Introduction to Markets

Today marks the start of a new textbook. The textbook that I will be using now is Intermediate Microeconomics A Modern Approach by Hal R. Varian. This is a more advanced microeconomic textbook. The reason that I am using it is very similar to the last one, basically I have it because I used it in a class. It seems to be a good textbook. It is quite a bit longer than the last textbook and so will take me longer to go through. Some of the concepts that I have gone over previously will be gone over again, either just in passing or in more detail.

The first chapter of the textbook is talking about some basic market examples. I will be following along with this example because it works very well to explain some of these economic concepts. As well, this example serves to show a very basic economic model and how it can be useful.

The example that is used is of a town that has a university. In this town there are two types of apartments, ones that are close to the university and ones that are far away. The ones that are close are considered more desirable since they allow easier access to the university. These two types of apartments will be called inner and outer apartments to make things simpler.

The focus on the model will be the market for the inner apartments. There are several assumptions that we are making in this model.

1. People who can’t find an inner apartment live in an outer apartment
2. Outer apartments price is fixed at some level
3. All apartments are identical except for location

The difference in the two prices in this model is a good example of exogenous variables and endogenous variables. The price of the outer apartments is an exogenous variable, which means that it is determined by forces outside of the model. The price of the inner apartments is an endogenous variable, which means that it is determined by forces within the model.

What will be determined with this model is:

1. The price of inner apartments
2. Who lives in the inner apartments and who lives in the outer apartments

The textbook at this point also discusses two economic principles that helps us try to explain human behaviour. The first of these is the optimization principle. This is pretty much just the maximization principle that we talked about earlier but states slightly differently. The optimization principle is that people try to choose the best patterns of consumption they can afford. The second principle that it discusses is what it calls the equilibrium principle. This is just the idea that prices adjust until the amount that is demanded of something is equal to the amount that is supplied.

The chapter has a brief description of the demand and supply curves and I really like how it is explained so I will talk about it here for a little bit. The chapter brings in the concept of the reservation price. A reservation price is the maximum price that someone would be willing to accept for a good and still buy it. In our example that would be the rent on an inner apartment.

For the moment let’s imagine that there are five people looking for apartments. The first person is willing to pay $500 for the apartment, the second person is willing to pay $490 and so on, until the last person will be willing to pay $460. These are the people’s reservation prices. The demand curve in this market then is made up of this. If the rent for an apartment is $500 then only one apartment will be rented. This means that the number of apartments that are rented will just be equal to the number of people whose reservation price is above the market price. When we plot this on a curve it looks like this.

It has steps because there are so few people in the market. When you introduce more and more people than we see the curved demand curve that we are used to.

 

After having looked at the demand curve briefly we can talk about the supply curve as well. For now we will be looking at the competitive market, which is where there are many independent landlords. We will be making a couple more assumptions here as well.

1. Consumers will have perfect information about price
2. There are no regulations or contracts
3. We are operating in the short-run.
4. Landlords have no costs

Under these conditions we can show that the equilibrium price of all the inner apartments will be the same. The easiest way to show this is to start with a situation where the prices are not all equal. In this situation there will be two prices, a high price and a low price. Under this situation what will happen is that people who are renting a place that has a high price will go to a landlord who has a low price and offer them more money than the low price but less money than the high price for a place. In this situation there will be a trade and both people will be made better off. This will continue to happen until the prices for all apartments are the same.

Since we have shown that prices will all be the same, it is time to look at why the third assumption is important. The reason that for now we will be looking at the short run is that in the short run the number of apartments will not change. This is pretty easy to imagine as it takes quite a while to build more apartments. As such the supply curve will just be a vertical line as such.

 

Using the basic information that we have so far, we have been able to come up with both a supply curve and a demand curve. In order to get our equilibrium now we will put them together.

In this graph now P* is equal to the price where the quantity demanded and the quantity supplied are equal. At this price, all consumers who are willing to pay more than P* find an apartment and the landlords are able to rent all of their apartments. Neither the consumers nor landlords have any reason to change their behaviour.

