Chapter 1 The Market 2 Economic Models Economic models are developed for a simplified representation of reality. An economic model eliminates irrelevant.

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).

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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?

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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.)

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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.

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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.

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Market Supply Curve for Apartments

p

QS100

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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.)

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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.

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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.

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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”.

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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?

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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.

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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.

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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.

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Market Equilibriump

QD,QS

pe

100

28

Market Equilibriump

QD,QS

pe

100

Higher incomes causehigher willingness-to-pay

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Market Equilibriump

QD,QS

pe

100

Higher incomes causehigher willingness-to-pay,higher market price, andthe same quantity traded.

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Taxation Policy Analysis

Local government taxes apartment owners.

What happens topricequantity of inner-ring apartments

rented? Is any of the tax “passed” to renters?

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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.

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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.

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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.

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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.

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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.

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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?

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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?).

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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?

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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.

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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.

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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.

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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.

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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?