Microeconomics — Consumer + Producer + Market Structures + General Equilibrium + Welfare + Game Theory + Behavioral

Microeconomics

1. At a glance

Microeconomics is the theory of how individual decision-makers — households, firms, regulators acting at the program level — allocate scarce resources under constraint, and how those choices aggregate into market outcomes, prices, and welfare consequences. It is the foundation of pricing, market design, antitrust, regulation, taxation, labour, public goods, environmental policy, and most of what economists are asked to evaluate in public + corporate settings. The discipline rests on three load-bearing ideas: optimisation under constraint (agents maximise an objective function subject to budget, technology, and information limits), equilibrium (prices and quantities adjust so that individual plans are mutually consistent), and welfare evaluation (outcomes scored against Pareto efficiency or explicit social welfare functions, with market failures flagged where decentralised choice diverges from the social optimum).

This note is the canonical microeconomics reference for the library — organised around the standard graduate-text sequence: consumer theory → producer theory → market structures → general equilibrium → welfare theorems → market failures → game theory → mechanism design → behavioral departures. It pairs with microeconomics-foundations (a complementary deep note with more empirical orientation), industrial-organization (oligopoly + antitrust + IO empirical methods), behavioral-economics (deeper behavioral treatment), game-theory (deeper game theory), labor-economics, public-economics-and-taxation, environmental-and-resource-economics.

Three reference texts anchor modern graduate study: Mas-Colell + Whinston + Green Microeconomic Theory (1995, often shortened “MWG”) for the comprehensive treatment, Kreps Microeconomic Foundations I + II (2013 + 2023) for the modern foundations + uncertainty + dynamic treatment, and Jehle + Reny Advanced Microeconomic Theory (3rd ed 2011) for accessible rigour. Intermediate: Varian Intermediate Microeconomics + Microeconomic Analysis. Specialty: Tirole Industrial Organization (1988), Roth Who Gets What and Why (2015), Milgrom Putting Auction Theory to Work (2004), Kahneman Thinking Fast and Slow (2011).

2. Consumer theory

2.1 Preferences and utility representation

The behavioural foundation. Agents are assumed to have preferences over consumption bundles, those preferences satisfy axioms that yield a utility representation, and agents choose the most-preferred affordable bundle.

Preference axioms (Debreu 1954; Arrow + Debreu 1954):

• Completeness — for any two bundles A, B, the agent ranks them: A ≽ B or B ≽ A (or both, in which case A ∼ B).
• Transitivity — A ≽ B and B ≽ C implies A ≽ C.
• Continuity — small changes in bundles preserve ranking (no jump discontinuities in preferences).
• Monotonicity — more of every good is weakly preferred (formally, x ≥ y component-wise implies x ≽ y; strict monotonicity if strictly more is strictly preferred).
• Convexity — averages are at least as good as extremes (formally, for any x, y in the upper-contour set of bundle z, λx + (1-λ)y is in the upper-contour set for λ ∈ [0,1]).

Debreu’s representation theorem: completeness + transitivity + continuity yield a continuous utility function u : ℝⁿ₊ → ℝ representing ≽. Adding monotonicity gives strictly increasing u; adding convexity gives quasiconcave u.

Budget set: with prices p ∈ ℝⁿ₊ and income m, the consumer’s budget set is B(p, m) = {x ∈ ℝⁿ₊ : p · x ≤ m}.

Consumer problem: max u(x) subject to p · x ≤ m, x ≥ 0. Under monotonicity the budget binds with equality. Under convexity the solution is unique (interior, or on a unique vertex of B).

2.2 Marshallian and Hicksian demand

Marshallian (Walrasian) demand x*(p, m) — the utility-maximising bundle as a function of prices and income. Solves the consumer problem under fixed nominal income.

Indirect utility function v(p, m) = u(x*(p, m)) — the maximum utility achievable. Properties: continuous, homogeneous of degree zero in (p, m), strictly increasing in m, decreasing in p, quasiconvex in p.

Hicksian (compensated) demand h*(p, ū) — solves the dual: min p · x subject to u(x) ≥ ū. Hicksian demand isolates the substitution effect by holding utility (not nominal income) constant.

Expenditure function e(p, ū) = p · h*(p, ū) — the minimum expenditure required to achieve utility ū at prices p. Properties: continuous, homogeneous of degree 1 in p, strictly increasing in ū, concave in p.

Duality — the value functions v + e and the demand functions x*+ h*are linked:

• e(p, v(p, m)) = m (Marshallian + expenditure compose to identity in income).
• v(p, e(p, ū)) = ū (analogous in utility).
• Shephard’s lemma: ∂e/∂pᵢ = hᵢ*(p, ū) — partial derivative of expenditure with respect to price equals Hicksian demand.
• Roy’s identity: xᵢ*(p, m) = −(∂v/∂pᵢ) / (∂v/∂m) — Marshallian demand from indirect utility.

2.3 Slutsky decomposition

The total response of Marshallian demand to a price change splits into substitution and income effects:

∂xᵢ/∂pⱼ  =  ∂hᵢ/∂pⱼ   −   xⱼ · (∂xᵢ/∂m)
            ──────       ─────────────
            substitution  income effect
            (always ≤ 0
            for own price
            by concavity)

• The substitution effect ∂hᵢ/∂pⱼ holds utility constant, isolates the pure price-induced rebalancing.
• The income effect xⱼ · (∂xᵢ/∂m) captures the real-income shift: a higher price of good j reduces purchasing power proportional to consumption of j; that reduction affects demand for i via income elasticity.