This has answered the first thing that we were looking for in our model which was to find the price. The second thing that we wanted to know was who rents which apartment. As was briefly mentioned before this is actually very simple. The people who get the inner apartments are the ones that are willing to pay the most for them. In this case everyone who is willing to pay above P*. The difference between P* and their reservation price is their consumer surplus. So apartments in the competitive will be assigned based on how much people are willing to pay.

Now that we have our model, we are able to play around with different situations and see how they affect the behaviour of the equilibrium price. In order to do this what we will do is look at two different equilibrium situations and see what the difference is. We will not worry for now about how the market moves from one equilibrium to another, what we are doing is known as comparative statics.

First we will look at what will happen when supply in the market increases.

We can see that it is pretty obvious that the price of the apartments will fall. The opposite is also true though, if supply were to decrease than prices would rise. This is a very basic and obvious change. We can also look at more complicated changes that could happen as well. The textbook uses the example of what might happen if some of the apartments were converted into condominiums. The first obvious thing that will happen is the supply of apartments will fall. However this is not necessarily the only change that will take place in the market. There is the question of who is going to buy the condos. In our model it is conceivable that the people who will buy the condos are those that are willing to pay the most for apartments, in other words people who were living in inner apartments already. If all of the people who buy condos used to live in inner apartments then there will be no change in price as both supply and demand for apartments will fall equally.

This shows that it is important not just to look at how the supply side changes but also at how the demand side changes. The reality is that most likely there will be some people who used to live in apartments that will buy condos and some people who didn’t live in apartments who buy condos. This means that prices will most likely rise for rent, but by less than people might think.

We can also look at another interesting example given in the textbook, that of a unit tax on the apartments. So now each landlord needs to pay $50 a year for each apartment. What would this do to the price of the apartments? The usual assumption that people make is that some of the tax will be paid by the landlord and some will be passed along to the consumer. However if we look at our model, keeping the assumption of the short run, we will find out that is not actually true.

It is actually fairly easy to see that prices will not actually change, the landlord will absorb the entire tax. If we look at our model, the supply curve is not changing, there are still the same number of apartments as before. The demand curve is also not changing. If neither the demand curve, nor the supply curve shift, then there will be no change in price.

From a logical point of view it is pretty easy to see this as well. Before the tax each landlord was charging the maximum price that they could to keep all of their apartments rented. After the tax, this is still the case. If the landlords try to raise the price in order to transfer some of the cost of the tax what will happen is the consumers at the margin will drop out of the market and move to outer apartments. This means that not all of the apartments will be rented and the landlords will lose money. This for now is assuming that supply is fixed and the landlords are unable to do anything else with them, it is also functioning off of the assumption that the landlords do not have any costs with the apartments. In the long run where supply can change, this will not hold true.

Now that we have done a bit of analysis of the competitive market we can look at other ways of allocating apartments and how that will change the price and who gets which apartment. Following the textbook we will look at three other ways in which we could allocate the apartments, the discriminating monopoly, the ordinary monopoly and rent control.

A monopoly could either be a single dominant landlord or it could be a number of individual landlords getting together and coordinating their actions to act as one. For this example let’s say that instead of a normal renting procedure, the landlord decides to auction off the apartments. This means that each person will be paying a different price for an apartment. This is called a discriminating monopolist. Right now for simplicity we will assume that the landlord has perfect information. That is, that he knows the reservation price for each person.

In this situation what the landlord will do then is rent out each apartment to each person at his or her reservation price. What is interesting about this is that the exact same people who got the apartments in the competitive market will get the apartments in this situation. The last person to rent an apartment in this situation will in fact be paying P*, the market equilibrium price. So people will pay more money for their apartments but the same number and same people will all rent the apartments as before.

