Environmental and Natural Resources Economics

1
Environmental and Natural Resources Economics

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

2
Overview
Section I Theory

• Fundamentals of economics (chapter 1)
• Values, value systems, and economics (chapter 2)
• Perfect competition and market failures (chapter
  3)
• Externality theory (chapter 4)
• Natural Resources (chapter 5)

3
Overview
Section II Policy

• Benefit/cost analysis (chapter 6)
• Political economy (chapter 7)
• Enforcement and compliance (chapter 8)
• Incentive regulation (chapter 9)
• Global climate change (chapter 10)

4
Internet resources
www.humboldt.edu/envecon/econ_423.html

• Lecture outlines
• Old exams with answers
• Student essays

5
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.
6
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.
7
Chapter 1 Fundamental Concepts

• Activity How to allocate something scarce

Need, favoritism, voting, auction/market, riot,
equal division, committee, lottery/random
8
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?

9
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?

10
Chapter 1 Fundamental Concepts
Scarcity

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

11
Chapter 1 Fundamental Concepts

• Since so many aspects of our world involve
  choices necessitated by a condition of scarcity,
  some element of economics is exists in most
  everything we do, whether we are aware of it (or
  whether we like it) or not.

12
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?

13
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 always
  conveniently revealed in a market, and thus is
  subject to inappropriate use.

14
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?

15
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.

16
Chapter 1 Production Possibilities
The concepts of scarcity and opportunity cost can
be illustrated in a production possibilities
frontier (PPF).
The PPF represents all the possible combinations
of food and clothing that can be produced in a
given time period when available resources are
fully and efficiently employed.
17
Chapter 1 Production Possibilities
18
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 model the
  choice environment confronting individuals,
  businesses, or government. With enough
  information we can construct economic models to
  predict choice.

19
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
20
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
21
Chapter 1 Fundamental Concepts
What sort of questions and problems are studied
in the area of ecological economics?

• Understanding and restoring stocks of natural
  capital, from which flow various forms of
  ecosystem goods and services.
• What are some examples of ecosystem goods and
  services?

22
Chapter 1 Fundamental Concepts
What are some examples of environmental or
natural resource policy success stories?
23
Chapter 1 Fundamental Concepts
What are some examples of continuing
environmental or natural resource problems that
need to be resolved?
24
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.
25
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?
26
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.
27
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.
28
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.
29
Chapter 2 Value Systems Economic Systems
Fundamentals of Ethical Systems Ethics is a
branch of philosophy that is concerned with
morality and ideal human character (right and
wrong, good and bad). Morality refers to a code
of conduct that is held to authoritative in
matters of right and wrong.
30
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.
31
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
32
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.
33
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.
34
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.
35
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.
36
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).
37
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.
38
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."
39
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)
40
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?
41
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
42
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.
43
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.
44
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
45
Chapter 2 Value Systems Economic Systems
Teleological Ethics There are three subdivisions
of consequentialism 1. Ethical Egoism The
moral rightness of an action depends upon how the
consequences affect the agent performing the
action. 2. Ethical Altruism The moral rightness
of an action depends upon how the consequences
affect everyone in society except the agent
performing the action.
46
Chapter 2 Value Systems Economic Systems
Teleological Ethics Three subdivisions of
consequentialism, cont 3. Utilitarianism The
moral rightness of an action depends upon how the
consequences affect everyone in society.
This third subdivision of consequentialism,
utilitarianism, is most relevant to economic
policy, and forms the ethical basis for
benefit/cost analysis
47
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.
48
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.
49
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.
50
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.
51
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.
52
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.
53
Illustration
54
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? relate to
ordinal utility
- Tyranny of the majority (same failing as
democracy)
55
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
56
Chapter 2 Value Systems Economic Systems
Pareto Efficiency What is Pareto efficiency?
Compares policy alternatives to the status
quo. To be a Pareto improvement overt the status
quo, 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).
57
Pareto Efficiency

• In terms of our table several slides ago, policy
  options B and C both offer a Pareto improvement
  over the status quo.
• If policies B and C cannot be further modified
  in any way that generates additional Pareto
  improvements, then both policies B and C are said
  to be Pareto efficient.

58
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? This presents ethical
problems when the status quo is widely held to be
unethical (e.g., slavery).
59
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.
60
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.
61
Kaldor-Hicks Efficiency

• Going back to the table, option A generates the
  largest net social utility, and thus is
  Kaldor-Hicks efficient.
• The problem is that option A makes Edwin worse
  off relative to the status quo, and thus does not
  represent a Pareto improvement over the status
  quo.

