1. Chapter One The Market

2. Economic Modeling u What causes what in economic systems? u At what level of detail shall we model an economic phenomenon? u Which variables are determined outside the model (exogenous) and which are to be determined by the model (endogenous)?

3. Modeling the Apartment Market u How are apartment rents determined? u Suppose –apartments are close or distant, but otherwise identical –distant apartments rents are exogenous and known –many potential renters and landlords

4. Modeling the Apartment Market u Who will rent close apartments? u At what price? u Will the allocation of apartments be desirable in any sense? u How can we construct an insightful model to answer these questions?

5. Economic Modeling Assumptions u Two basic postulates: –Rational Choice: Each person tries to choose the best alternative available to him or her. –Equilibrium: Market price adjusts until quantity demanded equals quantity supplied.

6. Modeling Apartment Demand u Demand: Suppose the most any one person is willing to pay to rent a close apartment is $500/month. Then p = $500  Q D = 1. u Suppose the price has to drop to $490 before a 2nd person would rent. Thenp = $490  Q D = 2.

7. Modeling Apartment Demand u The lower is the rental rate p, the larger is the quantity of close apartments demanded p   Q D . u The quantity demanded vs. price graph is the market demand curve for close apartments.

8. Market Demand Curve for Apartments p QDQD

9. Modeling Apartment Supply u Supply: It takes time to build more close apartments so in this short-run the quantity available is fixed (at say 100).

10. Market Supply Curve for Apartments p QSQS 100

11. Competitive Market Equilibrium u “low” rental price  quantity demanded of close apartments exceeds quantity available  price will rise. u “high” rental price  quantity demanded less than quantity available  price will fall.

12. Competitive Market Equilibrium u Quantity demanded = quantity available  price will neither rise nor fall u so the market is at a competitive equilibrium.

13. Competitive Market Equilibrium p Q D,Q S 100

14. Competitive Market Equilibrium p Q D,Q S pepe 100

15. Competitive Market Equilibrium p Q D,Q S pepe 100 People willing to pay p e for close apartments get close apartments.

16. Competitive Market Equilibrium p Q D,Q S pepe 100 People willing to pay p e for close apartments get close apartments. People not willing to pay p e for close apartments get distant apartments.

17. Competitive Market Equilibrium u Q: Who rents the close apartments? u A: Those most willing to pay. u Q: Who rents the distant apartments? u A: Those least willing to pay. u So the competitive market allocation is by “willingness-to-pay”.

18. Comparative Statics u What is exogenous in the model? –price of distant apartments –quantity of close apartments –incomes of potential renters. u What happens if these exogenous variables change?

19. Comparative Statics u Suppose the price of distant apartment rises. u Demand for close apartments increases (rightward shift), causing u a higher price for close apartments.

20. Market Equilibrium p Q D,Q S pepe 100

21. Market Equilibrium p Q D,Q S pepe 100 Higher demand

22. Market Equilibrium p Q D,Q S pepe 100 Higher demand causes higher market price; same quantity traded.

23. Comparative Statics u Suppose there were more close apartments. u Supply is greater, so u the price for close apartments falls.

24. Market Equilibrium p Q D,Q S pepe 100

25. Market Equilibrium p Q D,Q S 100 Higher supply pepe

26. Market Equilibrium p Q D,Q S pepe 100 Higher supply causes a lower market price and a larger quantity traded.

27. Comparative Statics u Suppose potential renters’ incomes rise, increasing their willingness-to- pay for close apartments. u Demand rises (upward shift), causing u higher price for close apartments.

28. Market Equilibrium p Q D,Q S pepe 100

29. Market Equilibrium p Q D,Q S pepe 100 Higher incomes cause higher willingness-to-pay

30. Market Equilibrium p Q D,Q S pepe 100 Higher incomes cause higher willingness-to-pay, higher market price, and the same quantity traded.