Now let’s look at a situation with an ordinary monopoly, this means that everyone will be charged the same price. Now the landlord faces a dilemma. He can set a low price and rent out all of his apartments or he can set a higher price and rent out less apartments but he may make more money. If we use D(p) to represent the demand function, which is the number of apartments that will be demanded based on the price. Then if the monopolist sets a price P, he will rent D(P) apartments and receives a revenue of P * D(P) or PD(P). The revenue can be thought of graphically as a box, where the height of the box is P and the width of the box is D(P). The area of the box is thus the revenue. If the monopolist has no costs, than he will want to maximize revenue and so choose the biggest box that he can. As can be seen, this will not always be at the equilibrium price.

 

In fact usually in a monopoly it is best to restrict the output and charge a higher price. So in the case of the ordinary monopoly, the price will be higher and fewer apartments will be rented as compared to the competitive market.

Finally let’s look at the case of rent control. This is where the government decides on a maximum amount of rent that can be charge for an apartment. In this situation we would have an excess of demand. Which means more people want apartments than are available. This begs the question, who will end up with an apartment? As it stands our model is unable to answer this question. There are really too many factors right now that would determine this to add to our model. So people who get the apartments will depend on how much time a person spends looking around, who knows current tenants, relationship with the landlord, and many other factors.

To make things simpler let’s just make the assumption that some of the people who had inner apartments before will have them now and some people who had outer apartments before will now have inner apartments and vice versa. The same number of apartments will be rented as in the competitive market just different people will have them. At least that is the situation in the short run.

We have now discussed four different ways to allocate the apartments, competitive market, discriminating monopolist, ordinary monopolist and through rent control. So which of these is the best way to allocate the apartments? It can be difficult to define best but here we will look at the economic positions of the people involved.

The landlords definitely end up in the best position if they are able to act as discriminating monopolists. This would maximize their revenue. Similarly the rent controlled situation is probably the worst for them.

The situation with the tenants is a little more complicated. Under the discriminating monopolist they will definitely be paying more money than under any of the other systems. However under the ordinary monopolist less people will get inner apartments than under the other systems. Finally under rent control some tenants will be better off, those who have inner apartments that otherwise would have had outer apartments. However the tenants who now have outer apartments but would have had inner apartments under the other systems are now made worse off. This shows that it is very difficult to determine which the best way is. One way that economists try to do this is to use the idea of Pareto efficiency.

If we are able to make some people better off without making anyone else worse off, we have a Pareto improvement. If we have a situation when we are unable to make any Pareto improvements, we say that the situation is Pareto efficient.

One way to think of Pareto efficiency in terms of our model is to look at the following situation. Suppose that who gets which apartment is decided by lottery. We then allow tenants to sublet their apartments to other people. If there are two people, person A that is assigned an inner apartment that he has a reservation price of $200 for, and there is person B that is assigned an outer apartment but has a reservation price of $300 for an inner apartment, then there is room for a Pareto improvement.

If person A trades apartments with person B, and person B pays person A some amount of money, both people are made better off, and no one is made worse off. In our model, what is important is that the people who have the highest reservation prices are the ones that get the inner apartments. This is because if people with low reservation prices get them, than there can be voluntary trade that makes both parties better off. Before we talked about efficiency as being when all gains from trade are maximize. We can see now that when all voluntary trades have been carried out, the situation will be Pareto efficient.

We can now use the idea of Pareto efficiency to look at our four ways of allocating the apartments. If we start with the competitive market we can see that since all voluntary trade is carried out, the situation is Pareto efficient.

If we look at the discriminating monopolist we can actually see that this is also Pareto efficient. The exact same people as in the competitive market get the apartments, and no one can be made better without making someone else worse off.

If we look at the ordinary monopolist we will see that this is not a Pareto efficient outcome. The reason for this is that all the apartments are not rented. As such the landlord could make more profit by renting a vacant apartment to another person at any positive price. Now the monopolist would only be able to do this if the other tenants were alright with people paying different prices. However as soon as that is the case we have a discriminating monopoly and not an ordinary monopoly. As such the ordinary monopoly is not Pareto efficient.

