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
Market Demand

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)
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

Market Supply

100

QS

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

COMPETITIVE MARKET
EQUILIBRIUM
p

100

QD,QS

COMPETITIVE MARKET
EQUILIBRIUM
p

pe
100

QD,QS

COMPETITIVE MARKET
EQUILIBRIUM
p
People willing to pay pe for
close apartments get close
apartments

pe
100

QD,QS

COMPETITIVE MARKET
EQUILIBRIUM
p
People willing to pay pe for
close apartments get close
apartments
People not willing to pay
pe for close apartments
get distant apartments

pe
100

QD,QS

COMPETITIVE MARKET
EQUILIBRIUM
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

pe
100

QD,QS

MARKET EQUILIBRIUM
p

Higher demand

pe
100

QD,QS

MARKET EQUILIBRIUM
p

Higher demand causes higher

market price; same quantity
traded

pe

100

QD,QS

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

MARKET EQUILIBRIUM
p

pe
100

QD,QS

MARKET EQUILIBRIUM
p

Higher supply

pe
100

QD,QS

MARKET EQUILIBRIUM
p

Higher supply causes a

lower market price and a
larger quantity traded

pe
100

QD,QS

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

MARKET EQUILIBRIUM
p

pe
100

QD,QS

MARKET EQUILIBRIUM
p

Higher incomes cause

higher willingness-to-pay

pe
100

QD,QS

MARKET EQUILIBRIUM
p

Higher incomes cause

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

pe

100

QD,QS

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

Low price, high quantity

demanded, low revenue

Low
price
QD

MONOPOLISTIC MARKET
EQUILIBRIUM
p
High
price

High price, low quantity

demanded, low revenue

QD

MONOPOLISTIC MARKET
EQUILIBRIUM
p

Middle price, medium quantity

demanded, larger revenue

Middle
price

QD

MONOPOLISTIC MARKET
EQUILIBRIUM
p

Middle price, medium quantity

demanded, larger revenue
Monopolist does not rent all the
close apartments

Middle
price

100

QD,QS

MONOPOLISTIC MARKET
EQUILIBRIUM
p

Middle price, medium quantity

demanded, larger revenue
vacant close
apartments

Middle
price

100

Monopolist does not rent all the

close apartments

QD,QS

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
p1 =$500

100

QD,QS

DISCRIMINATORY MONOPOLISTIC
MARKET EQUILIBRIUM
p
p1 =$500
p2 =$490

12

100

QD,QS

DISCRIMINATORY MONOPOLISTIC
MARKET EQUILIBRIUM
p
p1 =$500
p2 =$490
p3 =$475

1 23

100

QD,QS

DISCRIMINATORY MONOPOLISTIC
MARKET EQUILIBRIUM
p
p1 =$500
p2 =$490
p3 =$475

1 23

100

QD,QS

DISCRIMINATORY MONOPOLISTIC
MARKET EQUILIBRIUM
p

Discriminatory monopolist
charges the competitive
market price to the last renter

p1 =$500
p2 =$490

Quantity of close apartments

rented is the same as in the
competitive market

p3 =$475

pe
1 23

100

QD,QS

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

MARKET EQUILIBRIUM
p

pe
100

QD,QS

MARKET EQUILIBRIUM
p

pe
pmax
100

QD,QS

MARKET EQUILIBRIUM
p

Excess demand

pe
pmax
100

QD,QS

MARKET EQUILIBRIUM
p

The 100 close apartments are

no longer allocated by
willingness-to-pay (lottery, lines,
large families first, friends of JC
first)

Excess demand

pe
pmax
100

QD,QS

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