Modeling the Market Process: A Review of the Basies According to the materials balance model, environmental problems are dt- rectly linked to market activity. ‘The basie decisions made hy consumers and firms affect both the abundance and quality of the earth's source stock. Since enviranmental economics is concerned with resource damage, we need wo develup a thorough wnderstanding of how market activ ity gives rise to polluting residuals and why the usual market forces cannot solve the problem, From an economic perspective, envio: ail pollu tion is characterized as a ‘ket failure. Hence, environmental economics uses marker failure models tm analyze the problem and toidentify solutions Bur these models rely on a solid understanding of the market process itself ‘To that end, this chapter reviews the essential components of a market and the basic concepts used in microeconomic analysis. Essentially he focusing on the operation of the circular flow model, which is central to the materials balance paradigm, The fundamentals of supply and demand are reviewed to reestablish a good grasp of market behavior, the motiv tions for consumer and firm decision making, and price derer The context for our review is a hypothetical market for bo neral water in which competitive conditions are assumed. Through an analysis of market equilibrium, we discuss the economic criterion of efficiency —a notion used throughout the study of environmental economics to evaluate public and private responses ta pollution problems. From there, we develop welfare measures, which are useful in evaluating the effect of environmen- tal policy on society. All the analytical and madeling toals presented here will serve as the foundation for our study of market failure in the next chapter.10 © Pare Mg N arket Model: The Fundamentals Definin cet is given a broader market The iner a market ref raction, be lucers (or sellers) for the purpose of chang This more theoretical s purpe n-eeonomic marker fer ta es. For example lefini hor in the factor marker ies at a supermarket. As we will d » it ean even be applied co an analysis of poll relevant to the exchange of g market is defined, a model o ified. The form of the m study and hat market and its char To qua se relationships, models are refined Formal testing is accomplish tired velationships using real The Model of Supply and Demand: An Overview bn, a market exchange for any commodity comprises two sets of t decision rnakers vers and sellers, Ea enced ‘onstr the exchange of a pre while eo hen consic arket model of supply and dem. | pri lucers are m ugh a supply demand furChapter 2 Modeling the Market Prces: Review oft esl The Purpose of the Modet The primary objective of the supply and dem: alysis of market cond stig pluses, the existence of resource misallocations, and the econc plications of t policy initiatives. F ‘economists can use supply and dem: id model is to facilitate an ms and any observed changes in price, Au inn 19 of price m ern the presence of shortages and ic i= mental nd models to investi gas consumption as a way to help improve € asso and movements in gasoline prices, ban air quality. By studying ket cond id ehanges in m: conomists can deter ption patterns are affected, how the ¢ how x burden is shared betwe producer, and how income distribution is affected y when the markee system fails to ventional model of supply and account for thase conditions that weaken t operation of market forces. Economie theory suggests that the persistence of environmental problems such as urban smog and water pollution are the of failures or breakdowns in the market system. Of course, to under stand why this is so and to hegin to formulate solutions, itis necessary to have a good command of the market process, the underlying st mand conditions, ar cha the pr system, iding # Basic Medel: Com Markets for Private Goo 1 develop a basic adel of suppl First and demand, we make a number of a rket isassumed, which is character of independent buyers and s a homogeneou rs; (iv) perfect lers with no control or standardized product, ) perfect mobil the market for resmrces also is assumed to he competitive This implies thac the individual firm has no control over input prices—a result that will simplify the model. Finally, th inged in the market is assumed ta be a private good. A private good is a commod sources, Se ity that has twa characteristics—rivalry in consumption and excludabli ‘This means that ce sumption of the good by one person prechedes that another, and the benefits of consum sumer. This assumption of a private (as opposed to a public)* gaod is cr alysis of quant cal toa conventional ai srmpion. A mare oft de seit per32 * Pare Modeling Environmental Probicms Market Demand demand The quan biies of good the Cotsumer ts willing snl able ta parchase 218 Of prices dar- Law of Demand There isan inverse priceand Demand refers to the market response chasing decisions to maximize th. ty." There ners’ decisions, How= seeescinee 2 Key objective of marker analysis is price determi demand functio d by cons influence this deci breviated p., vo m i pur. or what economists term any factors that is specified as the relationship between the quantity de. mets and price, hold nt all other variables that J Conomists use the Latin phrase, ceteris parila, ab. else constant.” Hence, dem sumer is willing and able screte time period, cp. The ensumer’s “ability «0 pay” refers eo the income eonstrain choice, The “willing ng const ood the hase at some set of pri at limits con- he value or