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.
Microeconomics focuses on the study of individual decisions (consumer, firms) and markets of individual goods and services. In contrast, macroeconomics studies the performance of the economy as a whole.
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.
What causes what in economic systems? What simplifying assumptions do we make? Which variables are determined outside the model (exogenous) and which are to be determined by the model (endogenous)?
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): no dominating individuals.
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?
Two basic principles: 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 Q D = 1. Suppose the price has to drop to $490 before a 2nd person would rent. Thenp = $490 Q D = 2.
The lower is the rental price p, the larger is the quantity of inner-ring apartments demanded p Q D . 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.
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.
“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.)
Quantity demanded = quantity available price will neither rise nor fall so the market is at a competitive equilibrium. Equilibrium : no tendency to change We can also call the market clears.
p Q D,Q S pepe 100 Allocation: People who are willing to pay p e for Inner-ring apartments get them.
p Q D,Q S pepe 100 People who are not willing to pay p e for inner-ring apartments get outer-ring apartments. Allocation: People who are willing to pay p e for Inner-ring apartments get them.
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”.
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.
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 Q D,Q S pepe 100 Higher incomes cause higher willingness-to-pay
p Q D,Q S pepe 100 Higher incomes cause higher willingness-to-pay, higher market price, and the same quantity traded.
Local government taxes apartment owners. What happens to price quantity of close apartments rented? 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.
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). Details are omitted here. Will be discussed in future classes.
p Q D,Q S Middle price Middle price, medium quantity demanded, larger revenue. Monopolist does not rent all the close apartments. 100 Vacant close apartments.
p Q D,Q S 100 p 1 =$500 p 2 =$490 12 p 3 =$475 3 pepe Discriminatory monopolist charges the competitive market price to the last renter, and rents the competitive quantity of close apartments.
p Q D,Q S pepe 100 p max Excess demand The 100 close apartments are no longer allocated by willingness-to-pay (lottery, lines, large families first?).
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.”
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.
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%.
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.
Competitive equilibrium: all inner-ring apartment renters value them at the market price p e or more all others value inner-ring apartments at less than p e so no mutually beneficial trades remain so the outcome is Pareto efficient.
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.
Discriminatory Monopoly: assignment of apartments is the same as with the perfectly competitive market so the discriminatory monopoly outcome is also Pareto efficient.
Rent Control: some close apartments are assigned to renters valuing them at below the competitive price p e some renters valuing a close apartment above p e don’t get close apartments Pareto inefficient outcome.
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? 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.