ENV 536: Environmental Economics and Policy (Lecture 3) Modeling the Market Process: A Review of the Basics

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ENV 536 Environmental Economics and Policy
(Lecture 3) Modeling the Market Process A
Review of the Basics

• Asst.Prof. Dr. Sasitorn Suwannathep
• School of Liberal Arts
• King Mongkuts University of Technology Thonburi

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Circular Flow Model of Economic Activity

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Materials Balance Model The Interdependence of
Economic Activity and Nature
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The Materials Balance Model

• Environmental problems are directly linked to
  market activities.
• Environmental pollution is characterized as a
  market failure.
• Environmental economics uses market failure
  models to analyze the problem and to identify
  solutions.

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Market Models The Fundamentals

• A market refers to the interaction between
  consumers (or buyers) and producers (or sellers)
  for the purpose of exchanging a commodity.

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The Model of Supply and Demand

• The decisions for producers are modeled through a
  supply function.
• For consumers, the decisions are shown through a
  demand function.
• The main objective of the supply and demand model
  is to facilitate an analysis of market conditions
  and any observed price changes.

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The Model of Supply and Demand (cont)

• An investigate of price movements can identify
• shortages and surpluses
• The existence of resource misallocations
• And the economic implications of government
  policy.

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Basic Assumptions to Supply and Demand Model

• A competitive goods market
• A large number of buyers and sellers
• A homogeneous product
• The absence of entry barriers
• Perfect information
• A competitive resources market
• A private good
• Rivalry in consumption
• Excludability

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Demand Model

• The demand function is the relationship between
  quantity demanded and price.
• Demand is defined as the quantities of a good the
  consumer is willing and able to purchase at some
  set of prices during some time period, cetiris
  paribus (c.p.).
• Willing to pay demand price
  marginal benefit (MB)
• Ability to pay (income constraint)

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Individual Demand Curve (details in CC ch 3,
fig. 3.1 p. 36)
Price P
Demand Function qd -2P 23
11.50
d MB
0
Quantity Q
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Law of Demand

• The relationship between quantity demanded and
  price is inverse one.
• P Qd , P Qd

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Demand Model (cont)

• Many factors influence individual demand
• Wealth or income
• The prices of related goods (i.e., substitutes or
  complements)
• Preference
• Price expectations

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Market Demand

• Market demand is the sum of individual demands
  (we sum the quantities at each demand price).

Demand for consumer 1 qd1 -2P 23 Demand
for consumer 2 qd2 -4P 46
Market demand (Dm) -6P 69 (ass. There are two
persons in the market)
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Market Demand Curve
Price P
11.50
Market Demand Qd -6P 69
Dm
0
69
Quantity Q
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Supply Model

• Supply refers to the quantities of a good the
  producer is willing and able to bring to market
  at a given set of prices during some time period,
  c.p.

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Firm Supply Curve
Price P
Supply Function qs -4 16P
S MC
2.00
Note qs MC As the firm produces more output
(Q), the total costs (TC) will be rise, which
mean that change in Q ( ? Q) cause change in TC
(or ? TC) or (? TC/ ? Q) MC
0.25
0
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Quantity Q
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Law of Supply

• The relationship between quantity supplied and
  price is a positive one.

P Qs , P Qs
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Supply Model (cont)

• Several factors determine supply
• Production technology
• Input price
• Tax and subsidies
• Price expectations

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Market Supply

• Market supply is the sum of individual supply at
  each price.

Supply of producer 1 qs1 -4 16P Supply
of producer 2 qs2 -4 16P
Market Supply (Sm) -8 32P (ass. There are two
producers in the market)
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Market Supply Curve
Price P
Supply Function Qs -8 32P
Sm ? MC
2.00
0.25
0
Quantity Q
56
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Equilibrium Price and Quantity

• The forces of demand and supply determine a
  equilibrium price (PE) and quantity (QE)

Price
Surplus
Sm
P1
E
PE
Shortage
P2
Dm
Quantity
0
QE
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Economic Criteria of Efficiency

• Allocative Efficiency the proper allocation of
  resources among alternative uses.
• Technical Efficiency the economizing resources
  used in production.

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Allocative Efficiency

• To evaluate resource allocation, we can do
  through
• Assessment of benefits and costs
• The use of marginal analysis

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Allocative Efficiency (cont)

• Resource Allocation at the Market Level
• At market level, the price along the demand curve
  are measures of marginal benefit (MB).
• On supply side, the prices are measures of
  economic cost, the market supply is the sum of
  firms marginal cost (MC).
• Allocative efficiency requires that the
  additional value society place on another unit of
  the good is equal to what society must give up in
  resources to produce it.

MB MC
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Allocative Efficiency (cont)

• Resource Allocation at Firm Level
• the firm prefers profit maximization.
• TR P q when P market price
• q the sold output
• TC all economic costs associated with
  production

• Total profit ( ? ) Total Revenue (TR) Total
  Costs (TC)

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Allocative Efficiency (cont)

• If TR gt TC, the firm will increase production.
• MR gt MC , M ? gt 0
• when MR ? TR / ? q
• MC ? TC / ? q
• Profit maximization occurs when

MR MC , M ? 0
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MR lt MC, decrease output
MR gt MC, produce more output
MR MC
Source Callan, S. J. and Thomas, J. M. 2007.
Environmental Economics and Management
Theory, Policy, and Applications.
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Technical Efficiency

• Technical efficiency refers to production
  decisions that generate maximum output with a
  given resource or use minimum inputs with a given
  output.
• Market forces can achieve technical efficiency as
  long as competitive condition prevail.

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Welfare Measures

• We use welfare measures to assess the gains or
  losses of the society.
• Consumer surplus
• Producer surplus

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Consumer surplus

• A measure of net benefit to the buyers estimated
  by the excess of what they are willing to pay
  (WTP) over what they actually pay (P).

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Source Callan, S. J. and Thomas, J. M. 2007.
Environmental Economics and Management
Theory, Policy, and Applications.
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Producer Surplus

• Measures a net gain to sellers estimated by the
  excess of market price (P) over marginal cost
  (MC).

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Source Callan, S. J. and Thomas, J. M. 2007.
Environmental Economics and Management
Theory, Policy, and Applications.
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Societys Welfare Sum of Consumer and Producer
Surplus

• Societys welfare is measured as the sum of
  consumer and producer surplus, which is maximized
  when allocative efficiency is achieved.
• Deadweight loss to society the net loss of
  consumer and producer surplus due to an
  allocatively inefficient market event.

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Source Callan, S. J. and Thomas, J. M. 2007.
Environmental Economics and Management
Theory, Policy, and Applications.