1. ENV 536: Environmental Economics and Policy (Lecture 3) Modeling the Market Process: A Review of the Basics
Asst.Prof. Dr. Sasitorn Suwannathep
School of Liberal Arts
King Mongkut’s University of Technology Thonburi

2. Circular Flow Model of Economic Activity

3. Materials Balance Model: The Interdependence of Economic Activity and Nature

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

5. Market Models: The Fundamentals
A market refers to the interaction between consumers (or buyers) and producers (or sellers) for the purpose of exchanging a commodity.

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

7. The Model of Supply and Demand (con’t)
An investigate of price movements can identify
shortages and surpluses
The existence of resource misallocations
And the economic implications of government policy.

8. Basic Assumptions to Supply and Demand Model
A competitive goods market
A large number of buyers and sellers
A homogeneous product
The absence of entry barriers
Perfect information
A competitive resources market
A private good
Rivalry in consumption
Excludability

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

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

11. Law of Demand
The relationship between quantity demanded and price is inverse one.
P Qd , P Qd

12. Demand Model (con’t) Many factors influence individual demand:
Wealth or income
The prices of related goods (i.e., substitutes or complements)
Preference
Price expectations

13. Market Demand
Market demand is the sum of individual demands (we sum the quantities at each demand price).
Demand for consumer 1: qd1 = -2P + 23
Demand for consumer 2: qd2 = -4P + 46
Market demand (Dm) = -6P + 69
(ass. There are two persons in the market)

14. Market Demand Curve Qd = -6P + 69 Price: P 11.50 Market Demand Dm 6969
Quantity: Q

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

16. Firm Supply Curve qs = -4 + 16P Price: P Supply Function S = MC 2.00
Note: qs = MC
As the firm produces more output (Q),
the total costs (TC) will be rise, which
mean that change in Q ( ∆ Q) cause
change in TC (or ∆ TC) or
(∆ TC/ ∆ Q) = MC
0.25 28
Quantity: Q

17. Law of Supply
The relationship between quantity supplied and price is a positive one.
P Qs , P Qs

18. Supply Model (con’t) Several factors determine supply
Production technology
Input price
Tax and subsidies
Price expectations

19. Market Supply
Market supply is the sum of individual supply at each price.
Supply of producer 1: qs1 = P
Supply of producer 2: qs2 = P
Market Supply (Sm) = P
(ass. There are two producers in the market)

20. Market Supply Curve Qs = -8 + 32P Supply Function Price: P Sm = ∑ MC
2.00
0.25 56
Quantity: Q

21. Equilibrium Price and Quantity
The forces of demand and supply determine a equilibrium price (PE) and quantity (QE)
Price
Surplus Sm P1 E PE
Shortage P2 Dm
Quantity QE

22. Economic Criteria of Efficiency
Allocative Efficiency: the proper allocation of resources among alternative uses.
Technical Efficiency: the economizing resources used in production.

23. Allocative Efficiency
To evaluate resource allocation, we can do through:
Assessment of benefits and costs
The use of marginal analysis

24. Allocative Efficiency (con’t)
Resource Allocation at the Market Level
At market level, the price along the demand curve are measures of marginal benefit (MB).
On supply side, the prices are measures of economic cost, the market supply is the sum of firms’ marginal cost (MC).
Allocative efficiency requires that the additional value society place on another unit of the good is equal to what society must give up in resources to produce it.
MB = MC

25. Allocative Efficiency (con’t)
Resource Allocation at Firm Level
the firm prefers profit maximization.
TR = P * q when P: market price
q: the sold output
TC : all economic costs associated with production
Total profit (  )= Total Revenue (TR) – Total Costs (TC)

26. Allocative Efficiency (con’t)
If TR > TC, the firm will increase production.
MR > MC , M  > 0
when MR = ∆ TR / ∆ q
MC = ∆ TC / ∆ q
Profit maximization occurs when
MR = MC , M  = 0

27. MR < MC, decrease output
MR > MC, produce more output
MR = MC
Source: Callan, S. J. and Thomas, J. M Environmental Economics and Management:
Theory, Policy, and Applications.

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

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

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

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

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

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

34. Society’s Welfare: Sum of Consumer and Producer Surplus
Society’s welfare is measured as the sum of consumer and producer surplus, which is maximized when allocative efficiency is achieved.
Deadweight loss to society: the net loss of consumer and producer surplus due to an allocatively inefficient market event.

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