Consumer Preferences Part 2

Today’s post is on the second part of people’s preferences. This is a continuation of the post the day before yesterday. Yesterday’s post was missed because I was sick but hopefully I am feeling better now and will continue for the rest of the posts this week.

To start off with we will work on perfect complements. Perfect complements are goods that are consumed together in fixed portions. A good example of this is right and left shoes. People like shoes but they always wear left and right shoes together. Having only one shoes instead of both does the consumer no good. The indifference curve for perfect complements looks like this.

If we take a bundle of shoes say (2, 2) the consumer will gain a certain amount of utility from that bundle. Now if we add one more shoe so the bundle is (3, 2) the consumer will be indifferent because they will be no better off than they were before. In fact if the bundle gets changes to (10, 2) or (2, 10) the consumer will still be no better off. The only way they are made better off is when both goods increase at the same rate.

The important thing about perfect complements is that the consumer prefers to consume the goods in fixed proportions, not necessarily that the proportion is one to one.

A bad is a commodity that the consumer doesn’t like. An example of this would be if a person like some toppings on a pizza but didn’t like others, such as pepperoni and anchovies. The consumer may like pepperoni but not anchovies, however there may be some amount of pepperoni that would compensate the consumer for having to consume a given amount of anchovies.

First we pick a bundle (x₁, x₂) consisting of some pepperoni and anchovies. If we give the consumer more anchovies, we have to give the consumer more pepperoni to compensate them. Thus the consumer has an indifference curve that slopes up and to the right as in the following.

There are also neutral goods.  A neutral good is a good that the consumer doesn’t care about one way or the other. If we take our previous example of the anchovies and pepperoni we can change it so that instead of the anchovies being a bad, instead the consumer is now just neutral towards them. In this case the indifference curve will just be vertical lines. Increasing the amount of anchovies will not take away from the enjoyment of the consumer but neither will it add to it.

There is also satiation for consumers. This is where there is some overall best bundle for the consumer and the closer they get to that best bundle the better off they are in terms of their own preferences. We assume that the consumer has some most preferred bundle of goods (x-bar₁, x-bar₂), and the further away from the bundle the worse off they are. X-bar is usually written as an x with a line over it, I was unable to find a symbol that works here so I will just write it out as x-bar. In this case we say that (x-bar₁, x-bar₂) is a satiation point and the indifference curve looks like the following.

In this case, the indifference curves have a negative slope when the consumer has too little or too much of both goods and a positive slope when he too much of one good.

There is also the case of discrete goods. For most goods we consume, we think of measuring goods in units where fractional amounts make sense. Over the period of a month you will consumer so many litres of water for example. Sometimes though we want to examine preferences over goods that naturally come in discrete units.

A good example of this is a consumer’s demand for cars. While we could define the demand for cars in terms of the time spent using a car, this would give us a continuous variable. For a lot of people though it is the actually number of cars demanded that is of interest.

We can use our preference model that we have used previously to describe the behaviour of consumers in this situation the same as we do for anything else. Just like in other circumstances we can use x₁ and x₂. x₁  in this situation would be the discrete good and x₂ will be money, or everything else. The indifference curve for this would look like the following, with the other graph showing the bundles that are weakly preferred.

Usually unless the consumer is consuming only a very small amount of a good, it will be more useful to think about most goods as if they are continuous. As we have looked at several different types of preferences, however it is most useful to focus on a few general shapes of indifference curves. We make some assumptions about these, and with these assumption we call them well-behaved indifference curves.  The assumptions are as follows:

1. We assume monotonicity of preferences. This is basically that we assume more is better. Specifically we are talking about goods and not bads. As we discussed in satiation, there is probably a point where this does not hold, however we will assume that what we are examining are situations before that point is reached.
2. We assume that averages are preferred to extremes.

Using these two assumptions most indifference curves will look like the following.

This are some of the basic ideas behind consumer preferences, there is more to come and reality is definitely more complicated than we would like, but this gives us some basic tools to analyze consumer preferences. A key thing to remember is that preferences are generally thought of as over a time period, so our desire for something over a day, a week, or a year. As such this makes them behave differently than if we were just looking at them at a specific time.

