Topics in Environmental and Natural Resources Economics

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Topics in Environmental and Natural Resources
Economics

• Steven C. Hackett
• Professor of Economics
• Humboldt State University

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Chapter 1 Fundamental Concepts

• What are the traditional stereotypes regarding
  economics and the environment?
• Provide a general definition of economics

The study of how scarce resources are allocated
among competing uses.
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Chapter 1 Fundamental Concepts

• What is scarcity?

Something is said to be scarce if the following
is true If it were offered to people at no cost,
more would be wanted than is available. Scarcity
means not having enough of something to provide
for all that is wanted.
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Chapter 1 Fundamental Concepts

• What are some different ways to allocate
  something scarce?

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Chapter 1 Fundamental Concepts
Scarcity

• What are some examples of things that are scarce
  that you encountered this morning?
• Does scarcity only exist in industrialized or
  capitalist societies?

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Chapter 1 Fundamental Concepts
Scarcity

• If something has a price in a market, does that
  generally mean that it is scarce?
• What sort of things that occur outside of
  markets are scarce?
• Do animals, plants, and other life experience
  scarcity?

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Chapter 1 Fundamental Concepts
Scarcity

• Why is choice necessitated by scarcity? By
• Individuals
• Organizations (groups, NGOs, businesses)
• Governments
• Animals, plants, other life

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Chapter 1 Fundamental Concepts

• The choices necessitated by scarcity are at the
  core of economics

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Chapter 1 Fundamental Concepts

• Since scarcity forces us to make choices from a
  set of alternatives, on what basis can we (or do
  we) rank the various alternatives and choose the
  best one?

• Economics occurs in the context of value systems
  that guide us in ranking alternatives and in
  distinguishing good from less good allocations.
• Where do these values come from?

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Chapter 1 Fundamental Concepts
Economics vs. commercial activity What is the
difference?

• While markets are a prominent way of making
  allocation choices in the context of scarcity,
  economics encompasses the study of both market
  and non-market allocation of scarce resources.
• As Tom Power observes, economic analysis of the
  environment is challenging and important
  precisely because its value is not conveniently
  revealed in a market, and thus is subject to
  inappropriate use.

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Chapter 1 Fundamental Concepts
Economics vs. Environment-

• Can we really put economics all on one side,
  and environment all on the other side?
• Is this simply a convenient way for the media to
  characterize conflicting values?
• If scarcity means that choices must be made,
  then what are the tradeoffs?

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Chapter 1 Fundamental Concepts
What is opportunity cost?

• When something scarce is allocated to one
  particular use, the opportunity cost of that
  choice is the value of the best alternative given
  up.
• What is an example of an opportunity cost?
• Opportunity cost can be easy or very difficult
  to measure.

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Chapter 1 Fundamental Concepts
What is economic rationality?

• A choice from among competing options is said to
  be economically rational when it yields
  anticipated net benefits that exceed the
  opportunity cost
• In other words, economic rationality as used in
  this class simply means that we can predict
  behavior if we know values, preferences, and
  costs.

