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Department of University of Wisconsin-Milwaukee

Economics 801 Microeconomic Theory I – Consumers and Markets

Fall 2014 When: Mondays and Wednesdays, 2:00-3:15 PM Where: Bolton B76 Professor: Scott Drewianka E-mail: [email protected] Office: Bolton 886 Office Hours: Mondays and Wednesdays, 3:30-5:00 PM

Prerequisites: None, but Economics 506, 606, and 701 (or equivalent courses elsewhere) are strongly recommended.

Goals of This Course: This course is the first Ph.D. level microeconomic theory course at this university. It is designed to be taken in conjunction with Economics 803, and together they serve as a foundation for advanced field courses. Students will become proficient with the tools and methodology of microeconomic theory and familiar with useful models and results. While we shall stress the importance of rigor, substantial emphasis will be given to the practical uses of economic theory, particularly in an applied context.

Grading: Grades will be based on a midterm and final exam (40 percent each), homework (15 percent), and participation (5 percent).

Exams: Midterm: Wednesday, October 22 Final: Tuesday, December 16, 12:30-2:30 PM (NOTE THE SPECIAL DAY AND TIME.)

Expected time commitment: Plan to spend considerably more time than usual on this and all courses in the Ph.D. Sequence. While there will undoubtedly be great variation across students, the following is an approximate breakdown of time spent in Econ 801 by an average successful student: Class meetings and final exam (3 hours/week): 48 hours Problem sets (8 @ 2 hours each): 16 hours Reading and additional study (8 hours/week) : 128 hours 192 hours across the semester

You are strongly advised not to shortchange yourself in this respect. This material is not only critical for the course itself, but also for the preliminary exams you will take next summer and for all subsequent courses – indeed, even for your career as a researcher. Time spent mastering this material thus has an unusually high expected return, and you are encouraged to invest in it accordingly.

Homework: The purpose of homework is not to test your understanding (that is what exams are for), but rather to develop it. Mistakes are an opportunity to learn, provided that one puts in some thought and effort. Accordingly, full credit will be awarded on homework assignments whenever it is apparent that the student made a good-faith effort to solve the assigned problems, regardless of whether the student was ultimately successful. Students may work together but must submit their own work. Late work will not be accepted. A packet containing all of the assignments for the semester can be downloaded from the course webpage on D2L.

Department/University Policies and Procedures: The Economics Department and UWM maintain official policies on academic conduct, incompletes, grade appeals and other complaints, participation by students with disabilities, accommodation of religious observances, sexual harassment, and other matters. Information on these policies is available in the Economics Department main office, or at http://www4.uwm.edu/secu/SyllabusLinks.pdf. All such policies are important, but please take special note of the policy on academic misconduct: http://www4.uwm.edu/acad_aff/policy/academicmisconduct.cfm. Students needing accommodations of any sort (including for disabilities or religious observances) should notify me during the first two weeks of class.

H1N1 Virus Preparedness: As you may be aware, public health officials are concerned about a possible pandemic caused by the H1N1 virus (“swine flu”). Since the disease is spread primarily by personal contact, the University politely asks students not to shake hands, share food, and or take other actions that could transmit the virus. Please report illnesses via e-mail rather than in person. In the event of disruption of normal classroom activities due to an H1N1 swine flu outbreak, the format for this course MAY be modified to enable completion of the course. You would then be given an addendum to this syllabus that will supersede this version. Course Outline and Reading List

Main Textbook: Varian, Hal R. 1992. Microeconomic Analysis, 3rd Ed. (New York: W.W. Norton). Additional Book (recommended, not required): Deaton, Angus, and John Muellbauer. Economics and Consumer Behavior. 1980. (New York: Cambridge University Press). A More Advanced Treatment (optional; the main text in Econ 803): Mas-Colell, Andreu, Michael D. Whinston, and Jerry R. Green. 1995. Microeconomic Theory (New York: Oxford University Press). A Good Book on (optional; also used in Econ 803): Carter, Michael. 2001. Foundations of (Cambridge, MA: MIT Press).

THE BOOKS LISTED ABOVE ARE AVAILABLE AT THE UWM BOOKSTORE. ALL READINGS LISTED BELOW CAN BE DOWNLOADED FROM THE COURSE PAGE ON D2L (UNDER THE MODULE “READINGS”)

I. Introduction to Microeconomic Theory A. Purpose B. Distinguishing characteristics and methodology

Readings: Becker, Gary S. 1976. “The Economic Approach to Human Behavior,” Ch. 1 of The Economic Approach to Human Behavior (Chicago: U. of Chicago Press), pp. 3-14.

Optional: Kreps, David M. 1990. A Course in Microeconomic Theory (Princeton, NJ: Princeton U. Press). “Chapter 1: An Overview,” pp. 3-14. Friedman, Milton. 1966. “The Methodology of Positive Economics.” In Essays in Positive Economics (Chicago: U of Chicago Press): 3-43.

