Model for Market Equilibrium

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Class 1: A review of basicClass 1: A review of basic

microeconomicsmicroeconomics


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Objectives:Objectives:

CharacteriseCharacterise microeconomicsmicroeconomics..UnderstandUnderstand market demand & supplymarket demand & supply..

Explain marketExplain market equilibriumequilibrium..

AnalyseAnalyse changeschanges in markets.in markets.

Develop idea ofDevelop idea ofeconomiceconomicefficiencyefficiency..


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MicroeconomicsMicroeconomics

Study of firms, consumers & marketsStudy of firms, consumers & markets

(As opposed to macroeconomics).(As opposed to macroeconomics).

How do individualHow do individual agentsagents behave?behave?

How do individualHow do individual agentsagents interact ininteract inmarkets?markets?


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DemandDemand(buying)(buying)

Consider a group of individual buyersConsider a group of individual buyers(consumers).(consumers).

Define theDefine the reservation pricereservation price of a buyer asof a buyer asthe maximum they will pay.the maximum they will pay.

ThenThen market demandmarket demandshows purchases inshows purchases ina market ata market at anyany reservation price.reservation price.


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DemandDemand is ais a functionfunction::

QQdd

= Q= Qdd

(p)(p)

So quantity demanded QSo quantity demanded Qdd depends ondepends on

price p.price p.

As price increases less will be purchase.As price increases less will be purchase.


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Graphing demand in a market:Graphing demand in a market:

Quantity demanded Qd

Price p

As price goes up

people buy less


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An important point!An important point!

In this view of a market, consumers takeIn this view of a market, consumers takeprices as given.prices as given.

(Thus the market is(Thus the market is competitivecompetitive on buyerson buyersside).side).


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SupplySupply(selling)(selling)

Consider a group of vendors (sellers)Consider a group of vendors (sellers)

Define a vendorsDefine a vendors willingness-to-sellwillingness-to-sellas theas theminimum price they need to be offered tominimum price they need to be offered tosupply.supply.

ThenThen market supplymarket supplyshows how much isshows how much issupplied at any price.supplied at any price.


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ImportantImportant::

As with buyers individual sellers (vendors) areAs with buyers individual sellers (vendors) are

assumed small.assumed small.

They do not (individually) determine priceThey do not (individually) determine price

Thus the selling side of a market isThus the selling side of a market is competitivecompetitive..


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Supply is aSupply is a functionfunction::

QQss = Q= Qss(p)(p)

So the quantity demanded QSo the quantity demanded Qss depends ondepends on

price p.price p.

As price increases more will be offered forAs price increases more will be offered forsale.sale.


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Graphing supply in a market:Graphing supply in a market:

As price increases more is

offered for sale

Price p

Quantity supplied Qs


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What determines supply?What determines supply?

BasicallyBasically technology & coststechnology & costs..

If a firm takes prices given it produces toIf a firm takes prices given it produces to

the point where its extra costs (itsthe point where its extra costs (its

marginal costsmarginal costs) equal price.) equal price.

Hence firm supply is its MC curve.Hence firm supply is its MC curve.


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Market equilibrium: Putting supplyMarket equilibrium: Putting supply

and demand together:and demand together:

Now have a simple model:Now have a simple model:

QQdd = Q= Qdd(p)(p)

QQss = Q= Qss(p)(p)

This isThis is indeterminateindeterminate 3 variables 3 variables

QQss, Q, Qdd & p but only 2 equations. Help!!!!!!!!& p but only 2 equations. Help!!!!!!!!


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One way of closing the model:One way of closing the model:

Impose theImpose the equilibrium conditionequilibrium condition::

QQss=Q=Qdd..

Why?Why?

Think about excess demands QThink about excess demands Qdd>Q>Qss and excessand excess

supplies Qsupplies Qss > Q> Qdd..

These statesThese states cannot be an equilibriumcannot be an equilibrium..