benefirthe ee to pay or demand price isc Binal benefit (MB) associated with consum The key econ the wealth and les held constant when specify jcome of the consum *, prices of related goc stitute produets and complementary gore), tations. A cha ship, which represen effect on consumptios: « ferences, and price expec these variales alters the entire price aebange in t This is distinet from the < which causes only’ a change in le, consumers typically buy me 4 Thisis simply a change in the quantity d n it goes on the Product in cesponse to a price change. On the other hee for exe ample, consumers’ tastes change suck that chey desire more of a prod all possible prices, the result would be a chan, mand. & ease in paint is the observed Friendly” produces dara that speak hift in consumer preferences toward “caviron all possible prices. Application » this phenomenon and its imps ‘on marker Under conventional circumstances, the qualitative relatic ns se one. Her ity demanded, and the converse is cru Law of Demand, which asserts that there is madd aes onship between the price of a good and the quantine da ded of tha ly intuitive * consumers to view price as an abstacle th red teas th since itis reasonableChapter 2 Modeling the Marker Praca: Review ofthe Reser * 34 Consumer Demand and Environmental Issues: What Really Matters? According to 4 1991 survey of 410 New Yorks aduks, environmental safety has become an imporeane Jnwence on consumer decision making: Approximately 93 perceat of the respondents i this survey Price he protecting the tavironmenc isa "very important faccor” in ther purchasing decege However, while this new influence on consumer demand is a viable one, only lik 10 of the an spondents place chvironmental safety as atop priociey. Product price and quality continue to fe the Mh seibeve determinants of consumers’ buying decisions These findings have been supported by arher sources. A 19% national pol. or example, indicated that over 80 percent of Amnon cee favor ef more stringent environmental Laws, yet only 54 percent were willing to incur the ceeeorne ‘ost of achieving improved environmental quality. Notwithstanding the strong hold that price and quality have-on American buyers, theo rey of New “Th alls deer indicate that consumers wal switch bean in fava of exvirommnenally safer products [his ange in preferences implies shift in market demand toward thee produces and suay ho tne SAS subtiutes. Some of the nondurable consumer product groups afecid by this phcnomenn ae etegens, diapers, aerosol sprays, an cleaners. Overall, 446 percent of all survey paruciens Soot hae evitched brands for environmental reasons, with a higher proporson eeported forte 31. c, $ fest al age group, Gander diferces also exist wth respeet thn wwthing phenomena, Sane ‘Be4 percent of females in the survay express a willingness ro substitute toward seore savironmentally ‘afc brand, while che comparable proportion for males ix reported at 33.9 percent peeking the markt apportuniy, manufscearers rs respon lng to this trend by peotating thei brand names a8 “tviconmentally sae,” The survey proves some inlorination abo te ate se PGCE efor across competitive commodities. rand names such as Cloros, Arm & Harem Tad, UOreal, and Revlon are among those perceived by consumers as asocisted wit environmentally Perior products. This brand recognition suggests chat the advertised eommutmemt wa envitonee sal ‘concerns of certain manufacturers is perceived as more credible than thr of other five Just ts demand theory dictates, cansarer decision making éepents on a raity of maskct cond iene aad proxtuct characteristics. According to this survey, price contioues co be a major detarnanc p.demand. particularly in an economic slowdown. Nonctheles, environmental concer a hareeen ct fect on consumers’ buying habits —o« least for some noedusabie praucts ‘On the supply side, manu- Factores are adjusting their production and marketing strategies respond eo thi chang. inectenns preferences and not tis oct ona lucrative opportunity. OF cnarse, the demand fr seme prodece influence than others. And a time progresses, firms will hive tn monitor the de, grew of market responsiveness to environmental concerns tu desermine if this iva ahustacrry oe long ‘term phenomenon. SOURCES, Lovee Mi 1 Fiala. “Gore Fis Gol Respome woe res When Consumer ae Sci (Geb Warming” Te Hi Modeling Individwal Demand To illustrate the Law of Demand, Table 2.1 presents hypothetical data for an individual's demand for one-liter bottles of mineral water. The values show the utiicy-maximnizing quantity decisions in a one-month period for 4 set of prices ranging from $0.50 to $5.00 per bottle. Notice how the4 © Pare iad market demand 2 private goad a purch SINGLE CONSUMER'S DEMAND Daja FOR BOTTLED MINERAL Warr Quantity Demanded (bottles'month) 4a~ ~4P +20 relation our. While these di p between quantity dernay a give only a limited samplis an equation of the same relatiansh ind price holds thre onses for the consumer. In this ease, the demand fi shipt ae = ~4P + 20, whe on is the simple quantity di bet one-liter bottle, Notice th Substituted into the right-hand ulividual, and P represents the dollar price if any of the P values from Table 2.1 ty values can be obtained algebraically, For example, if P -4) +20=8 Hy convention, the graphical depiction of demand uses th reve form ” = Figs. Solving the equation for Pin terms of P= ~0.259, + 5. The graph gle con- is shown in Figure 3,1 al Demand Data For most applications in economics, the collective decision aking of tarket icmore relevane chan that ofa single consumer propriate concept is marker demand, representing all we willing and ableto se the c vidual desand data. For private goods, chis e quantity levels at each de isthere as “horizontal surnming,” since quantity is convention th lity. This is de‘Chapter 2 Madeling te Marker Prove A Retiew of the Basis # 3$ MAE ar siica mone or One Consumene DEMAND (d) FOR BOTTLED MINERAL WATER ‘This graphieal model of ane consumer's demand fd) usce the inverse Forcn oF the function, P = ~0.254, + 5, where ~.25 isthe slope and + 3 isthe nent al intercept, The negative slope illustrates che Law of Demand. | 0 20 gof one-fiter hordes Plotted on the #orisonral axis.’ Even though price is the same for all con: sumets, quantity decisions are variable because of differences in other fac. tors like consumer income, wealth, tastes, and expectations For simplicity, we firs illustrae this summing peucedure by adding the demand of only one other consumer to the model specified previously. In, dividual demand data for two hypothetical consumers, Consumers | and 2, are given in Table 2.2, Notice that each makes unique decisions about ‘quantity because each has a unique income level, stock of wealth, prefer ‘snce ordering, and so forth. The aggregate demand for these two individ wal i found by summing the two. quantity columns a¢ each price level, the result of which is shown in the far right-hand column of the table. ‘The same method can be applied to at algebraic madel by adding cach pair of corresponding terms in the two demand equations. This is shown below:* Demand for Consumer 1 qn = -4P +20 +D ner? gas Demand for Consumers 1 and Gay hand for Cons Horizon sessing ischaracarisic ol private ads. Becssecomeimpaoa of mach gs ieee ich india w shoo bis a her own uty Ae il dat te eat hopeh shila ‘beers for public oss an outcome wth important vismeacl eamomiciplosyeee vei ththe price-quanty pues piven in Table 2.2 eis each coremponding sgebaieCOMBINED DEMAND DATA FOR BOTTLED MINERAL WATER FOR Two Consumers, CONSUMER 1 AND CONSUMER 2 Combined Quantity Quantity Quantity Detsanded by Demanded by Demanded by Both € Consume (bottles month} Price in Dollars hoteles (bottles/mon funn = (a * fe Pr ta = —4P fn = ee rf 450 } 1 3 To derive the market demand, we ys Ht sumers, Maint there are 100 consumen etic ach price, in the second in the third, fourth. The corre- Demand for Con: Demand far Cons Market demand of the 100 individual demand (d) curves,Chapter 2 MARKET DEMAND Data FoR BOTTLED MINERAL WATER Quantity ded by Consumers Marke Vand 2 Demand Price in Dollars es/month) (botcles/month) Pp Gain OP +30 gay SMP +1120 Q,= ~100P = 1,150 GRAPHICAL MODEL OF THE MARKET DEMAND (0) FoR BOTTLED MINERAL WaTERa 38 * Pare 1 Modeling Ewiroumsental Problems Market Supply Gutheopposte side ofthe market, we derivea supply relationship based on the decisions of producers who are motivated by prof Each Fira supe decision is modeled as a function of price, even though this deviion fe supply The quansi- fluenced by many other variables, Hence, we say thar supply refers to the Seto a good the quantities of a good the producer is willing and able 1 ring to market pe willing at a given sct of prices during some discrete time period, «p. Among the Sieletors gat’, variables thae Potentially affect the price-quantity response of a firm are Gone eazome Production technology, input prices, anes and subsidies, and price expare, | dscrete time peried, tations. Analogous to the demand side of the market, changes in these “9 Severiminants fect the emtte price quantity relationship, cashing a cbnoge ‘in supply, while a movement in price is associated with change in quantity supplied. The Law of Supply ‘The qualitative relationship between quantity supplied and price s gener- ally 4 positive one. That is, a rise in price is associated with 4 rose quan tty supplied, and the converse holds as well. This relationship is referred 1a Law of Supply the Law of Supply, which asserts tht cere isa direct relationship be, There isa direct rela pween the rice of a good and che quantity supplied by producers. The con I prceanhetnstny Yentionalassumption that ems arcgrotit oe ce Suggests that a higher eed ottgeol, ice should bean incentive for fire to bring more of the product to mar- “ ket, A contemporary example of how powerful the profit motive cam be inthe context of “green markets" discussed in Application 22 Amore formal justification for the Law of Supply is based on the nas | ture of firm costs as production is carried out. As the Brn prodces more | atpue(Q), ts total casts (FC) rise pcuporcionally faster, meaning the rate ofthe change in TC the., ATC) tothe change in Q (i.e, 40) is increasing, This ratio, ATC/AQ, defines the firm's marginal cost (MC) of produces, the additional cost of producing another unit of output, Since MC rises Thee ses firme need to charge «higher price foreach extra unit of outer they produce, Hence, the existence of rising MC suppurts the ponte | Price-quancity relationship given by the Lav of Supply Modeling budividuat Supply | Fee Li of Supply is illustrated using iypothetical daa for a single pro- ducer of botcled mineral water given in Table 24. The quantity column shows a single firm's Profit-maximizing output decisions associated with prices ranging from $0.0 to $5.00. Nutice how the positive relationship petween che supply price and quantity supplicd holds throughour The linear equation associated with these data is. = 16P ~ 4, where lnwcreane 4. is used to