Finally we can look at rent control. We can immediately see that this is not Pareto efficient. If we look back to our example of person A and person B we can see why. Under rent control some people will have high reservation prices but be unable to get inner apartments. If we allowed voluntary trade then people would be able to trade and make at least one person better off, without making any one else worse off.

Everything that we have been talking about so far has been in the short run. However we do have to take a quick look at the long run as well because this is what will determine the supply. In the long run, supply of apartments will depend on how profitable it is for landlords to rent apartments as such, each situation will change the supply in the long run.

For today we have covered the simple model of apartments. The important idea of Pareto efficiency was introduced as well. Today was my first time introducing diagrams and I will try to go back over time and add more diagrams to my other posts.

Introduction to Summer Study

June 10, 2013

Over the course of my experience with education I have struggled over and over with motivation and procrastination. This summer I have decided to prove to myself that I can overcome these issue by writing a daily blog that reviews all of my economic studies starting at first year. I am looking to not only post notes from my studies but also discuss what I think of them as well as find interesting issues that are happening and attempt to discuss them within an economic framework. I welcome insight from other people as well as any corrections that need to be made. I am not perfect and this is meant as a learning opportunity. As such, I will make mistakes and I always appreciate constructive feedback.

I am starting with first year microeconomics and am using the textbook “Economic Principles: Seven Ideas for Thinking about Almost Anything” by Douglas Allen. I am using this textbook for two reasons, the first is that it was what I used in my first year course and the second is because I have it readily available to me. While I do not always completely agree with everything that is stated in the textbook it will serve as an outline to follow as I work my way through the material. I will try to discuss two chapters a day from the textbook, although today I will be starting with the first three as the first chapter is short and just an introduction to economics as a course of study. Towards the end of the textbook I may slow down depending on how much time I want to take with each economic concept in order to completely understand it for myself.

The discussion today will focus on what Professor Allen calls the first two principles of economics, maximization and substitution. In addition to that, there will be some discussion of what economics actually is as well as the ideas that go along with both maximization and substitution. As this is looking at the ideas through the first year course, a lot of these concepts will be greatly simplified.

To start off with I will talk about what economics actually is. The textbook defines economics as “A particular way of thinking about behavior.” I find this interesting as most textbooks define economics as the study of allocation of scarce resources. The textbook definition defends this by arguing that how people allocate scarce resources is their behavior and so both definitions are the same. While I find this convincing, I feel that the textbook definition is much too general as it could apply to any of the social sciences and many fields of study outside of that. As such, for myself, I will stick to the classic definition of economics as the study of scarce resources.

In order to talk about scarce resources I will have to define scarcity. Scarcity is when if a goods price is set to zero, in other words it is free, more will be desired than what is available. Scarcity is what forces us to make choices as if goods were not scarce we would not have to choose between them. It also forces prices to be positive (above zero) and as such is a core idea in economics.

To illustrate that it forces prices to be above zero, imagine the following scenario. Two people want one item, lets say a mug. The mug is being given away by a third person so who gets the mug? What would normally happen is person 1 would say I will give you $1 for the mug. In response person 2 would say I will give you $2. This will continue on until the price of the mug is equal to the value for the person who wants it the most. In this way scarcity makes prices positive.

In order for economists to study what they wish to, like many other areas, they make models. An economic model should satisfy four general criteria.

1. It should be formal, that is it should be clear about its assumptions.

2. It should be testable, in other words, it should be able to be proven wrong.

3. It should be simple and have a clear purpose.

4. Finally, it should hold consistent to the general facts about the world.

One of the key necessities in economic models for simplicity’s sake is that we make assumptions about the world.

One of the main assumptions that economics makes is that people are fundamentally the same. This is not the same as saying the people are all identical in all aspects but instead is just saying that people primarily want the same things. Around the world people want food and shelter, good health and security, and in general a better life for their children. There are other things as well that people all have similar motivations for.

