Chapter One,The Market,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 Apartment Market,How are apartment rents determined? Suppose apartments are close or distant, but otherwise identical distant apartments rents are exogenous and known many potential renters and landlords,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. Equilibrium: Market price adjusts until quantity demanded equals quantity supplied.,Modeling Apartment Demand,Demand: Suppose the most any one person is willing to pay to rent a close apartment is $500/month. Then p = $500 QD = 1. Suppose the price has to drop to $490 before a 2nd person would rent. Then p = $490 QD = 2.,Modeling Apartment Demand,The lower is the rental rate p, the larger is the quantity of close apartments demanded p QD . The quantity demanded vs. price graph is the market demand curve for close apartments.,Market Demand Curve for Apartments,p,QD,Modeling Apartment Supply,Supply: It takes time to build more close apartments so in this short-run the quantity available is fixed (at say 100).,Market Supply Curve for Apartments,p,QS,100,Competitive Market Equilibrium,“low” rental price quantity demanded of close apartments exceeds quantity available price will rise. “high” rental price quantity demanded less than quantity available price will fall.,Competitive Market Equilibrium,Quantity demanded = quantity available price will neither rise nor fall so the market is at a competitive equilibrium.,Competitive Market Equilibrium,p,QD,QS,100,Competitive Market Equilibrium,p,QD,QS,pe,100,Competitive Market Equilibrium,p,QD,QS,pe,100,People willing to pay pe for close apartments get close apartments.,Competitive Market Equilibrium,p,QD,QS,pe,100,People willing to pay pe for close apartments get close apartments.,People not willing to pay pe for close apartments get distant apartments.,Competitive Market Equilibrium,Q: Who rents the close apartments? A: Those most willing to pay. Q: Who rents the distant apartments? A: Those least willing to pay. So the competitive market allocation is by “willingness-to-pay”.,Comparative Statics,What is exogenous in the model? price of distant apartments quantity of close apartments incomes of potential renters. What happens if these exogenous variables change?,Comparative Statics,Suppose the price of distant apartment rises. Demand for close apartments increases (rightward shift), causing a higher price for close apartments.,Market Equilibrium,p,QD,QS,pe,100,Market Equilibrium,p,QD,QS,pe,100,Higher demand,Market Equilibrium,p,QD,QS,pe,100,Higher demand causes higher market price; same quantity traded.,Comparative Statics,Suppose there were more close apartments. Supply is greater, so the price for close apartments falls.,Market Equilibrium,p,QD,QS,pe,100,Market Equilibrium,p,QD,QS,100,Higher supply,pe,Market Equilibrium,p,QD,QS,pe,100,Higher supply causes a lower market price and a larger quantity traded.,Comparative Statics,Suppose potential renters incomes rise, increasing their willingness-to-pay for close apartments. Demand rises (upward shift), causing higher price for close apartments.,Market Equilibrium,p,QD,QS,pe,100,Market Equilibrium,p,QD,QS,pe,100,Higher incomes cause higher willingness-to-pay,Market Equilibrium,p,QD,QS,pe,100,Higher incomes cause higher willingness-to-pay, higher market price, and the same quantity traded.,Taxation Policy Analysis,Local government taxes apartment owners. What happens to price quantity of close apartments rented? Is any of the tax “passed” to renters?,Taxation Policy Analysis,Market supply is unaffected. Market demand is unaffected. So the competitive market equilibrium is unaffected by the tax. Price and the quantity of close apartments rented are not changed. Landlords pay all of the tax.,Imperfectly Competitive Markets,Amongst many possibilities are: a monopolistic landlord a perfectly discriminatory monopolistic landlord a competitive market subject to rent control.,A Monopolistic Landlord,When the landlord sets a rental price p he rents D(p) apartments. Revenue = pD(p). Revenue is low if p 0 Revenue is low if