Economic Theory

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Economic Theory

• Chapter 3

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Two important questions

• Do unregulated markets forces tend to damage
  natural resources and the environment?
• Can market forces be harnessed to protect natural
  resources and the environment?
• Answering these questions requires knowing
  something about economic theory

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Roles of Economic Theory

• Economic theory provides foundation for
  understanding the economic approach to the
  environment
• This chapter presents the concepts economists use
  to understand current environmental and natural
  resource problems as well as develop policy
  solutions.

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Objectives

• Explain how competitive markets channel consumer
  preferences into productive action
• Describe the factors that influence demand
• Describe the factors that influence supply
• Explain how demand and supply work together to
  determine market equilibrium
• Compare the performance of markets and
  governments as institutions for managing
  societys environmental resources

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Competitive Markets

• Q How do consumer preferences get turned into
  action to produce what they want to buy?
• Prices rise for goods in growing demand (e.g.,
  organically-produced grapes), which, through the
  profit signal, attracts more resources into
  producing those goods.
• Prices fall for goods in shrinking demand,
  attracting resources away from those goods.
• Q What is a market?
• Its an institution or framework for bringing
  buyers and sellers together to trade goods,
  services, or resources.
• In it, prices are determined by the joint
  decisions of sellers and buyers

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Demand

• Definition of Demand
• Demand is desire backed by purchasing power.
• It is summarized by a schedule that shows the
  amount of a product a consumer will buy at each
  possible price in a given time period.

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Demand

• Law of Demand
• Defined As price falls, the quantity demanded
  by consumers will rise.
• E.g., as the price of organic grapes falls,
  everything else equal, the quantity of grapes
  demanded will rise.
• Everything else must be equal for the law of
  demand to hold true. That is, other factors
  influencing grape demand, e.g. other fruit
  prices, income, must be unchanged.
• Three reasons for law of demand
• It squares with our intuition
• The buyer receives less added benefit from each
  extra unit of a product consumed.
• It can be explained by income and substitution
  effects.

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Demand

• Demand Curves
• A products inverse relation between price and
  quantity demanded on a simple graph is a demand
  curve

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Demand

• Market Demand
• Markets usually consist of many individual buyers
• The sum of individual demands is called the
  market demand.

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Demand

• Change in Quantity Demanded
• This change comes from a decrease or increase in
  the product price were interested in.
• Example a reduction in grape price from 5 to 4
  will increase the market quantity demanded from
  4,000 to 8,000 pounds per month. (movement along
  curve)
• But the curve itself is fixed, and does not move
  from a change in price.

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Demand

• Change in Demand It is a shift of the entire
  demand schedule to the right (increased demand)
  or left (decreased demand)
• Demand changes come from the influence of
  non-price factors influencing purchases
• Size of market of buyers
• Tastes and preferences e.g., fads/fashion
• Income more income typically increases demand
• Price of related goods important demand shifter
• Expectations e.g., expected future shortages
  increases current demand

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Supply

• Definition of Supply
• A schedule showing quantities of a good
  producers will supply at each of a series of
  possible prices during a set time period.

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Supply

• Law of Supply
• Defined As the price of a good rises, the
  quantity supplied rises
• Why do producers act this way?
• A higher price produces a higher incentive to
  offer more to the market.
• A higher price enables a producer to shift more
  resources out of competing enterprises.
• Market supply comes from a horizontal addition of
  all suppliers in the market.

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Supply

• Change in Quantity Supplied
• That change is s movement from one point to
  another on a fixed supply curve.
• Its cause is a change in the price of the good
  being considered (due to a shift in demand)

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Supply

• Change in Supply It is a shift of the entire
  supply schedule to the right (outward
  -increased supply) or left (backward
  -decreased supply)
• Supply changes come from the influence of
  non-price factors
• Seller numbers more producers increase mkt
  supply
• Input prices higher ones reduce supply
• Technology improvements increase supply
• Taxes and subsidies Increased taxes, like
  increased production costs, reduce supply.
• Prices of other goods Increased price of green
  certified lumber reduces supply of ordinary
  lumber
• Price expectations Expected higher future price
  of naturally-colored cotton reduces supply of
  conventional cotton.

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Equilibrium Demand and Supply

• Important question What price will actually
  prevail as the observed market price?
• Too low Shortage
• Consumers queue, complain
• Producers realize they can ask higher prices
• Too high Surplus
• Unwanted goods spoil or occupy expensive storage
  room
• Better Get rid of excess inventory by reducing
  prices
• Market price occurs where supply and demand
  decisions are compatible.

