INTERMEDIATE MICROECONOMICS (EC201) 
Course duration: 54 hours lecture and class time (Over three weeks) 
Summer School Programme Area: Economics   
LSE Teaching Department: Department of Economics 
Lead Faculty: Dr Andrew Ellis (first‐half) and Dr Francesco Nava (second‐half) (Dept. of Economics) 
Pre‐requisites: Introductory microeconomics, ordinary and partial differential calculus. 
 
Course Overview: 
The aim of this course is to give students the conceptual basis and the necessary tools for understanding 
modern microeconomics at the intermediate level. In the context of this theoretical framework the course will 
explore a number of applied issues such as contract design, insurance, and ownership structures.  
 
The course covers 6 broad areas:  
‐ Consumer Theory  
‐ The Theory of the Firm   1

‐ General Equilibrium  
‐ Game Theory  
‐ Oligopolistic Markets  
‐ Information Economics  
 
The theory of the consumer explores the demand side, while the theory of the firm discusses the supply side 
of the economy. General equilibrium puts the two parts together and discusses welfare implications, including 
in the presence of externalities.  
The second part of the course introduces basic concepts in non‐cooperative game theory, emphasising the 
strategic aspect of economic interaction. Game theory is then applied to analyse informational problems in 
economics, in particular problems of hidden information (adverse selection) and hidden action (moral hazard).  
Whilst not all of the presentations will be as mathematical as that provided in the course text, knowledge of 
differential calculus is essential for the study of quantitative solutions to economic problems and, indeed, 
enhances one’s understanding of the underlying concepts. In class on the first day of the course, partial 
differential calculus will be reviewed, and students will be introduced to the technique of constrained 
maximisation due to Lagrange. 

Course content is subject to change.  Last updated: December 2017      
 
       
 
Lecture Plan:  
Topic 1 ‐ Consumer Theory  
This part of the course studies consumers’ preferences and budget constraints. It derives individual demand 
functions and analyses how these can be aggregated to build the market demand curve. Also the concepts of 
consumer surplus and price indexes will be discussed.  
 
Topic 2 ‐ The Theory of the Firm  
This part of the course reviews the structure of production and studies the profit maximisation problem of the 
firm. It analyses how the firm responds to market stimuli both in the short and in the long run. The issues 
above are addressed for perfectly competitive firms as well as for monopolies. The market supply is also 
derived as the aggregate supply of firms that produce identical products.  
 
Topic 3 ‐ General Equilibrium and Welfare  
The topic provides conditions for an economy to reach equilibrium and studies how equilibrium prices and 
quantities are determined. It identifies conditions under which the market equilibrium is efficient as well as 
those under which a central planner can implement an efficient allocation as a market‐equilibrium.  
  2
Topic 4 ‐ Game Theory  
Game theory is used to study strategic interactions between agents and is a fundamental tool in modern 
economics. This topic analyses several general classes of games and defines relevant solution concepts in each 
of these. It begins by discussing static games of complete and incomplete information and by defining 
Dominant Strategy equilibria and Nash equilibria, in pure and mixed strategies. It proceeds by analysing 
dynamic and repeated games with complete information, and by introducing Subgame Perfection.  
 
Topic 5 – Oligopolistic Markets  
Two main game theoretic applications are considered. The first looks at the strategic behaviour of firms in a 
duopoly. The second looks at a model of entry‐deterrence with pre‐commitment strategies.  
 
Topic 6‐ Information Economics  
In many environments agents involved in economic transactions have access to different information about 
profitability of trade between them. The final topic considers such scenarios: firstly, in adverse‐selection and 
signalling models where one agent cannot observe another agent’s characteristics (insurance market); 
secondly, in moral hazard models where one agent cannot observe another agent’s action. The optimal design 
of contracts to provide incentives and elicit information is the main aim of the topic. 

