Chapter One
The Market
--- Appreciating Economic
Modeling
The Purpose of this Chapter
To begin to understand the art of
building an economic model
To begin to understand three basic
elements of modeling in economics:
–Purpose
–Simplification through
assumptions
–Value judgment
The Purpose of an Economic
Model
The purpose of an economic model
is to help provide precise insights (精确的洞察力） on a specific economic
phenomenon.
Thus:
–Different phenomena needs
different model;
–Simplification by assumption is
necessary
An Illustration,Modeling the
Apartment Market
Purpose,How are apartment rents
determined? Are rents,desirable”?
Simplifying assumptions,
–apartments are close or distant,but
otherwise identical
–distant apartments rents are
exogenous (外生变量） and known
–many potential renters and landlords
Two Very Common Modeling
Assumptions
–Rational Choice (理性选择）,Each
person tries to choose the best
alternative available to him or her.
–Equilibrium （ 均衡）,economic
agents interact with each other,
resulting in an equilibrium,in
which each person reaches an
optimal decision given others’
decisions.
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
QS100
Competitive Market Equilibrium
(竞争性市场均衡）
Quantity demanded = quantity available
price will neither rise nor fall
so the market is at a competitive
equilibrium.
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.
Comparative Statics
（ 静态比较分析）
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?
Note,We are not analyzing the
transition process or dynamic process.
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
Higher demand causes higher
market price; same quantity
traded.
More Comparative Statics
(Do Them Yourself)
Suppose there were more close
apartments.
Or,renters’ income rises;
Elaboration of the Basic Model,
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 Market
Case 1,A Monopolistic Landlord
Landlord sets a rental price p he rents
D(p) apartments.
Revenue = pD(p).
He chooses p to maximizes p D(p),
subject to D(p) <= S (total number of
apartments in his hands)
Typically,his optimal p is such that
D(p) < S,that is,there are vacant
apartments.
Monopolistic Market Equilibrium
p
QD,QS
Middle
price
Middle price,medium quantity
demanded,larger revenue.
Monopolist does not rent all the
close apartments.
100
Vacant close apartments.
Imperfectly Competitive Market
Case 2,Perfectly Discriminatory
Monopolistic Landlord
Imagine the monopolist knew
willingness-to-pay of everybody,
Charge $500 to the most willing-to-
pay,
charge $490 to the 2nd most willing-
to-pay,etc.
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
1
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
pe
Discriminatory monopolist
charges the competitive market
price to the last renter,and
rents the competitive quantity
of close apartments.
Rent Control
(房租管制）
Local government imposes a
maximum legal price,pmax < pe,the
competitive price.
Market Equilibrium
p
QD,QS
pe
100
pmax
Excess demand
The 100 close apartments are
no longer allocated by
willingness-to-pay (lottery,lines,
large families first?).
Value Judgement
（ 价值判断）
Which of the following is better?
–Rent control
–Perfect competition
–Monopoly
–Discriminatory monopoly
But,what do you mean by,better”?
Pareto Efficiency
（ 帕累托效率）
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,
Pareto Efficiency
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 Efficiency
Competitive equilibrium:
–all close apartment renters value
them at the market price pe or more
–all others value close apartments
at less than pe
–so no mutually beneficial trades
remain
–so the outcome is Pareto efficient.
Pareto Efficiency
Discriminatory Monopoly:
–assignment of apartments is the
same as with the perfectly
competitive market
–so the discriminatory monopoly
outcome is also Pareto efficient.
Pareto Efficiency
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.
Pareto Efficiency
Rent Control:
–some close apartments are assigned
to renters valuing them at below the
competitive price pe
–some renters valuing a close
apartment above pe don’t get close
apartments
–Pareto inefficient outcome.
Further Extensions of the Model
Over time,will
–the supply of close apartments
increase?
–rent control decrease the supply of
apartments?
–a monopolist supply more
apartments than a competitive
rental market?
A Quick Summary
Economic modeling serves a specific
purpose;
For the purpose,an economic model
needs to make simplifying
assumptions;
Economists do have value
judgments,which are based on
specified criterion.
