitting, bargaining theory, asymmetric information and ‘Principal-Agent’ models). Evidence. ($\approx$ 20-25%)

• Research/application skills considering/discussing ‘final project’; … How to consider, asses, write about and use models and evidence… building and incorporating these into an applied or research topic. ($\approx$ 5%)

• Supplemental material is provided, which we may discuss, time permitting; these may relate to your research project

### Motivation with puppets

Some key questions and topics for this module (video notes below the fold):

Key topics:

1. Preferences and choice
• Supermarket choice example; two ‘decision modes’; business ‘big data modeling’ implications
1. Consumer demand
• Esp., how it responds to prices and income, and the implications of this.
1. Preferences and choices under (probablistic) uncertainty (building blocks for finance!)
• How do we value ‘a bundle of possibilities’ against another bundle … and how do we choose among these?
• Insurance, investments, life choices (university, job), consumer choices
• ‘Risk aversion’ and the returns to risk
1. (Monopoly) firms: product offerings, pricing and segmentation
• How do they max (LR) profits in light of consumer choices?
• What are the implications of this for society?
• How can they ‘do segmentation’ to boost profits?
• What do they actually do? (Using data?)
1. Strategic interaction and game theory
• E.g., ‘which side of the street to walk on?’, ‘how much to charge/produce if there is a competing firm?’, ‘should I ask my partner to marry me?’, ‘how much should a political campaign invest in advertising in a particular state/county?’

• Is there an advantage or disadvantage to ‘being the first to make an offer’ in bargaining?

• When should I wear a mask? What should we predict about ‘who wears a mask’ and what should increase or decrease this?

• ‘Other-regarding’ preferences (BE) may enter here!

Throughout, but with supplements at the end:

• Behavioural economics
• Applications and evidence from the real world and the ‘laboratory’
• Research and research skills (reading/writing, mathematical modeling, critical thinking, considering applications to the real world and to data, research integrity)

Note: contrast from previous years (unfold)

The ‘story of this module’ (in the video and fold above) is modified from how I structured it in prior years. In contrast to the approach I’m taking now, Microeconomics is often taught in terms of:

1. ‘building blocks of the market’ on the consumer and producer side
2. putting this together to consider the market in ‘general equilibrium’ under perfect competition, and the welfare consequences of this
3. market failures and departures from perfect competition.

This year (in this web book) I’m taking a different path. We are focusing instead on the meaning, tools, and structure of decision-making and on how to consider and apply models. I will put a strong emphasis on uncertainty, strategic interaction, and behavioral economics/psychology. There is less focus on welfare, market equilibrium, or the model of production.

## Planned syllabus, coverage (detailed)

The planned module outline is below.

All timings are approximate and may need to be adjusted. Some material may be cut for time constraints. Feel free to skip over the first time you read these notes; you may want to refer to this later.

The relevant part of this outline will be repeated at the beginning of each section within this book. After I add the material to that section, I may remove it from this outline.

### Overview of module & rules, discussion/background, Economic models (& maths tools), ‘empirical’ evidence ($\frac{1}{2}$ week)

This content will take roughly half a week to cover, but we will return to it later.

### Sec. 2: Preferences and utility; Choice (1.5 weeks)

What can we reasonably say about ‘what people prefer and choose’? How can we state this carefully and precisely? What are the implications of particular ‘reasonable’ assumptions? (How) can we consider this in terms of ‘optimization’? How have Economists and decision-scientists considered these questions?

Note on mathematical precision (unfold)

This precision is relevant for Behavioral Economics (a specialty of Ariel Rubinstein and an interest of mine). The text involves behavioral economics throughout. … also relevant for building empirical ‘models of consumer choices and preferences’ in business/consulting settings.

We approach this in an abstract and logically and mathematically-rigorous, but not highly ‘computational’ way. Even if you have taken Economics as an undergraduate, you may not have seen this approach.

We will not always be quite so mathematically rigorous throughout the module. However, I want to give you a ‘flavour’ of this approach and, and the tools at the core of modern microeconomics (and the approach taught in PhD programmes).

