Chapter 1 The Market

1
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?

6
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.)

7
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.

8
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.

11
Market Supply Curve for Apartments
p
QS
100
12
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.)

13
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
pe
QD,QS
100
15
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
QD,QS
100
16
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.

17
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?

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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.

19
Market Equilibrium
p
pe
QD,QS
100
20
Market Equilibrium
p
Higher demand
pe
QD,QS
100
21
Market Equilibrium
p
Higher demand causes highermarket price same
quantitytraded.
pe
QD,QS
100
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 Equilibrium
p
pe
QD,QS
100
24
Market Equilibrium
p
Higher supply
pe
QD,QS
100
25
Market Equilibrium
p
Higher supply causes alower market price and
alarger quantity traded.
pe
QD,QS
100
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 Equilibrium
p
pe
QD,QS
100
28
Market Equilibrium
p
Higher incomes causehigher willingness-to-pay
pe
QD,QS
100
29
Market Equilibrium
p
Higher incomes causehigher willingness-to-pay,hi
gher market price, andthe same quantity traded.
pe
QD,QS
100
30
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?

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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.

32
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
Low price, high quantitydemanded, low revenue.
Lowprice
QD
35
Monopolistic Market Equilibrium
p
High price, low quantitydemanded, low revenue.
Highprice
QD
36
Monopolistic Market Equilibrium
p
Middle price, medium quantitydemanded, larger
revenue.
Middleprice
QD
37
Monopolistic Market Equilibrium
p
Middle price, medium quantitydemanded, larger
revenue.Monopolist does not rent all
theinner-ring apartments.
Middleprice
QD,QS
100
38
Monopolistic Market Equilibrium
p
Middle price, medium quantitydemanded, larger
revenue.Monopolist does not rent all
theinner-ring apartments.
Vacant inner-ring apartments.
Middleprice
QD,QS
100
39
Perfectly Discriminatory Monopolistic Landlord

• Imagine the monopolist knew everyones
  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
p1 500
QD,QS
100
1
41
Discriminatory Monopolistic Market Equilibrium
p
p1 500
p2 490
QD,QS
100
1
2
42
Discriminatory Monopolistic Market Equilibrium
p
p1 500
p2 490
p3 475
QD,QS
100
1
2
3
43
Discriminatory Monopolistic Market Equilibrium
p
p1 500
p2 490
p3 475
QD,QS
100
1
2
3
44
Discriminatory Monopolistic Market Equilibrium
p
Discriminatory monopolistcharges the competitive
marketprice to the last renter, andrents the
competitive quantityof inner-ring apartments.
p1 500
p2 490
p3 475
pe
QD,QS
100
1
2
3
45
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?

46
Market Equilibrium
p
pe
QD,QS
100
47
Market Equilibrium
p
pe
pmax
QD,QS
100
48
Market Equilibrium
p
Excess demand
pe
pmax
QD,QS
100
49
Market Equilibrium
p
The 100 inner-ring apartments are no longer
allocated bywillingness-to-pay (lottery,
lines,large families first?).
Excess demand
pe
pmax
QD,QS
100
50
Which Market Outcomes Are Desirable?

• Weve now described four possible ways of
  allocating apartments to people
• Rent control
• Perfect competition
• Monopoly
• Discriminatory monopoly
• Which one is the best?

51
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.

52
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.

54
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.

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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 doesnt
  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 doesnt 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 dont get inner-ring apartments.
• A Pareto improvement is possible. Thus the
  outcome is inefficient.

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Short Run vs. Long Run

• Weve 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?