Law of Supply and

Demand & Benefit

Cost Analysis
 INTRODUCTION
• Economic Actions, including environmental actions, have two sides:
On one side they create value and on the other side they encounter
costs.
• Law of supply and demand are inter related to each other.
• More the demand, more will be supply
• It can be related to every walk of life including economic, social, and
environmental aspects.
 WILLINGNESS TO PAY
• In simple words, Willingness to pay is the value to be paid of a good that the
person is willing to buy or obtain.
• Individuals have preferences for goods and services.
• Sacrificing generalized purchasing power can also be manipulated by
willingness to pay
• Some people are willing to pay for just visiting a theme park but others are not.
• Some people place a high value on trying to preserve the habitat of unique
animals and plants species and others do not.
• It is obvious that a person’s wealth affects the willingness to sacrifice; the
wealthier the person is, the better he pays for something.
 WILLINGNESS TO PAY
• Willingness to pay decreases as the number of items increases.
• As per study conducted on buying of a single unit of good rather than to go
without.
• Suppose she has bought one item at the rate of $38. We then ask, assuming she
already has one unit of this good, how much she would be willing to pay for a
second unit.
• The answer is $26.
• Similarly, her willingness to pay for each additional items keeps on decreasing i.e.
$17 for third, $12 for fourth, and so on.
• These numbers show the notion of diminishing willingness to pay for a same
item.
 MARGINAL AND TOTAL
WILLINGNESS TO PAY
• MARGINAL WILLINGNESS-TO-PAY: If a person is willing to pay for the
additional items, knowing he already has two items, is marginal
willingness to pay.
• Marginal is thus a word that describes the additional willingness to
pay of a person for one more unit.
• Total Willingness-to-Pay: TWTP for a given consumption level refers
to the total amount a person would be willing to pay to attain that
consumption level rather than to go without it entirely.
 DEMAND CURVE
• A demand curve shows the quantity of a good or service that an
individual would demand or require (i.e. purchase and consume) at
any particular price.
• An individual’s demand is a way of summarizing his personal
consumption attitudes and capabilities for that good.
• Thus, these values differ because of different taste of individuals.
• Some people are willing to pay more a particular item than any other
person and vice versa.
• These two graph shows two demand curve. It has two demand curves.
• One steeper than the other.
• The steeper one shows the marginal willingness to pay for an item falls
rapidly as the quantity increases. Whereas the flatter one shows marginal
willingness to pay, which although lower to begin with, goes down less
rapidly as quantity increases.
• This represent the case of two different consumers on a same item
• This graph has two demand curves; they have same general shape, but one is situated
well to the right of the other.
• The demand curve lying above and to the right shows a good for which the marginal
willingness to pay is substantially higher than it is for the same quantity of the other good.
• What could account for this difference? They might represent the demand curves of two
different people for the same good.
• But there are other possibilities as well.
• Pay issue, Willingness issue, etc
• Another way of looking at this curve would be : in the context of environmental
assets.
• People’s tastes depend on a lot of factors of a psychological and historical kind
that are hard to pin down and describe but are real.
• For example: The curve at the left side relates to the demand curve for outdoor
experience of a person having no knowledge about a particular experience. And
at the right is the one who has all knowledge of the fun he has to get by doing
that particular activity.
 The Law of Demand
• The law of demand states that, if all other factors remain equal, the
higher the price of a good, the less people will demand that good.
• In other words, the higher the price, the lower the quantity
demanded.
• The amount of a good that buyers purchase at a higher price is less
because as the price of a good goes up, so does the opportunity cost
of buying that good.
• As a result, people will naturally avoid buying a product that will force
them to forgo the consumption of something else they value more.
• A, B and C are points on the demand curve. Each point on the curve
reflects a direct correlation between quantity demanded (Q) and
price (P). So, at point A, the quantity demanded will be Q1 and the
price will be P1, and so on. The demand relationship curve illustrates
the negative relationship between price and quantity demanded. The
higher the price of a good the lower the quantity demanded (A), and
the lower the price, the more the good will be in demand (C)
 The Law of Supply
• Like the law of demand, the law of supply demonstrates the
quantities that will be sold at a certain price.
• But unlike the law of demand, the supply relationship shows an
upward slope.
• This means that the higher the price, the higher the quantity supplied.
• Producers supply more at a higher price because selling a higher
quantity at a higher price increases revenue.
• A, B and C are points on the supply curve. Each point on the curve
reflects a direct correlation between quantity supplied (Q) and price (P).
At point B, the quantity supplied will be Q2 and the price will be P2, and
so on.
 MARKET EQUILIBRIUM
• When supply and demand are equal (i.e. when the supply function and
demand function intersect) the economy is said to be at equilibrium.
• At this point, the allocation of goods is at its most efficient because the
amount of goods being supplied is exactly the same as the amount of
goods being demanded.
• Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition.
• At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are
demanding.
• As you can see on the chart, equilibrium occurs at the intersection of
the demand and supply curve, which indicates no allocative
inefficiency. At this point, the price of the goods will be P* and the
quantity will be Q*. These figures are referred to as equilibrium price
and quantity.
• In the real market place equilibrium can only ever be reached in
theory, so the prices of goods and services are constantly changing in
relation to fluctuations in demand and supply.
 Perfect Competition
Pure or perfect competition is rare in the real world, but the model is important because it helps
analyze industries with characteristics similar to pure competition. This model provides a context in
which to apply revenue and cost concepts developed in the previous lecture. Examples of this model
are stock market and agricultural industries.