For own-price elasticity, the substitution effect is always non-positive (Hicksian demand is non-increasing in own price by concavity of e). The income effect can have either sign — negative for normal goods, positive for inferior goods. For Giffen goods (inferior + dominant income effect), the income effect overwhelms substitution and own demand rises with price. Empirical Giffen behaviour documented in Jensen + Miller 2008 (rice + wheat in poor Chinese households); historical apocrypha around Irish potatoes in the 19th century.

2.4 Indifference curves, MRS, and common utility forms

Indifference curve — locus of bundles delivering constant utility. Marginal rate of substitution MRS_xy = −dy/dx along indifference curve = MU_x / MU_y, the rate at which the consumer is willing to trade y for x. At interior optimum, MRS = price ratio p_x / p_y.

Common utility forms:

• Cobb-Douglas: u(x, y) = x^α y^(1-α). Constant expenditure shares — fraction α of income spent on x regardless of prices. Workhorse for tractability.
• CES (constant elasticity of substitution): u(x, y) = (αx^ρ + (1-α)y^ρ)^(1/ρ). Elasticity of substitution σ = 1/(1-ρ). Cobb-Douglas is the σ = 1 limit; Leontief σ = 0; perfect substitutes σ = ∞.
• Quasilinear: u(x, y) = v(x) + y. No income effect on x; convenient for partial-equilibrium welfare analysis.
• Leontief (fixed proportions): u(x, y) = min(x/a, y/b). Perfect complements consumed in fixed proportions (left + right shoes; processor + RAM in fixed ratios).

2.5 Revealed preference

Revealed preference (Samuelson 1938). If bundle A is chosen when B is affordable, A is revealed preferred to B (Weak Axiom of Revealed Preference, WARP). Strong Axiom of Revealed Preference (SARP) requires transitivity of revealed preference across choice records. WARP + SARP let you recover preferences from observed choice without assuming utility a priori — a foundation for behavioral + experimental work + for nonparametric demand estimation.

Afriat’s theorem (1967) — finite consumption-choice data are consistent with utility maximisation if and only if SARP holds; in that case a finite set of monotone, concave, continuous utilities rationalise the data.

3. Producer theory

3.1 Production functions

Production function y = f(x_1, …, x_n) — maximum output from input vector x. Mirrors the consumer’s utility function in structure.

Marginal product MP_i = ∂f/∂x_i. Diminishing marginal product: as x_i rises with other inputs fixed, MP_i eventually falls (Turgot 1767 documented in agriculture).

Isoquants — loci of constant output in input space. Marginal rate of technical substitution MRTS = MP_i / MP_j, the rate at which input j substitutes for input i holding y fixed. At cost-minimising input mix, MRTS = w_i / w_j (input price ratio).

Returns to scale:

• Constant (CRS): f(λx) = λ f(x). Doubling all inputs doubles output.
• Increasing (IRS): f(λx) > λ f(x) for λ > 1. Natural-monopoly territory if persistent over relevant range.
• Decreasing (DRS): f(λx) < λ f(x) for λ > 1. Limits firm size in long run.

3.2 Cost functions

Cost function c(w, y) = min_x w · x s.t. f(x) ≥ y. The producer-side dual to the consumer’s expenditure function.

Short-run vs long-run:

• Short-run cost SRC(y) = F + VC(y). Fixed cost F (capital, plant) cannot be varied; variable cost VC(y) reflects input adjustments.
• Long-run cost LRC(y) lets all inputs adjust. LRC envelope of SRC curves (each SRC tangent to LRC at its associated capital stock).

Cost curves:

• Marginal cost MC = dC/dy.
• Average cost AC = C/y.
• Average variable cost AVC = VC/y.
• Average fixed cost AFC = F/y (declines monotonically with y).

Under standard assumptions (diminishing returns), AC and AVC are U-shaped; MC cuts both at their minima.

Hotelling’s lemma (producer-side analogue of Shephard): ∂C/∂w_i = x_i*(w, y) — partial derivative of cost with respect to input price equals conditional input demand.

3.3 Profit maximisation

Profit π(p, y) = p · y − c(w, y). Choose y to max. FOC: MR = MC.

• Under perfect competition firm is price-taker → MR = P, so P = MC at optimum.
• Under monopoly, MR < P (must lower price on all units to sell more), so MC = MR < P → markup price.
• Lerner index L = (P − MC)/P = −1/E_d measures markup power. Inversely proportional to absolute demand elasticity.

3.4 Common production forms

• Cobb-Douglas: y = A x_1^α x_2^β. α + β controls returns to scale (>1 IRS, =1 CRS, <1 DRS).
• CES: y = A (αx_1^ρ + (1-α)x_2^ρ)^(1/ρ). Spans substitution-elasticity continuum.
• Leontief: y = min(x_1/a_1, x_2/a_2). Fixed proportions; no substitution.
• Translog: ln y = α_0 + Σ α_i ln x_i + ½ Σ β_ij ln x_i ln x_j. Flexible second-order approximation; standard in empirical production estimation.

4. Market structures

The taxonomy classifies markets by number of sellers, product differentiation, entry conditions.

4.1 Perfect competition

Many small firms, homogeneous product, free entry/exit, perfect information, price-takers. Long-run equilibrium: P = MC = AC at minimum-AC point; zero economic profit (positive accounting profit covers opportunity cost of capital). First fundamental welfare theorem: competitive equilibrium with complete markets + no externalities is Pareto efficient.

4.2 Monopoly

Single seller, no close substitutes, blocked entry (legal, technological, network, scale). Firm chooses (P, Q) facing whole market demand.

