EC 501: Microeconomic Theory
Fall 2010
Professor Pankaj Tandon
270 Bay State Road, Room 526
Phone: (617) 353-3089
email: ptandon@bu.edu
Office Hours: M 9-10:30, W 8-9:30
Overview: This course is the Master’s level offering in microeconomics, in which we study
the functioning of the economy by looking at the behavior of individual agents: consumers,
producers and the government. The approach is mathematical.
Prerequisites: You must have taken courses in intermediate microeconomics and
multivariate calculus. A calculus review is provided in Chapter 2 of the textbook.
Examinations and grades: Your grade will be determined as follows:
20% on required problem sets,
30% on an in-class mid-term exam (to be held on Monday, October 25), and
50% on a final exam (to be held on a date to be announced later).
Examinations will be closed-book. Make-up examinations are offered only in the case of
extreme and documented emergencies. No make-up final examinations will be given to
accommodate travel plans that conflict with the assigned final exam date. Please make
your travel plans EARLY. University policy also requires me to remind you that you are
expected to be familiar with the CAS Academic Conduct Code, and that I am required to
report all violations of this to the Dean’s office.
Problem Sets: There will be regularly assigned problem sets (10 in all) which must be
turned in on their due dates. Late problem sets will not be accepted; the solutions are
handed out at the time when the assignments are turned in. You are encouraged to work
together on the problem sets, by actively discussing approaches to solutions (not by copying
one another’s work!). The purpose of the problem sets is to help you learn the material, not
to test you.
Textbook: The lectures will form the backbone of the course and your class notes
constitute the most essential reading. The required textbook for the course is:
Walter Nicholson: Microeconomic Theory: Basic Principles and Extensions,
10th edition, Thomson Southwestern, 2008.
The book is available at the BU Bookstore. Also, the workbook to Nicholson’s book (out of
print, but can be found second-hand on the internet), may be used for practice problems.
Class discussion: Because the material covered in class is not fully covered in the assigned
reading, it is important that you understand what is discussed in class. For this reason, it is
vital that you ask questions in class to make sure you understand the material.
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Contacting me: My office hours (posted above) are times when you can stop by my office
without an appointment to ask questions or otherwise discuss issues that come up. This is the
best way to be in touch with me. In addition, I check my email several times a day and
generally respond promptly. You can use this method to ask questions, or to set up
appointments. However, the best forum to ask substantive questions about the class (other
than in class itself) is the Class Discussion Board.
Class Discussion Board: All students should sign up for membership in the class discussion
board, which is based on Yahoo! Groups. You must be a registered member of Yahoo!
Groups to join (membership is free and easy). Register at http://groups.yahoo.com/ and, once
you are registered, join the Discussion Board at http://groups.yahoo.com/group/bu-ec5012010/. Use this forum to ask questions about material discussed in class, about the problem
sets, exams, or any other subject of relevance to the class. Posing your questions there allows
others to see them and to see my answers as well. And of course other students can also
respond or comment and get a discussion going.
Teaching Assistant: The TA (name to be announced) will grade the problem sets, hold the
discussion sections, and hold office hours. If you have any questions about the grading of
your problem set, you should go to the TA for an explanation.
Detailed Syllabus and Reading List
(Readings marked with * are optional)
Most of the hyperlinks to web-available articles require your BU login.
We will be covering a lot of material and the pace of the class is fast. It is best therefore if
you do the required reading before each class. You don’t have to understand everything, but
just try to get a rough idea of the basic concepts. You can come to class with a clear idea of
what you don’t understand and that will help me immensely to focus on the more difficult
parts of the subject matter. That way, your doubts can be cleared up and your understanding
can be deepened during class. Remember also that I do not follow the textbook closely, so be
prepared that my class lectures will feel quite different from the book. Ultimately, you are
responsible for the material I cover in class, not what is in the book, although there is
considerable overlap.
Mathematical Pre-requisites: Basic algebra. Functions and their properties, including
exponential and logarithmic functions. Implicit functions and inverse functions.
Differentiation of functions. Maximization and minimization of functions. Integrals, both
indefinite and definite. Multivariate constrained optimization. The envelope theorem.
Nicholson: Chapter 2.
Knut Sydsaeter and Peter Hammond: Essential Mathematics for Economic Analysis,
2nd edition, Chapters 1-14.
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1. Wednesday, September 8
Introduction and Theory of Consumer Behavior: Introduction to microeconomics. Basic
demand and supply model. Theory of demand. Cardinal utility and the Marshallian theory of
demand. Ordinal utility and the Hicksian theory of demand. Properties of utility functions.
Indifference curves and indifference maps. The cases of perfect substitutes and perfect
complements. The difference between the law of diminishing marginal utility and the
convexity of indifference curves.
Nicholson: Chapter 3.
2. Monday, September 13
Theory of Consumer Behavior (continued): The budget constraint. Complex cases:
rationing, multiple constraints, non-linear prices. The consumer’s choice problem: utility
maximization subject to the budget constraint. The demand function. Computation of the
demand function in three specific cases: Cobb-Douglas, Leontief, and linear utility functions.
