Lecture 1

Market Equilibrium & Budget
Constraints
Dr Seefat-E-Rabbi Khan
Email: seefat-e-rabbi.khan@city.ac.uk
City, University of London: Department of Economics

Economic Modeling
• A model is a simplified representation of reality.
• When developing an economic model, we need to think about:
o What causes what?
o At what level of detail shall we model an economic
phenomenon?
o Which variables are determined outside the model
(exogenous), and which are to be determined by the
model (endogenous)?
Copyright © 2019 Hal R. Varian

Modeling the Apartment Market – 1
How are apartment rents determined?
Suppose:
• Apartments are close or distant, but otherwise identical.
• Distant apartments’ rents are exogenous and known.
• There are many potential renters and landlords.

Modeling the Apartment Market – 2
• Who will rent apartments?
• At what price?
• Will the allocation of apartments be desirable in any sense?
➢ Can we construct an insightful model to answer these

questions?

Economic Modeling Assumptions
Two basic principles:
• Optimisation: Each person tries to choose the best

alternative available to him or her. Each person will do what
is in his or her own best interest given what is affordable.
• Equilibrium: Market price adjusts until quantity demanded

equals quantity supplied.
Example: Setting a thermostat.

Modeling Apartment Demand
Demand: Suppose the most any one person is willing to pay to rent an
apartment is $500/month. Then, p = $500  QD = 1.
Suppose the price must drop to $490 before a second person would rent.
Then, p = $490  QD = 2.
Thus, the lower the rental rate (p), the larger the quantity of apartments
demanded:

Market Demand Curve for Apartments

Modeling Apartment Supply
Supply: It takes time to build more apartments. So, in this short run the
quantity available is fixed (at say 100).

Market Supply Curve for Apartments

Market Equilibrium – 1
• At a “low” rental price, the quantity demanded of apartments > the quantity
supplied. Therefore, the price will ↑.
• At a “high” rental price, the quantity demanded of apartments < the quantity
supplied. Therefore, the price will ↓.
• When quantity demanded = quantity supplied, the price will neither rise
nor fall. So, the market is at a competitive equilibrium.

Competitive Market Equilibrium – 1


Who rents the apartments?
➢ Those who are most willing to pay.
So, the competitive market allocation is by “willingness to pay.”

Comparative Statics – 1
What is exogenous in the model?
• price of distant apartments
• quantity of close apartments
• incomes of potential renters
What if the price of apartments in a nearby city rises?

• Demand for close apartments increases (rightward shift), causing a
higher price for close apartments.


What if there is an increase in available apartments?
• Supply for apartments increases (rightward shift), causing a lower
price for apartments.


What if the incomes of potential renters increase (thereby increasing their
willingness to pay)?
• Demand for apartments increases (rightward shift), causing a higher
price for close apartments.


Taxation Policy Analysis – 1
• Suppose local government taxes apartment owners.
• What happens to:
o price?
o quantity of apartments rented?
• Is any of the tax “passed” to renters in the form of higher overall expenses
associated with renting an apartment?

Taxation Policy Analysis – 2
• In this scenario with fixed supply, the market supply is unaffected.
• So, the market equilibrium is unaffected by the tax.
• Landlords pay all the tax.

Imperfectly Competitive Markets
Imperfectly competitive markets come in many forms including:
• monopolistic landlords
• perfectly discriminatory monopolistic landlords
• rent controls

A Monopolistic Landlord
When the landlord sets a rental price (p), he or she rents D(p) apartments.
➢ Revenue = pD(p)
• If p  0, revenue would be very low.

• If p is too high, D(p)  0. So, revenue would be very low here too.
• An intermediate value for p maximizes revenue.

Monopolistic Market Equilibrium – 1
Note: Revenue is the shaded area. Since it is rectangular in shape, revenue = base*height
which, here, is quantity*price. Copyright © 2019 Hal R. Varian


Perfectly Discriminatory Monopolistic Landlord
Imagine the monopolist knew everyone’s willingness to pay:
➢ Charge $500 to the most willing to pay.
➢ Charge $490 to the second most willing to pay, etc.

Discriminatory Monopolistic Market Equilibrium – 1



Rent Control
Local government imposes a maximum legal price (say $250 per month for
rent), pmax < pe, the competitive price. This is often called a “price ceiling.”


Which Market Outcomes Are Desirable?
Which is better?
• Perfect competition
• Monopoly
• Discriminatory monopoly
• Rent control

Pareto Efficiency – 1
Italian Economist: 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.
Example:
• 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.

• 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.

Competitive equilibrium:
• All close apartment renters value them at the market price pe or more.
• All others value close apartments at less than pe.
• No mutually beneficial trades remain.
• The outcome is Pareto efficient.

Monopoly:
• Not all apartments are occupied.
• A non-renter could be assigned an apartment and have higher welfare
without lowering anybody else’s welfare.
• The monopoly outcome is Pareto inefficient.

Discriminatory monopoly:
• Assignment of apartments is the same as with the perfectly competitive
market.
• The discriminatory monopoly outcome is also Pareto efficient.

Rent control:
• Some apartments are assigned to renters valuing them at below the
competitive price pe.
• Some renters valuing an apartment above pe don’t get apartments.
• This is a Pareto inefficient outcome.

Consumption Choice Sets
A consumption choice set is the collection of all consumption choices available
to the consumer.
What constrains consumption choice?
• Budgetary, time, and other resource limitations.