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Chapter 1 Fundamental Concepts
What sort of questions and problems are studied
in the area of environmental economics?
Pollution and externalities causes,
consequences, instruments for their control,
policy, political economy
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Chapter 1 Fundamental Concepts
What sort of questions and problems are studied
in the area of natural resources economics?
Production, markets, management, uses, and abuses
of natural resources such as marine and
freshwater fisheries, forests, grazing lands,
aquifers, and energy and minerals
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Chapter 2 Value Systems Economic Systems
Throughout time and around the globe, individuals
and societies have been motivated by widely
different value systems, and so have had
different answers to the question of what a good
way to allocate things might be. As a consequence
we have observed many different kinds of
economies.
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Chapter 2 Value Systems Economic Systems
Society is frequently confronted with policy
decisions that must be made because of scarcity.
Examples include the allocation of budget monies
and the management of public land, water, and
wildlife. These policy decisions affect both
human and nonhuman communities. Because of
scarcity, any choice made by policy makers will
have an opportunity cost. What are the values
that will be used to rank policy alternatives?
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Chapter 2 Value Systems Economic Systems
From an economic point of view a decision is good
(or economically rational) when it generates net
value that exceeds the opportunity cost. Yet
different value systems will lead to a different
ranking of alternatives and so will provide
different answers to the question of which course
of action is best.
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Chapter 2 Value Systems Economic Systems
When individuals make choices in the context of
scarcity they are guided by their own values and
preferences, as influenced by their culture,
class, status, and many other factors. In order
to make public policy decisions that serve the
interests of the public, however, the economic
aspects of policy-making must somehow embody
society's shared values, and/or aggregate
individual values and preferences.
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Chapter 2 Value Systems Economic Systems
This is one reason why it is said that social
institutions (formal or informal rule systems
that provide the structure for political and
economic choices and interactions) embody the
shared (or dominant) values of the societies from
which they evolve.
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Chapter 2 Value Systems Economic Systems
Fundamentals of Ethical Systems Ethics is a
branch of philosophy that is concerned with moral
duty and ideal human character (right and wrong,
good and bad). "Ethics is the science of morals,
and morals are the practice of ethics"
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Chapter 2 Value Systems Economic Systems
Fundamentals of Ethical Systems What is the
relationship, if any, between ethical systems and
economic systems?
If economic policy is to serve the public good,
then the values that shape how alternatives are
ranked must have some basis in ethics.
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Chapter 2 Value Systems Economic Systems
Fundamentals of Ethical Systems Ethical systems
may describe particular shared values, or provide
a method for arriving at an aggregation of
individual values and preferences. Different
ethical systems lead to different economic
choices. We will look at two distinct ethical
systems
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Chapter 2 Value Systems Economic Systems
Deontological Ethics What is the core idea of
this ethical system?
The ethics of standards Deontological ethics
develop theories of action based on duty or moral
obligation. Under this system, an action is
judged by its intrinsic rightness and not by the
extent to which it serves as an instrumentality
in furthering ones goals or aspirations.
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Chapter 2 Value Systems Economic Systems
Deontological Ethics A duty is a moral
obligation that an agent has towards another
person, such as the duty not to lie.
Etymologically, duties are actions that are due
to someone else, such as paying money that one
owes to a creditor. In a broader sense, duties
are simply actions that are morally mandatory.
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Chapter 2 Value Systems Economic Systems
Deontological Ethics In this tradition,
philosophers held the normative theory that moral
conduct is that which follows a specific list of
duties. These theories are called deontological
theories, from the Greek word deon, or duty,
since they emphasize foundational duties or
obligations.
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Chapter 2 Value Systems Economic Systems
Deontological Ethics We find one of the first
clear indications of this view in The Law of War
and Peace (1625) by Dutch philosopher Hugo
Grotius (1583-1645). For Grotius, our ultimate
duties are fixed features of the universe, which
even God cannot change, and comprise the chief
obligations of natural law.
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Chapter 2 Value Systems Economic Systems
Deontological Ethics German philosopher Immanuel
Kant (1724-1804) draws on duty theory both in his
early Lectures on Ethics (1780), and also in his
later and more systematic ethical writings The
Foundations of the Metaphysics of Morals (1785),
The Critique of Practical Reason (1788), and The
Metaphysics of Morals (1798).
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Chapter 2 Value Systems Economic Systems
Deontological Ethics Kant further refines the
notion of duty by arguing that moral actions are
ultimately based on a single, "supreme principle
of morality" which is objective, rational, and
freely chosen the categorical imperative.
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Chapter 2 Value Systems Economic Systems
Deontological Ethics Kant and the categorical
imperative "Act as if the maxim of your action
were to become through your will a universal law
of nature."
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Chapter 2 Value Systems Economic Systems
Deontological Ethics W.D. Ross's The Right and
the Good (1930) Duties Fidelity (the duty to
keep promises), reparation (the duty to
compensate others when we harm them), gratitude
(the duty to thank those who help us), justice
(the duty to recognize merit), beneficence (the
duty to improve the conditions of others),
self-improvement (the duty to improve our virtue
and intelligence), and nonmalfeasance (the duty
to not injure others)
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Chapter 2 Value Systems Economic Systems
Deontological Ethics Are Leopold's Land Ethic
and Devall/Sessions/Naess's Deep Ecology within
the deontological ethical tradition? Duties?
Do some religious systems have features similar
to the categorical imperative?
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Chapter 2 Value Systems Economic Systems
Deontological Ethics Are there aspects of
deontological ethical ideals expressed in the
U.S. Constitution?
What happens if members of society cannot agree
on the validity and importance of a particular
set of duties?
Pooling (one big society) Dominant group imposes
values on others? Separation Groups form based
on shared values
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Chapter 2 Value Systems Economic Systems
Teleological Ethics What is teleological ethics
(sometimes known as consequentialism)?
The ethics of results This theory states that
the moral goodness or badness of an act or rule
is determined by the results or consequences of
the act or rule.
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Chapter 2 Value Systems Economic Systems
Teleological Ethics Telos is a Greek term for end
or purpose. Under teleological systems of
ethics, an action is judged not by a categorical
imperative to act in a certain way, but by the
extent to which the consequences of the action
are desirable.
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Chapter 2 Value Systems Economic Systems
Teleological Ethics Acts or rules are ethical or
not depending on their consequences or results.
No universal ethical standard is applied to acts
or rules.
British ethical philosophers such as Jeremy
Bentham and John Stuart Mill advocated for
teleological ethics
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Chapter 2 Value Systems Economic Systems
Teleological Ethics There are three subdivisions
of consequentialism 1. Ethical Egoism an
action is morally right if the consequences of
that action are more favorable than unfavorable
only to the agent performing the action. 2.
Ethical Altruism an action is morally right if
the consequences of that action are more
favorable than unfavorable to everyone except the
agent.
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Chapter 2 Value Systems Economic Systems