Consumer Preferences Part 1

The post today is on chapter three of the textbook which is all about preferences. The idea of consumer preferences is what economists mean when they talk about people acting in their own self-interest. In the last chapter we talked about how consumers look for the best thing that they can afford. Talking about what consumers are able to afford was what the last chapter was about and this chapter is about what we consider to be the “best thing”.

When we talk about consumer choice we need to talk about consumption bundles. Consumption bundles are a complete list of goods and services that are involved in the choice problem we are investigating. When we say that it is a complete list that is what we mean. We need to make sure that we are including all of the appropriate goods in the definition of the consumption bundle. It is also important when we are discussing consumption bundles to not only look at a complete list but to also consider when, where, and under what circumstances they would become available.

These things are important and it can sometimes be better to think of the same good in different circumstances as a different good. An example of this is an umbrella when it is raining will be valued more than when it is not. In this case it might be more useful to actually think of them as two separate goods.

We are still able to use our two good model however for this when looking at simple choice problems simply by looking at one good as what is relevant in the choice and the other good as everything else.

When we look at two consumption bundles we assume that the consumer can rank them as to their desirability. So if a consumer has a choice between two bundles (x₁, x₂) and (y₁, y₂) they would be able to say whether they preferred one bundle to another or whether they are indifferent.

We use the symbol > to mean that one bundle is strictly preferred to another, so that (x₁, x₂) > (y₁, y₂) should be interpreted as saying that the consumer strictly prefers (x₁, x₂) to (y₁, y₂), in the sense that they would definitely want the x-bundle rather than the y-bundle.  If the consumer is indifferent between two bundles we use the notation =. The symbols are a little bit different if we were writing them out but for the purposes of the blog this is the best I can do. If a consumer weakly prefers one consumption bundle to another then we use the symbol ≥. So in short

> means strictly preferred

= means indifferent

≥ means weakly preferred.

These are also not independent concept but these are all related. For example if we know that a consumers preferences for two bundles are the following. (x₁, x₂) ≥ (y₁, y₂) and (y₁, y₂) ≥ (x₁, x₂) then we know that (x₁, x₂) = (y₁, y₂).

Economists usually make some assumptions about the consistency of consumers’ preferences. For example it seems unreasonable to have a situation where (x₁, x₂) > (y₁, y₂) and at the same time (y₁, y₂) > (x₁, x₂). This would be saying that the consumer strictly prefers the x-bundle to the y-bundle, and that the consumer strictly prefers the y-bundle to the x-bundle. We end up making some assumptions about how preference relations can work. Some of the assumptions about preferences are so fundamental that we can refer to them as axioms of consumer theory. The textbook lists three of these axioms.

1. Complete. We assume that any two bundles can be compared. That is given any x-bundle and any y-bundle, we assume that (x₁, x₂) ≥ (y₁, y₂), or (y₁, y₂) ≥ (x₁, x₂), or both, in which case the consumer is indifferent between the two bundles.
2. Reflexive. We assume that any bundle is at least as good as itself. (x₁, x₂) ≥ (x₁, x₂).
3. Transitive. If (x₁, x₂) ≥ (y₁, y₂) and (y₁, y₂) ≥ (z₁, z₂), then we assume that (x₁, x₂) ≥ (z₁, z₂). In other words, if the consumer thinks that X is at least as good as Y and that Y is at least as good as Z, then the consumer thinks that X is at least as good as Z.

When we want to represent a consumers preference choices graphically we draw an indifference curve. An indifference curve is exactly what it sounds like. If we take a list of bundles for which the consumer is indifferent about and draw a line through them. This is the indifference curve. All of the bundles above it are called the weakly preferred set.

We are able to draw an indifference curve through any consumption bundle we want. This is because the indifference curve through a consumption bundle consists of all bundles of goods that leave the consumer indifferent to the given bundle.

One of the important part of indifference curves is that they cannot cross. More specifically, indifference curves representing distinct levels of preference cannot cross. Like the figure below.

