BASIC CONCEPTS FROM

MICROECONOMICS AND
WELFARE ECONOMICS
• ENVIRONMENTAL ECONOMICS AND MICROECONOMICS
• ENVIRONMENTAL ECONOMICS AND MACROECONOMICS
• MARGINALISM
• CONSUMER’S SURPLUS
• PRODUCER’S SURPLUS
• EXTERNALITIES
• SUBSIDIES
• PRODUCTION POSSIBILITY FRONTIER
• OPPORTUNITY COST
• CARRYING CAPACITY
• PARETO OPTIMALITY
• TRAGEDY OF COMMONS
• ECOSYSTEM VALUATION
ENVIRONMENTAL ECONOMICS AND
MICROECONOMICS
The microeconomic dimension of environmental economics deals with:
• The behaviour of individuals or small groups of consumers, polluting firms, and firms in the
pollution-control industry.
• How and why people make decisions that have consequences for natural environment. For
example, we can either spend resources on construction of dam or on the construction of road. If
we build roads, less will be left for other activities. Also building road may require felling of trees,
which will have a consequence for environment.
• Contributes significantly in non-market valuation. Most environmental goods and services, such
as clean air and water are not traded in markets. Their economic value -how much people would
be willing to pay for them- is not revealed in market prices. So environmental economics helps in
their valuation.
ENVIRONMENTAL ECONOMICS AND
MACROECONOMICS
• What overall preferences do citizens( whether they want a higher environmental protection or a higher
economic growth) have with respect to the balance between environmental protection and economic growth.
• Historically, how measures of environmental protection led to lower economic growths? The important being
the Paris agreement. The Paris Agreement is an agreement within the United Nations Framework Convention
on Climate Change (UNFCCC), dealing with greenhouse-gas-emissions mitigation, adaptation, and finance,
signed in 2016. It also aimed at keeping the rise in temperature below 2 degree Celsius.
• How to design environmental regulations to minimize their impacts on growth? For example the Environment
Impact Assessment in case of India has been strict regarding the developmental projects. As a result a
notification was issued to dilute the powers of EIA so that projects could be undertaken without any
hindrance. Also several NGO’s are against very developmental projects, which cite humane grounds against
such projects.
• When the focus shifts from economic growth to human welfare, how does environmental protection
measures change? When a country has developed its focus shifts from economic growth to the welfare of its
citizens. However when the country is developing, it focuses more on the growth to catch up with developed
countries. See the chart on the next slide.
In the coming years more of
developing countries like Brazil
and South Africa will be among
the largest emitters of CO2.
A developed country tries to put
pressure on developing
countries to regulate industries
more strictly as to ensure
reduction in pollution.
MARGINALISM
• Marginal costs and benefits are essential information for economists,
businesses, and consumers, for determining the optimum level of consumption and production.
• The cost of producing one more unit is know as marginal cost, whereas the benefit gained from
producing one more is termed as marginal benefit.
• The marginal cost curve is upward sloping because there are diminishing returns to inputs. As
output increases, the marginal product of the variable declines- this implies that more and more
of the variable input must be used to produce each additional unit of output as the amount of
output already produced rises- and since each unit of the variable input must be paid for, the cost
per additional unit of output also rises.
• The marginal benefit curve is downward sloping, MB falls as more of a product is consumed
because additional units of a good yield less satisfaction than previous units.
• When necessary, individual and social marginal cost and benefit curves can be
drawn separately in order to understand different effects that a given action or
policy might have. In the case of pollution, the social cost is generally higher
than the individual cost due to externalities. For example, in the toy making factory( considered
in lecture 1), $6 did not reflect the true cost as it did not include externality( effect of pollution on
environment), so the social cost in this example was higher than $6.
• It can be used to optimize pollution. For example, take an environment that has been polluted –
while the initial unit of cleanup may be cheap, it becomes more and more expensive as additional
cleanup is done.

• Again take an environment that has been polluted, the first

unit of this pollution that is cleaned up has a very high benefit
value to consumers of the environment. Each additional unit
that is cleaned up is valued at a somewhat lower level than
each previous one because the overall pollution level
continues to decrease. Once the pollution is reduced below a
certain point, the marginal benefit of additional pollution
control measures will be negligible because the environment
itself is able to absorb a low level of pollution.
• Oftentimes, benefits are more difficult to measure because they are not always
monetary. In cases such as these the measurement may involve utilizing
revealed preferences, through a survey or another mechanism, in order to
discover the maximum price consumers are willing to pay for a particular
quantity of a good. An average benefit is used when considering society as a
whole because each individual’s willingness to pay is different.
• When considering environmental issues, the efficient point at which marginal
costs and marginal benefits are equal is an important economic concept because
it captures the essence of tradeoffs
CONSUMER SURPLUS
• In the mid-19th century, engineer Jules Dupuit first propounded the concept of economic surplus,
but it was the economist Alfred Marshall who gave the concept its fame in the field of economics.
• Consumer surplus is a measure of the welfare that people gain from consuming goods and
services
• Consumer surplus is defined as the difference between the total amount that consumers
are willing and able to pay for a good or service (indicated by the demand curve) and the total
amount that they actually do pay (i.e. the market price).
• Consumer surplus is shown by the area under the demand curve and above the price.
 PRODUCER SURPLUS
• Producer surplus, or producers' surplus, is the amount that producers benefit by selling at a 
market price that is higher than the least that they would be willing to sell for.
• Producer surplus is given by the area above the supply curve but below the price.

