In this chapter we will study a general method for analyzing social and economic problems that take place over time, which we call dynamic games. I’ll start by explaining a simple example that will illustrate various key concepts that we will use to solve dynamic games.

The above discussion has focused on the ways in which the market mechanism gets things right, or, more specifically, on the ability of perfectly competitive markets to allocate various resources (efficiently) in accordance with the needs of the people when all goes well. However, it is important to acknowledge that the market mechanism may also occasionally get things wrong. In this chapter we focus on so-called market failures, or typical cases in which the market mechanism fails to achieve an efficient allocation of resources – for whatever reason – and how they might be best addressed.

In modern society, everything – including food, housing, and music – is traded with a number called “price.” We usually don’t give this much thought, but isn’t it puzzling, if you stop to think about it? The objective of Part I is to understand the basic function of a market and its limitations. To this end, we first try to understand consumer behavior and firm behavior, and then analyze what happens if they interact in a market.

Shareholders of a company cannot directly monitor what the company’s manager is doing in her/his office. So, what can the shareholders do to ensure that the manager works hard for the sake of the company? This is a problem of moral hazard (a problem in which certain people’s actions – the manager’s effort – are “hidden” from others). To solve this type of problem, one needs to consider the following two issues.

In Part II I explain the basic principles of game theory and economics of information, which are relatively new areas of economic theory compared to Part I. The development of game theory and economics of information was motivated by the need to analyze general economic and social problems beyond the realm of perfectly competitive markets.

First, let’s begin with the simplest situation, which we call the case of “simultaneous moves,” in which everyone makes his or her decision at the same time. In order to analyze such a situation, we will express the situation using a model, which we call a “game.”

It’s been a long journey, but we have finally covered the basics of economic analysis. Now that you have learned the analytical tools (theoretical models) we use in economics, I believe that you have gained a strong understanding of how society allocates resources via the market mechanism. However, that is not the end of the story.

Economists call (1) to (7) resource allocation issues. More specifically, (5) to (7) are called distribution issues. Each society resolves these issues with its own institutions and rules, which have historically included feudal systems, planned economies, and market economy mechanisms.

Let’s continue studying the basics of economic analysis when there is asymmetric information. As I explained in Chapter 8, there are two main types of problems with asymmetric information.