Course: Microeconomics Text: Varian’s Intermediate Microeconomics

 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.

p QDQD

 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.

p QSQS 100

 “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

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

p Q D,Q S pepe 100 Higher demand

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

 2. Suppose there were more inner-ring apartments.  Supply is greater;  The price for close apartments falls, while the quantity increases.

p Q D,Q S pepe 100

p Q D,Q S 100 Higher supply pepe

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

 3. Suppose potential renters’ incomes rise, increasing their willingness-to-pay for inner-ring apartments.  Demand rises (upward shift)  Higher price for inner-ring apartments.

p Q D,Q S pepe 100

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 =$500 p 2 =$ 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;  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.