Chapter One
The Market
The Theory of Economics does not
furnish a body of settled conclusions
immediately applicable to policy. It is
a method ra...
Economic Modeling
What causes what in economic
systems?
At what level of detail shall we model
an economic phenomenon?
Whi...
Modeling the Apartment Market
How are apartment rents determined?
Suppose
– apartments are close or distant, but
otherwise...
Modeling the Apartment Market
Who will rent close apartments?
At what price?
Will the allocation of apartments be
desirabl...
Economic Modeling
Assumptions
Two basic postulates:
– Rational Choice: Each person tries
to choose the best alternative
av...
Modeling Apartment Demand
Demand: Suppose the most any one
person is willing to pay to rent a
close apartment is $500/mont...
Modeling Apartment Demand
The lower is the rental rate p, the
larger is the quantity of close
apartments demanded
p ↓ ⇒ QD...
Market Demand Curve for
Apartments
p

QD
Modeling Apartment Supply
Supply: It takes time to build more
close apartments so in this short-run
the quantity available...
Market Supply Curve for
Apartments
p

100

QS
Competitive Market Equilibrium
“low” rental price ⇒ quantity
demanded of close apartments
exceeds quantity available ⇒ pri...
Competitive Market Equilibrium
Quantity demanded = quantity available
⇒ price will neither rise nor fall
so the market is ...
Competitive Market Equilibrium
p

100

QD,QS
Competitive Market Equilibrium
p

pe
100

QD,QS
Competitive Market Equilibrium
p
People willing to pay pe for
close apartments get close
apartments.

pe
100

QD,QS
Competitive Market Equilibrium
p
People willing to pay pe for
close apartments get close
apartments.
People not willing to...
Competitive Market Equilibrium
Q: Who rents the close apartments?
A: Those most willing to pay.
Q: Who rents the distant
a...
Comparative Statics
What is exogenous in the model?
– price of distant apartments
– quantity of close apartments
– incomes...
Comparative Statics
Suppose the price of distant
apartment rises.
Demand for close apartments
increases (rightward shift),...
Market Equilibrium
p

pe
100

QD,QS
Market Equilibrium
p

Higher demand

pe
100

QD,QS
Market Equilibrium
p

Higher demand causes higher
market price; same quantity
traded.

pe

100

QD,QS
Comparative Statics
Suppose there were more close
apartments.
Supply is greater, so
the price for close apartments falls.
Market Equilibrium
p

pe
100

QD,QS
Market Equilibrium
p

Higher supply

pe
100

QD,QS
Market Equilibrium
p

Higher supply causes a
lower market price and a
larger quantity traded.

pe
100

QD,QS
Comparative Statics
Suppose potential renters’ incomes
rise, increasing their willingness-topay for close apartments.
Dema...
Market Equilibrium
p

pe
100

QD,QS
Market Equilibrium
p

Higher incomes cause
higher willingness-to-pay

pe
100

QD,QS
Market Equilibrium
p

Higher incomes cause
higher willingness-to-pay,
higher market price, and
the same quantity traded.

...
Taxation Policy Analysis
Local government taxes apartment
owners.
What happens to
– price
– quantity of close apartments
r...
Taxation Policy Analysis
Market supply is unaffected.
Market demand is unaffected.
So the competitive market
equilibrium i...
Imperfectly Competitive Markets
Amongst many possibilities are:
– a monopolistic landlord
– a perfectly discriminatory
mon...
A Monopolistic Landlord
When the landlord sets a rental price
p he rents D(p) apartments.
Revenue = pD(p).
Revenue is low ...
Monopolistic Market
Equilibrium
p

Low price, high quantity
demanded, low revenue.

Low
price
QD
Monopolistic Market
Equilibrium
p
High
price

High price, low quantity
demanded, low revenue.

QD
Monopolistic Market
Equilibrium
p

Middle price, medium quantity
demanded, larger revenue.

Middle
price

QD
Monopolistic Market
Equilibrium
p

Middle price, medium quantity
demanded, larger revenue.
Monopolist does not rent all th...
Monopolistic Market
Equilibrium
p

Middle price, medium quantity
demanded, larger revenue.
Monopolist does not rent all th...
Perfectly Discriminatory
Monopolistic Landlord
Imagine the monopolist knew
everyone’s willingness-to-pay.
Charge $500 to t...
Discriminatory Monopolistic
Market Equilibrium
p
p1 =$500

1

100

QD,QS
Discriminatory Monopolistic
Market Equilibrium
p
p1 =$500
p2 =$490

12

100

QD,QS
Discriminatory Monopolistic
Market Equilibrium
p
p1 =$500
p2 =$490
p3 =$475

12 3

100

QD,QS
Discriminatory Monopolistic
Market Equilibrium
p
p1 =$500
p2 =$490
p3 =$475