• Teleological Ethics
• Three subdivisions of consequentialism, cont
• 3. Utilitarianism an action is morally right if
  the consequences of that action are more
  favorable than unfavorable to everyone.

This third subdivision of consequentialism,
utilitarianism, is most relevant to economic
policy, and forms the ethical basis for
benefit/cost analysis
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Chapter 2 Value Systems Economic Systems
Utilitarianism In diverse societies where people
cannot agree on a universal ethical standard of
action based on the categorical imperative, as is
required by deontological ethics, results-based
utilitarianism offers an alternative that
identifies ethical actions or rules by adding up
the pleasure or pain of consequences for all
members of society.
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Chapter 2 Value Systems Economic Systems
Utilitarianism Jeremy Bentham, a key utilitarian
theorist, was dissatisfied with the legal
theories of William Blackstone, which served to
justify the British legal system. In particular,
Bentham thought that the British system of
ranking crimes was wrong because it was based on
an abstract moral theory rather than on the
unhappiness, misery, or disutility a crime caused
to other members of society.
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Chapter 2 Value Systems Economic Systems
Utilitarianism Thus in Benthams view the
punishments prescribed by law should be
proportionate to the disutility created by the
crime and not based on notions of intrinsic
rightness or morality. Bentham described utility
as the principle that approves or disapproves of
actions according to their tendency to increase
or decrease an individuals pleasure.
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Chapter 2 Value Systems Economic Systems
Utilitarianism Bentham was a hedonist and so
believed that pleasure is the only intrinsic good
or end against which acts are to be evaluated.
As W.H. Auden (1962) observed, pleasure is by no
means an infallible critical guide, but it is the
least fallible.
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Chapter 2 Value Systems Economic Systems
Utilitarianism How does utilitarianism work?
1. Develop a set of alternative policies,
including the status-quo (no change). 2. Measure
the level of utility or disutility (degree of
pleasure or pain) induced on each member of
society for each of the alternatives.
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Chapter 2 Value Systems Economic Systems
Utilitarianism How does utilitarianism work,
continued
3. Add up the utility and disutility for each
alternative (note here that "adding up" assumes
that different peoples' utility and disutility
are commensurable--a notion called cardinal
utility). The net utility to all members of
society for a given policy alternative is called
net social utility. 4. The utilitarian-ethical
policy alternative is the one that generates the
largest net social utility.
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Chapter 2 Value Systems Economic Systems
Utilitarianism We have identified some problems
with deontological ethics. What are some problems
with utilitarianism?
- How do we measure social utility?
- Tyranny of the majority (same failing as
democracy) --
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Chapter 2 Value Systems Economic Systems
Ethics While no single system of ethics is
without flaws, they can be used together in a
complementary way.
For example, society may be able to agree on some
universal ethical standards of action and use
them to screen out actions that are
inappropriate for utilitarianism. Thus
utilitarianism may best operate in a
deontological context that limits its potential
for excesses.
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Chapter 2 Value Systems Economic Systems
Ethics Does the fundamental economic problem of
allocating scarce resources among competing ends
exist regardless of whether society subscribes to
a deontological or a teleological system of
ethics?
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Chapter 2 Value Systems Economic Systems
Utilitarianism and Efficiency Utilitarianism also
allows for the evaluation of efficiency. What is
a good general definition of efficiency?
Minimization of waste.
There are two different efficiency criteria
commonly used by economists for evaluating social
policy Pareto and Kaldor-Hicks
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Chapter 2 Value Systems Economic Systems
Pareto Efficiency What is Pareto efficiency?
Compares policy alternatives to the status
quo. To be Pareto efficient, a new policy
alternative must make some people better off
(increase their utility), perhaps leave some
people unaffected, and make nobody worse off
(decrease their utility), relative to the status
quo.
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Chapter 2 Value Systems Economic Systems
Pareto Efficiency Does wilderness designation
satisfy the Pareto criterion?
No. Why?
Did closure of Black Sands Beach by Shelter
Cove to ATV recreationalists satisfy the Pareto
criterion?
No. Why?
No. Why?
Did the emancipation of slaves in the U.S.
satisfy the Pareto criterion?
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Chapter 2 Value Systems Economic Systems
Pareto Efficiency Is it fair to say that the
Pareto efficiency criterion is biased toward
maintaining the status quo?
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Chapter 2 Value Systems Economic Systems