• MR = P(1 + 1/E_d) < P when E_d finite.
• Profit max MR = MC yields Q^M < Q^competitive and P^M > P^competitive.
• Deadweight loss = triangle between demand and MC over (Q^M, Q^competitive).
• Lerner index L = (P − MC)/P = −1/E_d.
• Sources of monopoly: patents + IP (statutory), natural monopoly (IRS over relevant range), network effects + lock-in, regulatory licensing, control of essential input, strategic deterrence.

Price discrimination (Pigou 1920 three degrees):

• First-degree (perfect) — charge each buyer reservation value. Captures full consumer surplus; eliminates DWL but transfers all surplus to producer. Rare in pure form; approximated by personalised pricing.
• Second-degree — non-linear pricing. Buyers self-select. Quantity discounts, two-part tariffs, versioning.
• Third-degree — segment by observable characteristic. Student + senior discounts, geographic pricing. Welfare ambiguous.

4.3 Monopolistic competition

Chamberlin 1933 + Robinson 1933. Many firms, differentiated products (brand, location, quality), free long-run entry. Each firm faces downward-sloping demand for its own variant but entry erodes profit. Long-run zero profit at tangency between firm demand and AC. Excess capacity result: P > MC, Q below min-AC point — but variety provides welfare offset.

Dixit + Stiglitz 1977 modelled the trade-off in a CES framework that became the foundation of:

• New trade theory (Krugman 1979, 1980; Krugman 2008 Nobel) — explains intra-industry trade between similar economies via love-of-variety + IRS.
• New economic geography (Krugman 1991, Fujita + Krugman + Venables 1999) — agglomeration, urban systems.
• New growth theory (Romer 1990; Romer 2018 Nobel) — varieties + endogenous innovation.

4.4 Oligopoly

Few firms, strategic interaction. Game-theoretic analysis required.

Cournot (1838) — firms simultaneously choose quantities; market clears at sum.

• Reaction functions q_i*(q_{-i}).
• Nash equilibrium: each firm best-responds to others.
• With n symmetric firms + linear demand + constant MC: P^Cournot lies between monopoly and competition; (P − MC)/P = 1/(n · |E_d|). As n → ∞, approaches competition.

Bertrand (1883) — firms simultaneously choose prices; consumers buy from lowest.

• With homogeneous product + identical constant MC, unique NE: P = MC and zero profit even with two firms (Bertrand paradox).
• Resolutions: capacity constraints (Edgeworth 1925; Kreps + Scheinkman 1983 showed Cournot can be derived from Bertrand + capacity choice), product differentiation, repeated interaction.

Stackelberg (1934) — sequential quantities. Leader moves first, anticipates follower’s reaction. Leader gets larger share + higher profit than under Cournot; total industry quantity higher (closer to competition).

Hotelling (1929) location model — firms choose location on a line (= product space) before competing in prices. Min-differentiation result: under quadratic transport costs + Bertrand pricing, both firms locate at the centre (the median voter analogue in spatial competition). With linear transport costs, differentiation emerges in equilibrium.

Cartel — explicit collusion to act as joint monopolist. OPEC (founded 1960), historical sugar + diamond cartels. Unstable: each member has incentive to overproduce (price above MC creates surplus for the firm that cheats first). Sustained by repeated interaction + trigger strategies (folk theorem) + external enforcement (legal in OPEC’s case via state sovereignty).

4.5 Monopsony

Single buyer. Often labour markets in concentrated local markets (Robinson 1933 coined the term). Firm faces upward-sloping labour supply; marginal cost of labour MCL > wage; profit max MRP = MCL yields wage below competitive level + employment below competitive. Empirically important — Card + Krueger 1994 minimum-wage natural experiment (NJ vs PA fast food after NJ raised min wage) found no employment loss and sometimes gains, consistent with monopsony power. Manning 2003 Monopsony in Motion developed the modern framework. Azar + Marinescu + Steinbaum 2022 showed substantial monopsony in US local labour markets.

4.6 Two-sided markets and platforms

Rochet + Tirole 2003 + Caillaud + Jullien 2003 + Evans 2003. Platform serves two groups whose values depend on each other’s participation (cross-side network effects). Examples:

• Apple App Store (developers + users)
• Uber (drivers + riders)
• Amazon Marketplace (sellers + buyers)
• Visa (merchants + cardholders)
• Newspapers (readers + advertisers)
• Operating systems (developers + users)

Optimal pricing often skewed — one side priced below cost (sometimes negative — subsidies, free) to attract participation, recovered from the other. Implications for antitrust: standard market-power tests + relevant-market definition need adaptation; Amex case (US Supreme Court 2018) explicitly recognised two-sided market analysis under Section 1 Sherman Act.

5. General equilibrium

Partial equilibrium analysis takes other markets’ prices as given. General equilibrium clears all markets simultaneously with prices that bring supply equal to demand everywhere.

5.1 Walras and the Arrow-Debreu model

Walras (1874) posed the general equilibrium problem as solving a system of demand-equals-supply equations across all markets. Walras’s law: if all but one market clears, the last clears automatically (budget constraints sum the value of excess demands to zero). Hence only n-1 independent market-clearing conditions for n goods.

Arrow + Debreu 1954 — Existence of an Equilibrium for a Competitive Economy (Econometrica). Provided the first rigorous proof of existence of competitive equilibrium under:

• complete markets (a contingent commodity for every state of the world × date × physical commodity),
• preferences are continuous + strictly convex + monotonic,
• production sets are closed + convex + contain 0 (no fixed costs that violate convexity),
• aggregate production is bounded + has a lower bound.