signify the quantity supplied by a single firm, Each of dhe rice quantity pairs given in Table 2.4 satisfies this equation,Chapter 2 Museting the Mar of the Banks ® 39 Profit Opportunities in Green Markets: Japan Takes the Lead [The lore of profits one ofthe most pawerfulinfluenceson firms! marker decisions. A case ia pointis the souepicneurial response to ciergingindustrics in pollotion abatement equipment and energy-saving techaologies. Nowhere isthe reacxion more striking than in Japan, Promoting technlog 1 to environmental problems, Japan's industrial sector has already taken the lead in these new high-growth "green markets.” Japan is pursuing opportunities praffced by environmental markets with a momencum virtually wn trance by any other nation. Patterned afer ther time-tested success in achieving dominance in orhor \forld markets, che Japanese are using a technology-based approach toward developing these new in. MC or as long as Mr >0, The firm contracts production as long as MR < MCor as long as Mr <0, [Rtoft maximization The firm achieves profit maximizati ‘Achieved atthe MR = MC, or where Ma = Oo arp level where { | Mrz" Notice that the individual fim’ ‘optimal output level occurs at precisely i the point where the marginal benefit to the firm of doing sa, MR, k easel oie hy the marginal cost ofthe resources it uses, MC Although this ont, I com validates the use of benefits und costs at the margin, it does nor nec. essarily result in an allocatively efficient outcome. Why? Because MR is the 4 marginal benefit t» the firm, which is fot necessarily eq | benefit r sorfery, which is measured by price, | firm's optimizing behavior achieves allocative efficiens | 2 and this equivalency occurs only under competitive conditians Fo un. ij | jon at the output level where I dertand this, we need to reconsider how the firm's profit-maximizing des cision is affected by a competitive market, As a price taker, each firm Market-devermined price as a since by assumption its product i "This, of eoare, sues that inthe shove ra the i sh don. lathe lang ten, the Sem paces at hg ‘evils from the earkee 9 everocs cover ier conc I ne wil Yoel revenue cual of ts wil eon >>... tt—t50 * Part Modeling Enzirsnmeutal Problems imarket. Thus, it were to rain price, consumers would demand none of its ce ak and by from other suppliers, Morcaver the fir has ac ieee ta lewer price, sinee it can sell all it wants at the market-determined price. Since the competitive firm has no contral over prevailing market con disions, itfices 3 peice that is constant. C nsequently, each additional unit the firm sells raises its total revenue by an amount exe ‘ly equal to the price of the good. This ourcame translates to an important equality that is ‘unique to competitive markets, namely thae P = AIR. Thus, although com. follow the profit-maximizing decision rules derived bove, m outcome is markedly different in that allocative ficiency ** sured automatically, Ths is summarized in the following darirncne ‘maximization requ MR = Me Competitive markets imply Poe Thus, ‘maximization for competitive firms requires: P= \iC itshould be clear why the competitive marker equilibrium achieves al- locative efficiency —because every firm in tha: market independently pro- duces where P = MC, illustrate this outcome, Table 2.8 presents selected revenue and cos lta for a representative firm in our mineral water machen First, let's #R at all ourput levels. In accordance with the tom’ Petitive model, notice that the prices faced by the firm are constant at the fhatket determined equilibrium price (P) of $2.50, The ai values are found by calculating the change in TR divided by the change in 4. So, for sxample, when output rises from 28 units to 34 units generating an ine S208 stom $70 to $90, MR = ATRAg = ($00 S7O)86 8 Ios 82078 = $2.50. As this calewation is repeated for al changes in g shown in the table, MR = $2.50 in every case—exactly equal to P "Naw Jets examine how the frm chooses 2 production level that mes mizes profit. As predicted by the competitive model, the MC values shown in the last column of the table are the same as the Set of prices associated {ash the fire's supply schedule To guide its productian decisions the firm tisiders the MC of production relative tothe MIR at cack ourpur level. kn this case, the profit-masimnizing equilibelum output occurs at g, = 36, phere MR = MMC = $2.50. And, since P = MR at al levels, this decision also assures that P = AMC, indicating that resources coe being allocated to Production in an efficient manner, Figure 2.6 illustrates this equilibrium ‘Two final observations are worth noting. First beam torecognize why erative outpur decisions would not maximize protic Nenete Figure 24 that at aay ousput level hls g, the firm's MR emcee MC, meaningChapter 2 Modeling she Market Proce Review ofthe Baris © § REVENUE AND Cost DATA For A REPRESENTATIVE RM IN THE BOTTLED MINERAL WaTER MARKET Price in Dollars Quantity Total Revenue Marginal Revenue Marginal Cost P, @ TR MR MC ‘ $ 10.00 sro QD 30.00 250 20 1. 