Intro to Econ: Sixth Lecture – Where do prices come from (in a market)?

Let us finish the discussion of the student accommodation problem from the last lecture. If there are no legal restrictions on rent, what “price” or rent will we get in the “market” for rental apartments?

One should probably distinguish here between market prices that will establish themselves in the short run versus those that will establish themselves in the long run. In the short run the total number of apartments that are, in principle, potentially available in a city (such as Graz) is sort of fixed. In the long run additional apartments can of course be built. In the short run also the number of people that are, in principle, potentially interested in renting an apartment in such a city is probably also fixed. In the long run people can move to and from this city.

I want to focus on the short run, building on the discussion from the last lecture. The key idea has three ingredients (derived from our general principles for theory development in which we focus on the relevant people involved, what they want, and what they can do). First, derived from our choice that apartment seekers are one of the two relevant groups of people in this market and from their goals, we get that there is a (not necessarily easily observable – more about this later) demand function for rental apartments. The demand for a particular apartment depends, of course, on many things. It depends on its size, its layout, the state it is in, the state of the kitchen, the bathroom(s), et cetera. It also depends on its price. Depending on the question we are asking about the market for rental apartments we might want to highlight the dependence of the demand for an apartment on any of these issues. As we are here mostly interested in the formation of prices I suggest we focus on the dependence of the demand on prices. This is, of course, a pretty unrealistic simplification. But recall that when we are building a model (or are trying to tell a consistent and plausible story) our goal is not to build a model that is as close to realistic as possible, but to identify a key mechanism that provides a (perhaps first order) important insight. In what follows we sort of implicitly assume that all apartments are really the same, but I think you will see for yourself that this is, for our purpose, a satisfactory approach.

So what do we expect this demand function, meaning a function of prices, to look like, when we keep the other attributes of apartments fixed? We expect that, ceteris paribus, people will prefer to rent any apartment for a lower rent than for a higher rent. After all, we feel somewhat justified in our assumption that, all else fixed, people prefer more money over less and this is just another application of this idea. Or expressed differently, the higher the rent per square meter the smaller will be the apartments that people will rent. So suppose that we plot the demand function with rental price (say, per square-meter of the apartment) on the x-axis and the total number of people willing to pay for an apartment at these prices on the y-axis. In fact we should probably put the total size of all apartments that people are willing to rent at this price on the y-axis. Then we expect to get a downward sloping line or curve. This was the first thing.

Second, derived from our choice that apartment owners are the other one of the two relevant groups or people in this market and from their goals, we get that there is a (not necessarily easily observable – more about this later) supply function for rental apartments. One could, if we were interested in these aspects now, go into the question of in which state the owner of an apartment will try to supply one. Should the owner renovate, put in a new kitchen, a new bathroom, or should they try to go for the low quality rental sector? For the purpose of our question none of these issues are particularly relevant. So suppose that the apartment is whatever it is. Then the central idea, again derived from the idea that people, ceteris paribus, prefer more money over less, is that the owner is more likely to put her apartment on the market the higher the rent she expects to get for it. So if we plot the supply function, meaning a function of rental prices, we expect an upward sloping line or curve with low supply at low prices and high supply at high prices.

So we used our choice of the relevant people for our problem and our choice of what goals we think they have to come up with a downward sloping demand function and an upward sloping supply function. Now, and third and finally, it remains for us to reason through what will be the final outcome in this market given our understanding of what these two groups of people can do (mostly make offers and accept or reject offers). Suppose you are an owner in such a market and you are making an offer of a rental price that nobody wants to take up. What will you do? Well, you will either stop putting the apartment on the market (because you do not want to rent it out for any lower price) or you will “have to” lower the price. On the other hand suppose you are an apartment seeker making offers to owners that no owner takes up. What will you do? You will probably either abandon your search and say stay with your parents or you “have to” accept higher rental prices. The idea is that gradually the offered prices will move in such a way that eventually a price establishes itself for which the demanded number (or total size) of apartments at this price is more or less exactly equal to the supplied number (or total size) of apartments at this price.

Economists call this the “equilibrium” price and the “equilibrium” demanded and supplied quantity of apartments in this market for rental apartments. Let me try to put it all into one picture (please forgive my low-tech rendering):

marketforapts

Note that this equilibrium has the property that there is a Pareto efficient allocation of apartments. There is no other allocation that would make at least one person better off without making somebody else worse off. Note again that we are not saying that this is necessarily fair: people with a lower “willingness” to pay for rental apartments will have smaller rental apartments (if any) and I guess people with a lower “willingness” to pay for rental apartments have a lower “willingness” to pay for rental apartments mostly because they don’t have a lot of money. But note also that a price cap at low prices is also not necessarily fair. In fact then many (more) people will not be able to rent at all while at the same time many apartments will be mostly empty (used perhaps only on weekends or once a year) and many people will be very angry about all this.

There is one additional ray of sunshine for letting the market determine prices. This has to do with the long-run. If rental prices are high property developers and construction companies will find it in their interest to build or develop new apartments, which should ultimately bring down the price (which in turn might attract more people to this city). Owing to building restrictions, whether natural or imposed by citizens, this does not necessarily always happen, though. Well, sometimes things are just really difficult. But if prices are kept low then this incentive for construction companies and developers to build is certainly also pretty low.

4 thoughts on “Intro to Econ: Sixth Lecture – Where do prices come from (in a market)?

  1. I enjoy reading about economics, but the arguments often feel like a “house of cards” – for example in this post, you acknowledge in several places that there is this or that simplifying assumption which leads us to the plausible conclusions. Whenever such arguments are made, I cannot help but be distracted by the question of whether one or another simplifying assumption might contain an oversight, or whether the plausible conclusion will later be found to have misguided us.

    For a specific example, take “all else fixed, people prefer more money over less”. All else fixed is a huge bite: what induces people to rent apartments? Many are in the business for the money because they desire the means to maximize utility; but sometimes societies devise alternative means to maximize utility and by taking the all-else-fixed approach, it feels like economics is excluding vast realms of potential that are rightfully the study of economics.

    Not saying you can single-handedly change economics; but the older I get the harder it is for me to swallow the basic model assumptions.

    • Thanks for reading the blog and for your comment, Cade!

      I get asked about assumptions a lot when teaching economics. One answer I like to give is: you don’t like this assumption? Well, then change it! This is a good way to build your economic intuition and model-building skills. You start with the simplest model possible and then relax this or that assumption and see how your conclusions change. I think playing around with alternative assumptions is good Scientific Practice and should be encouraged.

  2. I agree. The demand and supply model is surely only a small beginning in our quest to understand the (economic) world. Different questions need different models. See e.g. https://grazeconomics.wordpress.com/2017/09/03/economics-on-the-beach-iv-welfare-optimal-pricing-a-model/ or https://grazeconomics.wordpress.com/2018/08/09/economics-on-the-beach-v-on-towels-parking-spots-and-job-protection/. There are of course many more interesting models out there. Who was it that said “All models are wrong, but some are useful”?

  3. Pingback: Intro to Econ: Sixth Lecture – What is driving changes in prices? | Graz Economics Blog

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