Kaldor-Hicks Efficiency What is the Kaldor-Hicks
efficiency criterion?
Evaluates policy alternatives as well as the
status quo. The Kaldor-Hicks efficient policy
alternative (which may be the status quo)
generates the largest net social utility (or net
social benefit), even if some are made worse off.
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Chapter 2 Value Systems Economic Systems
Kaldor-Hicks Efficiency The Kaldor-Hicks
efficiency criterion is sometimes referred to as
being potentially Pareto efficient because the
potential exists for those made better off to
compensate those made worse off, which would lead
to Pareto efficiency by sharing net social
benefits with all members of society.
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Chapter 2 Value Systems Economic Systems
Self Interest, the Common Good, and Social
Order One of the central dilemmas that all
societies must confront is how to maintain social
order and thus balance the sometimes-conflicting
imperatives of self-interest and the common good.
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Chapter 2 Value Systems Economic Systems
Self Interest, the Common Good, and Social
Order What did Hobbes say was the natural order
of the human condition in the absence of a
common power to keep people in awe?
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Chapter 2 Value Systems Economic Systems
Self Interest, Common Good, and Social
Order Hobbes Hereby it is manifest that during
the time men live without a common power to keep
them all in awe, they are in that condition which
is called war and such a war as is of every man
against every man. Whatsoever therefore is
consequent to a time of war, where every man is
enemy to every man, the same consequent to the
time wherein men live without other security than
what their own strength and their own invention
shall furnish them withal. In such condition
there is no place for industry, because the fruit
thereof is uncertain and consequently no culture
of the earth no navigation, nor use of the
commodities that may be imported by sea no
commodious building no instruments of moving and
removing such things as require much force no
knowledge of the face of the earth no account of
time no arts no letters no society and which
is worst of all, continual fear, and danger of
violent death and the life of man, solitary,
poor, nasty, brutish, and short.
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Chapter 2 Value Systems Economic Systems
Self Interest, Common Good, and Social Order If
we assume for a moment that Hobbs is right, then
what is this common power that keeps people in
awe and prevents violent and destructive conflict?
According to Hobbes, these people will establish
fundamental moral laws to preserve peace. This
was called the social contract.
What are some criticisms of Hobbs view of human
interaction?
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Chapter 2 Value Systems Economic Systems
Social Contract Theory John Locke The natural
state (for humans) is a pre-political, yet moral,
society where humans are bound by divinely
commanded natural law. A social contract is made
between citizens who institute a government to
prevent people from occasionally violating
natural law and showing partiality.
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Chapter 2 Value Systems Economic Systems
Social Contract Theory Jean-Jacques Rousseau The
state of nature is not a state of war, but a
state of individual freedom where creativity
flourishes. Since a fully mature person is a
social person, a social contract is established
to regulate social interaction. This contract
between citizens establishes an absolute
democracy which is ruled by the general will, or
what is best for all people.
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Chapter 2 Value Systems Economic Systems
Social Contract Theory John Rawls (A Theory of
Justice, 1971) In the original position
(heavens waiting room?), a group of rational
and impartial people will establish a mutually
beneficial principle of justice as the foundation
for regulating all rights, duties, power, and
wealth.
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Chapter 2 Value Systems Economic Systems
Social Contract Theory Francis Fukuyama The
modern liberal state was premised on the notion
that in the interests of political peace,
government would not take sides among the
differing moral claims made by religion and
traditional culture. Church and State were to be
kept separate there would be pluralism in
opinions about the most important moral and
ethical questions, concerning the ultimate ends
or the nature the good. Tolerance would become
the cardinal virtue in place of moral consensus
would be a transparent framework of law and
institutions that produced political order. Such
a political system did not require that people be
particularly virtuous they need only be rational
and follow the law in their own self-interest
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Chapter 2 Value Systems Economic Systems
The Social Contract and Social Capital The
transparent framework of law and institutions
described by Fukuyama must be supplemented by at
least a minimum level of social capital. What is
social capital, and why is it important here?
Social capital refers to the stock of civic
virtues and networks of civic engagement,
involvement, volunteerism, reciprocity norms, and
trust essential to democratic communities.