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Equilibrium Demand and Supply

• Price as a Rationing Method
• Rationing means distributing a scarce resource or
  product.
• Synchronizing decisions by buyers and sellers
  that creates equilibrium is called the rationing
  function of prices.
• There are many non-price rationing methods,
  examples
• First-come first serve
• Access to political influence
• Physical force
• Price rationing (PR) is more efficient than other
  rationing methods.
• PR allocates goods to those who are willing to
  pay most and allocates supplies by those who can
  sell most cheaply.

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Equilibrium Demand and Supply

• Changes in Supply, Demand, and Equilibrium
• Demand is subject to increases (shifts right) or
  decreases (shifts left)
• Supply is also subject to increases (shifts
  right) or decreases (shifts left)
• Simultaneous shifts of demand and supply may
  have synergistic or opposing effects on price or
  quantity

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Supply in a Competitive Market

• Competitive Supply where price equals marginal
  cost
• Perfect competition occurs when no single firm
  can affect price, so each is a price taker.
• Each firm faces an infinite price elasticity of
  demand.
• Changes in a single firms output have no effect
  on market price.
• Q what is the competitive firms output
  decision?
• Principle produce what maximizes profit
• Requires setting P MC. But why?
• Reducing output when P gt MC reduces profits
• Increasing output when P lt MC reduces profit

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Markets (cont.) Importance of P MC

• If expanding output increases cost by more than
  price (MC gt P), the firm wont do it.
• If reducing output reduces cost by less than
  price (MC lt P), the firm wont do it.
• If MC P, the firm is maximizing profit, and
  wont change
• P MC is a powerful rule. It lets you predict
  firms behavior from a variety of environmental
  policy changes that affect P or MC.

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Markets (cont.)

• The competitive firms supply curve
• Competitive firms maximum profit behavior comes
  when it follows P MC
• This implies that the competitive firms supply
  curve is given by its MC curve
• Fig 3-9 shows that as the price increases, the
  firm responds by re-adjusting its
  profit-maximizing output by moving to a higher
  level on its marginal cost curve.
• So the marginal cost curve firms competitive
  supply curve

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Markets and Efficiency

• Economic efficiency of perfect competition
• Q How well does the institution of competitive
  markets perform the aim of meeting societys
  goals?
• Q We know markets can promote maximization of
  private profits, but is it a good way to satisfy
  societys overall needs?

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Economic efficiency of perfect competition

• Synergy of marginal cost and marginal benefit
• For consumer, the price is compared to the
  marginal benefit of added consumption.
• For producer, the price is compared to the
  marginal cost of added production
• Only at equilibrium is MB MC.
• So a competitive equilibrium can be economically
  efficient, because it only expands output when MB
  exceeds MC of resources used.
• Key no externalities, public good issues, and
  prices are observed (market goods)

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Economic efficiency of perfect competition (cont)

• Consumer and producer surplus
• Top triangle (fig 3-10), PGC is called consumer
  surplus
• Bottom triangle, PCF, is called producer surplus
• Only at competitive equilibrium is the sum of
  consumer and producer surplus maximized.)society
  s welfare for this specific market

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Accomplishing Environmental Goals Markets v.
Governments

• Econ eff. of perfect competition (cont)
• Interdependent markets
• Q Can an economy consisting of many markets
  operating at the same time perform the desired
  goal of economic efficiency?
• A yes, if the following 3 conditions occur
• Everyones demand their MB
• No externalities (this assures that marginal
  private cost marginal social cost)
• No monopoly power (A monopolist sets MR MC,
  which is at restricted output level than where P
  MC)

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Accomplishing Environmental Goals Markets v.
Governments

• Econ eff. of perfect competition (cont.)
• Marginal cost pricing
• Is about designing institutions that produce
  maximum human benefits from societys scarce
  resources.
• P must MC for society to be getting the most
  from its scarce resources.
• Efficiency of marginal cost pricing is valid for
  capitalistic and for socialist economies.
• MC pricing can be used to define, understand, and
  seek economic efficiency,
• For public policies affecting private firms
• For public organizations (e.g. government,
  military)

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Accomplishing Environmental Goals Markets v.
Governments

• Governments
• Collective choice process
• In democracies, politicians perform similar
  functions as markets. They interpret the demand
  for collective programs and look for ways to
  suply them efficiently
• Theory of public choice (Buchanan) assumes that
  politicians maximize their probability of
  re-election.
• So a political system can be judged on the extent
  to which it promotes economically efficient and
  fair outcomes.
• Collective choice and the environment
• Economically efficient public actions will be
  those for which total benefits to society exceed
  those actions total costs.