62
Illustration
63
Kaldor-Hicks Efficiency

• If option A could be further modified in such a
  way that Jing and Rose were to jointly transfer
  at least 20 units of utility to Edwin, then the
  new modified version of option A would be both
  Pareto efficient and Kaldor-Hicks efficient.

64
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.
65
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?
66
Chapter 2 Value Systems Economic Systems
Self Interest, the 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.
67
Chapter 2 Value Systems Economic Systems
Self Interest, the 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?
68
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 violating natural law.
69
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.
70
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 (including social
contract principles) as the foundation for
regulating all rights, duties, power, and wealth.
71
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
72
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.
73
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.
74
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."
75
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?
76
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.
77
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.
78
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?
79
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?
80
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.
81
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)?
82
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 equilibrium and
efficient resource allocation
Understand the different types of market failure,
and the types of interventions that may enhance
efficiency
83
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.
84
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)

85
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

86
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
87
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

88
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?

89
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
90
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
91
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.
92
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
93
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.

94
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

95
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
96
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?
97
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

98
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)

99
Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient

• Using statistical techniques called
  econometrics, one can quantitatively estimate a
  demand function (not required for this class)
• This allows economists to focus on key
  cause-effect relationships
• The most important cause-effect relationship is
  between price and quantity demanded

100
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.
Law of Demand Inverse relationship between price
and quantity demanded. Why?
101
Chapter 3 The Economics of Market Allocation
A well-functioning competitive market in
equilibrium is efficient
Individual consumer demand reflects
willingness-to-pay, a combination of (i)
preferences and (ii) ability to pay. Lets
consider the derivation of an individual demand
curve.
102
Chapter 3 The Economics of Market Allocation
Consider the following marginal utility data for
a simplified consumer choice problem
103
Chapter 3 The Economics of Market Allocation
If each lunch alternative below costs 4 and if
our consumer has a budget of 24 per week to
fully spend on lunches, how many of each will she
buy in order to maximize her total utility?
Use marginal analysis to shop for the largest
available marginal utility with each 4
expenditure. You identify these choices by
dividing the marginal utility values in the
preceding table by each items price, which gives
you marginal utility per dollar spent. Then shop
for the largest marginal utility per dollar spent
(biggest bang for the buck).
104
Chapter 3 The Economics of Market Allocation
Calculate Marginal Utility per Dollar Spent for
Each Option
105
Chapter 3 The Economics of Market Allocation
Our consumers weekly lunch choice will start
with buying a sub, followed by another sub. This
will continue until she has successively bought 4
subs and 2 burritos for her weekly lunches.
This fully expends her 24 weekly lunch budget,
and generates 146 units of total utility. Can you
spend 24 given her marginal utility data and get
more total utility?
106
Chapter 3 The Economics of Market Allocation
Now lets do a comparative-static experiment and
reduce the price of burritos to 2. Ceteris
paribus, how will this affect our consumers
utility-maximizing weekly lunch choices?
Now our hungry consumer will maximize her total
weekly utility by consuming six burritos and
three subs each week.
107
Chapter 3 The Economics of Market Allocation
Calculate Marginal Utility per Dollar Spent for
Each Option
108
Chapter 3 The Economics of Market Allocation
Now we can derive our consumers demand curve for
burritos, since we have two price observations
(4 and 2) and two quantity demanded
observations (2 and 6).
109
Chapter 3 The Economics of Market Allocation
110
Chapter 3 The Economics of Market Allocation
There are many consumers buying burritos in this
city. If at a price of 4 we added up the
quantity demanded by all burrito consumers in the
city, we would get one point on the MARKET demand
curve for burritos in the city.
Do the same at a price of 2. You can then draw
the market demand curve. This process is called
horizontal summation (adding up individual
quantities demanded at each price horizontal,
since quantity is on the horizontal or x axis).
111
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)
112
Chapter 3 The Economics of Market Allocation
Example Increase in demand for firewood when the
price of natural gas doubles
113
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?
114
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

115
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

116
Chapter 3 The Economics of Market Allocation
In a competitive market, sellers supply along
their marginal cost curves. Lets prove that.

• Defining terms
• Profit total revenue total cost.
• Marginal cost (MC) increase in total cost
  caused by a small increase in output.
• Marginal product of labor additional output
  added by an additional unit of labor.
• Marginal revenue (MR) increase or decrease in
  total revenue caused by a small increase in
  output. In a competitive market, MR is equal to
  market price P.

