Week 01 - Part A

MICROECONOMICS AND MARKETS

A QUICK (RE)VIEW AT THE WORKINGS OF MARKET MECHANISMS

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

If you can say so many interesting things just by watching the world, then you must really have a fantastic set of prescription spectacles, even if no one ever gets to see you wearing them.

--- referring to the sociologist Howard Becker

THE RISE OF FAST-CASUAL Shake Shack was opened in 2004 in Manhattan

today it has locations across the US, Europe and the Middle East it brings around a hundred million dollars a year in revenue

Guzman y Gomez was opened in 2006 in Newtown today it has 58 locations around Australia and Singapore

Both businesses managed to capitalized on a revolution in the fast-food business: the rise of fast-casual dining

fresh ingredients, more waiting time and higher prices Factors that contribute to their success

changes in income distribution (more affluent middle class) changes in taste (increasing demand for quality)

ROAD MAP Buying cheap and selling dear

demand and supply Reaching consensus through competition

equilibrium in competitive markets Rocking the status quo

exogenous variables and comparative statics Is there any other way?

alternative allocation mechanisms Nothing to waste in this life

Pareto efficiency and market outcomes

ECONOMIC MODELING What constitutes an economic system

agents with (competing) motivations and (finite) resources complex interaction among agents: it is not immediate to

understand causes and consequences

Economics uses (mathematical) models at what level of detail shall we model an economic

phenomenon which variables are determined outside the model

(exogenous) which are to be determined by the model (endogenous)

MODELING THE APARTMENT MARKET

Market for apartments around UNSW apartments are close or distant, but otherwise identical distant apartments rents are fixed (exogenous) many potential renters and landlords of close apartments

We want to understand

who will rent close apartments and at what price in what sense, if any, is the allocation desirable

ECONOMIC MODELING ASSUMPTIONS The two most basic postulates in Microeconomics are the

following optimization: each person tries to choose the best

alternative available to him or her equilibrium: the economic system (market) remains in

active change until it reaches an equilibrium position Everything else (almost) depends on these two postulates In a competitive market

firms want to sell dear and consumers want to buy cheap there will be adjustments until the amount people demand

is the same as the amount firms supply

MODELING APARTMENT DEMAND

Demand: suppose the most any one person is willing to pay to rent a close apartment is $500/month

p = $500 QD = 1

Incremental effects: suppose the price has to drop to $490 before a 2nd person would rent

p = $490 QD = 2

MARKET DEMAND CURVE FOR APARTMENTS

p

QD

Market Demand

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) we are using the measure of time (short-run) very loosely

here, but it will do for now because in the short run the supply is fixed, it is price

insensitive

MARKET SUPPLY CURVE FOR APARTMENTS

p

QS 100

Market Supply

COMPETITIVE MARKET EQUILIBRIUM

Low rental price quantity demanded of close apartments exceeds quantity available price will rise

High rental price quantity demanded is less than

quantity available price will fall When quantity demanded = quantity available

price will neither rise nor fall The market is at a competitive equilibrium


p

QD,QS 100


p

QD,QS

pe

100


p

QD,QS

pe

100

People willing to pay pe for close apartments get close apartments


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


Q: who rents the close apartments those most willing to pay

Q: who rents the distant apartments

those least willing to pay

The competitive market allocation is by willingness-to-pay

the underlying principle of competitive markets is to allocate goods to those who value them the most

notice most people pay a price that is less than their willingness to pay (the obtain a surplus)

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)

wait, what? This causes a higher price for close apartments

short-run adjustment via prices only

MARKET EQUILIBRIUM p

QD,QS

pe

100


QD,QS

pe

100

Higher demand


QD,QS

pe

100

Higher demand causes higher market price; same quantity traded

COMPARATIVE STATICS Suppose there were more close apartments

either magically or we allow some time to pass and new apartments to be built

Supply is greater (right shift), so the price for close apartments falls


QD,QS

pe

100


QD,QS 100

Higher supply

pe


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)

wait, what? This causes higher price for close apartments

here we are back assuming a short-run, fixed supply scenario


QD,QS

pe

100


QD,QS

pe

100

Higher incomes cause higher willingness-to-pay


QD,QS

pe

100

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

ALTERNATIVE WAYS TO ALLOCATE GOODS Amongst many possibilities are

a lottery system a monopolistic landlord that posts a single price a perfectly discriminatory monopolistic landlord a competitive market subject to rent controls

The first system does not take the willingness to pay into account at all pure random allocation why is this not desirable?