Readings: see sec. 2.2

### Sec. 3Preferences under uncertainty (and over time) (1 week)

Here we follow the order of O-R in covering preferences under uncertainty before consumer behavior and demand.

• ‘Expected Utility’
• Risk-aversion, finance and diversification
• time-preference and discounting (briefly)

With uncertainty (outcomes are unknown when choices are made, but we assume the probabilities of outcomes are known), again …

What can we reasonably say about ‘what people prefer and choose’? How can we state this carefully and precisely? What are the implications of particular ‘reasonable’ assumptions? (How) can we consider this in terms of ‘optimization’? How have Economists and decision-scientists considered these questions?

Applications (esp. to finance):

• How do we express and measure ‘risk aversion’?
• How does this affect (financial, investment, insurance) choices? Why does ‘diversification improve outcomes for the risk-averse’?
• How does this affect asset prices (Stocks, bonds, etc.) with ‘efficient markets’ (this will be briefly defined)
• Behavioral Economics: the “Allais Paradox” (first treatment, time-permitting)

Brief (first) presentation:

• Preferences (and optimization over) assets and consumption over time; ‘discounting’

Main Readings:

Web book, and also…

• O-R Chapter 3: “Preferences under Uncertainty”

Feel free to skip the following (unfold)

Feel free to SKIP:

… the proof of propositions 3.2 (‘Continuity and independence implies EU’). It’s interesting but we can’t cover everything.

If you don’t understand the proof of prop. 3.3. (the equivalence of risk aversion and the concavity of the Bernoulli function) that’s also OK.

• McDL: 13.3 on ‘dynamic choice’

Other resources/references (unfold)

• QMC: Ch 5, optimization and risk; selections (good discussion of diversification but doesn’t use utility functions)

• NS: Ch 4 (not including 4a)

• McDL: Ch 13, section 4 ‘Risk Aversion’

Supplementary recommended readings:

• Holt, C., and S. Laury (2002), Risk Aversion and Incentive Effects, American Economic Review, v. 92 (5): 1644-1655.

• For a popular audience: Reinstein (2016) ‘Should you hedge your bets on a Brexit?’ LINK

### Consumer preferences, indifference curves/sets (0.5 weeks)

• O-R Chapter 4, selected parts

Note this chapter covers only a simple 2-good example. If time permits, we will consider the properties of examples with “$N>2$ goods”; $N>2$ is necessary to consider reasonable substitution patterns between goods for many applications. You will also probably learn the N-good optimisation in your maths (optimisation techniques) module.

Within O-R chapter 4, feel free to SKIP (unfold):

Feel free to skip

• Section 4.6 “Differentiability” (just look at figure 4.5 to get the basic idea)

Further readings tbd.

### Consumer behavior/Individual (and market) demand functions and their properties (1 week)

• Formal definition

• Derivation of individual ‘demand’ from individual optimization

• ‘Comparative statics’: responses to changes in price, income, etc.;

• Elasticities

• Application: empirical models
• Aggregation and ‘market demand’

• Welfare and consumer surplus (brief)

Main reading (largely integrated into web book):

• O-R Chapter 5 (selections; see below)

• Alternative treatments (see below)

• Supplementary but recommended readings (see below)

### Noting a major “skip”

Note here that we are SKIPPING several key topics in consumer demand (unfold)

• In the consumer behavior, we are skipping core topics including formal definitions of Hicksian demand, substitution and income effects, and the Slutsky decomposition.

These are important for characterizing the welfare effects of price changes and policy changes (including taxation), and for conceptualizing issues involving multiple constraints on consumer optimization (e.g., rationing). I will provide notes on these for anyone who is interested.

We are also skipping most of the ‘production side’ (skipped material in fold)

• Production functions, firm optimisation

• Perfect competition/competitive equilibrium; short and long run

• Supply and demand systems

• General equilibrium and it’s welfare properties

• Market failures, including externalities/public goods (although these come back as examples in our Game Theory discussion)

We this skip these chapters in the text(s). So skip O-R chapter 6 and skip any material on this in the other texts.

