Lecture 3 Microeconomics

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Lecture 3Microeconomics

• Partial equilibrium

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Outline

• Properties of Equilibrium
• What can go wrong?
• Examples from the labour market model.
• The dynamics adjustment to equilibrium
• The cobweb model
• The role of expectations

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Economic Equilibrium

• The notion of equilibrium is based on two
  presumptions
• all agents are optimising, i.e., they are doing
  what is best for themselves given the constraints
  they face.
• the actions of the agents are consistent with
  each other.

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Properties of Equilibrium
Existence
Uniqueness
Stability
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When the price mechanism works...
Excess supply
p
PS(q)
pH
Excess Demand
E
p
Equilibrium
pL
PD(q)
q
q
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What can go wrong?

• Labour market model
• Cobweb model

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The neo-classical labour market model

• Many firms that hire workers
• Many workers who supply labour
• Flexible wage contracts
• nominal wage is flexible
• number of hours can be adjusted

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Demand and supply

• Firms demand less labour as the real wage goes up
  gt downwards sloping demand curve.
• Workers supply more hours as the real wage goes
  up gt labour supply upwards sloping

if the wage is high enough, a further increase
may induce workers to consume more leisure gt
labour supply downwards sloping.
But
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Equilibrium at the labour market
Real wage
S
Unique and stable equilibrium
(W/P)
D
Labour
L
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No equilibrium
Real wage
S
D
Labour
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Multiple Equilibria
Unstable equilibrium
Real wage
(W/P)2
Stable equilibrium
(W/P)1
D
S
Labour
E2
E1
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The Cobweb Theorem

• Consider the market for potatoes
• Time lag between production decision and supply
  to the market.
• Production decisions are based on expectations
  about future demand.
• Perfect competition.

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Price determined
Production decision
Demand revealed
Time
t
t-1
Spring
Fall
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How are Expectations formed?

• We assume that expectations are static
• farmers believe that the price this year is going
  to be the same as the price they got last year!
• Is this a smart way of forming expectations?

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Long-run equilibrium at the Potato market
P
S
Long-run equilibrium
P
D
Q
Q
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The Dynamic Adjustment

• In year 0, part of the harvest is destroyed
• From year 1 onwards, the harvest is normal.
• After this shock, will the market return to the
  long run equilibrium?

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P
S
Convergent fluctuations
A
B
P0
E
P2
P
P1
C
D
D
Q
Q0
Q1
Q2
Q
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Time Path for prices with convergent
fluctuations.
P
P
Time
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P
S
P2
E
A
B
P0
Divergent Fluctuations
P
P1
C
D
D
Q
Q1
Q
Q0
Q2
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Time Path for prices with divergent fluctuations.
P
P
Time
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Stability or not?
Stability when demand is less responsive than
long-run supply.
Instability when demand is more responsive than
long-run supply.
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The role of expectations
Rational expectations

• Suppose that farmers know how the potato market
  works and
• that they use this knowledge to form expectations
  about the price and
• they based their production decision on this.

No fluctuations gt Move directly to long-run
equilibrium
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Conclusion

• Existence cannot be taken for granted.
• Multiplicity arises often.
• Stability cannot be taken for granted.

Comparative statics should be used with care!
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What is next?

• Welfare economics
• Application to gasoline taxation