The reason for this has to do with something that we mentioned before about consistency. If we take the three bundles in the graph, X, Y and Z we now want to compare them. X lies on one indifference curve, Y on another and Z at the intersection. As Z is on both indifference curves we know that X = Z and Y = Z, by the property of transitivity that means that X = Y. However since they are distinct indifference curves we can see that X (or Y) should be strictly preferred to Y (or X). These two things contradict each other. There are several different types of preferences that people can have.

One type of preference is if two goods are perfect substitutes. This means that the consumer is willing to substitute one good for the other at a constant rate. The simplest case being when a consumer is willing to substitute a good at a one to one ratio. An example of this would be blue and red pencils.

If the consumer has no preference over colour then the red pencils and blue pencils are perfect substitutes. If we have a bundle of pencils which is (10, 10) or ten red and ten blue pencils than any other bundle that has 20 pencils in it the consumer will be indifferent about. When we draw it graphically it will look like this.

The important fact about perfect substitutes in that the indifference curves have a constant slope. There are several other types of consumer goods with different preferences and I will be moving on to them tomorrow. I apologize for the lack of updates the last couple of days. I am starting to find myself struggling with concentrating on this. However I am trying to move through it and just post as much as I can. See you tomorrow.

Budget Constraints

This post will be on chapter 2 of the textbook which talks about budget constraints. I would like to apologize for the lack of post yesterday. This week has been very difficult for me to keep motivated and work on my studying. Today I woke up though and I just said to myself that I would go for a walk, clear my head and work. I am not trying to make up for lost time this week, I am just going to pick up where I left off and continue working.

To sum up the economic theory of the consumer is very simple. Economists assume that consumers choose the best bundle of goods they can afford. This deals with some vague terminology that we have to define more carefully in order to study it. First off is what is meant by what a consumer can afford. The next chapter in the textbook talks about what is meant by best.
So now we want to examine what we mean by what a consumer can afford. This has to do with the concept of the budget constraint. People consumer all sorts of things and this can be very difficult to study. When we look at some set of goods that a consumer can choose from we want to do some things to make it a little easier to study. The main thing that economists do is simplify what a consumer can choose from down to two goods. When we only deal with two goods we are then able to display the consumer’s preferences graphically.
While there can be some problems with the two good assumption it works fairly well. The reason for this is that you can make the assumption that one good is a particular item and the second good can represent everything else. As such with two goods you are able to represent fairly accurately what choices a consumer might have in regards to a good. One of the tricks to do this is to say that good 2 is just money. This sets the price of good 2 to 1 and it is able to represent what you could spend on everything else.
We indicate the consumer’s consumption bundle by (x1, x2). This is simply numbers that tell us how much the consumer is choosing to consume of good 1, x1, and how much the consumer is choosing to consumer of good 2, x2. By adding in the prices of each of the goods, (p1, p2) and the amount of money the consumer has to spend, income (m). We can then write the budget constraint of the consumer as:

p1x1 + p2x2 ≤ m.

p1x1 is equal to the amount of money the consumer is spending on good 1.

p2x2 is equal to the amount of money the consumer is spending on good 2.

The budget constraint of the consumer requires that the amount of money spent on the two goods to be no more than the total amount the consumer has to spend. The consumer’s affordable consumption bundles are those that don’t cost any more than m. We call this set of affordable consumption bundles at prices (p1, p2), and income m, the budget set of the consumer.
When p1x1 + p2x2 = m we call it the budget line. These are the bundles of goods that just exhaust the consumer’s income.

If we want to rearrange the formula for the line to make it look more like the standard line for an equation in formation y = mx + b we can do that as well and it will look like this.
x2 = m/p2 – (p1/p2)x1.
In this form, m/p2 represents the vertical intercept and –p1/p2 represents the slope of the budget line. The formula tells us how many units of good 2 the consumer needs to consumer in order to just satisfy the budget constraint if they are consuming x1 units of good 1.
The slope of the budget line has a nice economic interpretation. It measures the rate at which the market is willing to substitute good 1 for good 2, alternatively you can also say that it measures the opportunity cost of consuming good 1.
Changes in the price of goods as well as changes in income all change the budget line. If we start with income it is fairly easy to see how income affects the budget line. If we look back at our equation we can see that income (m) affects the intercept but not the slope of the line. This means that a change in income will result in a parallel shift in the budget line.