12 3

100

QD,QS
Discriminatory Monopolistic
Market Equilibrium
p

Discriminatory monopolist
charges the competitive market
price to the la...
Rent Control
Local government imposes a
maximum legal price, pmax < pe, the
competitive price.
Market Equilibrium
p

pe
100

QD,QS
Market Equilibrium
p

pe
pmax
100

QD,QS
Market Equilibrium
p

Excess demand

pe
pmax
100

QD,QS
Market Equilibrium
p

The 100 close apartments are
no longer allocated by
willingness-to-pay (lottery, lines,
large famili...
Which Market Outcomes Are
Desirable?
Which is better?
– Rent control
– Perfect competition
– Monopoly
– Discriminatory mon...
Pareto Efficiency
Vilfredo Pareto; 1848-1923.
A Pareto outcome allows no “wasted
welfare”;
i.e. the only way one person’s
...
Pareto Efficiency
Jill has an apartment; Jack does not.
Jill values the apartment at $200; Jack
would pay $400 for it.
Jil...
Pareto Efficiency
A Pareto inefficient outcome means
there remain unrealized mutual
gains-to-trade.
Any market outcome tha...
Pareto Efficiency
Competitive equilibrium:
– all close apartment renters value
them at the market price pe or more
– all o...
Pareto Efficiency
Discriminatory Monopoly:
– assignment of apartments is the
same as with the perfectly
competitive market...
Pareto Efficiency
Monopoly:
– not all apartments are occupied
– so a distant apartment renter could
be assigned a close ap...
Pareto Efficiency
Rent Control:
– some close apartments are assigned
to renters valuing them at below the
competitive pric...
Harder Questions
Over time, will
– the supply of close apartments
increase?
– rent control decrease the supply of
apartmen...
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Ch1