II. Elements of Individual Optimization A. Producer optimization, supply, and profit B. Consumer optimization and demand theory C. Advanced topics in demand theory 1. Demand systems 2. Restrictions and observable implications of demand theory

Readings: Deaton and Muellbauer, Chapters 1-3. Varian, Chapters 1-10, 12, 27. Mas-Colell et al., Chapters 1-3, 5.

Optional: Browning, Martin, and Pierre-Andre Chiappori. 1998. “Efficient Intra-Household Allocations: A General Characterization and Empirical Tests.” Econometrica 66: 1241-78.

III. Risk A. Risk versus (Knightian) uncertainty B. Expected and the von Neumann-Morgenstern utility function C. Measurement of risk preferences: absolute and relative risk aversion D. Pratt’s Theorem: Three equivalent methods of measuring risk aversion E. Increasing risk: stochastic dominance and mean-preserving spreads F. Variation on risk preferences: State-dependent utility

Readings: Varian, Chapter 11, “Uncertainty,” pp. 172-97. Mas-Colell et al., Chapter 6. Deaton and Muellbauer, Chapter 14.

Optional: Townsend, Robert M. 1993. The Medieval Village Economy (Princeton: Press), Chapter 2. Rothschild, Michael, and Joseph E. Stiglitz. 1970. “Increasing Risk: I. A Definition.” Journal of Economic Theory 2: 225-43. Rothschild, Michael, and Joseph E. Stiglitz. 1971. “Increasing Risk II: Its Economic Consequences.” Journal of Economic Theory 3: 66-84. Pratt, John W. 1964. “Risk Aversion in the Small and in the Large.” Econometrica 32: 122-36. Eisner, Robert and Robert H. Strotz. 1961. “Flight Insurance and the Theory of Choice.” Journal of Political Economy 69: 355-68. Arrow, Kenneth. 1974. “Optimal Insurance and Generalized Deductibles.” Scandinavian Actuarial Journal 1: 1-42. Kimball, Miles. 1990. “Precautionary Savings in the Small and the Large.” Econometrica 58: 53-73. Chetty, Raj. 2006. “A New Method of Estimating Risk Aversion.” American Economic Review 96: 1821-34. Chetty, Raj, and Adam Szeidl. 2007. “Consumption Commitments and Risk Preferences.” Quarterly Journal of Economics 122, pp. 831-77. Gilboa, Itzhak, Andrew W. Postlewaite, and David Schmeidler. 2008. “Probability and Uncertainty in Economic Modeling.” Journal of Economic Perspectives 22, pp. 173-88. Finkelstein, Amy, Erzo F.P. Luttmer, and Matthew J. Notowidigdo. 2013. “What Good is Wealth without Health? The Effect of Health on the Marginal Utility of Consumption.” Journal of the European Economic Association 11(S1), pp. 221–258.

IV. Intertemporal Economics and Investments A. Investment without uncertainty 1. Consumption smoothing 2. Investment in specific assets over the business cycle B. Investment under uncertainty i. Arrow-Debreu markets and no-arbitrage pricing ii. Capital Asset Pricing Model iii. Option value and the Black-Scholes Theorem C. Variations on intertemporal preferences i. Hyperbolic discounting ii. Rational addiction

Readings: Varian, Chapter 20, “Asset Markets,” pp. 368-86. Mas-Collel et al., Chapters 19A-E and 20A-B. Deaton and Muellbauer, Chapters 4.2, 12-13

Optional: Laibson, David. 1997. "Golden Eggs and Hyperbolic Discounting." Quarterly Journal of Economics 112, pp. 443-477. Stigler, George J., and Gary S. Becker. 1977. “De Gustibus Non Est Disputandum.” American Economic Review 67: 76- 90. Mincer, Jacob, and Solomon Polachek. 1974. “Family Investments in Human Capital: Earnings of Women.” Journal of Political Economy 82: S76-S108. Becker, Gary S., and Kevin M. Murphy. 1988. “A Theory of Rational Addiction.” Journal of Political Economy 96: 675-700. Dixit, Avinash K., and Robert S. Pyndyck. 1994. Investment Under Uncertainty. (Princeton, NJ: Princeton University Press). (Chs. 1 & 2 are a good introduction; Chs. 3 & 4 present the mathematical topics needed for the rest of the book). Rosen, Sherwin. 1999. ``Potato Paradoxes.’’ Journal of Political Economy 107: S294-S313. Hendel, Igal, and Alessandro Lizzeri. 2002. “The Role of Leasing Under Adverse Selection.” Journal of Political Economy 110: 113-143. McClure, Samuel M., David I. Laibson, George Lowenstein, and Jonathan D. Cohen. 2004. “Separate Neural Systems Value Immediate and Delayed Monetary Rewards.” Science 306: 503-507.

V. General Equilibrium, , and Welfare A. Pareto efficiency B. Walrasian equilibrium C. The first welfare theorem D. Other argument against planning i. Hayek’s “Use of Knowledge” ii. Political economy E. Violations of assumptions: overview i. Transactions costs and incomplete markets ii. Imperfect competition and strategic considerations iii. Asymmetric Information F. Distributional concerns and the second welfare theorem G. Utilitarian social welfare functions and competitive equilibria

Readings: Varian, Chapter 17, “Exchange,” pp. 314-337. Mas-Colell et al., Chapters 15-16, 17A-C. Hayek, F.A. 1945. “The Use of Knowledge in Society.” American Economic Review 35: 519-30.