250 28 7.00 230 ie 0.00 250 4 110.00 250 52 130.00 25 oo 150.00 6k 170.00 Me cow eerinive Finws PROFIT-MAXIMIZING EQUILIBRIUM firm occurs at ¢,= 36, IR ac ally levels, it must be the ease libeium, indicating thac resources are allocated eff MR => MC, mea Hence, The profit-masimizing equilibrium for the carpi where MR = MC = $2.50, Since P that P = MC at eq, cently. Ar s better off reaing tha further Me82 Part] Madelng Karcircamuental Prams technical efficiency Production decisis ‘mum owrpat given some sock af thut is Mfr is greater than zero. Hen, the firm can increase x by expand- ing production. Conversely, at all ourput levels abvveq, its MR is le than MC) meaning its ais less than zero or its m is declining. So, the firm better aff contracting production. Only atg = Sis MR= MC or Mz =O, ‘meaning that further additions to = are not possible or that 7 is at ite maximue, The second observation i that cach of the other 24 firms in the bottled Inittetal water market would follow this same decision-making process and ach would arrive atthe same g, of Ssince competitive firms age ulemieal ‘Therefore, the market equilibrium quantity (Q) isequal 10 900 unite. the Imoduct ofthe suber of firms in the market, 25, and the frm-levelg, of 36. Notice that this result confirms the equilibrium quantity devermaed from the market supply and demand model, Technical Efficiency Another important economic criterion used in market analysis is technical efficiency: This refers to production decisions that generate masimnumane, ative some stockof resources, or saying the same thing froma slighty uliflerent perspective) decisions to produce a given ourput level using a minimam amount of resourees, In the context of the materials belesce model, achieving technical efficiency preserves the stack of natural re sara and mininnizes the subsequent generation of residals arising from resource use; Furthermore, given the relationship between production and casts, technical efficiency implies that economic costs are minimized when producing a given level of output. When viewed from this perspective, ie becomes apparent that technical efficiency is an application of he naire general cast-effectivencss criterion introduced in Chapter | A key point is to understand that market forces can achiew «efficiency as long as competitive conditions prevail. Tw remain viable rhe Spmpetitive firm must minimize costs, since it cannot raise price to eover the added expense of inefficient production, Were itto attempt such astews, ‘ay, demand for its product would fll to zero, since theve are many other firms bringing the same product to market ata lower price. Reon gnizing how technical efficiency is achieved under such ideal market eulitens helps economists determine iby it isnot being metin some uther marke context. More importantly, the magnitude of a technically ineficient dee sion can be assessed by comparing the resulting costs to what they wanld be ifthe market were allowed ta operate freely technical Welfare Measures: Consumer § urplus and Producer Surplus In econon portant objective is to assess the gains and losses to so- ciety as any-event that alters market price. The supply and de- man radel provides the information necessary to perform these types ofconsumer sucplias The nerbenett to buyers cated b the excess af the ginal benefit (V8) ot ‘sonsamption over marker price), ay: sgregzed overall units arehased, ‘Chapter 2 Modeling the Marker Proec l Review uf the Basis * $3 analyses, using concepts known as consumer surplus and producer sur~ plus. By comparing these measures before and after a market disturbance itis possible to quantify how society has been affected. Consumer Suerptas To get a sense of the logic of consumer surplus, we start with a general working definition, Consumer surplus is a ineasure of net benefit accra ing to buyers of a good estimated by the excess of what they are willing to ay over what they must actually pay, aggregated overall units of the good purchased in the market. Notice that consumer surplus depends on two dlstinet notions of price—one char measures a williagnesrt pay, and one ‘that measures what is actially paid. The series of prices consumers are w ing to pay for various quantities of a good are those that define the demand surve, And as discussed, each demand price is a measure of the Marginal Benefit (MB) associated with consumption, Conversely, the price that can sumers tmust actually pay is the prevailing market price (P) determined by o#6 demand and supply. ‘There are two major differences between these prices. First, they have different determinants. The demand price (MB) is determined sully by de- mand, a.sort of psychic price based on how consumers value a good. On the cother hand, market price (P) arises from the forces of supply. and demand and is driven by both producer and consumer incentives. Second, while there is a whole series of demand prices, there is only one market price charged for aff units sold. The result? Once the market price is determined, ail units are sold for that single price—even those for which the demand price is much higher. Hence, consumers receive a surplus benefit for every unit purchased whase demand price exceeds the market price To illustrate consuiner surplus graphically, Figure 2.7 reproduces the market demand for mineral water derived previously. Added to the diagram isa reference price line drawn horizontally at the equilibrium price level of $2.50. Notice that for every ourput level up w the equilibrium quantiey of ‘900, the demand price is higher than the market price. So each unit pur- ‘chased yields consumers a surplus benefit aver and ahove what they had to pay for it. Por example, for the first bottle of mineral water, consumers are ‘willing to-pay a price of $11.49 based on the market inverse demand funce tion. '? But they actually have to pay only $2.50. Thus, they receive a net benefit trom consuming the first unit of the good equal to the excess of S149 over $2.50, or $6.99. Geometrically, this