Characteristics
1. Many sellers: there are enough so that a single seller’s decision has no impact on market price.
2. Homogenous or standardized products: each seller’s product is identical to its competitors’.
3. Firms are price takers: individual firms must accept the market price and can exert no influence on
price.
4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.

Demand
The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a
horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears
that way to the individual firms, since they must take the market price no matter what quantity they
produce. Therefore, the firm’s demand curve is a horizontal line at the market price.

Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output.
Since the price is constant in the perfect competition. The increase in total revenue from producing 1
extra unit will equal to the price. Therefore, P= MR in perfect competition.
 Pure Monopoly
Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Examples
are public utilities and professional sports leagues.

Characteristics
1. A single seller: the firm and industry are synonymous.
2. Unique product: no close substitutes for the firm’s product.
3. The firm is the price maker: the firm has considerable control over the price because it can control the quantity supplied.
4. Entry or exit is blocked.

Barriers to Entry
Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low unit prices for consumers
depend on the existence of a small number of large firms, or in the case of monopoly, only one firm. Because a very large
firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale.
Public utilities are known as natural monopolies because they have economies of scale in the extreme case. More than one
firm would be inefficient because the maze of pipes or wires that would result if there were competition among water
companies or cable companies. Legal barriers also exist in the form of patents and licenses, such as radio and TV stations.
Ownership or control of essential resources is another barrier to entry, such as the professional sports leagues that control
player contracts and leases on major city stadiums. It has to be noted that barrier is rarely complete. Think about the
telephone companies a couple decades ago; there was no substitute for the telephone. Nowadays, cellular phones are very
popular. It creates a substitute for your house phone, causing the traditional telephone companies to lose their monopoly
position.

Demand Curve
Monopoly demand is the industry or market demand and is therefore downward sloping. Price will exceed marginal revenue
because the monopolist must lower price to boost sales and cannot price discriminate in most cases. The added revenue
will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output. The marginal
revenue curve is below the demand curve.
Price Discrimination
Price discrimination is selling a good or service at a number of different prices, and the
price differences is not justified by the cost differences. In order to price discriminate,
a monopoly must be able to
1. be able to segregate the market
2. make sure that buyers cannot resell the original product or services.

Perfect price discrimination is a price discrimination that extracts the entire consumer
surplus by charging the highest price that consumer are willing to pay for each unit.
Monopolistic Competition
Monopolistic competition refers to a market situation with a relatively large number of
sellers offering similar but not identical products. Examples are fast food restaurants
and clothing stores.