The proof uses Kakutani’s fixed-point theorem on the price simplex: define the excess demand correspondence ζ(p), find a fixed point of the auctioneer’s price-adjustment rule. Arrow + Hahn 1971 General Competitive Analysis + Debreu 1959 Theory of Value extended.

Sonnenschein-Mantel-Debreu theorem (1972-1974) — aggregate excess demand functions satisfy only continuity + homogeneity + Walras’s law; essentially any function can be an aggregate excess demand. Implication: GE theory does not pin down comparative statics from preference + technology assumptions alone — aggregation washes out individual structure.

5.2 Welfare theorems

First fundamental welfare theorem (1FWT). Every competitive equilibrium with complete markets, no externalities, and price-taking behaviour is Pareto efficient. The “invisible hand” formalised (Smith 1776 → Arrow + Debreu 1954). Proof: if a Pareto-improving allocation existed, agents would have rejected the equilibrium choice given budget.

Second fundamental welfare theorem (2FWT). Every Pareto-efficient allocation can be supported as a competitive equilibrium given suitable lump-sum redistribution of initial endowments + convex preferences + convex production sets. Separates efficiency from distribution — in principle, society can pursue any equitable allocation through transfers + markets. In practice, lump-sum transfers are rare; real-world taxation distorts.

The welfare theorems hold under strong conditions. Market failures identified the cases where they break: externalities, public goods, asymmetric information, missing markets, incomplete contracts. Modern welfare economics is largely the study of market failures + the design of corrective interventions.

5.3 Equilibrium and stability

Existence is generic under Arrow-Debreu conditions. Uniqueness is not — multiple equilibria can exist (the Marshallian story with rising MC for one firm + falling MC for another); examples in financial-crisis models (Diamond + Dybvig bank runs as multiple equilibria). Stability (does the tâtonnement price-adjustment process converge to equilibrium?) is generally fragile — Scarf 1960 showed simple economies where tâtonnement cycles without converging. Modern computational + agent-based approaches replace tâtonnement with stochastic learning dynamics.

6. Welfare and market failures

6.1 Externalities

A cost or benefit imposed on a third party not reflected in market price (Pigou 1920).

• Negative externality (pollution, congestion, antibiotic resistance, noise) → overproduction relative to social optimum (private MC < social MC).
• Positive externality (vaccination, R&D spillovers, basic research, network adoption) → underproduction relative to social optimum (private MB < social MB).

Pigouvian tax/subsidy — set tax equal to marginal external damage to internalise. Carbon pricing (Sweden 1991 carbon tax, EU ETS 2005, California 2013 cap-and-trade, Canada 2019 federal backstop) is the flagship modern application. EPA 2023 Social Cost of Carbon revised to ~$190/tCO2(upfrom$50 in Obama-era central estimates), driven by updated damage modelling + lower discount rate.

Coase theorem (Coase 1960; Nobel 1991). If property rights are well-defined and transaction costs are zero, parties will bargain to an efficient allocation regardless of who holds the initial right. The distribution of rents depends on initial assignment but the level of the externality does not. In practice transaction costs are rarely zero — Coase himself emphasised this. The theorem is mostly a benchmark for identifying when bargaining might substitute for regulation (small numbers, well-defined rights, low transaction cost — e.g. neighbour disputes; less so for diffuse externalities like carbon).

6.2 Public goods

Non-rival (one person’s use doesn’t reduce another’s) + non-excludable (cannot prevent free use). National defence, basic research, clean air, lighthouses (Coase 1974 disputed the canonical lighthouse example), open-source software, public-health pathogen surveillance.

• Free-rider problem: each agent’s privately optimal contribution is zero (or below social optimum); total provision below social optimum.
• Samuelson condition (1954): efficient provision when Σ_i MRS_i = MRT (sum of marginal willingness to pay across all consumers = marginal cost of production). Contrast with private-good condition (MRS = MRT for each individual).

Solutions:

• Government provision financed by taxation (defence, basic research, public health).
• Subscription / clubs (Buchanan 1965 club theory) — partial excludability via membership.
• Lindahl pricing — personalised prices reflecting individual marginal valuations; theoretically efficient but requires preference revelation.
• Voluntary contribution mechanisms with matching (charitable giving + public-broadcasting models).
• Mechanism design (VCG mechanisms — see §8).

6.3 Common-pool resources (commons)

Rival but non-excludable — fisheries, groundwater aquifers, atmospheric carbon, common grazing land, fishing in international waters, antibiotics (the patient → resistance population spillover).

Hardin 1968 “Tragedy of the Commons” — open access leads to overuse + degradation. Each user’s private MC is below social MC of overuse.

Ostrom 1990 + 2009 Nobel — empirical fieldwork on lobster fisheries, irrigation systems, common forests, alpine grazing showed community management with locally crafted rules can sustain commons without state ownership or privatisation. Ostrom’s design principles:

1. Clear boundaries (who is in, who is out).
2. Congruent rules (use rules matched to local conditions).
3. Collective choice (users participate in rule-making).
4. Monitoring (low-cost monitoring of compliance).
5. Graduated sanctions (proportional response to violation).
6. Conflict resolution (rapid + low-cost dispute-resolution).
7. Recognition by external authorities (legitimacy).
8. Nested enterprises (for large CPRs, multiple layers of nested governance).

Foundational for environmental governance, water + fishery management, climate cooperation, internet commons (DNS, IETF protocols).

