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Chapter 1 The Market
2
Economic Models
Economic models are developed for a simplified representation of reality.
An economic model eliminates irrelevant detail and focuses on the essential features of the economic reality one is attempting to understand.
We can add complications if the simple model is too simple to serve our purpose.
3
Economic Modeling
What causes what in economic systems?
At what level of detail shall we model an economic phenomenon?
Which variables are determined outside the model (exogenous) and which are to be determined by the model (endogenous)?
4
Modeling the Apartment Market How are apartment rents determined?
Suppose two types of apartments: inner-ring vs
outer-ring;otherwise identical;rents for outer-ring apartments are
exogenous and known; many potential renters and landlords
(competitive market).
5
Modeling the Apartment Market What determines the price? What determines who will live in the inner-
ring apartments and who will live farther out? What can be said about the desirability of
different economic mechanisms for allocating apartments?
What concepts can we use to judge the merit of different assignments of apartments to individuals?
6
Economic Modeling Assumptions Two basic principles:
Optimization principle: Each person tries to choose the best alternative that he or she can afford.
Equilibrium principle: Market price adjusts until quantity demanded equals quantity supplied. (Market clears.)
7
Modeling Apartment Demand Each renter only rents one apartment,
either inner-ring or outer-ring. Suppose there is only one person who
is willing to pay the highest price, $500/month to rent an inner-ring apartment. Then if p = $500 /month, QD = 1.
Suppose the price has to drop to $490 before a 2nd person would rent. Then
if p = $490, QD = 2.
8
Modeling Apartment Demand The lower the rental rate p, the larger the
quantity of inner-ring apartments demanded: p QD .
The quantity demanded vs. price graph is the demand curve for inner-ring apartments.
If the number of renters is large and the differences in willingness to pay are small from person to person, on can think of the demand curve as sloping smoothly downward.
9
Market Demand Curve for Apartments
p
QD
10
Modeling Apartment Supply
Supply: It takes time to build more apartments, so in the short-run, the quantity available is fixed at some predetermined level (say 100).
In the long run, new construction can take place, the number of apartments will certainly respond to the price that is charged.
In our apartment model, we focus on the short run case and hence the supply curve is vertical. However, in the long run, the supply curve is usually upward sloping.
11
Market Supply Curve for Apartments
p
QS100
12
Competitive Market Equilibrium “ low” rental price quantity demanded of
inner-ring apartments exceeds quantity available price will rise. (Some renters are willing to pay a higher price to attract landlords.)
“high” rental price quantity demanded less than quantity available price will fall. (Some landlords want to cut price to attract renters.)
13
Competitive Market Equilibrium
Quantity demanded = quantity supplied price will neither rise nor fall
so the market is at a competitive equilibrium
Equilibrium: no tendency to change At the equilibrium price, quantity
demanded equals quantity supplied. We say that market clears.
14
Competitive Market Equilibrium
p
QD,QS
pe
100
15
Competitive Market Equilibrium
p
QD,QS
pe
100
People willing to pay pe for inner-ring apartments get them.
People not willing to pay pe for inner-ring apartments get outer-ring ones.
16
Competitive Market Equilibrium Q: Who rents the inner-ring apartments? A: Those most willing to pay. Q: Who rents the outer-ring apartments? A: Those least willing to pay. So the competitive market allocation is
by “willingness-to-pay”.
17
Comparative Statics
What is exogenous in the model?price of outer-ring apartmentsquantity of inner-ring apartments incomes of potential renters.
What happens if these exogenous variables change?
18
Comparative Statics
Case 1: Suppose the price of outer-ring apartment rises.
Demand for inner-ring apartments increases (rightward shift).
Causing a higher price for inner-ring apartments.
19
Market Equilibriump
QD,QS
pe
100
20
Market Equilibriump
QD,QS
pe
100
Higher demand
21
Market Equilibriump
QD,QS
pe
100
Higher demand causes highermarket price; same quantitytraded.
22
Comparative Statics
Case 2: Suppose there were more inner-ring apartments.
Supply of inner-ring apartments is greater (rightward shift).
The price for inner-ring apartments falls, while the quantity traded increases.
23
Market Equilibriump
QD,QS
pe
100
24
Market Equilibriump
QD,QS100
Higher supply
pe
25
Market Equilibriump
QD,QS
pe
100
Higher supply causes alower market price and alarger quantity traded.
26
Comparative Statics
Case 3: Suppose potential renters’ incomes rise, increasing their willingness-to-pay for inner-ring apartments.
Demand rises (upward shift). Causing higher price for inner-ring
apartments.
27
Market Equilibriump
QD,QS
pe
100
28
Market Equilibriump
QD,QS
pe
100
Higher incomes causehigher willingness-to-pay
29
Market Equilibriump
QD,QS
pe
100
Higher incomes causehigher willingness-to-pay,higher market price, andthe same quantity traded.
30
Taxation Policy Analysis
Local government taxes apartment owners.
What happens topricequantity of inner-ring apartments
rented? Is any of the tax “passed” to renters?
31
Taxation Policy Analysis Market supply is unaffected. Market demand is unaffected. So the competitive market equilibrium
price and quantity are unaffected by the tax.
Landlords pay all of the tax. Note: this is largely driven by the perfectly
inelastic supply (i.e. fixed supply). In general, quantity is reduced and the tax
is shared by buyers and sellers.
