Liquidity, Markets and Trading in Action by Ozenbas, Deniz Pagano, Michael S. Schwartz, Robert A. Weber, Bruce W.

1 Economics and the Equity Market: 
A Microeconomics Course Application

Economics encompasses two broad subjects: macroeconomics and microeconom-

ics. Macroeconomics deals with an economy in aggregate and addresses issues such 
as infation, unemployment, interest rates, and economic growth. We present a mac-

roeconomic perspective in Chap. 3. Microeconomics, the focus of this chapter, 
operates, as its name indicates, on the micro level, addressing household consump-

tion decisions and the production decisions of frms. In this chapter, we focus on the 
parallels (and a few differences) between a standard microeconomics formulation (a 
household’s selection of an optimal consumption bundle) and a standard fnance 
model (an investor’s selection of a portfolio that optimally combines a riskless 
asset – cash – and a risky equity portfolio). The fnance formulation is the Capital 
Asset Pricing Model (CAPM). CAPM is a keystone of what is known as modern 
portfolio theory, the originator of which is Harry Markowitz who was awarded a 
Nobel Memorial Prize in Economic Sciences in 1990 for having developed the the-

ory of portfolio choice.
In both formulations, price plays a central role as it guides the decisions of both 
households and investors. Along with the decisions of households and frms, deter-

mination of an equilibrium price is of paramount importance. The price variable is 
so important that microeconomics courses can carry and have carried the name 
“price theory.”
It is one thing to analyze price equilibrium in a theoretical model, and something 
else for an equilibrium price to actually be attained in a real-world market, espe-

cially one where prices are changing with great frequency, as is the case in an equity 
market. A primary function of a fnancial marketplace such as the New York Stock 
Exchange or Nasdaq is to facilitate attainment of equilibrium prices, an objective 
referred to as price discovery. Effective price discovery, however, is not easily 
achieved. We discuss this in considerably more detail in Chap. 2 (Finance) and in 
Chap. 3 (Macroeconomics).
For most of our discussion in this chapter, we assume, as is standard in much 
microeconomics, that the marketplace is a totally frictionless environment. By fric-

tionless, we mean that there are no fees, taxes, or other impediments to buying and 

selling, which, therefore, are costless activities. Only toward the end of the chapter 
do we relax this assumption and consider the impact that friction can have on price 
determination and the operations of a real-world equity market.
While a theoretical, frictionless market equilibrium might not be fully achieved 
in a real-world marketplace, an unobservable equilibrium price nevertheless exerts 
a force that improves the quality of market outcomes. This force merits being under-

stood. By way of analogy, one might think of the power of the Gulf Stream, a strong, 
deep sea ocean current that brings warm water into the Atlantic Ocean from the Gulf 
of Mexico, moves up the Atlantic coast, and branches out to Europe. A ship crossing 
the Atlantic should take account of the Gulf Stream, but the vessel also has to con-

tend with the winds, waves, and storms on the surface of the sea. One might equate 
the power of the Gulf Stream with the force exerted by an unobservable frictionless 
market equilibrium price and equate the wind, waves, and storms with frictions that 
buffet real-world, non-frictionless markets.
1.1 Microeconomics in a Nutshell
The terms optimum, maximum, and equilibrium play a key role in microeconomic 
analysis. Households are assumed to make “optimal” decisions when confronted by 
something that lies at the heart of a microeconomic problem: resolving a trade-off 
between alternative possibilities (e.g., get a little more of this and a little less of that, 
or vice versa). Optimality is achieved with regard to the decision maker’s single, 
ultimate goal – maximize his/her personal utility. In a two-good environment (X and 
Y, for simplicity), a household determines the optimal amount of X to buy relative 
to Y when, because of a resource constraint (income or wealth), more of X can be 
obtained if and only if less of Y is obtained, and vice versa (more Y and less X). 
Having allocated its scarce resources optimally and, in so doing, having maximized 
utility, a household is in equilibrium. 
A frm makes two optimal decisions in order to achieve a single goal – the maxi-

mization of profts. In a two-input environment (again, we are keeping it simple), a 
frm maximizes profts by (1) optimally combining L (let us call it labor) and C (let 
us call it physical capital) and (2) producing an optimal quantity of its product (let 
us stay with X). When a frm has done this, it too is in equilibrium.
A household’s utility maximizing decisions are made with respect to tastes, 
income, and the prices of X and Y. An X-producing frm’s proft maximizing deci-

sions are made with respect to technology, the price of the product it is producing 
(the price of X), and the prices of its factors of production (L and C). When numer-

ous households are consuming X, when many frms are producing X, and when all 
households and all frms are in equilibrium, the market for X is in equilibrium. We 
can obtain this equilibrium with the use of a downward sloping market demand 
curve to consume X and an upward sloping market supply curve to produce X. The

Liquidity, Markets and Trading in Action by Ozenbas, Deniz Pagano, Michael S. Schwartz, Robert A. Weber, Bruce W.