6.4 Information asymmetry

Akerlof + Spence + Stiglitz shared 2001 Nobel.

Adverse selection — pre-contract hidden information. Akerlof 1970 “Market for Lemons” — used-car market may unravel when sellers know quality + buyers don’t; only the worst cars remain. Insurance markets: high-risk buyers self-select into coverage; market may unravel without mandates or pooling.

Moral hazard — post-contract hidden action. Insurance reduces care-taking; principal-agent in firms (manager effort, CEO compensation); credit markets (debtor risk-taking with limited liability).

Signalling (Spence 1973) — informed party takes costly action that reveals type. Education-as-signal: even if school adds no human capital, college degree separates high-ability from low-ability if cost of completing it is lower for high-ability. Separating equilibrium possible when signalling cost is correlated with type; pooling equilibrium otherwise. Refined by Cho + Kreps 1987 Intuitive Criterion.

Screening (Rothschild + Stiglitz 1976; Stiglitz 1975). Uninformed party offers menu; agents self-select. Insurance menus (high deductible / low premium vs low deductible / high premium); airline price discrimination (advance-purchase, Saturday-night-stay restrictions); credit-card sign-up bonuses.

6.5 Incomplete contracts and the firm

Hart + Moore 1990 + Hart 1995 Firms, Contracts, and Financial Structure — when contracts cannot specify all contingencies, ownership of residual rights matters. The firm exists because internal hierarchy economises on transaction costs that markets cannot manage (Coase 1937; Williamson 1971, 1975, 1985; 2009 Nobel).

The boundary of the firm is where marginal transaction cost in market = marginal cost of internal organisation. Hart-Holmström 2016 Nobel for incomplete contracts + organisation theory.

Modern themes:

• Vertical integration and the make-or-buy decision.
• Property-rights theory of the firm (Grossman + Hart 1986; Hart + Moore 1990) — residual control rights drive non-contractible investments.
• Relational contracts (Baker + Gibbons + Murphy 2002) — self-enforcing arrangements sustained by repeated interaction.
• Multitasking + multitask agency (Holmström + Milgrom 1991) — incentive contracts in multi-output settings.

7. Game theory primer

Strategic interaction is the engine of oligopoly, mechanism design, bargaining, voting, signalling, and most modern micro. See game-theory for the deeper treatment; key concepts here.

7.1 Normal-form games

Set of players N, strategy sets S_i, payoff functions u_i : S → ℝ. Normal form (matrix) representation; extensive form (game tree with information sets, capturing sequence + information structure) used for sequential games.

7.2 Nash equilibrium

Nash 1950, 1951; Nobel 1994. Strategy profile (s_1*, …, s_n*) where each s_iis best response to s_{-i}. Every finite game has at least one Nash equilibrium (possibly in mixed strategies — Nash’s theorem via Kakutani fixed-point).

Mixed strategies — randomisation over pure strategies. Necessary when no pure NE exists (matching pennies; rock-paper-scissors). Interpretation: deliberate randomisation, or as a Bayesian distribution over opponent types (Harsanyi purification 1973).

7.3 Subgame perfect equilibrium

Selten 1965, 1975; Nobel 1994. Refinement for extensive games: strategy profile that constitutes NE in every subgame. Eliminates non-credible threats. Solved by backward induction in finite games. Generalisations: perfect Bayesian equilibrium, sequential equilibrium (Kreps + Wilson 1982).

7.4 Repeated games and folk theorem

Friedman 1971; Fudenberg + Maskin 1986. In infinitely repeated games with sufficient patience (discount factor δ near 1), almost any feasible + individually rational payoff vector is sustainable as a SPE. Cooperation in PD can be sustained via trigger strategies, tit-for-tat, grim trigger. Cartel stability falls out as application.

7.5 Canonical 2×2 games

• Prisoner’s dilemma — dominant strategy is defect, but (cooperate, cooperate) Pareto-dominates (defect, defect). Public-goods provision, arms races, cartel cheating.
• Stag hunt — two pure NE: (stag, stag) Pareto-superior + (hare, hare) risk-dominant. Coordination problem with payoff-vs-risk trade-off (Skyrms 2004).
• Battle of the sexes — two pure NE corresponding to coordination on either party’s preferred outcome + a mixed NE.
• Chicken / hawk-dove — two pure NE (each player swerves while other doesn’t); models brinkmanship + bargaining.
• Matching pennies — zero-sum, no pure NE, unique mixed NE.

7.6 Bayesian games and incomplete information

Harsanyi 1967-68; Nobel 1994. Players have private information (types) drawn from a known distribution. Bayes-Nash equilibrium = NE in the expanded game with types. Foundation for auction theory + signalling + adverse-selection contracts.

8. Mechanism design

Reverse game theory. Given desired outcomes + private information, design rules so equilibrium yields the outcome.

Revelation principle (Myerson 1979; Gibbard 1973). Without loss, restrict to direct mechanisms in which truthful reporting is equilibrium. Reduces the search over all possible mechanisms to a search over incentive-compatible direct ones.

Vickrey-Clarke-Groves (VCG) mechanism (Vickrey 1961; Clarke 1971; Groves 1973). Truthful + efficient in quasilinear environments. Each agent pays the externality they impose on others — the change in others’ welfare due to the agent’s presence. Implements the efficient allocation in dominant strategies. Used in:

• Spectrum auctions (FCC SMR variants, incentive auction 2017).
• Google + Yahoo + Microsoft search ad auctions (initially GSP, partially VCG-aligned).
• Hospital + medical-residency matching (NRMP variants).
• Combinatorial auctions (procurement, spectrum, advertising).