Nicholson: Chapter 4.
3. Wednesday, September 15
The Law of Demand: Properties of demand functions. Comparative statics. The effect of
changes in income on demand. Normal and inferior goods. The income elasticity of demand.
The own-price effect. Substitution and income effects and the law of demand. Giffen goods.
Other goods that violate the law of demand.
Nicholson: Chapter 5, pp. 141-151.
* Robert T. Jensen and Nolan Miller. "Giffen Behavior: Theory and Evidence." KSG
Faculty Research Working Paper Series and NBER (RWP07-030 and w13243),
July 2007. Available at:
http://web.hks.harvard.edu/publications/workingpapers/citation.aspx?PubId=4876
* Harvey Leibenstein: “Bandwagon, Snob, and Veblen Effects in the Theory of
Consumers’ Demand,” Quarterly Journal of Economics, May 1950, pp. 183-207.
Available at: http://www.jstor.org.ezproxy.bu.edu/stable/1882692
4. Monday, September 20
The own-price effect (continued): Compensated demand functions and their
relationship with ordinary demand functions. The Expenditure Function. The Slutsky
equation.
Nicholson: Chapter 5, pp. 151-165.
5. Wednesday, September 22
Applications of Demand Theory: Welfare Measurement and Price indices: Consumer’s
surplus. The compensating and equivalent variations in income. The revealed preference
approach to demand theory. Laspeyre and Paasche price indices. True price indices.
Nicholson: Chapter 5, pp. 165-173.
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* Hal Varian: Microeconomic Analysis, 3rd edition, Chapter 10.
* Michael Boskin, et al, “Toward a more accurate measure of the cost of living,”
Final report to the Senate Finance Committee from the Advisory Commission to
Study the Consumer Price Index, December 4, 1996. Available at
http://www.ssa.gov/history/reports/boskinrpt.html#cpi4
6. Monday, September 27
Cross-price effects: Net and gross substitutes and complements. The Slutsky equation for
cross-price effects. Summary of the properties of demand functions and the relationships
between related elasticities. Aggregation of individual demand to market demand. Further
applications of the theory of consumer behavior.
Nicholson: Chapter 6 (pp. 182-188 only) and Chapter 12 (pp. 391-395).
7. Wednesday, September 29
Theory of Producer Behavior: Production functions and their properties. Returns to scale.
Elasticity of substitution. Cost functions in the short and long runs. Derivation of the cost
function from the production function.
Nicholson, Chapters 9 and 10.
8. Monday, October 4
Cost functions (continued): Cost functions for the Cobb-Douglas, Leontief and linear
production functions. Average and marginal cost functions and their relationship to one
another.
Nicholson, Chapter 10.
9. Wednesday, October 6
Supply curves: The profit maximizing behavior of competitive firms. Derivation of the
firm’s supply curve and the market supply curve in the short and long runs. Pecuniary and
technological externalities.
Nicholson, Chapter 11.
Monday, October 11
Holiday, Columbus Day
10. Tuesday, October 12 (note Tuesday class, substituting for the Monday holiday)
Partial equilibrium in a competitive market: The basic demand and supply model.
Comparative statics in the short and long run. The significance of the long run equilibrium.
Efficiency of perfect competition in partial equilibrium. Applications of the basic market
model.
Nicholson, Chapter 12 (pp. 391-423).
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11. Wednesday, October 13
Further applications of the market model: Commodity taxes: specific and ad valorem
taxes. Sales taxes and excise taxes. Tax incidence analysis. (Start on General Equilibrium
topic if time allows … see next entry.)
Nicholson, Chapter 12 (pp. 423-432).
* Richard Layard and A.A. Walters: Microeconomic Theory, Chapter 3.
12. Monday, October 18
General equilibrium and welfare economics: The concept of Pareto efficiency. Pareto
efficiency in the pure exchange model. The Edgeworth box and the contract curve. The
utility possibilities frontier. Offer curves and the principles of international trade. Efficiency
in production. The production possibilities frontier. Efficiency in product mix. The two
optimality theorems of welfare economics. The theory of second best.
Nicholson, Chapter 13.
13. Wednesday, October 20
Overflow and Review: Time allowed to catch up on remaining topics and to review for the
mid-term.
14. Monday, October 25
MID-TERM EXAM (to cover through General Equilibrium)
15. Wednesday, October 27
Monopoly: Basic monopoly model. Multi-plant monopoly. Cartels. Price discrimination.
Two-part pricing. Limit pricing. Contestable markets. The welfare cost of monopoly.
Monopoly in general equilibrium. Monopoly and innovation.
Nicholson, Chapter 12 (pp. 491-509).
16. Monday, November 1
Regulation of monopoly: Natural monopoly and the need for regulation. Marginal cost
pricing. Average cost pricing. Two-part pricing. The multi-product case: Ramsey pricing.
Rate of return regulation. The Averch-Johnson effect. Price cap regulation.
Nicholson, Chapter 12 (pp. 510-513).