Budget Constraints – 1
A consumption bundle containing x1 units of commodity 1, x2 units of
commodity 2, and so on up to xn units of commodity n is denoted by the vector
(x1, x2, . . . , xn).
• For two goods, the consumption bundle is (x1, x2).
Commodity prices are denoted by the vector (p1, p2, . . . , pn).
• For two goods, the price vector is (p1, p2).

When is a bundle (x1, . . . , xn) affordable at prices (p1, . . . , pn)?
• When
Where m is the consumer’s (disposable) income.

• For 2 goods,
Bundles that are only just affordable form the consumer’s budget constraint.
This is the set:
and

Budget Set and Constraint for Two Commodities – 1

Budget Set and Constraint for Two Commodities – 2
x2
Budget constraint is
m/p2
p1x1 + p2x2 = m (slope is -p1 /p2).
The collection of
all affordable bundles
m/p1 x1

Budget Constraint for Three Commodities

Budget Set for Three Commodities

For n = 2 and x1 on the horizontal axis, the constraint’s slope is –p1/p2. What
does it mean?
p1 m
x2 = − x1 +
p2 p2
• Increasing x1 by 1 must reduce x2 by p1/p2.

• The opportunity cost of an extra unit of commodity 1 is p1/p2 units
foregone of commodity 2.


Budget Sets & Constraints: Income and Price Changes
The budget constraint and budget set depend upon prices and income.
➢ What happens as prices or income change?

How Do the Budget Set & Constraint Change as Income m Changes?

Higher Income Gives More Choice

Lower Income Shrinks the Budget Set

Budget Constraints: Income Changes
➢ Increases in income m shift the constraint outward in a parallel manner,
thereby enlarging the budget set and improving choice.
• No original choice is lost, and new choices are added when income
increases, so higher income cannot make a consumer worse off.
➢ Decreases in income m shift the constraint inward in a parallel manner,
thereby shrinking the budget set and reducing choice.
• An income decrease may (and typically will) make the consumer
worse off.

How Do the Budget Set & Constraint Change as p1 Decreases
from p1ʹ to p1ʺ? – 1

How Do the Budget Set & Constraint Change as p1 Decreases
from p1ʹ to p1ʺ? – 2

Budget Constraints: Price Changes
• Reducing the price of one commodity pivots the constraint outward. No old
choice is lost, and new choices are added, so reducing price cannot make
the consumer worse off.
• Similarly, increasing one price pivots the constraint inward, reduces choice
and may (and typically will) make the consumer worse off.

Uniform Ad Valorem Sales Taxes – 1
• An ad valorem sales tax levied at a rate of 5% increases all prices by 5%,
from p to (1+ 0.05)p = 1.05p.
• An ad valorem sales tax levied at a rate of t increases all prices by tp from p
to (1+ t)p.
• A uniform sales tax is applied uniformly to all commodities.

A uniform sales tax levied at rate t changes the constraint from
to
Or equivalently,



Budget Constraints: Relative Prices – 1
• “Numeraire” means “unit of account.”
• Suppose prices and income are measured in dollars.
➢ Say:
➢ Then the constraint is:

If prices and income are measured in cents, then
and the constraint is the same as
➢ Changing the numeraire changes neither the budget constraint nor
the budget set.

The constraint for p1 = 2, p2 = 3, m = 12
is also
with p1 = 1, p2 = 3/2, m = 6. Setting p1 = 1 makes commodity 1 the numeraire

and defines all prices relative to p1. For e.g., 3/2 is the price of commodity 2
relative to the price of commodity 1.
➢ Any commodity can be chosen as the numeraire without changing the

budget set or the budget constraint.

Suppose p1 = 2, p2 = 3, and p3 = 6.
• Price of commodity 2 relative to commodity 1 is 3/2.
• Price of commodity 3 relative to commodity 1 is 3.
➢ Relative prices are the rates of exchange of commodities 2 and 3

for units of commodity 1.

Shapes of Budget Constraints
What makes a budget constraint a straight line?
➢ A straight line has a constant slope, and the constraint is
So, if prices are constants, then a constraint is a straight line.
But what if prices are not constants?

➢ For e.g., bulk buying discounts, or price penalties for buying “too much.”
➢ Then, constraints will be curved.

Shapes of Budget Constraints: Quantity Discounts
Suppose p2 is constant at $1 but that p1 = $2 for 0  x1  20 and p1 = $1 for x1 >
20. Then the constraint’s slope is: for and
for

Shapes of Budget Constraints with a Quantity Discount

Shapes of Budget Constraints with a Quantity Penalty

Things to do
• Read Varian, H.R. 9th Ed
― Chapter 1 & 2

Lecture 1

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Market Equilibrium & Budget

City, University of London: Department of Economics

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

➢ Can we construct an insightful model to answer these

Copyright © 2019 Hal R. Varian

• Optimisation: Each person tries to choose the best

• Equilibrium: Market price adjusts until quantity demanded

Example: Setting a thermostat.

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

So, the competitive market allocation is by “willingness to pay.”

Copyright © 2019 Hal R. Varian

What if the price of apartments in a nearby city rises?

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

• If p  0, revenue would be very low.

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Where m is the consumer’s (disposable) income.

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

• Increasing x1 by 1 must reduce x2 by p1/p2.

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian

Copyright © 2019 Hal R. Varian