Course content is subject to change.  Last updated: December 2017      
 
       
 
 
Suggested Reading:  
The following text is recommended as additional reading to the lecture notes and class exercises.  
Christopher Snyder and Walter Nicholson, Microeconomic Theory: Basic Principles and Extensions, (11th 
edition, International Edition), South‐Western College Publishing (2011).  
Please note that the textbook differs from previous editions as well as the American edition. 
 
Formative Assessments:  
1) Format: Hand‐in Problem Set 
Date: Friday week one 
Results due: Tuesday week two 
 
2) Format: Hand‐in Problem Set 
Date: Tuesday of week three 
Results due: Thursday week three 
 
Summative Assessments:  3
1) Format and Weight: Two Hour Midterm Exam (50%) 
Date: Wednesday of week two 
Results due: Monday of week three 
 
2) Format and Weight: Two Hour Final Exam (50%)  
Date: Friday of week three 
Results due: Thursday the following week 

Course content is subject to change.  Last updated: December 2017      
 
       
 

Credit  Transfer:  If  you  are  hoping  to  earn  credit  by  taking  this  course,  please  ensure  that  you 
confirm it is eligible for credit transfer well in advance of the start date. Please discuss this directly 
with your home institution or Study Abroad Advisor.  
As a guide, our LSE Summer School courses are typically eligible for three or four credits within the 
US system and 7.5 ECTS in Europe. Different institutions and countries can, and will, vary. You will 
receive  a  digital  transcript  and  a  printed  certificate  following  your  successful  completion  of  the 
course in order to make arrangements for transfer of credit.  
If you have any queries, please direct them to [email protected] 

Course content is subject to change.  Last updated: December 2017      
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Summer School 2018 – Francesco Nava

Homework Assignments

The list of daily assignments follows. I suggest that you attempt at least some of them prior to the class. Numbers
refer to exercises from the textbook. The problems labeled "extra" are not required, but are good practice.

1. Due Thursday June 28

Problem 1 (below)
Normal: 7.1, 7.4, 7.7
Extra: 7.3, 7.10

2. Due Friday June 29

Problem 2 (below)
Normal: 8.1, 8.2, 8.4
Extra: 8.9

3. Due Monday July 2

Problem 3 (below)
Normal: 15.1, 15.2, 8.7(a)
Extra: 8.5, Problem 4 (below)

4. Due Tuesday July 3

Hand-In Problem Set

8.3, Problem 5 (below)
Normal: 8.6, 15.7(a)

5. Due Wednesday July 4

Problem 6 (below)
Normal: 18.2, 18.3, 18.4
Extra: 18.5 (a-b)

6. Due Thursday July 5

Problem 7 and 8 (below)

Normal: 18.7
Extra: 18.1

Problem 1 (Uncertainty) Rick is considering whether to spend 5 dollars betting on Republicans winning the next
election. If Republicans were to win the election, Rick would be paid 4 dollars for any dollar that he has bet. The
utility that Rick derives from a (positive or negative) cash transfer of x dollars is determined by the following utility
function,
u(x) = (475 + 75x)1=2 .
Rick believes that the probability of republicans winning the next election is 1=3.

1. Find the expected value of such a lottery.

Intermediate Microeconomics F. Nava

2. Find Rick’s expected utility of taking such a gamble. Would he accept it? Or would he reject it and get x = 0?
3. What’s the certainty equivalent of such a lottery.

Problem 2 (Static Games) Consider the following static two-player game:

1n2 A B
A 1; 2 3; 7
B 7; 3 2; 2

Player 1 is the row player, and his payo¤ is the …rst to appear in each entry. Player 2 is the column player and his
payo¤ is the second to appear in each entry.

1. Find the pure strategy Nash equilibria of the game, and show that they are equilibria.
2. Find the mixed strategy Nash equilibrium of the game.
3. Derive the mixed strategy best responses.

