In Lecture 1, we began with a simple puzzle.

The supply-and-demand diagram shows an equilibrium price and quantity. But it does not show how the market gets there. It does not show who changes the price, what buyers and sellers know, how they meet, how they bargain, whether trade happens before equilibrium, or what happens when people make mistakes.

In this lecture, we take the next step.

We begin to ask: what assumptions are needed before the supply-and-demand diagram can even be drawn?

This is an important question. Most students are shown demand and supply curves as if they are natural objects. Demand slopes downward. Supply slopes upward. The curves cross. The market clears.

But these curves do not appear by magic. They are constructed from assumptions about human behavior. If those assumptions do not match real behavior, then the diagram may give us a misleading picture of how markets actually work.

The aim of this lecture is to uncover one of the most important hidden assumptions behind the standard supply-and-demand model: reservation prices.

1. The Diagram Is Not the Market

Textbooks usually present the market through a diagram.

In the case of a rental market, the diagram gives us one market-clearing rent. At that rent, the number of rooms demanded by students equals the number of rooms supplied by homeowners.

This picture is simple and elegant.

But compare it with real rental markets.

When students arrive in a city and look for housing, they do not all pay the same rent. Even similar rooms in similar areas may rent for different prices. One student may find a good deal quickly. Another may search for many days and pay more. Some landlords know the market well. Others do not. Some tenants bargain. Others accept the first available offer. Some people have better information. Others make mistakes.

These are not accidental details. They are the market.

The textbook diagram removes these complications. It assumes away limited information, search costs, bargaining problems, transaction costs, uncertainty, mistakes, and the time required for adjustment.

Once these features are brought back in, the neat textbook picture begins to break down. That is why we need a different method: one that studies markets as processes, not just as diagrams.

2. What Are Reservation Prices?

To draw a demand curve, textbooks usually assume that each buyer has a maximum price they are willing to pay.

This maximum price is called the buyer’s reservation price.

For example, suppose a student is looking for a room. If the rent is below $300, she is willing to rent. If the rent is above $300, she is not willing to rent. In this case, $300 is her maximum willingness to pay.

Similarly, to draw a supply curve, textbooks assume that each seller has a minimum acceptable price.

For example, suppose a homeowner is willing to rent a room if the rent is at least $250. If the rent is below $250, he refuses to rent. If the rent is above $250, he is willing to rent. In this case, $250 is his minimum acceptable rent.

Once every buyer and seller has a fixed reservation price, we can construct demand and supply schedules. We ask how many buyers are willing to buy at each price, and how many sellers are willing to sell at each price. From those schedules, we draw demand and supply curves.

But notice what this requires.

Every buyer must have a fixed cutoff price. Every seller must have a fixed cutoff price. Below or above that number, the answer must switch clearly from “yes” to “no.”

Without these fixed yes-or-no cutoffs, the demand and supply curves cannot be drawn in the usual textbook way.

3. Do Real People Have Fixed Reservation Prices?

Now we must ask a simple question:

Do real people behave like this?

Suppose a student arrives in a new city and discovers that rents are much higher than expected. What does the student do?

The textbook model suggests that the student has a fixed maximum rent. If the rent is below that number, the student rents. If the rent is above that number, the student exits the market.

But real students usually do not behave like this. They adapt.

A student facing high rent may share a room. She may live farther away from campus. She may reduce other expenses. She may ask family for help. She may take a loan. She may look for part-time work. She may negotiate. She may accept temporary housing while continuing to search.

This means that the so-called maximum rent is not fixed. It is shaped by circumstances, alternatives, urgency, expectations, and interaction with others.

The same is true for sellers. A homeowner may initially want a high rent, but if no tenant appears, he may reduce the rent. If many students are searching desperately, he may increase the rent. If he urgently needs income, he may accept less. If he expects better offers later, he may wait.

So reservation prices are not always fixed numbers inside people’s heads. They are often created and revised through the market process itself.

This creates a serious problem for the textbook model. To draw a demand curve, the model requires fixed cutoff prices. But if buyers and sellers adapt to the market, then those fixed cutoff prices may not exist.

The demand curve is therefore not a natural object. It is created by imposing a behavioral assumption on people.

4. Economics Must Begin with Real Behavior

This course follows a different first principle.

When we study human behavior, we begin by asking:

Does this model match our experience of how people actually behave?

We do not begin by asking:

Can this behavior be written conveniently in mathematics?

This is a major difference between Agent Based Microeconomics and conventional textbook methodology.

In standard microeconomics, behavior is often simplified until it becomes mathematically manageable. Consumers maximize utility. Firms maximize profit. Buyers have fixed reservation prices. Sellers have fixed minimum acceptable prices. Markets move toward equilibrium.

