2. © 2010 W. W. Norton & Company, Inc. 1 The Market

3. © 2010 W. W. Norton & Company, Inc. 2 The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions --- John Maynard Keynes

4. © 2010 W. W. Norton & Company, Inc. 3 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)?

5. © 2010 W. W. Norton & Company, Inc. 4 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

6. © 2010 W. W. Norton & Company, Inc. 5 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?

7. © 2010 W. W. Norton & Company, Inc. 6 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.

8. © 2010 W. W. Norton & Company, Inc. 7 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.

9. © 2010 W. W. Norton & Company, Inc. 8 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.

10. © 2010 W. W. Norton & Company, Inc. 9 Market Demand Curve for Apartments p QDQD

11. © 2010 W. W. Norton & Company, Inc. 10 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).

12. © 2010 W. W. Norton & Company, Inc. 11 Market Supply Curve for Apartments p QSQS 100

13. © 2010 W. W. Norton & Company, Inc. 12 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.

14. © 2010 W. W. Norton & Company, Inc. 13 Competitive Market Equilibrium u Quantity demanded = quantity available  price will neither rise nor fall u so the market is at a competitive equilibrium.

15. © 2010 W. W. Norton & Company, Inc. 14 Competitive Market Equilibrium p Q D,Q S 100

16. © 2010 W. W. Norton & Company, Inc. 15 Competitive Market Equilibrium p Q D,Q S pepe 100

17. © 2010 W. W. Norton & Company, Inc. 16 Competitive Market Equilibrium p Q D,Q S pepe 100 People willing to pay p e for close apartments get close apartments.

18. © 2010 W. W. Norton & Company, Inc. 17 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.

19. © 2010 W. W. Norton & Company, Inc. 18 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”.

20. © 2010 W. W. Norton & Company, Inc. 19 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?

21. © 2010 W. W. Norton & Company, Inc. 20 Comparative Statics u Suppose the price of distant apartment rises. u Demand for close apartments increases (rightward shift), causing a higher price for close apartments.

22. © 2010 W. W. Norton & Company, Inc. 21 Market Equilibrium p Q D,Q S pepe 100

23. © 2010 W. W. Norton & Company, Inc. 22 Market Equilibrium p Q D,Q S pepe 100 Higher demand

24. © 2010 W. W. Norton & Company, Inc. 23 Market Equilibrium p Q D,Q S pepe 100 Higher demand causes higher market price; same quantity traded.

25. © 2010 W. W. Norton & Company, Inc. 24 Comparative Statics u Suppose there were more close apartments. u Supply is greater, so the price for close apartments falls.

26. © 2010 W. W. Norton & Company, Inc. 25 Market Equilibrium p Q D,Q S pepe 100

27. © 2010 W. W. Norton & Company, Inc. 26 Market Equilibrium p Q D,Q S 100 Higher supply pepe

28. © 2010 W. W. Norton & Company, Inc. 27 Market Equilibrium p Q D,Q S pepe 100 Higher supply causes a lower market price and a larger quantity traded.

29. © 2010 W. W. Norton & Company, Inc. 28 Comparative Statics u Suppose potential renters’ incomes rise, increasing their willingness-to- pay for close apartments. u Demand rises (upward shift), causing higher price for close apartments.

30. © 2010 W. W. Norton & Company, Inc. 29 Market Equilibrium p Q D,Q S pepe 100

31. © 2010 W. W. Norton & Company, Inc. 30 Market Equilibrium p Q D,Q S pepe 100 Higher incomes cause higher willingness-to-pay

32. © 2010 W. W. Norton & Company, Inc. 31 Market Equilibrium p Q D,Q S pepe 100 Higher incomes cause higher willingness-to-pay, higher market price, and the same quantity traded.

33. © 2010 W. W. Norton & Company, Inc. 32 Taxation Policy Analysis u Local government taxes apartment owners. u What happens to –price –quantity of close apartments rented? u Is any of the tax “passed” to renters?

34. © 2010 W. W. Norton & Company, Inc. 33 Taxation Policy Analysis u Market supply is unaffected. u Market demand is unaffected. u So the competitive market equilibrium is unaffected by the tax. u Price and the quantity of close apartments rented are not changed. u Landlords pay all of the tax.

35. © 2010 W. W. Norton & Company, Inc. 34 Imperfectly Competitive Markets u Amongst many possibilities are: –a monopolistic landlord –a perfectly discriminatory monopolistic landlord –a competitive market subject to rent control.

36. © 2010 W. W. Norton & Company, Inc. 35 A Monopolistic Landlord u When the landlord sets a rental price p he rents D(p) apartments. u Revenue = pD(p).  Revenue is low if p  0 u Revenue is low if p is so high that D(p)  0. u An intermediate value for p maximizes revenue.