The Market
--- Appreciating Economic
Modeling
The Purpose of this Chapter
To begin to understand the art of
building an economic model
To begin to understand three basic
elements of modeling in economics:
–Purpose
–Simplification through
assumptions
–Value judgment
The Purpose of an Economic
Model
The purpose of an economic model
is to help provide precise insights (精确的洞察力） on a specific economic
phenomenon.
Thus:
–Different phenomena needs
different model;
–Simplification by assumption is
necessary
An Illustration,Modeling the
Apartment Market
Purpose,How are apartment rents
determined? Are rents,desirable”?
Simplifying assumptions,
–apartments are close or distant,but
otherwise identical
–distant apartments rents are
exogenous (外生变量） and known
–many potential renters and landlords
Two Very Common Modeling
Assumptions
–Rational Choice (理性选择）,Each
person tries to choose the best
alternative available to him or her.
–Equilibrium （ 均衡）,economic
agents interact with each other,
resulting in an equilibrium,in
which each person reaches an
optimal decision given others’
decisions.
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
QS100
Competitive Market Equilibrium
(竞争性市场均衡）
Quantity demanded = quantity available
price will neither rise nor fall
so the market is at a competitive
equilibrium.
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.
Comparative Statics
（ 静态比较分析）
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?
Note,We are not analyzing the
transition process or dynamic process.
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
Higher demand causes higher
market price; same quantity
traded.
More Comparative Statics
(Do Them Yourself)
Suppose there were more close
apartments.
Or,renters’ income rises;
Elaboration of the Basic Model,
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 Market
Case 1,A Monopolistic Landlord
Landlord sets a rental price p he rents
D(p) apartments.
Revenue = pD(p).
He chooses p to maximizes p D(p),
subject to D(p) <= S (total number of
apartments in his hands)
Typically,his optimal p is such that
D(p) < S,that is,there are vacant
apartments.
Monopolistic Market Equilibrium
p
QD,QS
Middle
price
Middle price,medium quantity
demanded,larger revenue.
Monopolist does not rent all the
close apartments.
100
Vacant close apartments.
Imperfectly Competitive Market
Case 2,Perfectly Discriminatory
Monopolistic Landlord
Imagine the monopolist knew
willingness-to-pay of everybody,
Charge $500 to the most willing-to-
pay,
charge $490 to the 2nd most willing-
to-pay,etc.
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
1
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
Discriminatory Monopolistic
Market Equilibrium
p
QD,QS100
p1 =$500
p2 =$490
12
p3 =$475
3
pe
Discriminatory monopolist
charges the competitive market
price to the last renter,and
rents the competitive quantity
of close apartments.
Rent Control
(房租管制）
Local government imposes a
maximum legal price,pmax < pe,the
competitive price.
Market Equilibrium
p
QD,QS
pe
100
pmax
Excess demand
The 100 close apartments are
no longer allocated by
willingness-to-pay (lottery,lines,
large families first?).
Value Judgement
（ 价值判断）
Which of the following is better?
–Rent control
–Perfect competition
–Monopoly
–Discriminatory monopoly
But,what do you mean by,better”?
Pareto Efficiency
（ 帕累托效率）
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,
Pareto Efficiency
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 Efficiency
Competitive equilibrium:
–all close apartment renters value
them at the market price pe or more
–all others value close apartments
at less than pe
–so no mutually beneficial trades
remain
–so the outcome is Pareto efficient.
Pareto Efficiency
Discriminatory Monopoly:
–assignment of apartments is the
same as with the perfectly
competitive market
–so the discriminatory monopoly
outcome is also Pareto efficient.
Pareto Efficiency
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.
Pareto Efficiency
Rent Control:
–some close apartments are assigned
to renters valuing them at below the
competitive price pe
–some renters valuing a close
apartment above pe don’t get close
apartments
–Pareto inefficient outcome.
Further Extensions of the Model
Over time,will
–the supply of close apartments
increase?
–rent control decrease the supply of
apartments?
–a monopolist supply more
apartments than a competitive
rental market?
A Quick Summary
Economic modeling serves a specific
purpose;
For the purpose,an economic model
needs to make simplifying
assumptions;
Economists do have value
judgments,which are based on
specified criterion.