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Chapter 2 Value Systems Economic Systems
The Social Contract and Social Capital While
social capital seems to be a precondition for
economic development and effective government, it
tends to be under-provided by private agents.
Thus the culture of individualism that is
reinforced by the modern liberal state undermines
the shared values and the contribution to social
capital that creates social order.
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Chapter 2 Value Systems Economic Systems
Origins of Property Locke Every man has a
Property in his own Person. . . . The Labor of
his Body, and the Work of his Hands, we may say,
are properly his. Whatsoever then he removes out
of the State that Nature hath provided, and left
it in, he hath mixed his Labor with, and joined
to it something that is his own, and thereby
makes it his Property. It being by him removed
from the common state nature placed it in, hath
by this Labor something annexed to it, that
excluded the common right of other Men. Yet
there are still greatest Tracts of Ground to be
found, which (the Inhabitants thereof not having
joyned with the rest of Mankind, in the consent
of Use of their common Money) lie wasts, and are
more than the People, who dwell on it, do, or can
make use of, and so still lie in common."
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Chapter 2 Value Systems Economic Systems
Origins of Property How do Lockes statements on
the necessary conditions for establishing a
property right to land relate to the U.S.
experience with Native Americans and homesteading?
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Chapter 2 Value Systems Economic Systems
Origins and Consequences of Property What was
Rousseau's view of the origin and the effect of
private property?
Skills and leisure time ?
Tools and other conveniences
Farmers use tools to increase ag. output to feed
artisans
Artisans need food ?
Rousseau The division of land necessarily
followed from its cultivation, and once property
had been recognized it gave rise to the first
rules of justice.... It is work alone that gives
a farmer title to the produce of the land he has
tilled, and consequently to the land itself.
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Chapter 2 Value Systems Economic Systems
Origins and Consequences of Property Rousseau
The division of land had produced a new kind of
right the right of property.
Natural inequality in skills, motivation, etc.
become heightened by inequalities of exchange
Status became a function of property, which
people are unhappy to lose, but not happy to
have.
The fall from the grace of a pre-property golden
age.
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Chapter 2 Value Systems Economic Systems
Origins and Consequences of Property Rousseau To
the poet it is gold and silver, but to the
philosopher it is iron and grain that made men
civilized and brought on the downfall of the
human race.
Freedom was lost as people became slaves to the
social demands for property, leading to
competition and rivalry on the one hand,
opposition of interests on the other, and always
the hidden desire to profit at the expense of
others. All these evils were the first effect of
property
What do you think?
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Chapter 2 Value Systems Economic Systems
Positive v. Normative Economics What is positive
economics?
Explains what is using best methods. Peer
review. Evolutionary process by which as
hypotheses are maintained rather than rejected
over time they come closer and closer to fact.
Attempts to be scientific and objective.
In what ways do scientists, the scientific
community, and society introduce their values
into so-called objective science?
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Chapter 2 Value Systems Economic Systems
Positive v. Normative Economics What is normative
economics?
Argues for what should be in terms of social
policy. Ex we should raise taxes on the rich to
fund services for the poor or we should cut
business taxes to encourage firms to create
jobs. Disputation naturally and necessarily
arises.
Normative economics is the arena for advocating
ones values.
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Chapter 2 Value Systems Economic Systems
The Three Economic Questions What are the three
economic questions that all economies must
answer, regardless of value system?
1. What to produce with our resources (land,
labor, capital, entrepreneurship).
2. How to produce what we have decided to produce.
3. For whom are we producing (who gets the stuff)?
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Chapter 3 The Economics of Market Allocation
Learning objectives
Understand the conditions that are required for
the existence of a well-functioning competitive
market
Learn about the concepts of market equilibrium
and efficient resource allocation
Understand the different types of market failure,
and the types of interventions that may enhance
efficiency
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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
What is the economic definition of capitalism?
Resources (land, labor, capital) are privately
owned, and production and exchange occurs by way
of decentralized markets.
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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
What does it mean to say that there is separation
of ownership and control in a modern corporation?