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Ch1

  1. 1. Chapter One The Market
  2. 2. The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions --- John Maynard Keynes
  3. 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. 4. Modeling the Apartment Market How are apartment rents determined? Suppose – apartments are close or distant, but otherwise identical – distant apartments rents are exogenous and known – many potential renters and landlords
  5. 5. Modeling the Apartment Market Who will rent close apartments? At what price? Will the allocation of apartments be desirable in any sense? How can we construct an insightful model to answer these questions?
  6. 6. Economic Modeling Assumptions Two basic postulates: – Rational Choice: Each person tries to choose the best alternative available to him or her. – Equilibrium: Market price adjusts until quantity demanded equals quantity supplied.
  7. 7. Modeling Apartment Demand Demand: Suppose the most any one person is willing to pay to rent a close apartment is $500/month. Then p = $500 ⇒ QD = 1. Suppose the price has to drop to $490 before a 2nd person would rent. Then p = $490 ⇒ QD = 2.
  8. 8. Modeling Apartment Demand The lower is the rental rate p, the larger is the quantity of close apartments demanded p ↓ ⇒ QD ↑. The quantity demanded vs. price graph is the market demand curve for close apartments.
  9. 9. Market Demand Curve for Apartments p QD
  10. 10. Modeling Apartment Supply Supply: It takes time to build more close apartments so in this short-run the quantity available is fixed (at say 100).
  11. 11. Market Supply Curve for Apartments p 100 QS
  12. 12. Competitive Market Equilibrium “low” rental price ⇒ quantity demanded of close apartments exceeds quantity available ⇒ price will rise. “high” rental price ⇒ quantity demanded less than quantity available ⇒ price will fall.
  13. 13. Competitive Market Equilibrium Quantity demanded = quantity available ⇒ price will neither rise nor fall so the market is at a competitive equilibrium.
  14. 14. Competitive Market Equilibrium p 100 QD,QS
  15. 15. Competitive Market Equilibrium p pe 100 QD,QS
  16. 16. Competitive Market Equilibrium p People willing to pay pe for close apartments get close apartments. pe 100 QD,QS
  17. 17. Competitive Market Equilibrium p People willing to pay pe for close apartments get close apartments. People not willing to pay pe for close apartments get distant apartments. pe 100 QD,QS
  18. 18. Competitive Market Equilibrium Q: Who rents the close apartments? A: Those most willing to pay. Q: Who rents the distant apartments? A: Those least willing to pay. So the competitive market allocation is by “willingness-to-pay”.
  19. 19. Comparative Statics What is exogenous in the model? – price of distant apartments – quantity of close apartments – incomes of potential renters. What happens if these exogenous variables change?
  20. 20. Comparative Statics Suppose the price of distant apartment rises. Demand for close apartments increases (rightward shift), causing a higher price for close apartments.
  21. 21. Market Equilibrium p pe 100 QD,QS
  22. 22. Market Equilibrium p Higher demand pe 100 QD,QS
  23. 23. Market Equilibrium p Higher demand causes higher market price; same quantity traded. pe 100 QD,QS
  24. 24. Comparative Statics Suppose there were more close apartments. Supply is greater, so the price for close apartments falls.
  25. 25. Market Equilibrium p pe 100 QD,QS
  26. 26. Market Equilibrium p Higher supply pe 100 QD,QS
  27. 27. Market Equilibrium p Higher supply causes a lower market price and a larger quantity traded. pe 100 QD,QS
  28. 28. Comparative Statics Suppose potential renters’ incomes rise, increasing their willingness-topay for close apartments. Demand rises (upward shift), causing higher price for close apartments.
  29. 29. Market Equilibrium p pe 100 QD,QS
  30. 30. Market Equilibrium p Higher incomes cause higher willingness-to-pay pe 100 QD,QS
  31. 31. Market Equilibrium p Higher incomes cause higher willingness-to-pay, higher market price, and the same quantity traded. pe 100 QD,QS
  32. 32. Taxation Policy Analysis Local government taxes apartment owners. What happens to – price – quantity of close apartments rented? Is any of the tax “passed” to renters?
  33. 33. Taxation Policy Analysis Market supply is unaffected. Market demand is unaffected. So the competitive market equilibrium is unaffected by the tax. Price and the quantity of close apartments rented are not changed. Landlords pay all of the tax.
  34. 34. Imperfectly Competitive Markets Amongst many possibilities are: – a monopolistic landlord – a perfectly discriminatory monopolistic landlord – a competitive market subject to rent control.
  35. 35. 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.
  36. 36. Monopolistic Market Equilibrium p Low price, high quantity demanded, low revenue. Low price QD
  37. 37. Monopolistic Market Equilibrium p High price High price, low quantity demanded, low revenue. QD
  38. 38. Monopolistic Market Equilibrium p Middle price, medium quantity demanded, larger revenue. Middle price QD
  39. 39. Monopolistic Market Equilibrium p Middle price, medium quantity demanded, larger revenue. Monopolist does not rent all the close apartments. Middle price 100 QD,QS
  40. 40. Monopolistic Market Equilibrium p Middle price, medium quantity demanded, larger revenue. Monopolist does not rent all the close apartments. Vacant close apartments. Middle price 100 QD,QS
  41. 41. Perfectly Discriminatory Monopolistic Landlord Imagine the monopolist knew everyone’s willingness-to-pay. Charge $500 to the most willing-topay, charge $490 to the 2nd most willingto-pay, etc.
  42. 42. Discriminatory Monopolistic Market Equilibrium p p1 =$500 1 100 QD,QS
  43. 43. Discriminatory Monopolistic Market Equilibrium p p1 =$500 p2 =$490 12 100 QD,QS
  44. 44. Discriminatory Monopolistic Market Equilibrium p p1 =$500 p2 =$490 p3 =$475 12 3 100 QD,QS
  45. 45. Discriminatory Monopolistic Market Equilibrium p p1 =$500 p2 =$490 p3 =$475 12 3 100 QD,QS
  46. 46. Discriminatory Monopolistic Market Equilibrium p Discriminatory monopolist charges the competitive market price to the last renter, and rents the competitive quantity of close apartments. p1 =$500 p2 =$490 p3 =$475 pe 12 3 100 QD,QS
  47. 47. Rent Control Local government imposes a maximum legal price, pmax < pe, the competitive price.
  48. 48. Market Equilibrium p pe 100 QD,QS
  49. 49. Market Equilibrium p pe pmax 100 QD,QS
  50. 50. Market Equilibrium p Excess demand pe pmax 100 QD,QS
  51. 51. Market Equilibrium p The 100 close apartments are no longer allocated by willingness-to-pay (lottery, lines, large families first?). Excess demand pe pmax 100 QD,QS
  52. 52. Which Market Outcomes Are Desirable? Which is better? – Rent control – Perfect competition – Monopoly – Discriminatory monopoly
  53. 53. Pareto Efficiency Vilfredo Pareto; 1848-1923. A Pareto outcome allows no “wasted welfare”; i.e. the only way one person’s welfare can be improved is to lower another person’s welfare.
  54. 54. 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.
  55. 55. 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.
  56. 56. Pareto Efficiency Competitive equilibrium: – all close apartment renters value them at the market price pe or more – all others value close apartments at less than pe – so no mutually beneficial trades remain – so the outcome is Pareto efficient.
  57. 57. Pareto Efficiency Discriminatory Monopoly: – assignment of apartments is the same as with the perfectly competitive market – so the discriminatory monopoly outcome is also Pareto efficient.
  58. 58. Pareto Efficiency Monopoly: – not all apartments are occupied – so a distant apartment renter could be assigned a close apartment and have higher welfare without lowering anybody else’s welfare. – so the monopoly outcome is Pareto inefficient.
  59. 59. Pareto Efficiency Rent Control: – some close apartments are assigned to renters valuing them at below the competitive price pe – some renters valuing a close apartment above pe don’t get close apartments – Pareto inefficient outcome.
  60. 60. Harder Questions Over time, will – the supply of close apartments increase? – rent control decrease the supply of apartments? – a monopolist supply more apartments than a competitive rental market?

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