Changes in price act a little bit differently though. If we increase the price of good 1 (p1) while holding the price of good 2 (p2) and income (m) constant then if we look at the equation we can see that it will not shift the vertical intercept but that it will change the slope.

If we change the price of both goods it gets slightly more complicated. If we increase the price of both goods by, let’s say, double. Than the slope will not change at all but both of the intercepts will change. If we look at our original budget line of p1x1 + p2x2 = m and multiply both prices by a constant t so that it becomes tp1x1 + tp2x2 = m, we can see that we could rewrite the equation as p1x1 + p2x2 = m/t. So multiply both prices by the same amount is the same as dividing the income by the same amount. So a change in both prices will change the budget line depending on how much the change in each price is compared to each other.
When we look at the budget line we can see that it is made up of two prices and one income. We can do some mathematical tricks though and peg one of the variables to some fixed value, and adjust the other variables to describe exactly the same budget set. Thus we can take the equation
p1x1 + p2x2 = m
with a bit of movement it is the exact same as
(p1/p2)x1 + x2 = m/p2
Or
(p1/m)x1 + (p2/m)x2 = 1
These all represent the same budget line but what we are doing is, in the first equation pegging p2 to 1 and in the second equation doing the same for income (m).
When we do this we refer to the price as the numeraire price. The numeraire price is the price relative to which we are measuring the other price and income.
There are other things besides changes in income and price that can affect a consumer’s budget set. Economic policy often this by taxes or subsidies.
There are a couple of different types of taxes and how the tax is implemented affects how it interacts with a consumer’s budget set. For example if there is a quantity tax this means that the consumer has to pay a certain amount for each unit of the good they purchase. From the consumer’s viewpoint this is basically just an increase in price. So a quantity tax of t dollars per unit of good 1 simply changes the price of good 1 from p1 to p1 + t. This will cause the budget line to get steeper.
Another kind of tax is a value tax. This is a tax on the value, or price, of a good rather than the quantity purchased. This would be what sales taxes are. Value taxes are also known as ad valorem taxes and they changed the price of the good as well. In the case of an ad valorem tax of τ on the price of good 1, the price of the good will change from p1 to (1 + τ)p1. τ is the Greek letter tau.
A subsidy is just the opposite of a tax and it operates in the same way just doing everything the opposite.
Another kind of tax or subsidy that the government can use is a lump-sum tax or subsidy. While quantity and ad valorem taxes tilt the budget line one way or the other, a lump-sum tax or subsidy shifts the budget line out or in.
Taxes and subsidies are not the only affect that the government can have on a consumer’s budget line. A government can also ration goods. This means that the level of consumption for some good is fixed to be no larger than some amount. Suppose for example that good 1 were rationed so that no more than x1* could be consumed by a given consumer. Then the budget set of the consumer would look like this.

Sometimes taxes, subsidies and rationing are all combined. For example perhaps over a certain level of consumption a good is taxed but under that it isn’t. In that case then the consumer’s budget set will look like the following.

A good example of these in real life is the food stamp program in the U.S. Using the information in the textbook I will outline the example they give.
Before 1979, households who met certain eligibility requirements were allowed to purchase food stamps, which could then be used to purchase food at retail outlets. In January 1975 for example, a family of four could receive a maximum monthly allotment of $153 in food coupons by participating in the program. The price of these coupons depended on the household income.
The pre-1979 Food Stamp program was an ad valorem subsidy on food. The rate at which the food was subsidized depended on the household income. The budget line of it would look like this.

After 1979 the Food Stamp program was modified. Instead of required that household purchase food stamps, they are now just given to qualified households. Suppose that now a household receives a grant of $200 of food stamps a month. This means that regardless of how much it is spending on other goods the budget line will shift to the right by $200. The slope of the budget line will not change. That will look like this.

This has been a brief look at budget sets of consumers, that is, looking at what is affordable for people. Tomorrow will be looking at what consumers want to consumer and how we figure that out.

