ECON130 Week 6: Markets and equilibrium
Hi all. As you will have noticed from the lecture videos there is a lot of content in this week – more than in any other single week. But it is because we are tying all the prior weeks together, and trying to make sure we are clear regarding what we are saying! The lecture slides can be found here and here.
Furthermore, we are focusing on a set of assumptions – so lets start with those:
Assumptions
In the past 4 weeks we’ve built a “profit maximising” firm and a “utility maximising” consumer. For a single good or service we are going to assume it is provided by many of these sorts of firms and demanded by many of these sorts of customers.
The product provided is the same irrespective of the firm. The customers and firms have perfect information. And, in the long-run, the number of firms and the scale of the firm can change.
Why do I put these at the front? Because when we describe a real market some of these assumptions may not hold, and yet our results depend on them. However, the example with these assumptions allows us to ask “so how does the result change as we change these assumptions”. Also it gives us a specific way of thinking about gains from trade – and when market (and government) structures prevent trade that would generate gains from trade for the buyer and the seller.
Equilibrium
We have individual demand curves and individual supply curves. Add the many individuals together and you have … market demand and supply curves. Congratulations.
Our individuals were given the price – they were all forms of price takers. This is because there were many others and so the individual quantity demanded and supplied by a single agent was not sufficient to influence the price.
Given that how do we make sense of this scissors thing as a way of determining that price?
When they cross, the quantity demanded and the quantity supplied are the same – all firms are selling everything they make, while all customers and buying everything they want too. So there is no incentive for them to try to shift the price down or up, as the firm is selling the product for the highest price they can while the consumer is buying it for the lowest price they can. Nice.
What happens when prices are higher? Well the quantity supplied is greater than the quantity demanded. Each firm then faces a choice – sell a rationed amount of output for that price, or cut the price by a tiny amount and sell as much as they want. Seeing this they all start cutting prices, and the price falls.
When prices are lower we face a similar issue from the demand side – seeing they can only buy a rationed amount individual consumers offer a slightly higher price to satisfy their demand, gradually driving prices up.
This is our tendency. But so what?
Surplus
Instead of thinking about the price, lets think about the quantity.
At every quantity left of equilibrium there is a potential buyer who values the product more than a potential seller. As a result, there are gains from trade.
At every quantity right of equilibrium every potential buyer values the product LESS than every potential seller. So there are no gains from trade.
At equilibrium we have all the leftward transactions happening and none of the rightward ones – so we have the maximum gains from trade. This is the idea behind surplus that we discussed in class:
We can see that, with perfect competition (the assumptions discussed above) all the potential situations with gains from trade occur! Nifty.
Now we may have reasons why we want some transfer between the firms and consumers, and we could do that by changing the price (eg an unfair initial allocation of resources). However, a different price would lead to some “rationing” and a lower quantity – which in turn comes with a deadweight loss. This is the lost value associated with transactions that have some gains from trade not occurring.
So even if there is value from the transfer associated with changing the price – there is an unintended consequence associated with the transactions that do not occur.
Questions
- Is Matt’s hypothetical cafe, which is located close to the train station and involves chats about economics, a perfectly competitive firm?
- What are potential market failures when we have a perfectly competitive market? (Hint: Think about the two ways we discussed missing property rights)
- Do we always want to maximise surplus?
- How do rationing rules influence how we think about deadweight loss?
- How might “non-price” means for purchasing rationed products undermine our ability to help the poor by forcing firms to set low prices?
Added explanation
Just like in the previous discussion of simulating choice it is possible to think of this as a form of simulation. When we discussed what was happening “outside of equilibrium” we talked about how agents would change their behaviour and that would describe our tendency back to that equilibrium.
The Youtube channel Primer does a great job of this with an actual simulation of little blobs – I suggest giving it a watch for another perspective on how this idea works!