Environmental economics and resource valuation (intero corso per Environmental engineering)

The competitive market model relies on the following basic assumptions:

Sellers are price takers (each seller acts as if it can sell as much or as little output as it

wants to without affecting the prevailing market price)

Sellers do not behave strategically

Entry into the market is free

Buyers are price takers

The market structure is the economic environment in which buyers and sellers in an

industry operate. There are several important dimensions to market structure:

size and number of buyers

size and number of suppliers

degree of substitutability of different sellers’ products

extent to which buyers are informed about prices and available alternatives

entry conditions

To find equilibrium market price and demand, the market demand and market supply curves

are needed.

market supply curve

For the since quantity is measured on the horizontal axis, add

(summing horizontally) the firms’ supply curves horizontally allows to find it:

market demand curve

The (recall) follow the assumption that buyers are price takers,

allowing to summarize buyer behavior in terms of a market demand curve. At the same

manner summing horizontally the individuals’ demand curves allows to find it.

Since all market participants are price takers, a competitive market is in equilibrium when:

buyers are choosing their optimal purchase levels, given prevailing prices

sellers are choosing their optimal output levels, given prevailing prices

suppliers are willing to produce as much as buyers wish to purchase and buyers are

willing to purchase as much as suppliers choose to produce

Find Find

An individual supplier bases its decisions on its firms specific demand curve. If the firm

sells any output, it will sell at the market price. The firm’s equilibrium quantity is where the

firm-specific supply curve intersects the firm-specific demand curve.

In the long run, new suppliers can enter the market and some old suppliers can exit. As a

result, the short- and long-run equilibrium may be very different.

When entry is free, and the price is greater than the minimum of long run average cost, a

firm can earn positive profit by entering the market.

The possibility of earning positive economic profit attracts new firms to enter the industry,

increasing the market quantity supplied ever more.

As in the short run, the equilibrium price is at the intersection of the market supply and

demand curves.

Total surplus can also be viewed as the total benefits derived from consumption of the

good minus (-) the total costs of producing it

When the quantity that a firm buys or sells significantly affects the price that the firm faces

price maker.

the firm is known as a The firm is said to be a price maker because it can

influence the price through its choice of quantity.

Another way of saying the firm has the ability to influence the market price is to say the firm

has market power. Focusing now on implications of price-making behaviour in a particular

setting called monopoly.

The monopoly model relies on the following basic assumptions:

sellers are price makers

sellers do not behave strategically

entry into the industry is completely blocked

buyers are price takers

A price-maker supplier can influence the price at which it sells its output by adjusting its

output level. In other words, the demand curve for a price-making firm slopes downwards,

the price falls as the amount of output rises and vice versa.

Recall that any profit-maximizing firm follows 2 rules in choosing its output level:

the marginal output rule

the shutdown rule

a monopolist is no exception to these two rules. A monopolist cost function is found the

same way as any other’s firm cost function.

The difference between monopoly and competition comes on the revenue side.

The two rules for the profit-maximizing choice of output level:

marginal output rule:

the if it remains in the business, the monopolist chooses the

output level at which MC=MR

shut down rule:

the the firm must compare its average revenue with its average cost

A monopolist charges an equilibrium price that is greater than marginal cost. For a price

making firm, price is greater than marginal revenues.

The analysis of short-run and long-run decisions is virtually identical for the two cases.

If it is making a short-run decision, monopolist bases its output choice on short-run

marginal and average economic costs. If the firm is making a long-run decision, then it

bases its output choice on long-run marginal and average economic costs.

Under monopoly, further entry into a monopolized market is completely blocked so in the

long run the incumbent merely adjusts its method of production.

The tools of economics help us to determine who gains and who loses when competition

turns to monopoly, as might happen when competitive firms merge into a monopoly. The

change from competition to monopoly leads to higher profit for suppliers an the equilibrium

price rises, which reduces consumer surplus. Therefore, when supply becomes

monopolized, the suppliers gain and the consumers lose.

Perfect competition leads to the efficient output level and the monopoly leads to less output

than perfect competition. It follows that a monopoly produces less than the total surplus

maximizing level of output.

The deadweight loss represents a loss for which there is no offsetting gain. This loss arises

under monopoly because there are consumers who would derive benefits from the

additional output that are greater than the MC of these units.

