### Economics 401 Intermediate Microeconomic Theory

```Chapter 1
The Market
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.

2
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)?

3
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).
4
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?
5
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.)
6
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. Thenif p = \$490,
 QD = 2.

7
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.
8
Market Demand Curve for
Apartments
p
QD
9
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.
10
Market Supply Curve for
Apartments
p
100
QS
11
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.)

12
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.

13
Competitive Market Equilibrium
p
pe
100
QD,QS
14
Competitive Market Equilibrium
p
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.
pe
100
QD,QS
15
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”.

16
Comparative Statics

What is exogenous in the model?
 price
of outer-ring apartments
 quantity of inner-ring apartments
 incomes of potential renters.

What happens if these exogenous variables
change?
17
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.

18
Market Equilibrium
p
pe
100
QD,QS
19
Market Equilibrium
p
Higher demand
pe
100
QD,QS
20
Market Equilibrium
p
Higher demand causes higher
market price; same quantity
pe
100
QD,QS
21
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.

22
Market Equilibrium
p
pe
100
QD,QS
23
Market Equilibrium
p
Higher supply
pe
100
QD,QS
24
Market Equilibrium
p
Higher supply causes a
lower market price and a
pe
100
QD,QS
25
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.

26
Market Equilibrium
p
pe
100
QD,QS
27
Market Equilibrium
p
Higher incomes cause
higher willingness-to-pay
pe
100
QD,QS
28
Market Equilibrium
p
Higher incomes cause
higher willingness-to-pay,
higher market price, and
the same quantity traded.
pe
100
QD,QS
29
Taxation Policy Analysis
Local government taxes apartment owners.
 What happens to

 price
 quantity

of inner-ring apartments rented?
Is any of the tax “passed” to renters?
30
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.
31
Other Market Structures

Among many possibilities are:
a
a
monopolistic landlord (single price)
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.
32
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.

33
Monopolistic Market Equilibrium
p
Low price, high quantity
demanded, low revenue.
Low
price
QD
34
Monopolistic Market Equilibrium
p
High
price
High price, low quantity
demanded, low revenue.
QD
35
Monopolistic Market Equilibrium
p
Middle price, medium quantity
demanded, larger revenue.
Middle
price
QD
36
Monopolistic Market Equilibrium
p
Middle price, medium quantity
demanded, larger revenue.
Monopolist does not rent all the
inner-ring apartments.
Middle
price
100
QD,QS
37
Monopolistic Market Equilibrium
p
Middle price, medium quantity
demanded, larger revenue.
Monopolist does not rent all the
inner-ring apartments.
Vacant inner-ring apartments.
Middle
price
100
QD,QS
38
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.

39
Discriminatory Monopolistic
Market
Equilibrium
p
p1 =\$500
1
100
QD,QS
40
Discriminatory Monopolistic
Market
Equilibrium
p
p1 =\$500
p2 =\$490
12
100
QD,QS
41
Discriminatory Monopolistic
Market
Equilibrium
p
p1 =\$500
p2 =\$490
p3 =\$475
123
100
QD,QS
42
Discriminatory Monopolistic
Market
Equilibrium
p
p1 =\$500
p2 =\$490
p3 =\$475
123
100
QD,QS
43
Discriminatory Monopolistic
Market
Equilibrium
p
Discriminatory monopolist
charges the competitive market
price to the last renter, and
rents the competitive quantity
of inner-ring apartments.
p1 =\$500
p2 =\$490
p3 =\$475
pe
123
100
QD,QS
44
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?
45
Market Equilibrium
p
pe
100
QD,QS
46
Market Equilibrium
p
pe
pmax
100
QD,QS
47
Market Equilibrium
p
Excess demand
pe
pmax
100
QD,QS
48
Market Equilibrium
p
The 100 inner-ring apartments are
no longer allocated by
willingness-to-pay (lottery, lines,
large families first?).
Excess demand
pe
pmax
100
QD,QS
49
Which Market Outcomes Are
Desirable?

We’ve now described four possible ways of
allocating apartments to people:
 Rent
control
 Perfect competition
 Monopoly
 Discriminatory monopoly

Which one is the best?
50
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.

51
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.
52
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.

53
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.

54
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.
55
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.
56
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.
57
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.
58
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?
59
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