Lecture 3: Market Equilibrium

Market Equilibrium

• Market Equilibrium: Occurs at the unique price and quantity where quantity demanded ($Q_D$) equals quantity supplied ($Q_S$), clearing the market.

• Law of Supply and Demand: Price adjusts in competitive markets to balance $Q_D$ and $Q_S$, allowing buyers to signal willingness to pay and sellers to signal willingness to sell.

• Shortage (Excess Demand): Occurs when $Q_D > Q_S$. Sellers raise prices, causing $Q_D$ to fall and $Q_S$ to rise until equilibrium is reached.

• Surplus (Excess Supply): Occurs when $Q_S > Q_D$. Sellers reduce prices, causing $Q_D$ to rise and $Q_S$ to fall until equilibrium is reached.

• Price Adjustment Signals:

  • Price rising indicates $Q_D > Q_S$.

  • Price falling indicates $Q_S > Q_D$.

• Disequilibrium Symptoms: Queuing, bundling of extras, and secondary markets.

Efficiency and Market Critiques

• Efficiency vs. Equity: Efficient market outcomes reflect the income distribution of participants. Inability to pay excludes individuals, creating a government responsibility to address equity alongside efficiency.

• Critiques of Perfect Competition Efficiency:

  • Lack of perfect information.

  • Disequilibrium transitions are harder for poor individuals and employees.

  • Presence of externalities.

  • Initial wealth differences.

  • Unrealistic baseline assumptions.

Profit and Decision-Making Concepts

• Objective of the Firm: Maximize profit ($\Pi$), defined as Total Revenue ($TR$) minus Total Cost ($TC$):   $\Pi = TR - TC$

• Accounting vs. Economic Profit:

  • Explicit Costs: Direct monetary payments for external resources (inputs, salaries, depreciation, interest).

  • Implicit Costs: Opportunity costs of self-owned resources and expected returns on capital.

  • Accounting Profit: Subtracts only explicit costs from total revenue.

  • Economic Profit: Subtracts both explicit and implicit costs from total revenue.

• Decision Rules and Relevant Costs:

  • Relevant Costs/Benefits: Only factors that vary with the consequences of a decision should be evaluated.

  • Sunk-Cost Fallacy: Basing decisions on past, unrecoverable costs that do not vary with future outcomes.

  • Hidden-Cost Fallacy: Ignoring relevant opportunity costs that vary with decision consequences.

  • Decision-Making Biases: Endowment Effect, Loss Aversion, Confirmation Bias, Anchoring Bias, Overconfidence Bias, and the Broken Window Fallacy.

Marginal Analysis and Optimization

• Marginal Analysis Definitions:

  • Marginal Revenue ($MR$): $\frac{\Delta TR}{\Delta Q}$

  • Marginal Cost ($MC$): $\frac{\Delta TC}{\Delta Q}$

• Optimization Rule for Extent Decisions:

  • If $MR > MC$, increase output to grow economic surplus.

  • If $MR < MC$, decrease output to increase economic surplus.

  • Economic surplus and profit are maximized where $MR = MC$

• Linear Demand Rule: For any linear inverse demand equation $P = a - bQ$, the corresponding marginal revenue curve is:   $MR = a - 2bQ$

Interactive Questions and Discussion

• Concert Ticket Scenario: After paying $\$100$ for a concert ticket, the performance after $20\,\text{minutes}$ is terrible.

  • Evaluation: The $\$100$ paid is a sunk cost and irrelevant. The decision to stay or leave depends strictly on marginal enjoyment versus available alternatives.

• Gym Membership Scenario: Deciding whether to go to the gym tonight after having already paid the quarterly membership fee.

  • Evaluation: The prepaid membership fee is a sunk cost. The primary economic cost of attending is the required time and energy.