The others do take willingness to pay into account but the resulting allocation is not necessarily the same

A MONOPOLISTIC LANDLORD

When the landlord sets a rental price p he rents D(p) apartments where D(p) represents the value of the inverse demand

function at price p Total revenue for the monopolist is R = p x D(p) Revenue is low if the price is very close to zero, but

revenue is also low if the price is so high that D(p) 0 trade-off between selling lots of goods cheaply and selling

dear just a few items An intermediate value for p maximizes revenue

we will study the way a monopolist solves this trade-off

MONOPOLISTIC MARKET EQUILIBRIUM

p

QD

Low price

Low price, high quantity demanded, low revenue


p

QD

High price

High price, low quantity demanded, low revenue


p

QD

Middle price

Middle price, medium quantity demanded, larger revenue


p

QD,QS

Middle price

Middle price, medium quantity demanded, larger revenue Monopolist does not rent all the close apartments

100


p

QD,QS

Middle price

Middle price, medium quantity demanded, larger revenue Monopolist does not rent all the close apartments

100

vacant close apartments

PERFECTLY DISCRIMINATORY MONOPOLISTIC LANDLORD

Now imagine the monopolist knew everyones willingness-to-pay (this is a monopolists dream) charge $500 to the most willing-to-pay charge $490 to the 2nd most willing-to-pay, etc

The monopolist can go down the demand curve and charge each agent exactly her willingness to pay this process captures all surplus from consumers

DISCRIMINATORY MONOPOLISTIC MARKET EQUILIBRIUM

p

QD,QS 100

p1 =$500

1


p

QD,QS 100

p1 =$500

p2 =$490

1 2


p

QD,QS 100

p1 =$500

p2 =$490

1 2

p3 =$475

3


p

QD,QS 100

p1 =$500

p2 =$490

1 2

p3 =$475

3

pe

Discriminatory monopolist charges the competitive market price to the last renter Quantity of close apartments rented is the same as in the competitive market

RENT CONTROL Local government imposes a maximum legal price pmax

if this maximum legal price is above pe, it has no effect on market allocation

to be effective, lets assume that pmax < pe


QD,QS

pe

100


QD,QS

pe

100

pmax


QD,QS

pe

100

pmax Excess demand


QD,QS

pe

100

pmax Excess demand

The 100 close apartments are no longer allocated by willingness-to-pay (lottery, lines, large families first, friends of JC first)

WHICH MARKET OUTCOMES ARE DESIRABLE? Which allocation mechanism is better?

Competitive market Monopoly with posted price Discriminatory monopoly Rent control

Most of economics focuses on one social desideratum: Pareto efficiency

named after Vilfredo Pareto (1848-1923) An outcome is Pareto efficient if it allows no wasted welfare

the only way one persons welfare can be improved is to lower another persons welfare

PARETO EFFICIENCY An example of an inefficient situation is the following

there is just one apartment and it was (randomly) allocated to Jill, who values it at $200

Jack was out of town when the allocation took place, but he would pay $400 for the apartment

Possible gains from trade Jill could sublet the apartment to Jack for $300 both gain, so it was Pareto inefficient for Jill to have the apartment

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 there are no mutually beneficial trades remain the outcome is Pareto efficient

PARETO EFFICIENCY Monopoly

at the monopolist posted price pm all people renting close apartments have a willingness to pay equal to or higher than pm

but not all apartments are occupied there are unrealized gains from trade

someone renting a distant apartment could be assigned a close apartment for a very small transfer (not available to the general public)

he/she is better off, the monopolist is better off, and nobodys welfare was affected

the monopoly outcome is not Pareto inefficient

PARETO EFFICIENCY

Discriminatory Monopoly the assignment of apartments is the same as with the

perfectly competitive market as there are no remaining gains from trade, the

discriminatory monopoly outcome is also Pareto efficient this is despite the fact that the monopolist captures all

consumer surplus

Efficiency is not a measure of equity (or social justice, or fairness, or equality)

PARETO EFFICIENCY Rent Control

there are say 110 people that want to rent close apartments at the controlled price pmax < pe

most likely, some close apartments are assigned to renters valuing them at below the competitive price pe

some renters valuing a close apartment above pe dont get close apartments

this is a Pareto inefficient outcome (as in Jack and Jill)

WHAT IS LEFT OUT In all our previous discussion, we have considered a stable

institutional framework in the background property rights equal treatment and the rule of law few transaction costs existence of a well-functioning market

But this is NOT a minor issue

BUZZKILL

From the New Yorker (Nov 18th, 2013) Washingtons law gave state officials only a year to answer difficult questions: Who could grow legal pot? Who could sell it? How much would an ounce of the drug cost? Photograph by Maureen Drennan

Documents

Week 01 - Part A