117
Chapter 3 The Economics of Market Allocation

• Defining terms, continued
• Economic short run Time period in which capital
  is fixed.
• Law of Diminishing Marginal Returns In the
  short run as more and more of a variable input is
  added to a fixed input, congestion occurs and the
  marginal productivity of the variable input
  eventually declines.

118
Chapter 3 The Economics of Market Allocation
We will now derive a competitive firms supply
curve from its marginal cost curve. We will do so
using a restaurant example. The following tables
show hypothetical information
119
Chapter 3 The Economics of Market Allocation
120
Chapter 3 The Economics of Market Allocation
The preceding table demonstrates something called
the Law of Diminishing Marginal Returns.
In the economic short run, where capital is
fixed, then as you use more and more of a
variable factor with the fixed factor, the
marginal productivity of the variable factor will
eventually decline. This is because the variable
factor (e.g., of chefs) experiences congestion
due to the capacity constraint of the fixed
factor (e.g., the size of the kitchen).
121
Chapter 3 The Economics of Market Allocation
122
Chapter 3 The Economics of Market Allocation
In the preceding slide we see that the
profit-maximizing quantity of food to produce
(and number of restaurant employees to hire)
occurs where marginal cost equals marginal
revenue. This is indicated in bold font in the
preceding slide.
123
Chapter 3 The Economics of Market Allocation
Lets see how the profit-maximizing quantity of
food to produce by the restaurant changes if the
menu price of the food increases. What do you
think will happen? Why?
124
Chapter 3 The Economics of Market Allocation
125
Chapter 3 The Economics of Market Allocation
As price rises, the restaurant can justify hiring
more workers and produce a larger quantity of
meals. In order to produce more in the short run,
price must rise in order to induce the firm to
justify paying a higher marginal cost.
As price rises, the firm increases output by
setting P MC. What do we call a curve that
explains the relationship between price and
quantity supplied?
126
Chapter 3 The Economics of Market Allocation
127
Chapter 3 The Economics of Market Allocation
As with demand, one can horizontally sum
quantities supplied at each market price in order
to get the market supply curve. Now lets put
market supply and demand together.
128
Chapter 3 The Economics of Market Allocation
129
Chapter 3 The Economics of Market Allocation
Market equilibrium The Law of One Price there
is one price where QS QD. There is no excess
supply or excess demand. Occurs at the
intersection of the supply and the demand curves.
Efficient resource allocation When we say that a
well-functioning competitive market in
equilibrium is efficient, we mean that we cannot
increase or decrease quantity produced and
improve the total gains from trade (or welfare)
of the market participants.
130
Chapter 3 The Economics of Market Allocation
Consumer Surplus Like getting a bargain,
consumer surplus measures the gains from
voluntary trade that flow to consumers. It is
measured by the difference between the demand
curve and price, up to quantity purchased.
Producer Surplus Like profit (except leaving out
fixed cost), producer surplus measures the gains
from voluntary trade that flow to producers
(firms). It is measured by the difference between
price and the supply curve, up to the quantity
sold.
131
Chapter 3 The Economics of Market Allocation
132
Chapter 3 The Economics of Market Allocation
133
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
Relative to the status quo of no exchange, the
competitive market equilibrium is Pareto
efficient. Why?
134
Chapter 3 The Economics of Market Allocation
Price above equilibrium ? (CS PS) smaller, thus
inefficient
135
Chapter 3 The Economics of Market Allocation
Price below equilibrium ? (CS PS) smaller, thus
inefficient
136
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
137
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 ?
138
Chapter 3 The Economics of Market Allocation
Market Failures
3. Collectively Consumed Goods
Common-pool resources (CPRs) are accessed by
multiple people, and feature subtractability
(what is used by one is not available to
another). Self-interested market allocation can
result in tragedy of the commons outcomes. More
in Chapter 5.
139
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
140
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.
141
Chapter 3 The Economics of Market Allocation
Government Failures
As we will learn in much more detail in Chapter
8, 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
142
Chapter 3 The Economics of Market Allocation
Practice Problem

• Supply P 100 0.1Q
• Demand P 1000 0.05Q
• Plot equations on a fully labeled diagram
• Solve for equilibrium P and Q
• Compute CS, PS, and total surplus
• Can Q and P be rearranged in a way that would
  increase total surplus?