• For example, the equilibrium price is P′. However, at P1, the producers are
willing to sell one unit of a commodity for a price that is lower than P′. The
resulting rectangle from P1 on the y-axis, to its intersection with the supply
curve, up to the level of P′ is the producer surplus at price level P1.
• Similarly, at P2, the producers are willing to sell two units of a commodity at a
price that is still lower than P′. The rectangle from P2 on the y-axis, to its
intersection with the supply curve, up to the level of P′ is the new producer
surplus at price P2. The total producer surplus at P2 is the first rectangle at
the P1 price, plus the new rectangle from the P2 price.
• This process is repeated for every price level up to the equilibrium price. To
find the resulting total producer surplus, all of the rectangles for the individual
price levels are added together, and the total area is the total produce surplus.
The total producer surplus is made of all three pink rectangles – the surpluses
at price levels of P1, P2, and P3 – added together
EXTERNALITIES
• In economics, an externality is the cost or benefit that affects a third party who did not choose to
incur that cost or benefit. Externalities often occur when the production or consumption of a
product or service's private price( or a free-market price) equilibrium cannot reflect the true costs
or benefits of that product or service for society as a whole. For example, in the toy making
industry, $6 reflected only the free market price and did not include externalities, when
externalities were included the price was higher than $6.
• Externalities can be either positive or negative. Governments and institutions often take actions
to internalize externalities, thus market-priced transactions can incorporate all the benefits and
costs associated with transactions between economic agents. The most common way this is done
is by imposing taxes on the producers of this externality.
• For example, manufacturing activities that cause air pollution impose health and clean-up costs
on the whole society, whereas the neighbors of individuals who choose to fire-proof their homes
may benefit from a reduced risk of a fire spreading to their own houses.
Classification of externalities
Consumption Production

Negative Negative externalities in Negative externalities in

consumption( smoking, loud music) production( firms producing pollution)

Positive externalities in Positive externalities in

Positive production( free software, bee keeping
consumption( music you like,
and apple orchard)
 Examples for negative production externalities include:
• Air pollution from burning fossil fuels. This activity causes damages to crops, materials and
(historic) buildings and public health.
• Water pollution by industries that adds effluent, which harms plants, animals, and humans. Water
usage from growing plants could impose a negative externality on citizens of counties or states
who are harmed by decreased water.

An unregulated market leads to equilibrium price and quantity determined at

the intersection of the supply, or marginal private cost (MPC), curve and the
demand curve: P1, Q1.
Unfortunately, production of Q generates some harmful side (i.e., external)
effects such as fewer healthy days, fewer recreation opportunities, etc.:-
marginal external cost = MEC. If these costs are constant then the full costs to
society of production of Q is the marginal social cost curve: MSC = MPC +
MEC.
Environmental regulation is designed to get firms to "internalize the
externality" by considering the external costs of production. If firms face a
constant pollution tax on each unit of output so that they face production
costs equivalent to the MSC curve then the new market equilibrium will be
P2, Q2. The regulated product market will have a higher price and lower
quantity.
• Traditionally, both negative and positive externalities are considered to be forms of market failure
- when a free market does not allocate resources efficiently. Arthur Pigou, a British economist
best known for his work in welfare economics, argued that the existence of externalities justified
government intervention through legislation or regulation. Pigou supported taxes to discourage
activities that created harmful effects and subsidies for those creating benefits to further
encourage those activities. These are now known as Pigovian taxes and subsidies.
• Also, when a group voluntarily chooses to create a benefit, such as a community park, others may
benefit without contributing to the project. Any individuals or groups that gain additional benefits
without contributing are known as "free riders".
SUBSIDIES
• A subsidy or government incentive is a form of financial aid or support extended to an economic
sector (business, or individual) generally with the aim of promoting economic and social policy.
Although commonly extended from government, the term subsidy can relate to any type of support
– for example from NGOs or as implicit subsidies. Subsidies come in various forms including: direct
(cash grants, interest-free loans) and indirect (insurance, low-interest loans, accelerated
depreciation, rent rebates).

