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

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)?

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.

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?

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.

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)

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

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.

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?

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.

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.

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.

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.

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.