Update July 9th

Today I was not feeling well, so I focused mainly on a couple of Econtalks. The first one can be found here http://www.econtalk.org/archives/2013/07/morris_fiorina.html. It was a very interesting talk on the state of the U.S. political parties and how they have changed and why. As well as looking at how the U.S. people have not changed as much as the parties have. The second talk can be found here http://www.econtalk.org/archives/2013/05/epstein_on_the_1.html. It is on the U.S. constitution and how it has affected the U.S.

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.

Update July 5th, 2013

Today I listened to two EconTalks that go together. Both of them are talking about a recent study done in the states that looks at the effects of Medicaid. The first one can be found here http://www.econtalk.org/archives/2013/05/frakt_on_medica.html and the second one can be found here http://www.econtalk.org/archives/2013/05/jim_manzi_on_th.html. Both podcasts talk about the statistics behind the study and why there can be problems with studies in general.

July 4th Update

Today as with the past couple of days I have really just worked on updating the glossary. I however did also listen to a fascinating econ talk that can be found here http://www.econtalk.org/archives/2013/07/munger_on_sport.html. Essentially the talk is using sports to talk about written rules, unwritten rules and how they affect us.

July 3rd Update

As you may has noticed I have not posted anything for the last two days. The reason for the lack of post on Monday was because as a Canadian, I took Canada Day off. As for the lack of post yesterday it was because I ended up feeling pretty sick. This week I am not going to be doing too much and instead of starting a new textbook like I was originally planning I will instead be doing editing and my previous posts as well as working to get the glossary that I added updated and working. In addition I will be listening to an econ talk each day. Today’s talk was with Bruce Schneier on Power, the internet and security. It can be found here http://www.econtalk.org/archives/2013/06/schneier_on_pow.html. The talk was very interesting and was discussing how technology has helped empower the powerless but has also given more power to the powerful as well. They discuss where this might possibly end up and what implications this has for the average person.

I will give another update tomorrow as well as a brief description of the next Econ Talk.

Glossary

Arc Elasticity: the average elasticity between two points on a demand curve

Avoidable Costs: Costs that will not be incurred if a particular activity is not performed.

Comparative Statics: comparing two static equilibria without worrying about how the market moves from one to the other.

Competitive Market: many producers and suppliers each interacting with each other.

Consumer’s Surplus: How much the consumer benefits from engaging in trade. Total value minus total expenditure.

Cross Price Elasticity: how the change in price of one good affects the quantity demanded for another good

Diminishing Marginal Value: what people are willing to give up for each additional unit of a good, declines the more one has of that good, all other things held constant.

Discriminating Monopoly: A monopoly which is able to charge different prices to different consumers.

Economics: The study of scarce resources

Endogenous Variable: A variable determined by the forces described in the model.

Equilibrium: a situation where no one wants to change their behavior

Exogenous Variable: A variable determined by forces outside of the model.

Extensive Margin: As price falls, people enter the market who were indifferent before.

Fixed Costs: A cost that does not change with an increase or decrease in the amount of goods or services produced.

Gains from Trade: consumer’s surplus plus the seller’s surplus.

Historical Cost: What you pay for something.

Income Elasticity: how much impact the change in income has on the quantity demanded of a good.

Indifferent: an individual receives the same utility for a set of options, you would be alright with letting someone else choose for you

Inferior Good: demand for the good decreases as income increases

Intensive Margin: As price falls people buy more of a good.

Law of Demand: there is an inverse relationship between a good’s price and the quantity demanded of the good, all other things being constant.

Marginal Value: the maximum amount of one good an individual is willing to sacrifice in order to obtain one additional unit of another good.

Maximization: All individuals are motivated by self-interest

Monopoly: A market dominated by a single seller of a product.

Nominal Income: The amount of money a person makes in dollars

Normal Good: demand for the good increases as income increases

Opportunity Cost: the value of the next best alternative.

Optimization Principle: People try to choose the best patterns of consumption that they can afford.

Ordinary Monopoly: A monopoly which is only able to charge one price.

Own Price Elasticity: how much impact the change in price has on the quantity demanded of a good.

Pareto Efficiency: when a situation is such that by making any changes at least one person would be made worse off.

Preferences:

Price Index: a normalized average of prices for a given class of goods or services in a given region, during a given time interval

Principles of Economics: maximization, substitution

Real Income: What a person can actually buy. Nominal Income divided by a price index.

