Current Issues in Microeconomics

This Series of books is aimed at students of economics and non-specialist economists interested in learning about recent developments in economics. Usually, such recent developments first see the light of day in one of the academic journals, and take some time to filter through to the general economist. This process often takes several years. At the same time, however, the developments are assimilated — often in an informal (and sometimes mistaken) fashion by the leading economists, and are implicit in various pedagogical activities carried out within the profession. This puts the non-specialist at a considerable disadvantage. Unfortunately, there is usually no easy way for the non-specialist to make him-/or her-self aware of these recent developments, given that they are typically communicated in specialist language in high-level journals, from one highbrow economist to another. Often, advanced mathematics is used, and much — in the way of prior knowledge — is taken for granted in the exposition. Nevertheless, knowledge of such recent developments is of great importance: the greater the degree of dissemination of such developments, the more likely it is that those elements which are of practical importance for economics will eventually be put to use.

Fifteen years ago, the theory of choice under uncertainty could be considered one of the ‘success stories’ of economic analysis: it rested on solid axiomatic foundations, it had seen important breakthroughs in the analytics of risk, risk aversion and their applications to economic issues, and it stood ready to provide the theoretical underpinnings for the newly emerging ‘information revolution’ in economics.¹ Today choice under uncertainty is a field in flux: the standard theory is being challenged on several grounds from both within and outside economics. The nature of these challenges, and of economists’ responses to them, is the topic of this chapter.

Insurance is a form of economic activity which can only exist in a world of uncertainty. By entering into an insurance contract, an individual gives up some amount of wealth — the premium — for certain in exchange for a payment if and only if some specified set of uncertain events occurs. A rigorous economic analysis of insurance markets could not have been contemplated until the theory of individual choice under uncertainty had been developed, and the results of this analysis are one of the major achievements of the application of expected utility theory.

Game theory is currently having as much impact on certain topics in microeconomics as rational expectations has had on macroeconomics.¹ Yet whilst the modern undergraduate typically has a reasonable grasp of rational expectations macroeconomics, his or her understanding of game theory is likely to be both rudimentary and, even worse, faulty. Most microeconomic texts have a section on the ‘prisoners’ dilemma’ to highlight the problem of establishing cooperation; and somewhere else there will be an exposition of Cournot duopoly which suggests it could only apply to shortsighted firms which cannot predict a rival’s reactions; and that is about it. It is one of the purposes of this chapter to point out the richness of the prisoners’ dilemma game and another to correct the misperceptions surrounding Cournot. But our hope is that we can take the reader much further. Game theory provides a unifying framework with which to analyse properly any question involving the interaction of rational agents. This includes topics as apparently diverse as oligopoly, externality, public goods, tariff-setting, bequests by parents to their children, wage-bargaining, Mrs Thatcher’s macroeconomics, and much more besides. Clearly, there is insufficient space to treat each of these adequately here.

What is a contract? In essence, it is a mutual agreement between people to act in some specified way. A common example is an agreement to pay a sum of money on the occurrence of some event that may or may not be controlled by one of the parties. You may place a bet with a bookmaker to receive a specified pay-off if a particular horse wins a race. Whether or not that horse wins is not (or, at least, is not supposed to be) controlled by either of you. An insurance company may agree to pay you a specified sum if your house burns down. Whether or not it does is at least partly under your control. An employer may offer you a job at a specified salary provided that you graduate. Whether or not you do depends not only on how hard you work but also on how clever you are and you may know that better than your prospective employer. All these are examples of contracts.

Laboratory experiments are such a firmly established part of teaching and research in the natural sciences that it is hard to imagine how any Department of Physics or Chemistry could function for long without access to a suite of laboratories. In certain behavioural sciences, too, experimentation is regarded as a key part of the discipline: for example, almost every undergraduate student of psychology will be encouraged to learn something about the basic principles and techniques of experimental investigation.

The elementary theory of consumer and producer behaviour under competitive conditions, and the resulting elementary supply/demand model of the partial equilibrium of a single market are the foundations on which the models of general (economy-wide) Walrasian equilibrium are built. By 1960 a rigorous development of such models, in the context of what has become known as the Arrow-Debreu economy, had taken place. As economy-wide models, these can claim to be macroeconomic; and yet their clear specification of the behaviour of individual agents (consumers and firms) which leads to the macroeconomic outcome, gives them a microfoundation. However, at that time they presented a dilemma to economic theory, since most of the central features of interest to macroeconomists (including e.g. money, expectations, involuntary unemployment) are missing from these Walrasian, Arrow-Debreu models. On the other hand, the then popular macroeconomics built on aggregate demand/supply analysis, IS-LM analysis and the Phillips curve trade-off between output and inflation clearly involved money, expectations, etc., and thus did not rest on the Walrasian, Arrow-Debreu base; the appropriate microeconomic foundation for this macroeconomics was not clear. From then on it is possible to identify a number of themes in the literature aimed at providing a microfoundation for macroeconomics. The objective of this chapter is to introduce the reader to some of the important surviving themes from this literature.

In recent years the empirical analysis of households with respect to expenditure patterns, labour-market behaviour and savings have increasingly been conducted using data on households. This is both a reflection of and is reflected in the increasing availability of such data, and the advent of more powerful computers and more accommodating software. It is also, I think, a consequence of the attraction of researching in an area where there is a close relationship between economic theory, model specification (both deterministic and stochastic) and estimation strategy.

A country’s income distribution can have many different shapes. It can be spread out or sharply peaked, skewed or symmetrical, perhaps even bimodal between the sexes. It is obviously impossible to capture all this variety in a single statistic such as the variance. But this is not the difficulty in measuring inequality. The purpose of an inequality measure is not to compress a lot of information into one number. There is often no need to do that anyway. If someone wants to know, say, whether income is more equally distributed now than it was ten years ago, there may be no difficulty about presenting her with the whole distribution for each date. The difficulty is that, when she has all this information, she may still not know whether the distribution has become more or less unequal.

This chapter is addressed to the student who has worked through this book, who has mastered and feels at home with the microeco-nomic model, and who would like know how ‘institutional economics’ relates to what he has already learned; to answer, in effect, what it is about institutional economics that might interest the fledgling economist flushed from a neoclassical nest.