Myerson’s optimal auction (1981). Revenue-maximising single-item auction under independent private values. The optimal mechanism is a second-price auction with reserve set at the value where virtual valuation = 0 (where virtual valuation = v − (1−F(v))/f(v) for type distribution F). Hurwicz + Maskin + Myerson shared 2007 Nobel for mechanism-design foundations.

Auction taxonomy:

• First-price sealed-bid — highest bid wins, pays own bid. Bidders shade below value; equilibrium bid increases in value with shading factor depending on N and distribution.
• Second-price sealed-bid / Vickrey — highest bid wins, pays second-highest. Truthful bidding is weakly dominant strategy.
• English ascending — open bidding rises until one bidder remains. Strategically equivalent to second-price under IPV.
• Dutch descending — price falls until first bidder accepts. Strategically equivalent to first-price.
• Revenue equivalence theorem (Vickrey 1961; Myerson 1981; Riley + Samuelson 1981) — under IPV + risk-neutrality + symmetric bidders, all standard auctions yield the same expected revenue.

Matching theory (Roth + Shapley 2012 Nobel):

• Deferred-acceptance algorithm (Gale + Shapley 1962) — solves stable-marriage problem. Each side proposes/accepts iteratively until no instability remains. Yields stable matching; proposer-optimal among stable matchings.
• NRMP — National Resident Matching Program (US medical residency) used variants since 1952; Roth 1984 analyzed; Roth + Peranson 1999 redesigned for couples’ constraints.
• School choice — Boston (Boston mechanism, manipulable) replaced with deferred-acceptance variants (Abdulkadiroğlu + Pathak + Roth 2005, 2009); NYC public high school 2003-04 redesign.
• Kidney exchange (Roth + Sönmez + Ünver 2004, 2007) — chains + cycles let incompatible donor-patient pairs swap. National Kidney Registry + UNOS systems; thousands of additional transplants per year.

FCC spectrum auctions (Milgrom + Wilson 2020 Nobel). Simultaneous Multiple Round (SMR) auction designed by Milgrom + Wilson + McAfee for selling licences with complementarities. Incentive auction 2017 — two-sided clock auction repurposing broadcast TV spectrum to wireless; raised $19.8B in net revenue + cleared 84 MHz.

9. Behavioral economics

Departure from strict rationality, grounded in psychology + experiments. See behavioral-economics for full treatment.

9.1 Prospect theory

Kahneman + Tversky 1979 (original); Tversky + Kahneman 1992 (cumulative prospect theory). Kahneman 2002 Nobel; Tversky died 1996 before the prize. Four components:

1. Reference-dependence — utility is over gains + losses relative to a reference point, not over wealth levels.
2. Loss aversion — losses loom larger than equivalent gains (λ ≈ 2 in early estimates; subsequent meta-analyses suggest λ ≈ 1.5-2.5 depending on context).
3. Diminishing sensitivity — concave over gains, convex over losses (S-shaped value function).
4. Probability weighting — overweighting of small probabilities (why lottery + insurance coexist) + underweighting of moderate-to-large.

Empirical anchor experiments: Asian disease problem (framing reversal), endowment-effect mug experiment (Kahneman + Knetsch + Thaler 1990), insurance + lottery puzzles.

9.2 Hyperbolic discounting

Laibson 1997; Frederick + Loewenstein + O’Donoghue 2002 review. Quasi-hyperbolic (β, δ) discounting — agents apply an extra discount β < 1 to all future periods uniformly relative to the present. Weight on period t = β · δ^t for t ≥ 1; weight on period 0 = 1.

Implications:

• Present bias — immediate consumption disproportionately weighted; leads to procrastination + savings shortfall + dieting failure + addiction.
• Time-inconsistency — preferences at time 0 over (consumption at 1, consumption at 2) reverse when 1 becomes the present.
• Self-control devices — sophisticated quasi-hyperbolic agents use commitment devices (illiquid savings, gym pre-payment, smoking-quitting bets).

Modern empirical estimates (Augenblick + Niederle + Sprenger 2015; DellaVigna 2018 review) put β ≈ 0.7-0.9 + δ ≈ 0.99 in monetary tasks, with present-bias substantially larger for effort + immediate consumption.

9.3 Heuristics and biases

Tversky + Kahneman 1974 Judgment under Uncertainty: Heuristics and Biases (Science).

• Availability — judge probability by ease of recall (overestimate plane crashes, underestimate diabetes mortality).
• Anchoring — estimates pulled toward initial value (judges’ sentences influenced by rolled dice in laboratory experiments).
• Representativeness — judge by similarity to stereotype, ignoring base rates (Linda problem; conjunction fallacy).
• Confirmation bias — seek confirming evidence, discount disconfirming.
• Status-quo bias + default effects — Madrian + Shea 2001 on 401(k) auto-enrollment; Johnson + Goldstein 2003 on organ donation defaults.
• Framing — preferences reverse with reframing (Asian disease problem).
• Mental accounting — money treated as non-fungible across labelled categories (Thaler 1985, 1999).
• Sunk cost fallacy — past unrecoverable costs influence forward-looking decisions; strictly irrational under standard theory but pervasive.
• Endowment effect (Kahneman + Knetsch + Thaler 1990 mugs experiment) — willingness to accept >> willingness to pay for an item you own; consistent with loss aversion.

