AECO 27A10 - Microeconomics: Information, Design, and Institutions

This course studies the design of institutions that optimally cope with fundamental, longstanding economic questions (allocation of private goods, public good provision, externalities). We start from a simple, institution-free description of each question, try to understand the basic tensions at work (for example environmental externalities), and derive institutions that optimally address these tensions (for instance systems of permits or taxes). In the process, we introduce the important ideas of social choice, game theory, and market design. We will shed light on the theoretical concepts using empirical applications and in class games.

The course is divided into four parts:

• Social Choice, Efficiency and Welfare: We discuss normative criteria to evaluate collective choices made by a society comprised of individuals with possibly conflicting preferences (e.g. unanimity, not ruling out any preferences, not being dictatorial), and show that it is impossible to create institutions leading to choices that always satisfy even a minimal list of criteria. Next, we introduce the possibility of pecuniary transfers to compensate individuals for social choices that harm them. We show that, when they are acceptable, Pareto efficiency and utilitarianism are equivalent, and a natural notion of social welfare emerges that ranks possible social choices.
• Game Theory and Incentives: With this natural notion of optimal social choices, the question becomes a positive one: how can such choices be implemented. The difficulty is that the social value of different choices can only be assessed from the preferences of individuals. But each individual is the only one to know her true preferences, and must therefore be incentivized to provide this information. Institutions can be understood as rules of a game in which individuals strategically report their preferences. Game theory is the science of such strategic interactions, and we will introduce its basic ideas and some applications (e.g. competition between firms, pollution abatement).
• Institutions as Mechanisms: At this stage, we are equipped to look for institutions that lead to efficient social choices in spite of asymmetric information about preferences. We will do so for three types of important economic problems: the allocation of private goods, the provision of public goods, and the organization of trade. We show that well designed auctions can solve the allocation problem. Using this as a starting point, we derive a general class of mechanisms that solve the incentive problem and lead to efficient social choices. They do so by using transfers that lead individuals to internalize the externality they exercise on others, and therefore align their incentives with social welfare. Such mechanisms however lead to budget deficits when applied to public good provision or trade. In fact, we show that efficiency cannot be achieved for these problems and we derive second-best solutions, that is, institutions that are optimal given the need to incentivize individuals. As the number of agents increases, we show that the inefficiency disappears, and that these second-best solutions come to resemble the ideal situation of perfectly competitive markets, thus providing support for the idea of market efficiency. For the public good problem, however, scaling if of no use.
• Limits to Efficiency: In the last part of the course, we examine other possible sources of economic inefficiency. We start by looking at monopolies and their pricing strategies. We explain first, second and third-degree price discrimination. Then we show how asymmetric information can destroy efficient trade even in competitive markets when they are subject to adverse selection and apply this idea to financial markets, job markets and insurance markets.

The course will introduce formal tools, using basic mathematical concepts, necessary to understand key economic concepts.

First year core economics course or equivalent introductory undergraduate course in economics

The course will be evaluated as follows.

• One third of the grade will be a final exam. The final exam is a two hours closed book exam.
• Two third will be contrôle continu organized as follows:
• 40% midterm exam, organized around week 7
• 30% correction on the board during TD sessions. We will hand out solutions when we give the exercises to be prepared for the TD, but you will be randomly picked to come and correct one of the exercises on the board in class.
• 30% TD participation including participation in Moodle quizzes Moodle between each lecture and the next conference.