Transcript The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy.

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
Economic Modeling
• What causes what in economic systems?
• At what level of detail shall we model an
economic phenomenon?
• Which variables are determined outside the
model (exogenous) and which are to be
determined by the model (endogenous)?
Modeling the Flat Rental Market
• How are flats/apartments rent determined?
• Suppose
– flats are close or distant, but otherwise identical
– distant flats rents are exogenous and known
– many potential renters and landlords
• Price of close flats is endogenous.
An Economist’s concerns:
Modeling the Apartment Market
• 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?
Economic Modeling
Assumptions
• Two basic postulates:
– Rational Choice: Each person tries to choose
the best alternative available to him or her.
– Competitive Equilibrium: Market price adjusts
until quantity demanded equals quantity
supplied.
Solving:
• What does the demand curve look like?
• Supply curve.
• Equilibrium.
What if there isn’t a competitive equilibrium?
(If there is Monopolist or Rent Control)
Discrete Demand
• If Jack has a willingness to
pay of £300, what does that
mean.
• Can get far flat at £200.
With £100, travel and
inconvenience costs.
• If p>300, he won’t buy.
• If p<300, he would buy and
get surplus of:
Sample Demand
Bill
200
Sam
100
George
300
Pete
400
Ted
200
Pareto Efficiency/Optimality
• Vilfredo Pareto; 1848-1923.
• A Pareto outcome allows no “wasted
welfare”;
• i.e. the only way one person’s welfare can
be improved is to lower another person’s
welfare.
• You can’t make someone better off without
making someone else worse off.
Pareto Optimality/Efficiency
• An allocation is a possible distribution of
goods in the economy.
• An allocation is Pareto optimal if there does
not exist another allocation where no one is
worse off and at least one person is strictly
better off.
• Bill & Ted have £10 between them. What
are the P.O. allocations?
Pareto Efficiency
• 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.
Pareto Efficiency
• Competitive equilibrium:
– all close flat renters value them at the market
price p* or more
– all others value close apartments at less than p*
– so no mutually beneficial trades remain
– so the outcome is Pareto efficient.
Pareto Efficiency
• Discriminatory Monopoly:
– assignment of flats is the same as with the
perfectly competitive market
– so the discriminatory monopoly outcome is also
Pareto efficient.
Pareto Efficiency
• Monopoly:
– not all flats are occupied
– so a distant flat renter could be assigned a close
flat and have higher welfare without lowering
anybody else’s welfare.
– so the monopoly outcome is Pareto inefficient.
Pareto Efficiency
• Rent Control:
– some close flats are assigned to renters valuing
them at below the competitive price p*
– some renters valuing a close flat above p* don’t
get close flats
– Pareto inefficient outcome.
Housemates problem
• Bill and Ted rent an apartment together for
£400.
• There is a large room and a small room.
• Bill values the large room £100 more than
the small room and Ted values the large
room £20 more.
• Which allocations are Pareto Optimal?
• How will they divide up the rent?
Envy-Free Allocations
• An allocation is envy free if neither party is
willing to swap situations.
• For instance, Todd and Will Young are in
envy-free allocations.
• What are the Envy-Free allocations of the
previous example?
Envy Free Example
• If Bill gets the large room,
–
–
–
–
–
Rent is B & T.
Rent must be paid: B+T=400
Bill must not envy Ted 100-B>-T
Ted must not envy Bill –T>20-B
Show that B must be between £210 and £250 with
T=400-B.
• If Ted gets the large room,
– ???
• Are the Envy-Free allocations Pareto optimal?