Another assumption that economics makes has to do with the first principle in the textbook, that of maximization. According to the textbook maximization is the idea that “all individuals are motivated by greed.” Greed and self-interest are the same thing according to the textbook and as such any economist who says that individuals are self-interested is really just saying that people are greedy. I disagree with this statement though and to show what I mean I will give the definitions of both words from the Merriam-Webster dictionary. According to the dictionary greed is defined as a selfish and excessive desire for more of something than is needed. Self-interest however is defined as a concern for one’s of advantage and well-being. I believe that this second idea is much closer to what economists believe. Most definitions about greed define it as being excessive or abnormal whereas self-interest does not. As the textbook itself says more is not always better. So for my own purposes I will define maximization as the idea that all individuals are motivated by their own self-interest.

When both firms and individuals follow the idea of maximization we end up in an equilibrium. In economics an equilibrium is a situation in which no one wants to change their behavior. This is defined as people at equilibrium are indifferent. Indifferent according to the textbook is defined as “letting someone choose for you.” While this works as a general understanding of indifference it is not really a strict definition and so I am not a big fan of this definition. In economics indifference means that an individual receives the same utility between all of the options. In this sense someone could choose any of them for you and you would receive the same amount of utility as if they had chosen any other option. Utility in economics is a representation of preferences over some set of goods and services. It is the idea that you receive satisfaction from these things.

In order for a person to be indifferent they are required to have a choice. In economics substitution is the idea that everyone is willing to trade some amount of good for some amount of another. In other words people are willing to substitute one good for another. Substitution does not specify quantities it just says that there is some quantity that one would be willing to trade at even if it is very high.

People use substitution in order to trade-off quantities of one good for quantities of another. This way you can get different bundles of goods in order to maximize your utility. In order to trade there has to be a difference between the marginal values of the people involved.

Marginal value is the maximum amount of one good an individual is willing to sacrifice in order to obtain one additional unit of another good. Without marginal value we could not have trade. Some misconceptions that are often stated are that trade always involves one party with a surplus and that trade involves exchanging items of equal value. While trade can involve people with a surplus it does not need to. As for items of equal value, that would make trade very difficult as if people view what they are giving away as having the exact same value as what they are getting that will make them indifferent to the trade and as such they will have no incentive to participate it in. Instead what happens is that people with differing marginal values get together and so are able to trade with each other.

Economics textbooks tend to use the example of two people with two goods and so I will give an example here. We have two people Mark and Suzie and they have apples and oranges in differing quantities:

Mark	Suzie
3 apples, 12 oranges	6 apples, 6 oranges
4 apples, 7 oranges	7 apples, 4 oranges
5 apples, 3 oranges	8 apples, 3 oranges

Each person has three bundles which they are indifferent about, in other words they don’t care which bundle they have. These bundles are just given to them and they are able to get any of these bundles without trading with each other.

If we say that each person has the middle bundle then we can see how they can be made better off through trade. Mark will have 4 apples and 7 oranges and he is willing to trade 4 more oranges for 1 apple. This means that the apple has a marginal value of 4. Suzie meanwhile is willing to trade 1 apple for 2 oranges. So the apple to her only has a marginal value of 2.

If Mark gives Suzie 3 oranges and she gives him 1 apple, both of them are made better off than if they had not traded as Mark ends up with 5 apples and 4 oranges and Suzie ends up with 6 apples and 7 oranges. This demonstrates how voluntary trade can be mutually beneficial.

According to the textbook voluntary trade is mutually beneficial to all parties involved and I believe that this is a key concept that I want to talk about for a little bit. The key concept here is that the trade must be voluntary. There are situations where people are involved in a trade between third parties and as such have no say, in these cases the trade is not voluntary for those people and often the trade is not beneficial.

This is a summary of the talking points in the first three chapters of the textbook and I hope that I have explained and summarized it accurately. I will be posting again tomorrow about the next two chapters and will in the future hope to talk about other things such as economic books and what is going on in the news. Feedback is always appreciated.