• Publicly traded ownership shares make it much
  easier for firms to raise money from investors
  (why?)
• Shareholders own the corporation, but management
  runs the company (subj. to board oversight)

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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
How are the three economic questions answered in
a capitalist system?

• What to produce driven by consumer demand
• How to produce driven by incentive of profit
  maximizers to minimize cost.
• For whom to produce driven by
  willingness-to-pay

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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
What are the origins of capitalism?

• Motivation for trade (spices, silk, jewels, etc)
  ?

Need for physical capital (ships, mules,
inventory, )

• People with talent to be traders (entrepreneurs)
  usually lacked money to buy capital
  ?

Development of banks, insurance, etc
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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
Current concerns?

• Corporate power, ethics, influence, and
  accountability
• Can a national government have sovereignty over
  modern transnationals?
• International trade and investment treaties may
  provide inadequate labor and environ. protection

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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
Current concerns, continued

• Large corporations may partner with undemocratic
  governments on projects that exploit the
  unempowered
• Other?

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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
The corporate structure is so prevalent in part
because it is very effective at raising funds
from small investors and limiting liability
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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
What did Adam Smith mean by the concept of the
invisible hand of the market?
Remarkable outcome that efficient system-wide
resource allocation can result from the
interaction of self-interested parties in
markets, rather than the visible hand of a
central planner
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Chapter 3 The Economics of Market Allocation
Capitalism A Brief Overview
Suppose that we wanted to replace decentralized
market allocation with central planning. How much
information would the planner need in order to
know what to produce, how much, how to produce,
etc?
Hayek Billions of bits of information are
integrated in market exchanges.
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Chapter 3 The Economics of Market Allocation
Assertion A well-functioning competitive market
in equilibrium is efficient
Lets work through each part of this assertion
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
What is required in order to have a
well-functioning competitive market?

• Well-defined and enforceable property rights
  that determine ownership and the right to sell
• A market institution that sets prices and
  facilitates trades at low transaction costs
• Large numbers of buyers and sellers, each small
  in size relative to the overall market, and thus
  lacking the market power to individually
  manipulate market price.

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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
What is required in order to have a
well-functioning competitive market, continued

• There are no significant positive or negative
  externalities (to be discussed in Chapter 4)
• Buyers and sellers cannot collude
• There is potential for low-cost entry and exit
  by potential buyers and sellers
• Information on price, quality, availability, etc
  is low cost

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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
When one or more of these conditions fail to hold
in an important way, the result is called market
failure, which we will discuss later
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Now lets explore the concept of a
well-functioning competitive market being in
equilibrium
Demand What are the various factors that
influence the quantity of a particular good or
service demanded by consumers in a market?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Quantity demanded (QD) function of

• the price of the good

• overall consumer incomes (macroeconomic
  conditions)

• price of substitutes and complements

• number of buyers

• buyers expectations regarding future price
  changes

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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Quantity demanded (QD) function of (cont)

• perceived product quality

• consumer confidence (economic stability)

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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Regular demand equation Q f(P, Ps, Pc, I, )
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Demand Curve Graphical illustration of a demand
schedule, which indicates the relationship
between price (y variable) and quantity demanded
(x variable), holding all other demand factors
constant.
Regular demand Q f(P) Inverse demand P g(Q)
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Law of Demand Inverse relationship between price
and quantity demanded. Why?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Market demand horizontally sums individual
consumer demand (adding up individual quantities
demanded at a given market price)
Origin of individual consumer demand
Willingness-to-pay, a combination of (i)
preferences (utility) and (ii) ability to pay
(relative prices and budget)
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Chapter 3 The Economics of Market Allocation
Sidebar Consumer theory and individual consumer
demand
Consumers are assumed to be utility maximizers,
but are constrained by their limited budget.
Consumers select a consumption bundle that is the
solution to a constrained optimization problem
MaxX U(X) s.t. PX Y, X 0
Where PX is the dot product of the vector of
quantities of various consumer goods X and the
vector of prices P. Y is the consumers income
(or resources).
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Chapter 3 The Economics of Market Allocation
Sidebar Consumer theory and individual consumer
demand
In a simple two-good case, the consumer
equilibrium features equality of the marginal
rate of substitution (the ratio of the two goods
marginal utilities) to the ratio of the two
goods prices. MUx1/MUx2 Px1/Px2
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Chapter 3 The Economics of Market Allocation
Sidebar Consumer theory and individual consumer
demand
Law of Diminishing Marginal Utility As
consumption of good xi increases, MUxi
decreases. Therefore, in the preceding two good
example, if Px1 rises, returning to a consumer
equilibrium requires some combination of MUx1
increasing (from consumption of x1 decreasing)
and MUx2 decreasing (from consumption of x2
increasing). Normally as price rises quantity
consumed (demanded) falls. This is the law of
demand. Now, back to demand
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
Note If a factor other than price changes (such
as perceived quality, number of buyers, price of
substitutes or complements, etc), the demand
curve itself will shift out (increase in demand)
or in (decrease in demand)
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Chapter 3 The Economics of Market Allocation
Example Increase in demand for firewood when the
price of natural gas doubles
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Supply What are the various factors that
explain the quantity of a good or service
supplied by sellers in a market?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Quantity supplied (QS) function of

