Chapter 1 Market

Report
Course: Microeconomics
Text: Varian’s Intermediate
Microeconomics
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It studies the allocation of scarce resources to
alternative uses.
Western mainstream economics emphasizes:
Rational decision/optimization: actors choose the
best among all feasible alternatives.
 The use of market mechanism and the role of price.
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Microeconomics focuses on the study of
individual decisions (consumer, firms) and
markets of individual goods and services.
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In contrast, macroeconomics studies the
performance of the economy as a whole.
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Economic Models are developed for a simplified
representation of reality.
A model focus 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.
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What causes what in economic systems?
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What simplifying assumptions do we make?
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Which variables are determined outside the
model (exogenous) and which are to be
determined by the model (endogenous)?
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How are apartment rents determined?
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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):
no dominating individuals.

Who will rent close apartments?
 At what price?
 Will the allocation of apartments be desirable
in any sense?
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How can we construct an insightful model to
answer these questions?
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Two basic principles:
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Optimization Principle: Each person tries to
choose the best alternative that they can afford.
Equilibrium Principle: Market price adjusts until
quantity demanded equals quantity supplied
(market clears.)
Demand: Each renter only rents one
apartment, either inner-ring or outer-ring.
 Suppose the most any one person is willing
to pay to rent an inner-ring apartment is
$500/month. Then p = $500  QD = 1.
 Suppose the price has to drop to $490 before
a 2nd person would rent. Thenp = $490 
QD = 2.
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The lower is the rental price p, the larger is the
quantity of inner-ring apartments demanded
p   QD .
 The price quantity vs. demanded graph is the
market demand curve for inner-ring
apartments.
 If the number of renters is large and the
differences in willingness to pay is small, the
demand curve can be plot as a continuous.
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p
QD
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Supply: It takes time to build more apartments,
so in the short-run, the quantity available is
fixed (at say 100).
In the long run, more buildings can be built or
demolish in response to price changes, so it can
be upward sloping.
 Here we only consider the short-run case.
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p
100
QS
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“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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Quantity demanded = quantity available
 price will neither rise nor fall
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so the market is at a competitive equilibrium.
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Equilibrium: no tendency to change
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We can also call the market clears.
p
pe
100
QD,QS
p
Allocation: People who are willing to pay pe for
Inner-ring apartments get them.
pe
100
QD,QS
p
Allocation: People who are willing to pay pe for
Inner-ring apartments get them.
People who are not willing to pay
pe for inner-ring apartments get
outer-ring apartments.
pe
100
QD,QS
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.
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So the competitive market allocation is by
“willingness-to-pay”.
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What happens to the equilibrium price and
quantity if an exogenous variable changes?
What is exogenous in the model?
price of outer-ring apartments
 quantity of inner-ring apartments
 incomes of potential renters.
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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.
p
pe
100
QD,QS
p
Higher demand
pe
100
QD,QS
p
Higher demand causes higher
market price; same quantity
traded.
pe
100
QD,QS
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2. Suppose there were more inner-ring
apartments.
Supply is greater;
The price for close apartments falls, while the
quantity increases.
p
pe
100
QD,QS
p
Higher supply
pe
100
QD,QS
p
Higher supply causes a
lower market price and a
larger quantity traded.
pe
100
QD,QS
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3. Suppose potential renters’ incomes rise,
increasing their willingness-to-pay for inner-ring
apartments.
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Demand rises (upward shift)
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Higher price for inner-ring apartments.
p
pe
100
QD,QS
p
Higher incomes cause
higher willingness-to-pay
pe
100
QD,QS
p
Higher incomes cause
higher willingness-to-pay,
higher market price, and
the same quantity traded.
pe
100
QD,QS
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Local government taxes apartment owners.
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What happens to
price
 quantity of close apartments rented?
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Is any of the tax “passed” to renters?
Market supply is unaffected.
 Market demand is unaffected.
 So, the competitive market equilibrium price
an 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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Among many possibilities are:
a monopolistic landlord (single price)
 a perfectly discriminatory monopolistic landlord
(monopolist can charge different prices for different
consumers)
 a competitive market subject to rent control
(maximum rent).
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Details are omitted here. Will be discussed in
future classes.
p
Middle price, medium quantity
demanded, larger revenue.
Monopolist does not rent all the
close apartments.
Vacant close apartments.
Middle
price
100
QD,QS
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
123
100
QD,QS
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
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What criteria might we use to compare ways of
allocating resources?
Different parties would have a different
evaluation because of different interests.
We would like to examine the desirability of
different ways to allocate resources, taking all
parties into account.
Vilfredo Pareto; 1848-1923.
 Pareto Improvement: We are able to find a way
to make some people better off without making
anybody worse off.
 Pareto Efficiency: The situation where it is
impossible to have Pareto Improvement.
 A Pareto outcome allows no “wasted welfare.”
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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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Question: When we divide a cake between two
people, what allocations are Pareto Efficient?
What are Pareto Inefficient?
1. Each person gets half of the cake.
 2. One gets all the other gets nothing.
 3. One gets 40% and the other gets 55%.
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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.
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Pareto efficient outcome is not necessarily
unique.
 This criterion does not take care of fairness.
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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
 so no mutually beneficial trades remain
 so the outcome is Pareto efficient.
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Monopoly (one price):
not all inner-ring apartments are occupied
 so an outer-ring apartment renter could be assigned
an inner-ring apartment and have higher welfare
without lowering anybody else’s welfare.
 so the monopoly outcome is Pareto inefficient.
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Discriminatory Monopoly:
assignment of apartments is the same as with the
perfectly competitive market
 so the discriminatory monopoly outcome is also
Pareto efficient.
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Rent Control:
some close apartments are assigned to renters
valuing them at below the competitive price pe
e
 some renters valuing a close apartment above p
don’t get close apartments
 Pareto inefficient outcome.
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Over time, when
the supply of inner-ring apartments increase?
 rent control decrease the supply of apartments?
 a monopolist supply more apartments than a
competitive rental market?
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We may answer these questions when we learn
the tools along in these course.
In this chapter, we demonstrate how we do
simple economic analysis through a simple
model of apartment market.
 We set up a model about renters and landlords,
see how they make decisions, how apartments
are allocated, and how outcomes change when
exogenous variables changes.
 We also talk about a criteria for evaluating
outcome: Pareto Efficiency.
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