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p

Qd

Qs

pe

Qd, QsQd(pe)=Qs(pe)

market price pmarket price pee, purchases & sales, purchases & sales


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Explains market price pExplains market price pee, purchases Q, purchases Qdd(p(pee))

& sales Q& sales Qss

(p(pee

) as solution to:) as solution to:

QQdd = Q= Qdd(p)(p)

QQss = Q= Qss(p)(p)QQss = Q= Qdd

An equilibrium since itAn equilibrium since itpersistspersists..

At pAt pee actions of buyers & sellersactions of buyers & sellers consistent.consistent.


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Its only a model!Its only a model!

Lots of markets are almost never inLots of markets are almost never inequilibrium (e.g. labour market).equilibrium (e.g. labour market).

Other markets may involve buyer or sellerOther markets may involve buyer or sellerpower does not arise inpower does not arise in competitivecompetitivesetting.setting.

But the competitive model is the basis ofBut the competitive model is the basis ofmuch microeconomics.much microeconomics.


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Comparative staticsComparative statics

Endogenous variablesEndogenous variables are explained by a modelare explained by a model

(here p(here pee, Q, Qdd(p(pee), Q), Qss(p(pee) ).) ).

Exogenous variablesExogenous variables have values taken ashave values taken as

given in a model (tastes, technologies,given in a model (tastes, technologies,

incomes.)incomes.)

Comparative staticsComparative statics studies how exogenousstudies how exogenous

variables affect endogenous variables.variables affect endogenous variables.


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p

Qd

Qs

pe

Qd, QsQd(pe)=Qs(pe)

Qdnew

Increased consumer income


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p

Qd

Qs

pe

Qd, QsQd(pe)=Qs(pe)

A technology improvementA technology improvement

Qsnew


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These graphical techniques areThese graphical techniques are

used a lot.used a lot.

One is comparing equilibria henceOne is comparing equilibria hencecomparativecomparative..

The transition path is ignored henceThe transition path is ignored hencestaticsstatics..


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EfficiencyEfficiency

Supply & demand drive an equilibrium thatSupply & demand drive an equilibrium that

isis efficientefficient..

DefinitionDefinition: If no one can be made better-: If no one can be made better-

off without someone being worse off thenoff without someone being worse off thenPareto efficiencyPareto efficiencyor simplyor simply efficiencyefficiency

prevails.prevails.


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Idea of efficiencyIdea of efficiency

Suppose a group trade among themselvesSuppose a group trade among themselveswithout restriction anyone can trade whateverwithout restriction anyone can trade whateverthey wantthey want without restrictionwithout restriction..

The resulting allocation isThe resulting allocation is efficientefficient- if any 2- if any 2people could have made themselves better-offpeople could have made themselves better-offthey would have.they would have.

An all powerful being (a government) couldAn all powerful being (a government) couldmake someone better off but only by makingmake someone better off but only by makingsomeone else worse off.someone else worse off.


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PropositionProposition: Market equilibrium is efficient: Market equilibrium is efficient

ProofProof (intuitive)(intuitive)

If no constraints are placed on buyers or sellersIf no constraints are placed on buyers or sellers

efficiency must obtain. If there were options forefficiency must obtain. If there were options for

groups to make themselves better-off with tradegroups to make themselves better-off with tradethey would be exploited.they would be exploited.


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Market outcomes (thoughMarket outcomes (though efficientefficient) may be) may be

unfairunfairin the sense that the rich get most of thein the sense that the rich get most of the

resources.resources.

But competitive market outcomes are efficient inBut competitive market outcomes are efficient in

the sense of being non-wasteful.the sense of being non-wasteful.

We characterise manyWe characterise many environmental problemsenvironmental problems

asas inefficienciesinefficiencies..


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Main points of this class:Main points of this class:

MicroeconomicsMicroeconomics

MarketsMarkets

Buyers and sellersBuyers and sellers

Demand & WTPDemand & WTP

Supply & WT sellSupply & WT sell

Market equilibriumMarket equilibrium

Excess demand excessExcess demand excesssupplysupply

Comparative staticsComparative statics

Pareto efficiency.Pareto efficiency.

Marginal cost.Marginal cost.


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End of class 1End of class 1

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Model for Market Equilibrium