Problem 3 (Bayesian Games) Consider the following Bayesian game played by two players (1 and 2) who are
deciding whether to cooperate, C, or defect, D. Two states are possible, Good and Bad. Suppose that Player 2
knows the state, while Player 1 thinks that the state is Good with probability p. Payo¤s in each state respectively
satisfy
1n2 C D 1n2 C D
State Good: C 0; 0 1; 1 State Bad: C 0; 0 0; 1 .
D 1; 1 0; 0 D 1; 0 3; 3
Player 1 is the row player, and his payo¤ is the …rst to appear in each entry. Player 2 is the column player and his
payo¤ is the second to appear in each entry.

1. What is the set of possible strategies for the two players in this game?
2. Find the pure strategy Bayes-Nash equilibria for all values of p 2 (0; 1).

Problem 4 (Cournot Uncertainty) Two …rms compete to sell a good. Firm 1 has total costs of production
2
C1 (q1 ) = (q1 ) + 2q1 and its costs are known to Firm 2. The total costs of Firm 2 depends on its type. If Firm 2
2
is of type L, its costs are CL (qL ) = 2qL . If Firm 2 is of type H, its costs are CH (qH ) = 2 (qH ) . Firm 2 knows its
type. But Firm 1 only knows that Firm 2 can have either cost structure with equal probability. The inverse demand
for the output produced by the two …rms in this market satis…es:

p(q1 + q2 ) = 10 2(q1 + q2 )

Firms choose how much output to produce in order to maximize their pro…ts. Find the Bayes-Nash equilibrium of
this game. Characterize the equilibrium output strategies for both …rms. Find the market price for each of the two
possible cost con…gurations.

Problem 5 (Repeated Games) Consider the following asymmetric Prisoner’s Dilemma:

1n2 C D
C 3; 4 1; 6
D 4; 0 2; 2

1. Find the minmax values of this game.

2. Then, consider the following "trigger" strategy: any player chooses C provided that no player ever played D;
otherwise any player chooses D. Write the two incentive constraints that if satis…ed would make such a strategy
a NE. Then, write the two additional incentive constraints that if satis…ed would make such a strategy a SPE.
What is the lowest discount rate for which such strategy satis…es all the constraints.

2
Intermediate Microeconomics F. Nava

Problem 6 (Adverse Selection) Consider an economy with a monopolistic electricity supplier. Assume that the
costs of producing a unit of electricity are 1$. There are only two goods in this economy namely money, y, and
electricity, x. All consumers in this economy are endowed with 100$ in money and no electricity. There are two
types of buyers in the economy: type H has high value for electricity, while type L does not. In particular assume
that preferences satisfy:

u(x; yjH) = 8x1=2 + y

u(x; yjL) = (9=2)x1=2 + y

1. If the monopolist can recognize the type of any individual, …nd the optimal bundles sold to both types. Why
is this outcome e¢ cient?
2. Suppose that 1/8 of all individuals in the population are of type H. If the monopolist cannot recognize the type
of any individual, …nd the optimal bundles sold to both types in equilibrium. Why is the outcome ine¢ cient?

Problem 7 (Signaling) Consider Spence’s signalling model. A worker’s type is t 2 f0; 1g. The probability that
any worker is of type t = 1 is equal to 2=3, while the probability that t = 0 is equal to 1=3. The productivity of a
worker in a job is (t + 1)2 . Each worker chooses a level of education e 0. The total cost of obtaining education
level e is C(ejt) = e2 (2 t). The worker’s wage is equal to his expected productivity.

1. Find pooling equilibrium education levels.

2. Find separating equilibrium education levels.

Problem 8 (Moral Hazard) Consider the Principal-Agent model discussed in the slides. Suppose that the e¤ort
exerted by the agent can take one of three values e 2 f1=3; 2=3g. Also suppose that the Agent’s preferences are given
by u(w; e) = 2w1=2 e. Leisure yields to the Agent a reservation utility u = 1. The principal’s problem can have one
of two outcomes: success or failure q; q . The payo¤s to the Principal in these two events are: q = 4 if the outcome
is a success and q = 0 if the outcome is a failure. The probability of a success is: p1=3 = 1=3 if the Agent chooses the
low e¤ort; and p2=3 = 2=3 if the agent chooses the high e¤ort.

