2.2. Equilibrium analysis

The importance of economic equilibrium in understanding and applying economic principles cannot be overstated. An equilibrium can be regarded as an artificial construct that allows one to examine the properties of the model in a situation where every agents’ choices and activities are consistent with each other and no agent would have an incentive to change its choices or activities.

Equilibrium and economic context. The equilibrium has to be defined relative to the economic environment. So if we make the environment more complicated within the economic model it should not come as a surprise that we need a more carefully specified definition of what an equilibrium state is. We can imagine this by analogy with a mechanical model: the more intricate the system of levers, wheels and pulleys, the more you add on extra subsystems, the more carefully you will need to specify the conditions for the whole contraption to be in balance.

The comparative statics method. How do things in the model change as things in the environment around it change? The comparative statics method provides a way of dealing with this issue. It is built on the concept of equilibrium and focuses on the relationship between the equilibrium itself and one or more key parameters. It is not a description of a process but is more like a set of snapshots of di¤erent instances of equilibrium that leave a trace of a process.

The comparative statics method is sometimes incorporated into specific relationships that are used as a shorthand to characterise the behaviour of an economic agent. The prime example of this is demand and supply functions collectively referred to as response functions.

We use the comparative statics method time and again to get some insight on here the economic machine might move if certain levers were pulled. How the machine moves from point to point requires an explicit model of dynamic processes.

2. 3. Positive and Normative Analysis

cies.

Summury

Lecture 2

Demand and Supply in a Market System

The market system is an interrelated set of markets for goods, services and inputs. A market is defined as the interaction of all potential buyers and sellers of a good or class of goods that are close substitutes. The economic analysis that is used to analyze the overall equilibrium that results from the interrelationships of all markets is called a "general equilibrium" approach.

In principles of economics, most models deal with partial equilibrium. Partial equilibrium is the analysis of the equilibrium conditions in a single market (or a select subset of markets in a market system).

In a partial equilibrium model, usually the process of a single market is considered. The behavior of potential buyers is represented by a market demand function. Supply represents the behavioral pattern of the producers/sellers.

1. Demand Function

A demand function that represents the behavior of buyers, can be constructed for an individual or a group of buyers in a market. The market demand function is the horizontal summation of the individuals' demand functions.

The nature of the "demand function" depends on the nature of the good considered and the relationship being modeled. In most cases the demand relationship is based on an inverse or negative relationship between the price and quantity of a good purchased. BUT: The demand for purely competitive firm's output is usually depicted as horizontal (or perfectly elastic). In rare cases, under extreme conditions, a "Giffen good" may result in a positively sloped demand function. These Giffen goods rarely occur.