A Pareto improvement is a reallocation of resourcesthat makes at least one person better

off without making anyone else worse off.

A Pareto efficient allocation is an allocation of commodities and inputs such that the only

way to make one individual better off is to make another worse off. Clearly, a Pareto

consumption efficient production

efficient allocation must be (on the contract curve) and

efficient (on the production possibilities curve).

Considering a central planner who knows scarcity constraints, individuals’ perferences,

production technologies and processes and who is willing to allocate resources in a Pareto

efficient way (input e output).

In order to obtain a Pareto efficient allocation of x and y between A and B, how should x and

y be distributed? A maximization problem must be solved:

By solving the Lagrangian function (Lagrangian dual problem) the result is:

The contract curve shows all the allocations at which

the gains from trade are fully exhausted.

When people are on the contract curve, there are no

further opportunities for mutually beneficial trade.

The production efficiency is a production efficient allocation that is an allocation of inputs

such that the only way to increase the output of one commodity is to decrease the output of

another commodity.

Production-efficient allocations are defined by mutual tangencies between isoquants

(mutual tangencies are points where the slopes are equal).

Starting from the locus of production-efficient allocations, the production possibilities curve

can be derived. It shows the maximum amount of 1 output that can be produced, given the

amount of the other output. The negative of the slope of the production possibilities curve

represents the marginal rate of transformation between x and y.

The marginal rate of transformation (MRT) is the rate at which the economy can transform

one output into another, by shifting resources.

It's time to bring the models of exchange and production together, consumption and

production efficiency compared. Considering simultaneously how commodities are

allocated among individuals, and how inputs are used to produce these commodities.

The goal is to find condition for Pareto efficient allocations of commodities and inputs.

When MRSyx=MRT are equal it is impossible to make someone better off without making

anybody worse off, hence, it is a necessary condition for Pareto efficiency.

In fact, in real world situations, it is not likely that consequently to a reallocation of

resources at least one individual is better off and no one is worse off.

Therefore the Pareto-efficiency criterion can be relaxed into the Kaldor-Hicks criterion.

The Kaldor-Hicks compensation principle established the idea of hypothetical

compensation as a practical rule for deciding on policies and projects in these real-life

contexts. It relies on the concept of a potential Pareto improvement. All that is required is

that gainers can compensate losers to achieve a ‘potential’ Pareto improvement, though the

compensation have not actually to be carried out.

The compensation principle thus establishes that the prima facie ("first impression") rule

that benefits (i.e. gains in human well-being) should exceed costs (i.e. losses in human well-

being) for policies and projects to be sanctioned.

The Kaldor-Hicks compensation test is called the overcompensation test, because the

gainers can compensate the losers and have something positive left over.

The formal statement of the test is: "an economic allocation of resources x is superior to an

allocation y if and only if it is possible to reach allocation z through redistribution from x

such that z is preferred to y according to the Pareto test".

An economy composed entirely of price takers, a competitive economy, "automatically"

allocates resources efficiently, without any need for centralized direction.

An economy with freely operating markets may fail to generate an efficient allocation of

resources for 2 reasons:

market power

The is the ability of a firm to profitably influence the price of a commodity,

setting it above marginal cost without losing customers (monopoly debut).

non-existence of markets

The means that in reality, markets for certain commodities may

fail to emerge. This leads to different types of inefficiencies:

Asymmetric information (i.e. one party in a transaction has information that is not

available to another)

Externality (i.e. a situation in which one person’s behaviour affects the welfare of

another in a way that is outside existing markets)

A social welfare function (W) is a function or schedule that shows how the well-being of

society depends on the utilities of its members.

An externality is a direct effect of the actions of one person or firm on the welfare of

another person or firm, in a way that is not transmitted by market prices.

When the activity of one entity (a person or a firm) directly affects the welfare of another in

a way that is not transmitted by market prices, that effect is called an externality (because

one entity directly affects the welfare of another entity that is "external" to it).

Unlike effects that are transmitted through market prices, externalities can adversely affect

economic efficiency.

Negative externality (ES-): the privately optimal production/consumption level Q*p is

greater than the socially optimal production/consumption level. There is an excessive

production/consumption.

Positive externality (ES+): the privately optimal production/consumption level