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 clears.) : Market price adjusts until quantity demanded equals quantity supplied

 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 Q D

 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 100 Q S

 “low” rental price inner-ring apartments exceeds quantity available   quantity demanded of 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 p e 100 Q D ,Q S

p Allocation: People who are willing to pay p e for Inner-ring apartments get them.

p e 100 Q D ,Q S

p p e 100 Allocation: People who are willing to pay p e for Inner-ring apartments get them.

People who are not willing to pay p e for inner-ring apartments get outer-ring apartments.

Q D ,Q S

 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 p e 100 Q D ,Q S

p Higher demand p e 100 Q D ,Q S

p p e Higher demand causes higher market price; same quantity traded.

100 Q D ,Q S

 2. Suppose there were more inner-ring apartments.

 Supply is greater;  The price for close apartments falls, while the quantity increases.

p p e 100 Q D ,Q S

p Higher supply p e 100 Q D ,Q S

p Higher supply causes a lower market price and a larger quantity traded.

p e 100 Q D ,Q S

 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 p e 100 Q D ,Q S

p Higher incomes cause higher willingness-to-pay p e 100 Q D ,Q S

p p e Higher incomes cause higher willingness-to-pay, higher market price, and the same quantity traded.

100 Q D ,Q S

 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.

Middle price p 100 Middle price, medium quantity demanded, larger revenue.

Monopolist does not rent all the close apartments.

Vacant close apartments.

Q D ,Q S

p 1 =$500 p 2 =$490 p 3 =$475 p p e 1 2 3 100 Discriminatory monopolist charges the competitive market price to the last renter, and rents the competitive quantity of close apartments.

Q D ,Q S

p p e p max The 100 close apartments are no longer allocated by willingness-to-pay (lottery, lines, large families first?).

100 Excess demand Q D ,Q S

 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.