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The Theory of Economics does notfurnish a body of settled conclusionsimmediately applicable to policy. It isa method rather than a doctrine, anapparatus of the mind, a technique ofthinking which helps its possessor todraw correct conclusions
--- John Maynard Keynes
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Economic Modeling
• What causes what in economic systems?
• At what level of detail shall we model an economic phenomenon?
• Which variables are determined outside the model (exogenous) and which are to be determined by the model (endogenous)?
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Modeling the Flat Rental Market
• How are flats/apartments rents determined?
• Suppose – flats are close or distant, but otherwise identical– distant flats rents are exogenous and known– many potential renters and landlords
• Price of close flats is endogenous.
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An Economist’s concerns: Modeling the Apartment Market
• Who will rent close apartments?
• At what price?
• Will the allocation of apartments be desirable in any sense?
• How can we construct an insightful model to answer these questions?
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Economic Modeling Assumptions
• Two basic postulates:– Rational Choice: Each person tries to choose
the best alternative available to him or her.– Competitive Equilibrium: Market price adjusts
until quantity demanded equals quantity supplied.
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Solving:
• What does the demand curve look like?
• Supply curve.
• Equilibrium.
What if there isn’t a competitive equilibrium?
(If there is Monopolist or Rent Control)
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Discrete Demand
• If Jack has a willingness to pay of £300, what does that mean.
• Can get far flat at £200. With £100, travel and inconvenience costs.
• If p>300, he won’t buy.• If p<300, he would buy and
get surplus of:
Sample Demand
Bill 200
Sam 100
George 300
Pete 400
Ted 200
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Pareto Efficiency/Optimality
• Vilfredo Pareto; 1848-1923.
• A Pareto outcome allows no “wasted welfare”;
• i.e. the only way one person’s welfare can be improved is to lower another person’s welfare.
• You can’t make someone better off without making someone else worse off.
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Pareto Optimality/Efficiency
• An allocation is a possible distribution of goods in the economy.
• An allocation is Pareto optimal if there does not exist another allocation where no one is worse off and at least one person is strictly better off.
• Bill & Ted have £10 between them. What are the P.O. allocations?
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Pareto Efficiency
• Jill has an apartment; Jack does not.
• Jill values the apartment at $200; Jack would pay $400 for it.
• Jill could sublet the apartment to Jack for $300.
• Both gain, so it was Pareto inefficient for Jill to have the apartment.
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Pareto Efficiency
• Competitive equilibrium:– all close flat renters value them at the market
price p* or more– all others value close apartments at less than p*– so no mutually beneficial trades remain– so the outcome is Pareto efficient.
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Pareto Efficiency
• Discriminatory Monopoly:– assignment of flats is the same as with the
perfectly competitive market– so the discriminatory monopoly outcome is also
Pareto efficient.
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Pareto Efficiency
• Monopoly:– not all flats are occupied– so a distant flat renter could be assigned a close
flat and have higher welfare without lowering anybody else’s welfare.
– so the monopoly outcome is Pareto inefficient.
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Pareto Efficiency
• Rent Control:– some close flats are assigned to renters valuing
them at below the competitive price p*
– some renters valuing a close flat above p* don’t get close flats
– Pareto inefficient outcome.