amount is measured as the vertical distance from the demand curve ta the price line at @ — 1, shown n Figure 2.7 as distance a ‘Te price of $1119 fond by subsinaing Q, = Tint he invese demand function. P = 0.010,540 * Pare Modeling Esosrrumtenta Probleme MEE concen SURPLUS IN THE CoMPETiTive MARKET FOR BOTTLED MINERAL WATER {rth fst botde of mineral water, consumers demand price S11 49, ut thas maar esermined price is only 8250, sa they eecene see Bea” from ths fist borde of water equal w $11.49 ~ $2 40.2 Seam et asthe verti« sagetanee#é: Aggregating this nx bene overall ie of ees ‘consumed int ease of consumer surplos shown asthe trinngulae oe a r “The dollar wale ofthis ares is (4-000 = $9.00) ~ $450 ‘The net benefit fom consuming the first bottle of water cquals $8.90 901,150 Qf anecliter bowler ance consumers receive a net benef for every unit purchased uptothe equilibrium point, this value must be aggregated over all units consumed to derive the measure of consumer surplus: Graphically hg the trian the ay Magregation of the marginal hene- wular area under the price line us the difference between ‘the cwo area of thetriangle that represents tin the graphical mol "In Figure 2.7, the base of the IVY triangle isthe horizontal distance fron he vertical Ta the equilibrium quantity oF 900. The heights $9 00, ufos the ‘The dollar value of consumer surplus can be found by calculating the "Real hare fread for Sing the aren fa triangle is Ys. Bas Highs,producer eurphas ‘The ner gain tele 8 ofa good esti mated by the excess ‘of marker price (P) over uarginal cost (MO) aggregated ‘over al units so Chapter 2 Modeling the Marr Proes A Resies ofthe Bass + $5 jrre applicability of consumer surplus stems from the fact that its mags hitide is related to equilibrium price and quantity. So any distushanee 6, ‘market equilibrium will change the size of consumer surplus. Since che, surplus is a measure of consumer benefit, any change in its value can he used to assess the associated gain or lays to consumer welfare Producer Surplus On the supply side of the market, the comparable measure of welfare producer surplus. It isa measure of net gain accruing to sellers estimated ty the excess of the market price (P) ofa product over the marginal cost GMC) to produce it, aggregated aver all units sald Based on our discussion of supply decisions, we know that firms must charge a price for their product chat covers MC. Further, we know thatthe competitive market supply curve is the horizontal sum of all fry’ Mc curves, Therefore, since market price is determined by the intersection of mmatket supply and demand, ic mast be the case that P— MIC ata compen tive equilibrium. However, atevery output level below equilibrium, MC is fower than P. So, firms are actually willing to supply these smaller quanti- {Hes at prices below what is dictated by the market. The price that firme are “willing to accepe” for each ourput level is their supply price, and its this price hats reflected i the MC curve, Thus, a each quantity below equ, brium, firms acerue a net gain measured by the excess of Paver MC “This net gain is illustrated in Figure 2.8, ‘The diagram shows the coms pentive market supply for mineral water, which is alse the MC curve, and 4 feferenee line drawn horizontally at the equilibrium price of $2.50. For every unit of output supplied up fo the equilibrium ducers receive a surplas equal to the exeess of P over MC. For example, for the first unit of mineral water produced, the MC is $0.2525 based on the snarket supply function.!* But firms can sell this first hortle at the market determined price of $2.50, Thus, the net gain associated with this unit of Output is the excess of $2.50 aver $0.2525, of $2.2475, Geometrically, this is the vertical distance from the supply curve to the price line at @ = 1, la beled as distanee ed in Figure 2.8, Just as on the demand side ofthe market, this net gain must be aggre- gaced over all units sold up to the equilibrium quantity to find the stescure of producer surplus. Graphically, thisis the sum of all the vertical diseances hecween the MG curve and the price line, or the triangular area bounded by ‘the MC curve and the price line, up to the equilibrium point. In Figure 2.8, this is shown as the area lahel: AXYZ. Using the same method as described for consumer surplus, the dollar value of producer surplus can be found by calculating is representative the Sv unit af exrputis ound by evauating the mathe spp as = sazses a t—ne 56 © Part] Modeling Environmental Probl MEE eropucen sunpius in tHe Comerivive MARKET FOR BOTTLED MINERAL WATER ed, the MC is $0.28; ction at Q, = 1. Bu at price wn as the vertical dis ds the measure of producer surplus repaesented by $2.25) = SI T 00 del. Refer sa magnirude af 900, and its hei at $2.50. and the se of the triangle XYZ das the ice between the price rept of the supply curve, $0.25, Thus, producer su in the mineral water market is » 900 + $2.2 magnitude of producer surplus, just li equilibrium price and quantity. Hence, a bance will its value and thus provide a way t ted welfar to firms, The Welfare of Society of Consimer a Economists use the sm of consumer and producer surplus to capture the Ssicty'swelfire gains accruing ta both sides of the m. y's welfare. Applying Th sum ofconsumer this coneepe to-the matke vater, We see that society en 5,062.50. Because this value is ¢ alued at $4,050 + $1,012 is based on ac tive equilibrium mized, This isChapter 2 Maicing the Markee Prac: A Reales of the Basics © 57 so because of the