Characteristics
1. A lot of firms: each has a small percentage of the total market.
2. Differentiated products: variety of the product makes this model different from pure
competition model. Product differentiated in style, brand name, location,
advertisement, packaging, pricing strategies, etc.
3. Easy entry or exit.

Demand Curve
The firm’s demand curve is highly elastic, but not perfectly elastic. It is more elastic
than the monopoly’s demand curve because the seller has many rivals producing close
substitutes; it is less elastic than pure competition, because the seller’s product is
differentiated from its rivals.
Monopolistic Competition
• Hybrid of perfect competition and monopoly, sharing some of
features of each
• A monopolistically competitive market has three fundamental characteristics
• Many buyers and sellers
• Sellers offer a differentiated product
• Sellers can easily enter or exit the market

BY AHSAN MORAI 21
Many Buyers and Sellers
• Under monopolistic competition, an individual buyer is unable to
influence price he pays

• But an individual seller, in spite of having many competitors, decides

what price to charge

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Oligopoly
Oligopoly exits where few large firms producing a homogeneous or differentiated
product dominate a market. Examples are automobile and gasoline industries.

Characteristics
1. Few large firms: each must consider its rivals’ reactions in response to its decisions
about prices, output, and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may be the barriers to
enter.

Demand Curve
Facing competition or in tacit collusion, oligopolies believe that
rivals will match any price cuts and not follow their price rise. Firms
view their demands as inelastic for price cuts, and elastic for price
rise. Firms face kinked demand curves. This analysis explains the
fact that prices tend to be inflexible in some oligopolistic industries.
Oligopoly
• An oligopoly is a market dominated by a small number of strategically
interdependent firms

• In such a market, each firm recognizes its strategic interdependence

with others

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Number of Firms
• Oligopoly requires that a few firms dominate the market

• No absolute number at which oligopoly ends and monopolistic

competition begins

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Market Domination
• Strategic interdependence requires that a few firms dominate the
market
• As combined market share shrinks, strategic interdependence
becomes weaker
• Oligopoly is a matter of degree
• Not an absolute classification

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Economies of Scale: Natural Oligopolies
• When minimum efficient scale (MES) for a typical firm is a relatively
large percentage of market
• A large firm will have lower cost per unit than a small firm

• Does it remind you of monopoly? How is this different?

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 Barriers to entry
• Reputation - A new entrant may suffer just from being
new

• Strategic barriers - Oligopoly firms often pursue

strategies designed to keep out potential competitors

• Legal barriers - Patents and copyrights, Govt.

legislation

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 Examples of Different Market Forms

Perfect Monopolist Oligopoly Monopoly

Competition ic
Competiti
on
1) Agriculture 1) Fast 1) Cars 1) Window
2) Lumber Food and s
2) Long Trucks Operati
Distan 2) Soft ng
ce Drinks system
Service 2) Local
Residen
tial
 Distinguishing Characteristics Between
Market Forms
Perfect Monopolis Oligopol Monopoly
competiti tic y
on Competiti
on
Numbe Many-often Several* Few* One
thousands
r of or even
Firms millions
Barrier None Few Substanti Insurmounta
al ble, at least
s to in the short
Entry run
Product Identical Similar but Similar or N/A
not identical Identical
Similari
ty
* The line between “several” and “few” is not definite
Benefit-Cost Analysis
What is benefit-cost analysis?

BCA is an economic technique used to:

1.Evaluate a project or investment over time
2. Compare the merits of a set of projects

BCA is conducted by comparing economic benefits of

an activity with economic costs of an activity.
Key Point

As a tool for economic analysis, BCA

seeks to examine potential actions with
the objective of increasing well being...