9.4 Nudge

Thaler + Sunstein 2008 Nudge. Libertarian paternalism using defaults + framing + choice architecture to improve outcomes while preserving choice. Implemented via:

• UK Behavioural Insights Team (formed 2010, partially privatised 2014).
• US OIRA + nudge unit under Cass Sunstein 2009-2012.
• Dozens of nudge units worldwide (Australia, Denmark, Germany, Singapore, World Bank, OECD).

Famous applications: 401(k) auto-enrolment, organ donation defaults, tax-payment letters with social comparisons, energy-use comparison letters (Opower / Oracle Utilities).

Thaler 2017 Nobel for behavioural economics contributions.

9.5 Bounded rationality

Simon 1957; Nobel 1978. Agents satisfice rather than optimise under cognitive constraint. Foundational for behavioural + organisational economics + computational economics + bounded-rationality general-equilibrium models.

Vernon Smith 2002 Nobel for experimental economics — double-auction experiments converge to competitive prediction under minimal conditions (Smith 1962). Public-goods games show partial cooperation with conditional cooperators + free-riders. Ultimatum game (Güth + Schmittberger + Schwarze 1982) — fairness concerns reject low offers, refuting pure self-interest.

10. Pricing and market design

Price discrimination (covered §4.2 above): first-degree (perfect), second-degree (non-linear pricing), third-degree (segment by observable).

Bundling + tying:

• Bundling (offering goods only together — cable TV channels, Microsoft Office) extracts more surplus when valuations are negatively correlated (Stigler 1963; Adams + Yellen 1976).
• Tying (sale of A conditional on buying B) — Microsoft Windows + IE (US 1998 antitrust + EU 2004), Apple App Store + IAP (Epic v Apple 2020-24). Antitrust analyses whether tying leverages market power from one market to another.

Dynamic pricing + revenue management. Airlines (since 1980s deregulation), hotels, Uber surge, Amazon dynamic prices. Inventory + capacity constrained; demand uncertain. Tools: yield management algorithms, ML demand estimation, reinforcement learning, multi-armed bandits for pricing.

Network effects + lock-in:

• Direct network effects — value grows with user base (telephones, social networks, messaging apps).
• Indirect / cross-side — more users attract more developers attract more users (operating systems, video-game consoles).
• Switching costs + lock-in — proprietary file formats, training, contracts; create market power even ex post (Klemperer 1995).
• Standards wars — VHS vs Betamax (1976-88), Blu-ray vs HD-DVD (2006-08), HTTPS vs HTTP transition. Tipping + winner-take-most outcomes common.

11. Industrial organisation primer

See industrial-organization for full treatment.

Concentration: Herfindahl-Hirschman Index HHI = Σ_i s_i² where s_i is firm i’s market share in percentage points. DOJ + FTC 2023 Merger Guidelines thresholds: HHI ≤ 1000 unconcentrated, 1000-1800 moderately concentrated, > 1800 highly concentrated (tightened from prior 2010 thresholds). ΔHHI from a merger flags scrutiny.

Entry barriers. Capital requirements, regulation (licensing, certification), network effects, learning curves, switching costs, brand loyalty, IP, strategic deterrence (excess capacity, limit pricing, product proliferation).

Modern antitrust enforcement:

• US — Sherman Act 1890 (§1 conspiracies, §2 monopolisation), Clayton Act 1914, FTC Act 1914. DOJ Antitrust Division + FTC.
• Major cases 2020-25: DOJ Google Search (2020 filed → liability ruling Aug 2024 + remedies pending), DOJ Google Ad Tech (2023 filed → liability ruling Apr 2025), DOJ Apple App Store (2024 filed), FTC Meta (2020 ongoing), FTC + 17 states v Amazon (2023 ongoing).
• EU — Digital Markets Act in force 2023, gatekeeper designations 2023-24 imposing ex-ante obligations on Apple, Meta, Google, Amazon, Microsoft, ByteDance, Booking.com.
• Algorithmic collusion theme (RealPage litigation 2022+).
• Labour-market antitrust (FTC non-compete rule 2024 struck in district court, on appeal; no-poach enforcement under DOJ since 2016).

12. Recent topics (2022-26)

AI economic impacts. Brynjolfsson + McAfee + Mollick + Acemoglu + Autor + Goldin + Korinek + Trammell debates. Productivity studies: Brynjolfsson + Li + Raymond 2023 on customer support (+14% productivity, larger gains for novices); Noy + Zhang 2023 ChatGPT writing tasks (+37% productivity); Peng et al. 2023 GitHub Copilot (+55% on coding tasks). Acemoglu + Autor 2024 on AI macroeconomic effects — modest aggregate impact under conservative assumptions, larger if AI both substitutes + complements heterogeneously.

Industrial policy renaissance. US CHIPS + Science Act Aug 2022 ($52Bsemiconductors).USIRAAug2022($369B clean energy + IRA tax credits driving battery + EV + solar siting). EU Green Deal Industrial Plan Feb 2023 + Net-Zero Industry Act Jun 2024 + Critical Raw Materials Act May 2024. China Made-in-China 2025 + dual-circulation. Debates: efficiency cost (Krugman, Furman) vs security + climate rationale (Rodrik, Tooze, Mazzucato); Acemoglu + Robinson on institutional risk.

Inequality. Piketty 2014 Capital in the Twenty-First Century + Piketty + Saez + Zucman work (DINA distributional national accounts), Chetty + Hendren on intergenerational mobility (Opportunity Atlas), Auten + Splinter 2024 critique of top-share trend magnitudes. Wealth tax proposals (Saez + Zucman); cross-country comparisons (WID).