• the price of the good

• production costs

• price of production substitutes (e.g., corn v.
  wheat prices for a farmer capable of growing
  either

• sellers expectations regarding future price
  changes

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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Quantity supplied (QS) function of (cont)

• number of sellers

• taxes, subsidies, and other government
  interventions

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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Supply Curve Graphical illustration of a supply
schedule, which indicates the relationship
between price (y variable) and quantity supplied
(x variable), holding all other demand factors
constant.
Law of Supply Direct relationship between price
and quantity supplied. Why?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Note Individual sellers have an opportunity cost
associated with selling a given quantity of good
or service in the market. Points along the market
supply curve represent suppliers opportunity
costs
Activity How many of you who own a car will sell
at 100, 500, 1000, 2000, 5000, 10,000,
25,000?
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
Equilibrium
1. At prices above point A on the previous
diagram, is there a shortage (excess demand) or a
surplus (excess supply)?
Surplus (excess supply) At prices above point
A quantity supplied exceeds quantity demanded
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
Equilibrium
1. When there is excess supply, what tends to
happen to price?
Price tends to fall. Why?
Can you think of a real-world example?
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Chapter 3 The Economics of Market Allocation
Equilibrium
2. At prices below point A on the previous
diagram, is there a shortage (excess demand) or a
surplus (excess supply)?
Shortage (excess demand) At prices below point
A quantity demanded exceeds quantity supplied
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Chapter 3 The Economics of Market Allocation
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Chapter 3 The Economics of Market Allocation
Equilibrium
2. When there is excess demand, what tends to
happen to price?
Price tends to rise. Why?
Can you think of a real-world example?
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Chapter 3 The Economics of Market Allocation
3. What is an equilibrium price?
In a well-functioning competitive market, market
forces tend to push prices toward the
equilibrium price. At the equilibrium price QD
QS and there is neither excess demand nor excess
supply.
If demand and supply are stable, then price may
stabilize at the equilibrium price. If demand
and/or supply fluctuate frequently, then price
will constantly be displaced as it is moving
toward an equilibrium that itself will be
changing.
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Chapter 3 The Economics of Market Allocation
The simple algebra of equilibrium and
comparative-static analysis
Suppose that inverse demand is given by the
equation P a bQ And supply is given by the
equation P c dQ First Intuition regarding
these equations? Second What is a reduced-form
equation?
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Chapter 3 The Economics of Market Allocation
The simple algebra of equilibrium and
comparative-static analysis, continued
Inverse Demand p a bq Inverse Supply p c
dq Third Derive the reduced-form solutions for
equilibrium p and q (denoted p and q) Fourth
What is comparative-static analysis? Fifth
Derive the comparative-static partial derivatives
for P with regard to a and b. Interpret
diagrammatically on a S/D diagram.
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Chapter 3 The Economics of Market Allocation
The simple algebra of equilibrium and
comparative-static analysis, continued
The sign of a comparative-static partial
derivative provides us with qualitative
information about how a small change in the
parameter affects the endogenous variable. The
magnitude of a comparative-static partial
derivative provides us with quantitative
information about how a small change in the
parameter affects the endogenous variable.
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Last step What does it mean to say that this
equilibrium is efficient?
Resources in this market are said to be
efficiently allocated when the welfare of the
market participants (as measured by gains from
trade) is maximized.
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
The share of the gains from trade that flow to
consumers is called consumers surplus (CS). For
a single unit purchased,
CS (willingness-to-pay) price 0
Summing for all consumers, consumers surplus is
the area between the demand curve and the price
line
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
The share of the gains from trade that flow to
producers is called producers surplus (PS). For
a single unit sold,
PS price opportunity cost 0
Summing for all producers, producers surplus is
the area between the price line and the supply
curve
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
PS CS total surplus, or total gains from
voluntary exchange in this well-functioning
competitive market
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Chapter 3 The Economics of Market Allocation
p
q
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Using our simple linear equations, consumer