32
Other Market Structures
Among many possibilities are:a monopolistic landlord (single price)a perfectly discriminatory
monopolistic landlord (monopolist can charge different prices to different consumers)
a competitive market subject to rent control (maximum rent).
Details are omitted here. Will be discussed later on.
33
A Monopolistic Landlord When the landlord sets a rental
price p, he rents D(p) apartments. Revenue = pD(p). Revenue is low if p 0 Revenue is low if p is so high that
D(p) 0. An intermediate value for p
maximizes revenue.
34
Monopolistic Market Equilibrium
p
QD
Lowprice
Low price, high quantitydemanded, low revenue.
35
Monopolistic Market Equilibrium
p
QD
Highprice
High price, low quantitydemanded, low revenue.
36
Monopolistic Market Equilibrium
p
QD
Middleprice
Middle price, medium quantitydemanded, larger revenue.
37
Monopolistic Market Equilibrium
p
QD,QS
Middleprice
Middle price, medium quantitydemanded, larger revenue.Monopolist does not rent all theinner-ring apartments.
100
38
Monopolistic Market Equilibrium
p
QD,QS
Middleprice
Middle price, medium quantitydemanded, larger revenue.Monopolist does not rent all theinner-ring apartments.
100
Vacant inner-ring apartments.
39
Perfectly Discriminatory Monopolistic Landlord Imagine the monopolist knew
everyone’s willingness-to-pay. Charge $500 to the most willing-to-
pay. Charge $490 to the 2nd most willing-
to-pay. And so on.
40
Discriminatory Monopolistic Market Equilibrium
p
QD,QS100
p1 =$500
1
41
Discriminatory Monopolistic Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
42
Discriminatory Monopolistic Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
43
Discriminatory Monopolistic Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
44
Discriminatory Monopolistic Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
pe
Discriminatory monopolistcharges the competitive marketprice to the last renter, andrents the competitive quantityof inner-ring apartments.
45
Rent Control
Suppose that the local government decides to impose a maximum rent that can be charged for apartments, say pmax , which is less than the competitive equilibrium price pe.
We would have a situation of excess demand: quantity demanded is greater than quantity supplied.
Who will end up with the apartments?
46
Market Equilibriump
QD,QS
pe
100
47
Market Equilibriump
QD,QS
pe
100
pmax
48
Market Equilibriump
QD,QS
pe
100
pmax
Excess demand
49
Market Equilibriump
QD,QS
pe
100
pmax
Excess demand
The 100 inner-ring apartments areno longer allocated bywillingness-to-pay (lottery, lines,large families first?).
50
Which Market Outcomes Are Desirable? We’ve now described four possible
ways of allocating apartments to people: Rent controlPerfect competitionMonopolyDiscriminatory monopoly
Which one is the best?
51
Evaluation of Market Outcomes What criteria might we use to compare
ways of allocating resources? Different parties would have different
evaluations because of different interests. We would like to examine the desirability
of different ways to allocate resources, taking all parties into account.
52
Pareto Efficiency
Named after Vilfredo Pareto (1848-1923). If we can find a way to make some people
better off without making anybody else worse off, we have a Pareto improvement.
If an allocation allows for a Pareto improvement, it is called Pareto inefficient.
If an allocation is such that no Pareto improvements are possible, it is called Pareto efficient.
53
Pareto Efficiency
Jill has an apartment; Jack does not. Jill values the apartment at $200;
Jack would pay $400 for it. Jill could sublet the apartment to Jack
for $300. Both gain. So it was Pareto inefficient
for Jill to have the apartment.
54
Pareto Efficiency
A Pareto inefficient outcome means there remain unrealized mutual gains-to-trade.
Any market outcome that achieves all possible gains-to-trade must be Pareto efficient.
Pareto efficient outcome is not necessarily unique.
This criterion does not take care of fairness.
55
Pareto Efficiency Competitive equilibrium:
All inner-ring apartment renters value them at the market price pe or more.
All others value inner-ring apartments at less than pe.
No mutually beneficial trades remain.The outcome is Pareto efficient.
56
Pareto Efficiency
Monopoly (one price): Not all inner-ring apartments are occupied. The monopolist can increase his profits by
renting a vacant apartment to someone who doesn’t have one at any positive price.
There is some price at which both the monopolist and the renter must be better off. And as long as the monopolist doesn’t change the price that anybody else pays, the other renters are just as well off as they were before.
So the monopoly outcome is Pareto inefficient.
57
Pareto Efficiency
Discriminatory Monopoly: Assignment of apartments is the same as with the
perfectly competitive market. So the outcome is also Pareto efficient. Note that although both the competitive market
and the discriminating monopolist generate Pareto efficient outcomes, they can result in quite different distributions of income. The consumers are much worse off under the discriminating monopolist than under the competitive market, and the landlord(s) are much better off.
58
Pareto Efficiency
Rent Control:Some inner-ring apartments are
assigned to renters valuing them at below the competitive price pe.
Some renters valuing an inner-ring apartment above pe don’t get inner-ring apartments.
A Pareto improvement is possible. Thus the outcome is inefficient.
59
Short Run vs. Long Run
We’ve analyzed the equilibrium pricing of apartments in the short run when there is a fixed supply of apartments. But in the long run, the supply can change.
When supply is variable, will a monopolist supply more or fewer
apartments than a competitive rental market? will rent control increase or decrease the
equilibrium number of apartments? which institutions will provide a Pareto efficient
number of apartments?