• The effect of a specific per unit subsidy is to

shift the supply curve vertically downwards by
the amount of the subsidy. In this case the
new supply curve will be parallel to the
original. Depending on elasticity of demand,
the effect is to reduce price and increase
output.
PRODUCTION POSSIBILITY FRONTIER
• A production–possibility frontier (PPF), production possibility curve (PPC), or production
possibility boundary (PPB) is a curve which shows various combinations of the amounts of two
goods which can be produced within the given resources and technology/a graphical
representation showing all the possible options of output for two products that can be produced
using all factors of production, where the given resources are fully and efficiently utilized per unit
time. A PPF illustrates several economic concepts, such as allocative efficiency, economies of scale
, opportunity cost (or marginal rate of transformation), productive efficiency, and scarcity of
resources (the fundamental economic problem that all societies face)
• It defines productive efficiency in the context of that production set: a point on the frontier
indicates efficient use of the available inputs (such as points B, D and C in the graph), a point
beneath the curve (such as A) indicates inefficiency, and a point beyond the curve (such as X)
indicates impossibility.
• The two main determinants of the position of the PPF at any given time
are the state of technology and management expertise (which are
reflected in the available production functions) and the available quantities
of factors of production (materials, direct labor, and factory overhead).

• The slope of the production–possibility frontier (PPF) at any given point is

called the marginal rate of transformation (MRT). The slope defines the
rate at which production of one good can be redirected (by reallocation
of productive resources) into production of the other. It is also called the
(marginal) "opportunity cost" of a commodity, that is, it is the
opportunity cost of X in terms of Y at the margin. It measures how much
of good Y is given up for one more unit of good X or vice versa. The shape
of a PPF is commonly drawn as concave to the origin to represent
increasing opportunity cost with increased output of a good. Thus, MRT
increases in absolute size as one moves from the top left of the PPF to
the bottom right of the PPF.
PARETO OPTIMALITY
• This efficiency criterion was developed by Vilfredo Pareto in his book “Manual of Political
Economy”, 1906.
• Pareto efficiency is said to occur when it is impossible to make one party better off without
making someone worse off.
• A Pareto improvement is said to occur when at least one individual becomes better off without
anyone becoming worse off.
• Pareto efficiency will occur on a production possibility frontier. When an economy is operating on
a simple production possibility frontier, (e.g. at point A, B or C) it is not possible to increase
output of goods without reducing output of services.

• However, at Point D (16 goods and 17 services) It is

possible to increase either without leading to a decline in
the output of the other. Thus to be at point D would be
classed as Pareto inefficient, and this is generally
considered to be bad for the economy.
CARRYING CAPACITY
• Changes in population can have a variety of economic, ecological, and social implications. One
population issue is that of carrying capacity – the number of individuals an ecosystem can support
without having any negative effects. It also includes a limit of resources and pollution levels that can
be maintained without experiencing high levels of change.
• If carrying capacity is exceeded, living organisms must adapt to new levels of consumption or find
alternative resources. Carrying capacity can be affected by the size of the human population,
consumption of resources, and the level of pollution and environmental degradation that results.
Carrying capacity, however, need not be fixed and can be expanded through good management and
the development of new resource-saving technologies.
TRAGEDY OF THE COMMONS
• The tragedy of the commons is a situation in a shared-resource system where individual users,
acting independently according to their own self-interest, behave contrary to the common good
of all users by depleting or spoiling the shared resource through their collective action.
• In this modern economic context, "commons" is taken to mean any shared and unregulated
resource such as atmosphere, oceans, rivers, and ocean fish stocks.
• The term is used in environmental science. The "tragedy of the commons" is often cited in
connection with sustainable development, meshing economic growth and environmental
protection, as well as in the debate over global warming.
ECOSYSTEM VALUATION
• Ecosystem valuation is the process by which policymakers assign a value – monetary or otherwise
– to environmental resources or to the outputs and/or services provided by those resources. For
example, a mountain forest may provide environmental services by preventing downstream
flooding.
• Environmental resources and/or services are particularly hard to quantify due to their intangible
benefits and multiple value options. It is almost impossible to attach a specific value to
some of the experiences we have in nature, such as viewing a beautiful sunset.
• Problems also exist when a resource can be used for multiple purposes, such as a tree – the wood
is valued differently if it is used for flood control versus if it is used for building a house.
• There are typically two ways to assign value to environmental resources and services – use and
non-use – and there are approaches to measuring environmental benefits based on these
defined values. When environmental resources or services are being used, it is easier to observe
the price consumers are willing to pay for the conservation or preservation of those resources.
• Hedonic pricing will measure the effect that negative environmental qualities have on the price of
related market goods. When evaluating non-use value, contingent valuation is employed through
the use of surveys that attempt to assess an individual's willingness to pay(WTP) for a resource
that they do not consume.
• Ecosystem valuation is a complex process by which economists attempt to assign a value to
natural resources or to the ecological outputs and/or services provided by those resources.
Although challenging, it allows policymakers to make decisions based on specific comparisons,
typically monetary, rather than some other arbitrary basis. In recent years, the government
has placed increasing emphasis on cost-effective laws and projects.