1. Let e¤ort be observable. Compute the full-information wages at each e¤ort level. What is the pro…t maximizing
e¤ort for the Principal?
2. Now suppose that the Principal cannot observe e¤ort. For each e¤ort level …nd output dependent wages that
induce the Agent to exert such an e¤ort.
3. Which e¤ort level maximizes the pro…ts of the principal if he cannot observe e¤ort? Which wage schedule
should he set to induce the agent to exert such e¤ort.

3
EC201 Hand-In Problem Set

Short Questions (17 MARKS EACH)

1. Ann is deciding whether to bet on a tennis match. A friend o¤ers to give her 20 dollars if the
lower ranked player wins, while she has to pay him 12 dollars otherwise. The utility that she
derives from a (positive or negative) cash transfer of x dollars is determined by the following
utility function,
u(x) = (16 + x)1=2 .
Ann believes that the probability of the lower ranked player winning the match is p.

(a) Find the expected value of this lottery. For what values of p is the expected value positive?
(5 marks)

(b) Find Ann’s expected utility when betting on the match. For what values of p would she
accept the bet? (6 marks)

(c) Find Ann’s certainty equivalent for this lottery when p = 3=4. (6 marks)

2. Consider the following Bayesian game played by two players 1 and 2. Two states are possible,
A and B. Suppose that player 2 knows state, while player 1 deems both states equally likely.
Payo¤s in each state respectively satisfy

1n2 s p 1n2 s p
State A: s 1; 1 0; 2 State B: s 0; 2 1; 1 .
p 0; 0 2; 0 p 2; 0 0; 0

Player 1 is the row player, and his payo¤ is the …rst to appear in each entry. Player 2 is the
column player and his payo¤ is the second to appear in each entry.

(a) What is the set of possible strategies for either player in this game? (7 marks)

(b) Find a pure strategy Bayes Nash equilibrium of the game. (10 marks)

3. Suppose that two friends have split 5 indivisible cookies according to the following protocol.
Player 1 gets to divide the cookies between two dishes and Player 2 gets to choose which of
the two dishes to consume (while the remaining dish is consumed by Player 1). First, assume
that all cookies are alike, so that both players value every cookie equally, and care only about
consuming more cookies.

(a) Set up this problem as an extensive form game. [4 marks]

(b) Find a Subgame Perfect equilibrium of this game. Write the behavioral strategy for both
players, and check that no deviation is pro…table. [6 marks]
(c) Does the game possess any Nash equilibrium that is not Subgame Perfect? [7 marks]
Intermediate Microeconomics Hand-In

LONG QUESTION (49 Marks)

4. Two …rms compete to sell a good. Total costs of the two …rms respectively satisfy

C1 (q1 ) = 2q1 and C2 (q2 ) = q22 .

The total output produced in the economy is Q = q1 + q2 . The inverse demand for the total
output produced by the two …rms in this market satis…es

10 2Q if Q 5
p(Q) = .
0 if Q > 5

Remember that the inverse demand curve identi…es the highest price for which all the units
supplied to the market are purchased.

(a) First assume that …rms compete on quantities. Find the Cournot equilibrium output at
the two …rms, the equilibrium price, and the pro…ts at each of the two …rms. (20 marks)

(b) Then suppose that the two …rms form a cartel. Find the cartel price and the output
produced at the two …rms? Compare your results with part (a). Does the cartel make
higher pro…ts than the two …rms in part (a)? Does it produce more output on aggregate?
(15 marks)

(c) Finally assume that …rms choose their output taking prices as given. Find the perfect
competition price and the output produced at the two …rms? Again, compare your results
with parts (a) and (b). (14 marks)

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