Equilibrium with prices and expectations

In the models of markets we have discussed so far, equilibrium prices make the individuals’ decisions compatible. Each individual takes the prices as given when deciding on his action, and at the equilibrium prices the demand and supply of every good are equal.

In this chapter, an individual’s behavior is affected not only by the prices but also by his expectations regarding other parameters. Each individual takes these expectations, like the prices, as given. In equilibrium, each individual behaves optimally, the supply and demand for each good are equal, and the expectations of individuals are correct.

We present three models. In the first model, each individual chooses one of two bank branches. His decision is affected only by his belief about the expected service time in each branch. In the second model, potential buyers of a used car, who cannot observe the quality of the cars for sale, take into account their expectation of the average quality of these cars as well as the price. In the third model, the unit cost of catching fish depends on the total amount of fish caught. Each fisher makes his decision taking as given both the price of fish and his expectation about the unit cost he will incur.