surplus is given by
q
? (a bq)dq pq
0
What is the solution?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Solving this definite integral yields consumer
surplus
CS q(a bq/2 p)
Where p and q are equilibrium price and
quantity values
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Using our simple linear equations, producer
surplus is given by
q
pq - ? (c dq)dq
0
What is the solution?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Solving this definite integral yields producer
surplus
q(p c dq/2)
Where p and q are equilibrium price and
quantity values
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Thus total surplus (the total gains from trade)
is given by
TS q(a c (bd)q/2)
Where p and q are equilibrium price and
quantity values
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
TS q(a c (bd)q/2)
What are the signs of the comparative-static
partial derivatives for TS with regard to a and b
(note substitute the reduced form solution for
q first)? Interpretation?
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Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
The equilibrium is efficient because the total
gains from trade are as large as possible.
At any other price there is excess supply or
demand, and the total gains from trade are smaller
Remember Pareto efficiency? Is the equilibrium
above Pareto efficient? Why or why not?
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Chapter 3 The Economics of Market Allocation
Price above equilibrium ? (CS PS) smaller, thus
inefficient
p
DWL
q
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Chapter 3 The Economics of Market Allocation
Price below equilibrium ? (CS PS) smaller, thus
inefficient
DWL
p
q
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Chapter 3 The Economics of Market Allocation
Market Failures
Note that DWL in the preceding diagrams stands
for deadweight (social) loss, and refers to the
loss of gains from trade due to non-equilibrium
prices and quantities.
q
DWL ? a c (bd)qdq
DWL ? a c (bd)qdq
q
Where q is the non-equilibrium quantity. What is
the solution?
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Chapter 3 The Economics of Market Allocation
Market Failures
Solving this definite integral yields
DWL (a-c)(q-q) (bd)(q2-q2)/2
Where q is the non-equilibrium quantity.
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Chapter 3 The Economics of Market Allocation
Market Failures
A market failure occurs when one or more of the
requirements for a well-functioning competitive
market fails to hold in a significant way
1. Monopolies, cartels, and market power ? firms
are able to withhold quantity from the market to
raise price, which results in inefficiency.
Intervention Antitrust and regulation policy
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Chapter 3 The Economics of Market Allocation
Market Failures
2. Externalities (positive or negative to be
discussed in Chapter 4)
Prices and quantities distorted in the market ?
inefficiency. Government interventions Wait till
next chapter ?
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Chapter 3 The Economics of Market Allocation
Market Failures
4. Imperfect information on quality, safety, etc
Too much or too little is produced and consumed,
depending on whether quality/safety is over or
understated, leading to inefficiency.
Intervention (1) provide labeling information.
(2) set minimum standards
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Chapter 3 The Economics of Market Allocation
Market Failures
5. Inequity
Does not imply inefficiency, because most all
markets, even those that are highly efficient,
feature inequities. Recall Rousseau.
Interventions Redistribution through tax and
government programs subsidized education, etc.
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Chapter 3 The Economics of Market Allocation
Government Failures
As we will learn in much more detail in Chapter
7, government interventions also suffer
inefficiencies. Alas!, efficiency-enhancing
policies may not be politically feasible, and
those policies that are politically feasible may
lead to substantial inefficiencies
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Chapter 3 The Economics of Market Allocation
Practice problem

• Supply P c dq Demand P a
  bq
• Create an Excel spreadsheet file called Econ 523
  homework. Put S and D equations in sheet 1
  (label as S/D Analysis). Let a 2000, b
  1, c 100, and d 2. Plot the supply and
  demand curves for different p and q parameter
  values in a fully labeled diagram.
• Solve for equilibrium p and q in the same sheet
  (carefully label your answer) using parameters
  above. Build a table showing comparative-static
  results for p and q when a is 1000, 2000, and
  3000, and when and c is 50, 100, and 200.
  Provide a brief economic interpretation.

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Chapter 3 The Economics of Market Allocation
Practice problem, continued
3. Put reduced-form equations for consumer and
producer surplus in the same sheet and build a
table showing consumer and producer surplus for
the different values for a and c given in
part 2 above. Provide a brief economic
interpretation. 4. In the same sheet provide
one example of out of equilibrium p and q
values (perhaps due monopoly or false product
information) and derive consumer surplus,
producer surplus, and deadweight loss. Provide a
brief economic interpretation.