17. Wednesday, November 3
Imperfect Competition: The Cournot model. Reaction functions and Cournot-Nash
equilibrium. Symmetric and asymmetric Cournot equilibria. Long run (free entry) Cournot
equilibrium. The Stackelberg model.
Nicholson, Chapter 15.
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18. Monday, November 8
Imperfect Competition (continued): The price leadership model in the short and long run.
The Bertrand model. Monopolistic competition and product differentiation. The excess
capacity theorem.
Nicholson, Chapter 15.
19. Wednesday, November 10
Theory of Games: Static games of complete information. Nash equilibrium in pure and
mixed strategies. Repeated games. Dynamic games: normal and extensive forms. Subgame
perfect equilibria.
Nicholson, Chapter 8.
* Eric Rasmusen: Games and Information, 4th edition, Blackwell, 2007. Some parts
available at: http://www.rasmusen.org/GI/download.htm
20. Monday, November 15
Input Markets, Labor: The basic labor-leisure tradeoff and labor supply. Marginal
productivity and labor demand. Monopsony in labor markets. Wage discrimination. The
effect of unions in labor markets. Bilateral monopoly.
Nicholson, Chapter 16.
* Gary Becker: “A Theory of the Allocation of Time,” Economic Journal, September
1965, pp. 493-517. Available at:
http://www.jstor.org.ezproxy.bu.edu/stable/2228949
21. Wednesday, November 17
Input Markets, Capital: The intertemporal consumption decision and the supply of capital.
Saving and borrowing. The firm’s investment decision and the demand for capital.
Intertemporal aggregation and the concept of present value. Discrete and continuous
compounding. The price of natural resources.
Nicholson, Chapter 17.
22. Monday, November 22
Decisions under Uncertainty: The choice problem under uncertainty. The St. Petersburg
Paradox. The expected utility hypothesis. Cost of risk and maximum willingness to pay for
insurance. Decision trees. Risk-pooling and risk-spreading. The problem of correlated risks.
Critiques of the expected utility hypothesis.
Nicholson, Chapter 7, pp. 202-213.
* Wolfgang Pesendorfer: “Behavioral Economics comes of age: A review essay on
Advances in Behavioral Economics,” Journal of Economic Literature, September
2006, pp. 712-721. Available at:
http://www.jstor.org.ezproxy.bu.edu/stable/30032350
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Wednesday, November 24
Holiday, Thanksgiving.
23. Monday, November 29
Imperfect Information: The problems of moral hazard and adverse selection. The statecontingent approach to decision-making under uncertainty. Solutions to the problem of
asymmetric information: screening and signaling.
Nicholson, Chapter 7, pp. 213-226.
* George A. Akerlof: “The Market for “Lemons”: Quality Uncertainty and the
Market Mechanism,” Quarterly Journal of Economics, August 1970, pp. 488-500.
Available at: http://www.jstor.org.ezproxy.bu.edu/stable/1879431
* Michael Spence: “Job Market Signalling,” Quarterly Journal of Economics, August
1973, pp. 355-374. Available at:
http://www.jstor.org.ezproxy.bu.edu/stable/1882010
24. Wednesday, December 1
Externalities: Positive and negative externalities. Allocative effects of externalities.
Solutions to the problem of negative externalities: Pigouvian taxes and quantity restrictions.
Effluent charges. The cap and trade option. The transactions cost approach to externalities.
The Coase Theorem.
Nicholson, Chapter 19, pp. 670-679.
Pankaj Tandon: “An Integrated Approach to the Theory of Externalities: An
Exposition,” unpublished draft, Boston University. Available at:
http://pankajtandon.com/Externalities-An%20Exposition.pdf
* Ronald Coase: “The Problem of Social Cost,” Journal of Law and Economics,
October 1960, pp. 1-44. Available at:
http://www.jstor.org.ezproxy.bu.edu/stable/724810
25. Monday, December 6
Externalities (continued) and Public Goods: The tragedy of the common and common
property resources. Public goods. Efficient provision of public goods: partial equilibrium and
general equilibrium approaches. The free rider problem.
Nicholson, Chapter 19, pp. 679-687.
26. Wednesday, December 8
Social Choice, Justice and Wrap-up: Political solutions to the problem of public good
provision. The median voter rule. The paradox of voting and Arrow’s impossibility theorem.
Other concepts of efficient allocation: the Kaldor-Hicks Compensation Criterion,
utilitarianism, and Rawls’s Theory of Justice. Social choice criteria as decisions under
uncertainty. Final course wrap-up: What have we learned?
Nicholson: Chapter 19, pp. 687-693.
* John Rawls: A Theory of Justice, revised edition, 1999.
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* John C. Harsanyi: “Cardinal Welfare, Individualistic Ethics, and Interpersonal
Comparisons of Utility,” Journal of Political Economy, August 1955, pp. 309-321.
Available at: http://www.jstor.org.ezproxy.bu.edu/stable/1827289
* William Vickrey: “Utility, Strategy, and Social Decision Rules,” Quarterly Journal
of Economics, November 1960, pp. 507-535. Available at:
http://www.jstor.org.ezproxy.bu.edu/stable/1884349