efficient allocation of resources that characterizes a com- petitive market, Put another way, it is not possible to reallocate resources to improve society's welfare. By default, chis implies that any market out- come that does nat meet the criterion of allocative efficiency has a negative effect om sociery’s well-being, In such an instance, the loss can be mone- tized by comparing the resulting sum of consumer and producer surplus t0 what it wault be if allocative efficiency were achieved. Measuring Welfire Changes By way of illustration, let's consider a hypothetical policy mineral water market that forces up price above MC to $6.50 per unit. To ‘measure the effect on society's welfare, we-need to compare the post-policy: level nfeonsumer and producer surplus to che benchmark competitive level of $5062.50. We begin by reproducing the madel af the mineral water market in Figure 2.9, adding to the diagram the policy price and quantity of $6, $0 and 500 respectively." Capital letters A through F have been added to facilitate our discussion. The benchmark level of consumer: surplus is rep- resented in this diagram by the area (A + B + C) and producer surplus by the area (D + E+ F). Now we determine the comparable surplus values under the policy determined price and quantity. Ar the $6.50 price level, consumer surplus is reduced to the triangular area A valued at $1,250, ‘This new value is $2,800 dower chan it was before the policy, so we know that the poliey gen erates a net dosrto-consumers, The producer surplus at the $6.50 price level isarca(B + D + F) valued at $2,812.30, found by surnming the area of the rectangle (B + D) and the area of the «riangle (F), Sine this magnitude is $1,800 higher than the original surplus, we see that producers enjoy a net gain a8 a result of the policy. Finally, consider the overall effect. The total surplus under the new policy is $1,250 + $2,812.50 or $4,062.50, which is $1,000 less than the original value. Although producers enjoy a net gain of $1,800, it weighed by the loss to consumers of $2,800, Hence the new pricing policy causes a decline in society’s welfare of $1,000. This change can be eon firmed geometrically by looking at the areas representing surplus before and after the policy: ‘Change in consumer surplus (AY-(A+ B+ C= - B40) + Change in producer surplus: (B+ D+ E) = (D+E+F)=+(B-E) Net loss to society: =-(C+BE) >-Q., nthe quuminy exchanged ithe matet is Q, Thi, gui demand equation a Slows Q, = ~1N6 SH) + 1,190 S08 1 ul byomental Probinas MEE oe soweicnr Lose ro society UNDER A PRICING REGULATION IN THE BOTTLED MINERAL WATER MARKET At the allocatively efficient equilibrium, area (A + B+ C) is the consumer surplus valued at $4,080, and area {D+ B+ B er surplus valued at $1012.50, for ‘of $8,062.50, Under a pricing polie that sets price at $4. 4 0 $1,250, shown as area (4), surplus ws area (B + D+F) fora incur 4 net E) valued at $1,8 is paticy, there is a deadweight loss to society of ~ (C ued at $1,000. lued at $2,800, while producers g Deadweight loss to society 5 = SMe 0 50 90 a) beau cight Loss to Area (C + E), valued at $1,000 is referred to as the deadweight loss society “Ther to society because it was once a part of the surplus accruing to. producers and consumers under allocatively efficient conditions, but as a result of the ee iicaeae policy is lost or unaccounted for. Notice that area B, while a loss to con- ent Othe sumers, is a gain to firms. Thus it to another, While some may vie is chatsuch er dist from ane market sector his outcome as unfair, the relevant poine flicient, since the amount is captured some- where within the market system. What is problematic is that the policyConclusions Summary Chapter 2 Madeling the Marker Procesr Review of the Bases © 5% generates a loss to saciety as a whole because it forces P above JMC, violat~ ing the allocative efficiency criterion, Understanding the fundamentals af how markets operate is an important basis for the study of environmental eeonomics. To that end, we have lim= ited our discussion in this chapter to the eircular flow inudel—reviewing the mechanies of supply and demand, the signaling mechanism of price, and the importance of marginal analysis —all within the context ofa classi~ cal competitive market system, Competitive markets establish a benchmark that helps economists evaluate the effects of market failures and market dis turbances, both of which are important to environmental economics, From. 4 practical perspective, we can assess the effects of environmental pollution or any policy initiative using allocative efficiency as a criterion, Further: more, these effects can be measured by quantifying the associated changes in consumer and producer surplus. Iris also the case that the competitive model illustrates how an eco- nomic system operates in the absence of any condition that impedes natural market forces. Recognizing howa fully functioning market perfarms is nec- ‘essary to understanding the economic perception of environmental pollu= tion as a market failure—the subject of our next chapter. ‘To make this ‘transition, we will expand our analysis to the full materials balance model, allowing for the interdependence of the circular flow with the natural en- vironment. Using the modeling tools shown in this chapter and expanding ‘on the concepts of marginal benefits and costs, we will develop more elabo- rate marker models that explicitly account for this interdependence, These dels will show how and why the market fuils to correct environmental