Climate economics. Nordhaus 2018 Nobel DICE integrated assessment model. Stern Review 2006 — low discount rate → urgent action. Weitzman 2009 dismal theorem — fat tails of catastrophic damage dominate cost-benefit. EPA 2023 SCC ~$190/tCO2. EU CBAM transitional Oct 2023, definitive Jan 2026.

Crypto + DeFi + CBDC. Crypto winter 2022-23 + FTX collapse Nov 2022 + Tornado Cash enforcement 2023 → ETF approval Jan 2024 + revived activity 2024-26. CBDC: Chinese e-CNY in pilot; ECB digital euro preparation Nov 2023 → 2025-26 decision; US Project Hamilton + FedNow 2023.

13. Common pitfalls

• Nominal vs real — failing to deflate nominal series by appropriate price index; comparing wages across decades in nominal terms.
• Accounting vs economic profit — economic profit subtracts opportunity cost of all factors (including owner’s labour + equity); positive accounting profit can mean zero economic profit.
• Sunk cost — past unrecoverable costs are irrelevant for forward-looking decisions; pervasive fallacy.
• Marginal vs average — pricing + production decisions hinge on marginal, not average; averages mislead.
• Partial vs general equilibrium — partial-equilibrium answer can reverse in GE (tariff incidence, tax incidence with multiple markets).
• Assuming perfect competition where market power exists — labour monopsony, hospital markets, online platforms.
• Confusing correlation with causation without identification strategy (see causal-inference or microeconomics-foundations §9).
• p-hacking + specification searching — addressed by preregistration (AEA RCT Registry mandatory since 2018), multiple-hypothesis correction, replication archives (AEA Data Editor since 2019).

14. Cross-references

• _index — library index
• microeconomics-foundations — complementary empirical-orientation deep note
• macroeconomics — macro counterpart
• macroeconomics-foundations — complementary macro deep note
• industrial-organization — oligopoly + antitrust + IO empirical methods
• game-theory — deeper game theory
• behavioral-economics — deeper behavioral
• labor-economics — labour markets + human capital + minimum wage
• public-economics-and-taxation — optimal taxation + social insurance
• environmental-and-resource-economics — externalities + carbon pricing + commons
• development-economics — RCTs + poverty + institutions
• monetary-economics-and-banking — money + central banks + financial intermediation
• econometrics-foundations — empirical toolkit
• history-of-economic-thought — intellectual history

15. References

Graduate texts:

• Mas-Colell + Whinston + Green Microeconomic Theory 1995 — the standard graduate text.
• Kreps Microeconomic Foundations I 2013 + II 2023 — modern foundations + uncertainty + dynamic theory.
• Jehle + Reny Advanced Microeconomic Theory 3rd ed 2011.
• Varian Microeconomic Analysis 3rd ed 1992 — intermediate-graduate bridge.

Undergraduate / intermediate: Varian Intermediate Microeconomics 9th ed 2014; Mankiw Principles of Microeconomics 9th ed 2020; Acemoglu + Laibson + List Microeconomics 3rd ed 2024; Goolsbee + Levitt + Syverson Microeconomics 3rd ed 2019.

Specialty:

• Tirole The Theory of Industrial Organization 1988 — IO classic (Tirole 2014 Nobel).
• Belleflamme + Peitz Industrial Organization 2nd ed 2015.
• Cabral Introduction to Industrial Organization 2nd ed 2017.
• Roth Who Gets What and Why 2015 — matching markets.
• Milgrom Putting Auction Theory to Work 2004.
• Kahneman Thinking Fast and Slow 2011.
• Thaler + Sunstein Nudge 2008 + 2021 revised.
• Thaler Misbehaving 2015.
• Hart Firms, Contracts, and Financial Structure 1995.

Foundational papers:

• Akerlof 1970 QJE — Market for Lemons.
• Spence 1973 QJE — Job Market Signaling.
• Rothschild + Stiglitz 1976 QJE — insurance screening.
• Kahneman + Tversky 1979 Econometrica — Prospect Theory.
• Vickrey 1961 J Finance — Counterspeculation + auctions.
• Myerson 1981 Math Op Res — Optimal Auction.
• Gale + Shapley 1962 AMM — College Admissions and Stability of Marriage.
• Hardin 1968 Science — Tragedy of the Commons.
• Samuelson 1954 REStat — Pure Theory of Public Expenditure.
• Coase 1937 Economica — Nature of the Firm.
• Coase 1960 JLE — Problem of Social Cost.
• Rochet + Tirole 2003 JEEA — Platform Competition.
• Berry + Levinsohn + Pakes 1995 Econometrica — BLP demand estimation.

Nobel laureates referenced: Samuelson 1970; Arrow 1972; Hayek 1974; Simon 1978; Stigler 1982; Debreu 1983; Buchanan 1986; Coase 1991; Becker 1992; Nash + Selten + Harsanyi 1994; Lucas 1995; Mirrlees + Vickrey 1996; Akerlof + Spence + Stiglitz 2001; Kahneman + Smith 2002; Hurwicz + Maskin + Myerson 2007; Krugman 2008; Ostrom + Williamson 2009; Diamond + Mortensen + Pissarides 2010; Roth + Shapley 2012; Tirole 2014; Deaton 2015; Hart + Holmström 2016; Thaler 2017; Nordhaus + Romer 2018; Banerjee + Duflo + Kremer 2019; Milgrom + Wilson 2020; Card + Angrist + Imbens 2021; Bernanke + Diamond + Dybvig 2022; Goldin 2023; Acemoglu + Johnson + Robinson 2024.