Chapter 1: The Market

Prof. Jesse Schwartz

Kennesaw State University

Fall 2010

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 Models

Nothing is less real than realism. Details are confusing. It is only

by selection, by elimination, by emphasis that we get at the real
meaning of things. – Georgia O’Keefe, painter, 1922

Economists study economic and other social phenomena using

models.

A model is a simpli…ed representation of the reality.

A good model, like a map, must strike a balance between

simpli…cation and detail.

A work-horse model economists use is the supply and demand model.

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 Example: The Market for Apartments Near the University

Fix the price of the apartments far away from the university.
This price is an an exogenous variable, outside of our model.
Other exogenous variables include the cost of transportation, incomes,
etc.

The price of the apartments close to the university is an endogenous

variable, a variable predicted by our model.

The number of apartments available in the area is another

endogenous variable.

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 Optimization, Equilibrium, and Scarcity
How do people behave in markets? How do markets work?

Two principles guide economists answers to these questions:

The optimization principle: People try to choose the best
consumption bundles that they can a¤ord.
The equilibrium principle: Prices adjust until the quantity of a good
demanded is equal to the quantity supplied.

Scarcity underlies both of these principles. Economics is generally

concerned with how society allocates its scarce resources:

People’s wealth and income is scarce.

People’s time is scarce.
Society’s minerals and energy sources are scarce.
The current state of technology is limited.

The ‡ip side of scarcity is that people have unlimited wants.

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 The Demand Curve

The demand curve describes the relationship between the number of

apartments that people want to rent and the price of the apartments.

Under usual circumstances, this relationship is negative: the higher

the price, the fewer apartments people want to rent.

In consumer choice theory, we will develop a model to show how a

consumer chooses her consumption bundle, a model that yields the
consumer’s demand curve.

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 The Demand Curve

price
6

demand curve

-
0 number of apartments

Figure 1.2 Demand curve for apartments.

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 The Supply Curve

The supply curve describes the relationship between the number of

apartments available for rent and the price. Under usual
circumstances, this relationship is positive.
In the theory of …rms, we will develop a model of how a …rm
formulates a supply curve.
In a competitive market, no individual agent has power to in‡uence
the market price.
In the short run, the supply of apartments is a constant.
In the long run, supply may change with price.
Applying the equilibrium principle,
— the market equilibrium price is at p ,
— where quantity demanded equals quantity supplied equals q .

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 The Supply Curve

price
6
supply curve

-
0 number of apartments

Figure 1.3 Short-run supply curve.

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 The Market for Apartments

price
6
supply curve

equilibrium

p r

demand curve

-
0 q number of apartments

Figure 1.4 Equilibrium in the apartment market.

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 Equilibrium in the Market for Apartments
Price p is the market equilibrium price.
When p > p , there would be an excess supply.
When p < p , there would be an excess demand.

Suppose the demand curve/function is D (p ) = 2000 2p, and

the supply curve/function is S (p ) = 1000.

To …nd the market equilibrium p , set D (p ) = S (p )

2000 2p = 1000
) p = 500
q = D (p ) = S (p ) = 1000

Comparative statics: How the equilibrium changes when various

aspects of the market change.
Increasing supply will shift the supply curve to the right.
Consequently, the equilibrium price will decrease.
J. Schwartz (Kennesaw State University) Chapter 1: The Market Fall 2010 10 / 13
 Comparative Statics

price
6
old
supply

old p r

demand curve

-
0 old q q

Figure 1.5 Increasing the supply of apartments.

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 Comparative Statics

price
6
old new
supply supply
-

old p r
? r
new p demand curve

-
0 old q new q q

Figure 1.5 Increasing the supply of apartments.

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 E¢ ciency

When the market is not competitive, the model described above may
not be suitable.
such as monopolistic market (discriminating and ordinary monopolist)
and rent control.
How do we evaluate whether an equilibrium is good or bad?
One way is to measure Pareto e¢ ciency, due to Vilfredo Pareto
(1848-1923).
If there is a way to make some agents better o¤ without making any
one worse o¤, then this is a Pareto improvement.
A situation that can be Pareto improved is Pareto ine¢ cient.
A situation that cannot be Pareto improved is Pareto e¢ cient.
A remarkable result:
competitive markets lead to Pareto e¢ cient outcomes.
ordinary monopolistic markets and rent control often lead to Pareto
ine¢ cient outcomes.
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