Contents
README.TXT vii
I One: The Optimizing Individual 1
1 Decision Theory 3
1.1 Decision Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Example: Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . 6
2 Optimization and Risk 11
2.1 Reducing Risk with Diversification . . . . . . . . . . . . . . . . . 13
3 Optimization over Time 19
3.1 Lump Sums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3 Perpetuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.4 Capital Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
4 More Optimization over Time 33
4.1 Nominal and Real Interest Rates . . . . . . . . . . . . . . . . . . 33
4.2 Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.3 Mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5 Transition: Arbitrage 39
5.1 No Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
5.2 Rush-Hour Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . 40
5.3 Financial Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . 41
II One v. One, One v. Many 45
6 Cake-Cutting 47
6.1 Some Applications of Game Theory . . . . . . . . . . . . . . . . 47
6.2 Cake-Cutting: The Problem of Fair Division . . . . . . . . . . . . 49
6.3 The Importance of Trade . . . . . . . . . . . . . . . . . . . . . . 52

7 Economics and Social Welfare 57
7.1 Cost-Benefit Analysis . . . . . . . . . . . . . . . . . . . . . . . . 58
7.2 Pareto . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
7.3 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
8 Sequential Move Games 67
8.1 Backward Induction . . . . . . . . . . . . . . . . . . . . . . . . . 67
9 Simultaneous Move Games 77
9.1 Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
9.2 The Prisoners’ Dilemma . . . . . . . . . . . . . . . . . . . . . . . 78
9.3 Finitely Repeated Games . . . . . . . . . . . . . . . . . . . . . . 80
10 Application: Auctions 83
10.1 Kinds of Auctions . . . . . . . . . . . . . . . . . . . . . . . . . . 84
10.2 Auction Equivalences . . . . . . . . . . . . . . . . . . . . . . . . . 86
10.3 Auction Miscellany . . . . . . . . . . . . . . . . . . . . . . . . . . 88
11 Application: Marine Affairs 93
11.1 An Economic Perspective . . . . . . . . . . . . . . . . . . . . . . 94
11.2 A Brief Look at Government Intervention . . . . . . . . . . . . . 94
11.3 ITQs to the Rescue? . . . . . . . . . . . . . . . . . . . . . . . . . 97
12 Transition: Game Theory v. Price Theory 99
12.1 Monopolies in the Long Run . . . . . . . . . . . . . . . . . . . . 100
12.2 Barriers to Entry . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
III Many v. Many 103
13 Supply and Demand Basics 105
13.1 The Story of Supply and Demand . . . . . . . . . . . . . . . . . . 106
13.2 Shifts in Supply and Demand . . . . . . . . . . . . . . . . . . . . 108
13.3 Math: The Algebra of Markets . . . . . . . . . . . . . . . . . . . 109
14 Taxes 115
14.1 A Per-Unit Tax Levied on the Sellers . . . . . . . . . . . . . . . . 115
14.2 A Per-Unit Tax Levied on the Buyers . . . . . . . . . . . . . . . 116
14.3 Tax Equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
14.4 Math: The Algebra of Taxes . . . . . . . . . . . . . . . . . . . . . 120
15 Elasticities 125
15.1 The Price Elasticity of Demand . . . . . . . . . . . . . . . . . . . 126
15.2 Elasticities of Supply (and Beyond) . . . . . . . . . . . . . . . . . 129

16 Supply and Demand Details 133
16.1 Deconstructing Supply and Demand . . . . . . . . . . . . . . . . 133
16.2 Reconstructing Supply and Demand . . . . . . . . . . . . . . . . 134
16.3 Math: The Algebra of Markets . . . . . . . . . . . . . . . . . . . 135
16.4 On the Shape of the Demand Curve . . . . . . . . . . . . . . . . 135
16.5 On the Shape of the Supply Curve . . . . . . . . . . . . . . . . . 138
16.6 Comparing Supply and Demand . . . . . . . . . . . . . . . . . . 139
17 Margins 143
17.1 Reinterpreting the Supply Curve . . . . . . . . . . . . . . . . . . 143
17.2 Total Variable Cost and Producer Surplus . . . . . . . . . . . . . 145
17.3 Reinterpreting the Demand Curve . . . . . . . . . . . . . . . . . 146
17.4 Total Benefit and Consumer Surplus . . . . . . . . . . . . . . . . 147
17.5 Conclusion: Carrots and Sticks . . . . . . . . . . . . . . . . . . . 148
18 Transition: Welfare Economics 151
18.1 From Theory to Reality . . . . . . . . . . . . . . . . . . . . . . . 153
Appendices &etc. 155
A Government in Practice 157
A.1 Rules and Regulations . . . . . . . . . . . . . . . . . . . . . . . . 158
B Answer Key for Part I 163
C Answer Key for Part II 173
D Answer Key for Part III 183
Glossary 193
Index 200