37. © 2010 W. W. Norton & Company, Inc. 36 Monopolistic Market Equilibrium p QDQD Low price Low price, high quantity demanded, low revenue.

38. © 2010 W. W. Norton & Company, Inc. 37 Monopolistic Market Equilibrium p QDQD High price High price, low quantity demanded, low revenue.

39. © 2010 W. W. Norton & Company, Inc. 38 Monopolistic Market Equilibrium p QDQD Middle price Middle price, medium quantity demanded, larger revenue.

40. © 2010 W. W. Norton & Company, Inc. 39 Monopolistic Market Equilibrium p Q D,Q S Middle price Middle price, medium quantity demanded, larger revenue. Monopolist does not rent all the close apartments. 100

41. © 2010 W. W. Norton & Company, Inc. 40 Monopolistic Market Equilibrium 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.

42. © 2010 W. W. Norton & Company, Inc. 41 Perfectly Discriminatory Monopolistic Landlord u Imagine the monopolist knew everyone’s willingness-to-pay. u Charge $500 to the most willing-to- pay, u charge $490 to the 2nd most willing- to-pay, etc.

43. © 2010 W. W. Norton & Company, Inc. 42 Discriminatory Monopolistic Market Equilibrium p Q D,Q S 100 p 1 =$500 1

44. © 2010 W. W. Norton & Company, Inc. 43 Discriminatory Monopolistic Market Equilibrium p Q D,Q S 100 p 1 =$500 p 2 =$490 12

45. © 2010 W. W. Norton & Company, Inc. 44 Discriminatory Monopolistic Market Equilibrium p Q D,Q S 100 p 1 =$500 p 2 =$490 12 p 3 =$475 3

46. © 2010 W. W. Norton & Company, Inc. 45 Discriminatory Monopolistic Market Equilibrium p Q D,Q S 100 p 1 =$500 p 2 =$490 12 p 3 =$475 3

47. © 2010 W. W. Norton & Company, Inc. 46 Discriminatory Monopolistic Market Equilibrium 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.

48. © 2010 W. W. Norton & Company, Inc. 47 Rent Control u Local government imposes a maximum legal price, p max < p e, the competitive price.

49. © 2010 W. W. Norton & Company, Inc. 48 Market Equilibrium p Q D,Q S pepe 100

50. © 2010 W. W. Norton & Company, Inc. 49 Market Equilibrium p Q D,Q S pepe 100 p max

51. © 2010 W. W. Norton & Company, Inc. 50 Market Equilibrium p Q D,Q S pepe 100 p max Excess demand

52. © 2010 W. W. Norton & Company, Inc. 51 Market Equilibrium 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?).

53. © 2010 W. W. Norton & Company, Inc. 52 Which Market Outcomes Are Desirable? u Which is better? –Rent control –Perfect competition –Monopoly –Discriminatory monopoly

54. © 2010 W. W. Norton & Company, Inc. 53 Pareto Efficiency u Vilfredo Pareto; 1848-1923. u A Pareto outcome allows no “wasted welfare”; u i.e. the only way one person’s welfare can be improved is to lower another person’s welfare.

55. © 2010 W. W. Norton & Company, Inc. 54 Pareto Efficiency u Ali has an apartment; Veli does not. u Ali values the apartment at $200; Veli would pay $400 for it. u Ali could sublet the apartment to Veli for $300. u Both gain, so it was Pareto inefficient for Ali to have the apartment.

56. © 2010 W. W. Norton & Company, Inc. 55 Pareto Efficiency u A Pareto inefficient outcome means there remain unrealized mutual gains-to-trade. u Any market outcome that achieves all possible gains-to-trade must be Pareto efficient.

57. © 2010 W. W. Norton & Company, Inc. 56 Pareto Efficiency u Competitive equilibrium: –all close apartment renters value them at the market price p e or more –all others value close apartments at less than p e –so no mutually beneficial trades remain –so the outcome is Pareto efficient.

58. © 2010 W. W. Norton & Company, Inc. 57 Pareto Efficiency u Discriminatory Monopoly: –assignment of apartments is the same as with the perfectly competitive market –so the discriminatory monopoly outcome is also Pareto efficient.

59. © 2010 W. W. Norton & Company, Inc. 58 Pareto Efficiency u Monopoly: –not all apartments are occupied –so a distant apartment renter could be assigned a close apartment and have higher welfare without lowering anybody else’s welfare. –so the monopoly outcome is Pareto inefficient.

60. © 2010 W. W. Norton & Company, Inc. 59 Pareto Efficiency u 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.