…seeking an activity or use that provides

greater benefit than cost, or the greatest
benefit among competing uses.
Key Point

Decisions are typically not made on the

basis of BCA alone…

but BCA can be useful for providing

information on economic features of
projects or activities, and can therefore be
useful for informing the debate.
 BCA in a timeless world

Dam construction

Costs:

Materials = $500,000
Labor = $600,000

Total Cost = $1,100,000

BCA in a timeless world

Dam construction
Benefits:
Recreation = $400,000
Flood control = $300,000
Electricity = $500,000
Total Benefit =$1,200,000
BCA in a timeless world

Dam construction
Total Benefit =$1,200,000
Total Cost = 1,100,000

Net Benefit = 100,000

Benefit exceeds cost, so dam appears to be a good

investment
BCA as “Approach”

To know whether society should build the

dam, other information may be needed:

1. Are there non-economic impacts?

2. What is the opportunity cost of the dam?

Time and Discounting

Often the benefits and costs of a project accrue

at different times. The technique used to deal
with this issue is discounting.
Discounting

Discounting is a technique used to convert all

benefits and costs to a common point in time,
usually the present.

The value of a project, expressed in terms of

the present, is called the Present Value.
Discounting

Discounting is based on the premise that a

dollar of benefit received today is worth more
than a dollar of benefit received in the future.

The bias arises because current resources can

be invested.

Discounting is the opposite of compounding.

Discounting

The rate at which a current value is

compounded is called the interest rate.

The rate at which a future value is discounted

is called the discount rate.
Computing a present value

PV = Pt / (1 + r) t

PV = present value
Pt = value at time t
r = interest (discount) rate
t = year in which Pt is realized
 BCA with discounting

Dam revisited
Total Benefits
when dam is finished
(t = 1)
Total Costs at
start of construction
(t = 0)

Discount rate = 10% Should the dam be built?

 Dam construction revisited

Total Benefits when dam is finished (t = 1), so

Pt = $1,200,000 and PV of benefit is:
$1,200,000 / (1+0.10)1 = $1,090,909

Total Costs at start of construction (t = 0), so

Pt = $1,100,000 and PV of benefit is:
$1,100,000 / (1+0.10)0 = $1,100,000

PV(B) < PV(C) The dam shouldn’t be built.

 Why the reversal?

Total Benefits accrue in the future (i.e. when dam is

finished). The process of discounting reduces the
value of those benefits because they occur in the
future.

Because the merit of a project can hinge on the

choice of discount rate, it can be a source of debate.

There is no simple rule for choosing a discount rate.

Often a “well known” interest rate is used.
 Key Points

Whenever benefits and costs accrue at different

points in time, amounts should be converted to
present values for comparison.

BCA is a decision-support tool, not a decision-

making tool.

Discounting can be used regardless of the length of

time under consideration, but discounting has
implications for equity.
BCA tools:

1. Net Present Value (NPV)

2. Benefit-Cost Ratio (BCR)

Net Present Value (NPV)
NPV is the current value of all net benefits
associated with a project

Net benefit is simply the sum of benefits minus

the sum of costs.

The net present value of benefits is the present

value of those net benefits.

The net benefits are converted to present value

by discounting.
NPV Formula

t T
NPV  
 Benefit t  Cost t 
t 1 1  r  t
Positive NPV:
If present value of cash inflows is greater than the
present value of the cash outflows, the net present
value is said to be positive and the investment
proposal is considered to be acceptable.
Zero NPV:
If present value of cash inflow is equal to present
value of cash outflow, the net present value is said
to be zero and the investment proposal is
considered to be acceptable.
Negative NPV:
If present value of cash inflow is less than present
value of cash outflow, the net present value is said
to be negative and the investment proposal is
rejected.
Key Point

If the project has a NPV > 0, then it is

worth considering on its economic merits.

If the project has a NPV < 0, then it fails

to return benefits greater than the value of
the resources used.
NPV Example
Time Benefit Cost Net Benefit

0 100 150 -50

1 100 100 0

2 100 50 50

all 300 300 0

-50/(1+.1)0 + 0/(1+.1)1 + 50/(1+.1)2 = -8.68

Advantages of BCA
1. Provides a framework

2. BCA is quantitative
3. BCA is based on facts
4. The methods provide clarity
5. Results allow comparability
Disadvantages of BCA
1. Requires valuation

2. Discount rate sensitivity

3. Plagued by uncertainty
4. Silent on equity