(Or read it if you want to; you might find it useful in getting an overall picture, but it’s up to you.)

To the extent that these are relevant to material we cover later, I will give you the ‘short version’ when it comes up.

### ‘Monopolies and pricing of profit-maximizing price-setting firms’ (especially monopolies); price discrimination/market segmentation (1.5 weeks)

How would a firm that knows all the stuff above about consumer demand set prices in order to maximise its profit? What if it can segment its customers into different ‘markets’ with distinct demand functions? What are the consequences of all of this for profit and welfare?

Today’s businesses, consultants, data analysts, and regulators are extremely interested in these questions. This is a very practical topic. We will consider it both from the theoretical optimization point view (while always gaining insights from the maths). We will also dig into “what do firms actually do in setting pricing” and “how can data be used to do this better?”

Main reading

• O-R ch. 7 “Monopoly”

We will focus on the (standard) profit-maximisation goal, although their discussion of other goals is interesting.

They define consumer and producer surplus here to give a brief treatment of the deadweight loss of monopoly.

They also have a very interesting treatment of the two main types of price discrimination; ‘Implicit discrimination’ foreshadows asymmetric information and agency problems.

There are various names of each of these … I am familiar with “second degree = self-selection” and “third degree or ‘explicit segmentation’”. They call the latter ’Implicit discrimination.

Alternative treatments (unfold):

• McDL: Ch 15 – Monopoly
• NS: 11.2-11.4
• QMC: Appendix A.1 - Monopoly - the vanilla version

Supplementary recommended readings (unfold):

• With accompanying worked examples

• More advanced: ‘The Government May Want to Encourage Price Discrimination by Income’ Linked here

• Material from data science and industry pricing practice to be incorporated here; see “Marketing” chapter in Business analytics with R

#### Interactive exercises (‘problem set’) (tbd; unfold for basic idea)

OR question 1, double marginalization (very relevant and interesting!)

OR question 5-7

Possible exercise involving data and ‘choosing a firm’s best price and segmentation’

### Notes: Mid-term examination, and a major “skip”

We will have a mid-term examination at this point in the module. This examination will cover all of the material up to this point, but it will be more heavily-focused on the earlier material.

Note that here we are largely skipping ‘imperfect competition’ and interactions between firms. We may come back to this briefly in our ‘game theory’ examples.

### Strategic interactions: Game theory (and evidence) (2 weeks)

The outcomes we care about don’t only depend on what we choose, but on what others’ choose (and perhaps we can also influence the latter). How should we think about choices and outcomes in such settings? What will we predict will happen in single or repeated interactions, and what will affect these outcomes?

• Strategic interactions

• Stating the game in ‘normal’ form

• Dominance, iterated dominance, Rationalisability

• Best response functions, Nash equilibrium in pure and mixed strategies

• Extensive-form games; sequential and repeated games

• Backwards induction and Subgame Perfection (subgame-perfect Nash equilibrium)

• Infinitely or indefinitely repeated games

• Games of imperfect information

• Behavioral economics: transforming material payoffs into true payoffs

• Evidence on play in strategic situations, including in ‘experiments’

• Time-permitting: Research applications, e.g., ‘Marriage markets and Tinder; Losing Face’, ‘Fair trade and consumer altruism’

Here the web-book is a key resource. We will incorporate material from:

• O-R Chapters 15-16
• Skip sections 15.5 (Strictly competitive games), and 15.6 (Kantian equilibrium)
• In chapter 16, we may or may not skip the formal depiction of extensive/sequential games; this depends on our timing

In addition to (some) of the Game Theory material covered in O-R:

• We will also focus on ‘Dominant strategies’, and ‘Iterated-strict-dominance’. Compared to ‘Nash equilibria’, these are (IMHO) more justifiable as predictors of choices especially in one-shot games.
• We will consider games involving asymmetric information, especially ‘signaling games’

Alternative resources (unfold):

• QMC: Ch 9, 10, 12 (includes ‘iterated dominance’)
• McDL: Ch 16
• NS: Ch 5 (parts)
• Several additional concepts from handout, plus supplement on experiments