damage, which in turn will suggest approaches to finding effective policy solutions, * A market refers to the interaction between consumers and producers for the purpose of exchanging a well-defined commodity, * A competitive market model is characterized by a large number of independent buyers and sellers who cannot control market price, a ho- mogeneous product, the absence of entry barriers, perfect information, and perfect mobility of resources + Demand is a relationship between quantity demanded (Q,) and price (P),helding constant all other factors that may influence this decision such as wealth, income, peices of related goods, preferences, and price expectations.ing Es The Law of Demand posits an inverse relationship quantity demanded and price, «p Market demand for a private good is found by s individu demand horizontal Supply is a relationship between quantity supplied (Q,) and price holding constant all input prices, taxes e+ supply as technology { price expectations The Law of Supply states there is a di itionship between quan: supplied and price, cp. ood is found by summing the individual supplies horizontally The equilibrium or market-clearing price (P) is th 2 = @, If price is above (below) its equilibrium level, there is a surpl (shortage! of the commodity, which will put pressure on the prevaiin price to fall (rise) toward its equilibrium level. Allocative efficiency requires shat the adic value sociery places on another unit of a good is precise equivalent to what society must giv Up in Scarce resources to produce i All profit(rr}-maximizing firms expand (contract) ourput as long as the associated additional revenue (MR) is gr fer) than the i crease in costs (MC), The o-maximizing level toccurs whi MC, or where marginal profit ( Competitive firms are akers. Si MR for ec fi IR = MC is also it where P= MC, the nifying allocative efficiency Technical eficieney arises when the maximum amount of output is produced from some fixed stock of resources Consumer surplus measures the net benefit accruing to buyers mea- sured as the excess of wh: to pay, MB, over what they rust actualy er all units purchased Producer surplus me ceruing to sellers est the excess P over i over all units 5 Society's welfare is measured er and p ney is achieved. ich is maximized when allocative The deadweight loss‘Chapter 2 Mudeling the Marker Proves: 1 Review of the Basics * 61 Key Concepts market surplus private good allocative efficiency demand coal profit Law of Demand profit maximization market demand fora private good technical eficiency supply consumer surplus Law of Supph producer surplus market supply af a private gond ——_soeiety's welfare equilibrium price and quantity deadweight loss to society shortage Review Questions 1. Suppose Q, = 200 ~ 4P and @ = 100. Describe market demand and market supply in a given market, a, algebraically find equilibrium price and quantity, and support your answer graphically b. What is unmsual about this marker? Give an example of a good or setviee that might be characterized in this way. 2. In 1995, the Food and Drug Administration (FDA) published new labeling standards for bottled water. (The full text of the final rule ‘can be found at vm.efsan.fda.gov/-Ird/n 095-323 txt.) Prior to that time, bottlers could sell regular tap water under a bottled water label, In fact, the FDA estimated that approximately 25 percent of the sup ply of bottled water was nothing more than ordinary tap water. Gon: sider haw these tougher standards eliminated 25 percent of the supply of bottled water. If market demand is unaffected, what qualitative im- pact would this labeling change have on equilibrium price and quan- { tity for bottled water? Support your answer with a graphical model ; 3, Reconsider the implications of the revised labeling standards discussed in Question 2 in the context of the hypothetical market for hottled water modeled in the text, Recall that the market demand and market supply equations are: Q, = —100P + 1,150; @, = 400P -100, where P, = $2.50and Q, = 900. Now, suppose the change in standards results in a new market supply of Q, = 400P — 350, with no change in marker demand. a, Determine the new P and Q,’ for bottled water. Do your results agree with your intuitive answer ta Question 2?_ aa 62 * Part Modeling Eacironmentat Problems 5. Graphically illustrate the market for bottled water before and after {he change in labeling standards. Be sure to las! all re ©. Compare the values of consumer after the change in labeling st or why noe 4. a. Describe real-world government policy that creates a market sur. Plus, Be sure to carefully define the relevant marker b. Explain the efficiency mplications of such a policy, Be specific © nth ave described, what is the government's motic vation for intervening in che market in this tance you Additional Readings Friedman, Milton. Capi am and Freedom, Chicago: University of Chicago Press 1962 regan: Robert L. The Writ Php, New York: Simon and Schumer 1980. Jenkinson, Tim i Mirscconmic. New Yorks Onford University Press, | Mankiw, N, Gregory, Pring votics. Fort Worth. EX: Drea Press, 1398 son, Walter. Intcromediate Mcraccomomucy X: Dryden Press, 1997 Pindyck; Robert S.,and Daniel Ru NI: Prentice-Hall, 1998, en. Fort Worth, App nfeld. Micoeromemis, Upper Sod River, Related Web Sites US. Food and Drug Rule on bortled water vm an fda govy—Ind/n095-323,001 Greening the Government: A Guide to Anplementing Bwecutice Oner 12873 “Federal Acquisition, Recyelin Prevention” (referenced in App! wwwofce.gov/huml/guide.htm