# What is the equilibrium price in this case?

From the Review Questions to Chapter 1: The Market in Hal Varian's Intermediate Microeconomics with Calculus, 9th ed.:

1. Suppose that there are 25 people who had a reservation price of $$\\\500$$, and the 26th person had a reservation price of $$\\\200$$. What would the demand curve look like?
2. In the above example, what would be the equilibrium price if there were 24 apartments to rent? What if there were 26 apartments to rent? What if there were 25 apartments to rent?

Please note that in this chapter, the supply of apartments is taken to be fixed.

I have drawn the demand curve, and attempted to solve the first two cases in the second question in the following way:

If there are 24 apartments, they go to the 24 people with the highest reservation price. This happens to be $$\\\500$$, so that is the equilibrium price in this case.

When there are 26 apartments, we can imagine 25 landlords successfully leasing their property for $$\\\500$$, and one landlord who is unable to net the $$\\\500$$ lowering his price until he reaches $$\\\200$$. This prompts a surge of potential tenants at his doorstep, but the apartment does not necessarily go to the tenant who had a reservation of price of $$\\\200$$; it goes to whomever spends most time bargaining with the landlord, has the best connections, etc. Since this apartment generally goes to someone who had a reservation price of $$\\\500$$, the new tenant vacates an apartment in her wake, which is then leased for $$\\\200$$, and so on until everybody is living in a $$\\\200$$ apartment.

The third case is confusing. The answer at the end of the book says that the equilibrium price would be "any price between $$\\\200$$ and $$\\\500$$" when there are 25 apartments. Why is this true? It seems to me that since the supply of apartments is fixed, the price of one apartment would depend only on the reservation price of tenants. If the equilibrium price is anything lower than $$\\\500$$, landlords would have an incentive to arbitrarily increase the rent to the highest the market can absorb, i.e., $$\\\500$$. What's keeping the equilibrium price below $$\\\500$$?

Please also tell me if my reasoning about the other two cases is flawed, or there are other, better ways to reason about them.

I have quickly skimmed the chapter and there does not seem to be much about bargaining models so as the question says you have to solve this using supply and demand.

We know that an equilibrium price on the market will occur when supply intersect demand. Given that the supply is fixed at $$24$$ and $$25$$ apartments respectively it will be just straight vertical line in each case. Now when it comes to demand, if we assume each person wants only one single apartment the demand will be given in step-wise fashion, with two steps given by reservation prices $${\\\}500$$ and $${\\\}200$$ respectively. So this situation will look like shown on the tikz picture I made below (supply is blue, demand is red):

At point where supply is equal to $$24$$ the equilibrium price given by intersection of supply and demand ($$S=D$$) is clearly $${\\\}500$$. However, when supply is equal to $$25$$, supply and demand will intersect at a whole range of different prices $$[200,500]$$.

Consequently, in this case using this simple supply and demand model we cannot say anything more that price will be something between $${\\\}200$$ and $${\\\}500$$. There are more advanced ways how we could model this situation which might yield unique price instead of range (maybe some models with explicitly modeled bargaining process or some matching models), but here the author of the book gives you hints by asking how demand would look like etc., that you are supposed to use this solution concept (also the first chapter uses only simple supply and demand models so that is another hint).

• Thank you for your answer. By your logic, though, shouldn't the S = 26 graph intersect with the demand curve at every price from [\$0, \$200]? Why then does Varian say that the equilibrium price for 26 apartments is a fixed \\$200? – Ray Bradbury Oct 24 '20 at 11:26
• @ijm no because there is no excess demand after Q=26, so in that case the price will be given just by the maximum reservation price. – 1muflon1 Oct 24 '20 at 11:28
• @ijm the intuition here is that since landlords can’t price discriminate here and can’t directly observe the reservation prices at S=24 there is only single price at which D=24 which is 500, at S=25 there is a whole range of prices that will make supply and demand equal because we do not know what is the mechanism of competition between the buyer with 500 and 200 reservation price so any price there is possible, and at S=26 there again will be one price that is guaranteed to produce D=26 and that is 200 – 1muflon1 Oct 24 '20 at 12:21
• @ijm these things are covered mainly by market/mechanism design and auction theory. I have older version of the textbook so I am not sure if chapters are correct but the Varian textbook ch 17 should cover auctions which is an intro to auction theory. Also the book will make the concepts for standard supply and demand more rigorous in later chapters. Other than that this is also covered in some length in MWG microeconomic theory and in Tadelis game theory (game theory is actually recommended prerequisite in these fields). – 1muflon1 Oct 24 '20 at 13:18
• There are for sure texts that focus only on auction theory and market design but I can’t give more narrow recommendations there as I do not specialize in these two subfields, but the books I listed above have introductory treatments to those topics and they contain references to further papers/books. Alternatively, you can do your own additional search using the names of the field as key words, or you can make separate question as a reference request for such texts (but prior that you should do at least a bit of search yourself since users here don’t like Q that don’t show any effort). – 1muflon1 Oct 24 '20 at 13:21