Supplementary recommended readings (unfold):

• Spence, M. (1973): ‘Job market signaling,’ The Quarterly Journal of Economics, vol. 87, pp. 355-374. A fairly readable and extremely influential (theory) paper, extending this to games of incomplete (asymmetric) information

• ‘Ten Little Treasures of Game Theory and Ten Intuitive Contradictions’ Goeree and Holt, 2001

Considering experimental evidence:

• Skim or read the introduction of any of the ‘Handbooks’ like ‘Handbook of Experimental Economics’

Meta-analysis papers like:

• Oosterbeek, Hessel, Randolph Sloof, and Gijs Van De Kuilen. “Cultural differences in ultimatum game experiments: Evidence from a meta-analysis.” Experimental economics 7.2 (2004): 171-188 or

• Johnson, Noel D., and Alexandra A. Mislin. “Trust games: A meta-analysis.” Journal of Economic Psychology 32.5 (2011): 865-889.

I also advise looking at recent ‘replication’ and ‘many labs’ project work; there are now more systematic attempts to get robust evidence on which patterns and effects are ‘real’ and which were a ‘lucky draw’ or ‘publication bias’. This also applies to our later discussion of behavioral economics.

### 0.0.1Project, discussion of research (1 week)

BEEM101: The majority of your mark for this module will be based on a project that you will do, and on your presentation of this project to me.

For this project you will construct, evaluate and discuss one or more mathematical models dealing with a specific applied or theoretical economics research question. Ideally, this will be related to the work you intend to pursue for your MSc dissertation. You will be required to present and discuss this work in a short live session (10-15 minutes).

This project can be an individual project or done in a group of 2-3 people. If it is done as a group, each student will also be asked to present a single page outlining their own contribution to the project, and each will be required to present their work to me individually.

Further details and parameters will be given. In the final half week, we will discuss our projects.

A key reading/resource:

Researching and writing for Economics students, by David Reinstein

### Supplement (optional): Behavioural economics: Selected further concepts

• Overview: Limits to cognition, willpower, self-interest, applications

• Time-inconsistent preferences (‘hyperbolic’ or $\beta$-$\delta$ discounting)

• Reference-dependent preferences and ‘prospect theory’ (also re-capping the Allais paradox)

• Evidence for these ‘anomalies’

• Aside on the nature of credible evidence, replication and open-science
• Modeling charitable giving and ‘other-regarding behavior’; departures from and barriers to ‘effective altruism’

Supplementary readings (unfold)

Supplementary reading: theory

(31 Jul 2020 note: This will be revised)

• Amos Tversky & Daniel Kahneman, 1979. “Prospect Theory: An Analysis of Decision under Risk” (Seminal)

Supplementary reading: applications and empirical work

• DellaVigna, Stefano. “Psychology and economics: Evidence from the field.” Journal of Economic literature 47.2 (2009): 315-372.
• Benartzi, S. & Thaler, R.H., 2007. Heuristics and biases in retirement savings behavior. The journal of economic perspectives, pp.81-104.
• Farber, H., 2008. Reference-dependent preferences and labor supply: The case of New York City taxi drivers. The American Economic Review. Available at: http://www.ingentaconnect.com/content/aea/aer/2008/00000098/00000003/art00021 [Accessed November 19, 2015].

Other-regarding behavior and charitable giving:

### Supplement (optional): Asymmetric information (Moral hazard, adverse selection, signaling) and applications

‘Principal-agent’ models to be integrated into lecture notes

• Moral hazard and incentives
• ‘Lemons model’
• Hidden information about types/adverse-selection (time-permitting)
• ‘Live research’ application (time-permitting): Financial market micro-structure and government policy

Readings (tbd, unfold):

• O-R Chapter 14 on a market with Asymmetric Information (a highly formal treatment of the adverse-selection context)

## Scheduled lectures/tutorials, rules for assesment: see ELE page and module descriptor

The assessment will be a combination of a midterm examination, and a project and presentation due by end of term.