Optional: Townsend, Robert M. 1993. The Medieval Village Economy (Princeton: Princeton University Press), esp. Chapter 2. Harberger, Arnold C. 1962. “The Incidence of the Corporation Income Tax.” Journal of Political Economy 70: 215-240. Debreu, Gerard. 1959. Theory of Value: An Axiomatic Analysis of Economic Equilibrium (New Haven, CT: Yale University Press). Arrow, Kenneth, and Gerard Debreu. 1954. “Existence of Equilibrium for a Competitive Economy.” Econometrica 22: 265-290.

VI. Incomplete Markets I: Externalities, Public Goods, and Interpersonal Preferences A. Externalities B. The Coase Theorem and property rights C. Pigouvian taxes D. Public and club goods E. Property crime F. Interpersonal preferences 1. Social effects and network externalities 2. Rank-dependent tastes and prizes 3. Altruism and discrimination

Readings: Varian, Chapter 24, “Externalities,” pp. 432-439. Mas-Colell et al., Chapter 11. Coase, Ronald. 1960. “The Problem of Social Cost.” Journal of Law and Economics 3: 1-44.

Optional: Rosen, Sherwin. 1981. “The Economics of Superstars.” American Economic Review 71: 845-858. Becker, Gary S., and Kevin M. Murphy. 2000. Social Economics: Market Behavior in a Social Environment (Cambridge, MA: Bellnap Press). Akerlof, George A. 1976. “The Economics of Caste and of the Rat Race and Other Woeful Tales.” Quarterly Journal of Economics 90: 599-617. Coase, Ronald. 1988. “Notes on the Problem of Social Cost.” Chapter 6 of The Firm, the Market, and the Law (Chicago: U. of Chicago Press): 157-185. Ayres, Ian, and Steven D. Levitt. 1998. “Measuring Positive Externalities from Unobservable Victim Precaution: An Empirical Analysis of Lojack.” Quarterly Journal of Economics 113: 43-77. Coase, Ronald. 1974. “The Lighthouse in Economics.” Journal of Law and Economics 17: 357-376. Pigou, A.C. 1920. The Economics of Welfare (London: Macmillan). Gordon, H. S. 1954. “The Economic Theory of a Common Property Resource: The Fishery.” Journal of Political Economy 62: 124-142. Loury, Glenn C. 1979. “Market Structure and Innovation.” Quarterly Journal of Economics 93: 395-410. Schelling, Thomas. 1978. Micromotives and Macrobehavior (New York: Norton). Becker, Gary S. 1991. “A Note on Restaurant Pricing and Other Examples of Social Influences on Price.” Journal of Political Economy 99: 1109-1116. Rohlfs, Jeffrey H. 2003. Bandwagon Effects in High-Tech Industries. (Cambridge, MA: MIT Press).

VII. Matching and Search Models A. Matching with prices B. Matching without prices C. Search

Readings: Deaton and Muellbauer, Chapter 14.5. Sargent, Thomas J. 1987. Dynamic Macroeconomic Theory. (Cambridge, MA: Press). Chapter 2. Koopmans, Tjalling C., and Martin Beckmann. 1957. “Assignment Problems and the Location of Economic Activities.” Econometrica 25: 53-76. Gale, David, and Lloyd Shapley. 1962. “College Admissions and the Stability of Marriage.” American Mathematical Monthly 69: 9-15. Roth, Alvin E., and Marilda A. Oliveira Sotomayor. 1990. Two-sided Matching: A Study in Game-Theoretic Modeling and Analysis, Monographs No. 18 (Cambridge, U.K.: Cambridge University Press). Especially Chapters 1-2.

Optional: Stigler, George J. 1961. “The Economics of Information.” Journal of Political Economy 69: 213-25. Diamond, Peter A. 1981. “Mobility Costs, Frictional Unemployment, and Efficiency.” Journal of Political Economy 89: 798-812. Jovanovic, Boyan. 1979. “Job Matching and the Theory of Turnover.” Journal of Political Economy 87: 972-90. Becker, Gary S. 1973. “A Theory of Marriage: Part I.” Journal of Political Economy 81: 813-46. Shimer, Robert, and Lones Smith. 2000. “Assortative Matching and Search.” Econometrica 68: 343-69.

VIII. Incomplete Markets II: Goods as Bundles of Commodities A. Household Production B. Hedonic Pricing

Readings: Deaton and Muellbauer, Chapter 10. Becker, Gary S. 1965. “A Theory of the Allocation of Time.” Economic Journal 75: 493-517.

Optional: Rosen, Sherwin. 1974. “Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition.” Journal of Political Economy 82: 34-55. Lancaster, Kelvin J. 1966. “A New Approach to Consumer Theory.” Journal of Political Economy 74: 132-57.

Heckman, James, and Jose Scheinkman. 1987. “The Importance of Bundling in a Gorman-Lancaster Model of Earnings.” Review of Economic Studies 54(2): 243-55.