These assumptions make the mathematics possible. But they may not describe real human beings.

In this course, we begin with real people, real decisions, and real markets. We then build models to help us understand them.

This does not mean that every model must include every detail. All models simplify. But the simplification must serve understanding. It should not remove the very features we are trying to understand.

5. The Deeper Methodological Problem

Reservation prices are not an isolated issue. They are an example of a deeper problem within mainstream economics.

Many textbook models rely on assumptions that conflict with ordinary experience and empirical evidence. Yet the models continue to be taught as if they describe economic reality.

For example, textbooks often teach that firms set output where marginal cost equals marginal revenue, or that competitive supply curves arise from rising marginal costs. But empirical studies of actual firms have often found that many firms report constant or declining marginal costs over relevant ranges of output.

Similarly, consumers are often modeled as utility-maximizing agents with stable preferences and full information. But real consumers often act with limited information, habits, uncertainty, social influence, mistakes, and changing preferences.

The issue is not that models simplify. Every model simplifies. The issue is whether the simplification helps us understand reality or prevents us from seeing it.

If evidence contradicts the theory, but the theory continues unchanged, then the problem is methodological. The discipline has adopted a way of thinking that protects its models from correction.

6. The “As-If” Defense

One famous defense of unrealistic assumptions is the “as-if” argument.

According to this view, a theory does not need realistic assumptions if it produces good predictions. Firms do not need to actually calculate marginal revenue and marginal cost. It is enough if they behave as if they do. Consumers do not need to literally maximize utility. It is enough if their choices can be modeled as if they do.

This defense may be useful for certain kinds of prediction. But it does not help us if our goal is understanding.

In this course, we are not satisfied with saying that markets behave “as if” agents follow the textbook model. We want to understand how markets actually work.

How do buyers search?
How do sellers set prices?
How do agents learn?
How do they bargain?
How do contracts form?
How does limited information affect outcomes?
How do institutions and rules shape the market?

The “as-if” defense sets these questions aside. But for us, these are precisely the questions that matter.

7. Why Agent-Based Models Offer a Different Path

Agent-based modeling gives us a different way to build economic models.

Instead of beginning with curves, equations, and equilibrium conditions, we begin with agents.

We describe who the agents are, what they know, what they want, how they behave, how they meet, how they bargain, what rules they follow, and how they adapt over time.

This allows us to model real-world complexity without forcing human behavior into fictional assumptions.

In an ABM, every assumption must be made visible. If agents have limited information, we say so. If search is costly, we say so. If contracts can be broken, we say so. If agents can bargain, learn, imitate, cooperate, or make mistakes, we say so.

This is a major advantage. In mathematical models, many assumptions are buried deep inside the formal structure. Students may manipulate the equations without seeing what has been assumed. In agent-based models, assumptions become part of the visible model.

The model becomes easier to question, modify, and understand.

8. Markets as Living Processes

Real markets are not static diagrams. They are living processes.

People enter markets with incomplete knowledge. They search. They compare. They meet others. They make offers. They reject offers. They bargain. They revise plans. They learn from experience. They respond to urgency, disappointment, opportunity, and changing expectations.

Textbook economics often handles this complexity by simplifying behavior until it becomes mathematically manageable. This produces elegant models, but often at the cost of realism.

Today, we have another path.

Modern computational tools allow us to build models with many agents, simple behavioral rules, limited information, changing expectations, and interaction over time. We do not need to force the world into a formula before we can study it.

In this course, we will begin with very simple models, often small enough to understand by hand. Later, such models can be extended using Excel or computer simulations. But the essential idea is the same:

Start with agents. Specify the rules. Let the outcome emerge.

9. Main Lesson of Lecture 2

The main lesson of this lecture is simple but powerful.

The supply-and-demand diagram depends on hidden assumptions about human behavior. One of the most important of these is the assumption of fixed reservation prices.

But real people often do not enter markets with fixed, precise maximum and minimum prices. They adapt to circumstances. They revise plans. They respond to information, urgency, alternatives, bargaining, and interaction with others.

This means that the demand and supply curves are not natural objects waiting to be discovered. They are built by imposing strong assumptions on human behavior.

Agent Based Microeconomics allows us to take a different route. Instead of forcing behavior into curves, we begin with agents and model the market process directly.

That is the path we will follow in this course.

Before Moving On

Before going to the next lecture, think carefully about the following question:

If demand and supply curves require fixed reservation prices, but real people often adapt their willingness to buy or sell, what happens to the textbook model?

This question will prepare us for the next lecture, where we step back and ask a deeper methodological question:

What is a model, and what should a model do?