W. Bentley MacLeod. - Advanced microeconomics for contract, institutional, and organizational economics /

Advanced Microeconomics for Contract, Institutional, and Organizational Economics

W. Bentley MacLeod

The MIT Press
Cambridge, Massachusetts
London, England

2022 Massachusetts Institute of Technology

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Library of Congress Cataloging-in-Publication Data

Names: MacLeod, W. Bentley (William Bentley), 1954 author.

Title: Advanced microeconomics for contract, institutional, and organizational economics / W. Bentley MacLeod.

Description: Cambridge, Massachusetts: The MIT Press, 2022. | Includes bibliographical references and index.

Identifiers: LCCN 2021023060 | ISBN 9780262046879 (hardcover)

Subjects: LCSH: Microeconomics.

Classification: LCC HB172.M273 2022 | DDC 338.5dc23

LC record available at https://lccn.loc.gov/2021023060

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This book is intended for use in a graduate economics course, either as a text or for supplementary material. It reviews, from the ground up, the microeconomic theory of exchange, which includes decision theory, game theory, and the foundations of contract theory. A distinguishing feature of this book, relative to the many fine books on contract theory, is the references to related empirical work. Ultimately, good theory should provide insights into observable phenomena. A course in optimization theory and general equilibrium theory is a recommended prerequisite. The appendix provides a brief introduction to optimization theory and the welfare theorem of general equilibrium theory.

Such a book would not be possible without the support and insights from many people. I am very grateful to my teachers from graduate school, particularly Charles Blackorby, Curtis Eaton, Tracy Lewis, Keizo Nagatani, Hugh Neary, and John Weymark. After graduate school I was very fortunate to spend time at CORE in Belgium, where I learned a great deal about game theory and mechanism design from Claude dAspremont, Jean Gabszewicz, Jean-Franois Mertens, and Jacques Thisse. I also learned a great deal from the other visitors, including Jean-Charles Rochet and Jan Svenjar. I am particularly grateful to Jim Malcomson, with whom I started to collaborate at CORE. Our work on relational contracts began by combining the insights from Jan Svenjars work on self-management with Jims ideas on incomplete labor contracts.

I also learned a great deal from a wonderful set of coauthors, including Jennifer Arlen, Elliott Ash, Jim Bergin, Jordi Brandts, Lorne Carmichael, Surajeet Chakravarty, Daniel Carvell, Janet Currie, Herbert Dawid, Armin Falk, Mehdi Farsi, Paul Gomme, Jon Hamilton, David Huffman, Yoshi Kanemoto, Lewis Kornhauser, Thomas Lemieux, George Norman, Daniel Parent, Mark Pingle, Evan Riehl, Juan Savedrea, Jessica van Parys, and Miguel Urquiola.

Finally, I greatly appreciate the feedback on the book from colleagues and graduate students. These include Iain Bamford, Thomas Braun, Danny Bressler, Daniel Deibler, Matthias Fahn, Ricard Gil, Jared Grogan, Florian Grosset, Tianshu Guo, Sakshi Gupta, Utkarsh Kumar, Lorenzo Lagos, Rui Duarte Mascarenhas, Suneil Parimoo, Roman Rivera, Yifan Shi, Carol Shou, Meredith Startz, Katherine Strair, Haoran Wang, Ding Yuan, and Georgio Zanarone. I also appreciated the input from the many graduate students who attended lectures based on this material at USC, Princeton, Caltech, and Columbia. Finally, I would like to thank both the Institute for Advanced Studies in Princeton and the Russell Sage Foundation in New York who hosted one-year visits while I was working on this book.

And as for principles of law, he should know those which are necessary in the case of buildings having party walls, with regard to water dripping from the eaves, and also the laws about drains, windows, and water supply. And other things of this sort should be known to architects, so that, before they begin upon buildings, they may be careful not to leave disputed points for the householders to settle after the works are finished, and so that in drawing up contracts the interests of both employer and contractor may be wisely safe-guarded. For if a contract is skillfully drawn, each may obtain a release from the other without disadvantage.

Vitruvius (1914, bk. 1, chap. 1, sec. 10), ca. 15 BCE

The purpose of this book is to present a review of the theory of exchange that can be used to produce a set of models and hypotheses amenable to empirical exploration, with particular focus on models that are useful for the study of contracts, institutions, and organizations. This introduction provides an overview of the terrain. The next subsection discusses price theory and why it is the dominant tool in economics. That discussion is followed by a summary of some work that extends price theory. The introduction concludes with a review of the agenda for the book.

This book is appropriate for the second part of the graduate sequence in microeconomics. As such, it is assumed that the student has taken general equilibrium theory and basic constrained optimization theory. Debreus 1959 book A Theory of Value remains a good source for general equilibrium theory. This book views the microeconomics for contract, institution and organizational economics as building upon the ideas outlined in Debreus brilliant work. The appendix of this book includes a brief outline of general equilibrium theory for reference purposes. There are many excellent sources for optimization theory, though the work of Luenberger and Ye (2008) for finite dimension problems and Luenberger (1969) for infinite dimension problems, such as control theory, remain among my favorite sources.

A feature of this book, which distinguishes it from the many excellent texts on microeconomics, is a discussion of evidence and how one might link theory and evidence. The discussion on this point is necessarily incomplete but it is included to highlight the fact that all models are imperfect representations of observed phenomena. Advancing knowledge entails exploring the empirical implications of the many models described here and documenting how they may be used to explain features of observed economic institutions that are difficult to describe from the perspective of price theory alone.

The fundamental theoretical building block of modern economics is general equilibrium theory, developed by John Hicks, Kenneth Arrow, and Gerard Debreu. The theory, laid out beautifully in Debreus (1959)s Theory of Value, provides a clear definition of an efficient allocation of resources, along with the conditions under which such an allocation can be achieved via the price system. The theory is the cornerstone of a modern graduate education not because it is true, but because it provides a precise general framework within which it is possible to define what one means by an efficient allocation of resources. The theory provides few normative presumptions beyond requiring that commodities are well defined and that each person has a way to evaluate and then rank commodities according to their preferences.