Relative Price: The price of one good in terms of another good.

Rent Control: When a government sets the maximum price that can be charged for rent.

Reservation Price: The highest price that a given person will accept and still purchase the good. The maximum that someone is willing to and able to pay for a good.

Scarcity: Is when if the price for a good is set to zero (free), more of the good will be desired than what is available.

Seller’s Surplus: is equal to the total revenue minus their total value.

Substitution: everyone is willing to trade some amount of one good, for some amount of another good

Sunk Costs: a past cost that cannot be recovered.

Theorem of Exchange: All gains from trade are exhausted at the margin. In equilibrium there are no gains to be found from increasing or decreasing the quantity traded.

Total Expenditure: The price multiplied by the quantity for a set of goods.

Total Value: The maximum amount that one would be willing to pay for a given quantity of a good, rather than have none at all.

Utility: representation of preferences over some set of goods and services.

Variable Costs: A costs that varies with the amount of output produced.

EconTalk: Theory of Moral Sentiments Part 2

This post is following the series on EconTalk about The Theory of Moral Sentiments with Dan Klein and is talking about part one of the book.

The very first sentence in the book is “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and renders their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” This is just something that Smith takes for granted and that the reader accepts it. He does not try to prove this point but just takes this as given by nature.

Smith in the book seems to be showing his vision for a liberal society, with shared sympathy between people. Dan Klein sees the sympathy in the book, as not being mine or yours but as a mutually coordinated sentiment. This grows outward in all interactions and is what forms the basis for Smiths vision.

Smith also seems to differentiate between sentiment and passion. Klein sees passion as being active and sentiment as being more passive. Passion is what drives us to act as moral agents. Imagination is also something that plays a very central role as without imagination we would not be able to sympathize with other people and function as a moral agent.

While we sympathize with others and expect other to sympathize with us, we should not expect others to feel just as strongly as we do but realize that they will probably feel sympathy to us to a lesser degree than what we feel ourselves. Overwhelmingly Smith talks about our happiness not in strictly economic terms in terms of utility but as a function of how we are viewed by others. One of our responses to this is our modulation of our own emotions. This is the idea that if we are overly emotional in public of something this can reduce the sympathy that we receive from others. Russ Roberts points out that while this is still true it is a very eighteenth century idea of propriety. However even now as people if we feel that someone is over reacting to something, we are unable to as deeply sympathize with the person as we might otherwise be able to.

Smith seems very concerned about harmony between people. Klein sees the Wealth of Nations as an attempt by Smith to inform people and try to get people’s opinions on the same page so that people can be more harmonious with other people. Roberts comments that he is very struck with Smith’s account of the aesthetics and how when you try to share something with someone else, such as music or a novel and the other person doesn’t like it, this will affect you deeply. That interactions between people in regards to aesthetics can lead to disharmony when people have different views on them.

Sympathy towards an action comes from the motive of the agent as well as from the reception that the action receives. This to Klein, is in part helped by local knowledge which helps us to understand and even know what the motivations behind an action are.

Roberts says that for most of the book Smith is try to just remark on the observations and not try to say what ought to be, but is trying to look at what is. Klein seems to disagree a bit and say that the whole work is Smiths expression of what he feels ought to be, he is expressing his sensibilities about the big picture. Klein feels that later economists have forgotten that and have missed out on expressing what their own sensibilities about what the big picture of the good life is. Instead they are trying to be scientists in economics. When we are partial about something though we have a harder time modulating our sentiments and taking a look at the bigger picture.

Klein remarks that when Smith was talking about harmony, he was not saying that it is perfect and Klein even quotes Smith as saying “Though they will never be unisons, they may be concords, and this is all that is wanted or require.” So people don’t need to think or feel the exact same thing but it works out better when they can feel or think in ways that are harmonious with each other.

This is most of what is talked about in part one section one of the book. I realized right at the end of writing this that all I had read when I started this podcast was part one section one, instead of the entirety of part one. As such I will leave the rest of part one for tomorrow and wrap up this blog here. The podcast for this section can be found here http://www.econtalk.org/archives/2009/04/klein_on_the_th_1.html