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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 traded. 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 larger quantity traded. 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