Title: 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 ---
1 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
2Economic 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)?
3Modeling the Flat Rental Market
- How are flats/apartments rent 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.
4An Economists 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?
5Economic 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.
6Solving
- What does the demand curve look like?
- Supply curve.
- Equilibrium.
- What if there isnt a competitive equilibrium?
- (If there is Monopolist or Rent Control)
7Discrete 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 pgt300, he wont buy.
- If plt300, he would buy and get surplus of
- Sample Demand
- Bill 200
- Sam 100
- George 300
- Pete 400
- Ted 200
8Pareto Efficiency/Optimality
- Vilfredo Pareto 1848-1923.
- A Pareto outcome allows no wasted welfare
- i.e. the only way one persons welfare can be
improved is to lower another persons welfare. - You cant make someone better off without making
someone else worse off.
9Pareto 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?
10Pareto 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.
11Pareto 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.
12Pareto Efficiency
- Discriminatory Monopoly
- assignment of flats is the same as with the
perfectly competitive market - so the discriminatory monopoly outcome is also
Pareto efficient.
13Pareto 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 elses welfare. - so the monopoly outcome is Pareto inefficient.
14Pareto 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 dont
get close flats - Pareto inefficient outcome.
15Housemates problem
- Bill and Ted rent an apartment together for 400.
- There is a large room and a small room.
- Bill values the large room 100 more than the
small room and Ted values the large room 20
more. - Which allocations are Pareto Optimal?
- How will they divide up the rent?
16Envy-Free Allocations
- An allocation is envy free if neither party is
willing to swap situations. - For instance, Todd and Will Young are in
envy-free allocations. - What are the Envy-Free allocations of the
previous example?
17Envy Free Example
- If Bill gets the large room,
- Rent is B T.
- Rent must be paid BT400
- Bill must not envy Ted 100-Bgt-T
- Ted must not envy Bill Tgt20-B
- Show that B must be between 210 and 250 with
T400-B. - If Ted gets the large room,
- ???
- Are the Envy-Free allocations Pareto optimal?