Week 1: Fundamentals & Policy Instruments
▪ H&R Chapter 3: The Theory of Environmental Externalities, pp. 42-85.
• How can pollution and environmental damage be represented in economics?
• What economic policies can be instituted to respond to environmental problems?
• How and when can property rights be relied upon to solve environmental problems?
Concepts
Negative externality = negative impacts of a market transaction affecting those not involved in the
transaction.
Positive externality = the positive impacts of a market transaction that affect those not involved in the
transaction.
Marginal cost = the cost of producing or consuming one more unit of a good or service. marginal
benefit the benefit of producing or consuming one more unit of a good or service.
Equilibrium price = the market price where the quantity supplied equals the quantity demanded.
Economic efficiency = an allocation of resources that maximizes net social benefits; perfectly
competitive markets in the absence of externalities are efficient.
Internalizing external costs = externalities using approaches such as taxation to incorporate external
costs into market decisions. External cost(s) is a cost, not necessarily monetary, that is not reflected in
a market transaction.
• Environmental impacts hard to internalize →
▪ H&R Chapter 4: Common Property Resources and Public Goods, only Section 4.2, pp. 100-103.
Box 4.2 The nature of conservancy
- Voluntary donations cannot be relied on to provide an efficient level of public goods,
voluntary efforts can effectively supplement government efforts.
o Nature Conservancy, an environmental group that purchases land with donations.
o Uses a means for individuals to use the market to promote habitat conservation
Common property resource = a resource that is available to everyone (non-excludable), but use of
the resource may diminish the quantity or quality available to others (rival)
Nonexcludable good = good that is available to all users, under conditions in which it is impossible to
exclude potential users
Rival good = good whose use by one person diminishes the quantity/quality of the good available to
others
Open-access resources = a resource that offers unrestricted and unregulated access such as an ocean
fishery or the atmosphere
Free riders = individual / group that obtains a benefit from a public good without having to pay for it
Vertical addition = adding the price of more than one demand curve at the same quantity demanded
Social benefits = the market and nonmarket benefits associated with a good or service aggregated
across all members of a society
1
,Lecture 1: Fundamentals
Economics = study of allocating & managing scarce natural & environmental resources optimally
accounting for externalities
• Choices have to be made (consumption and production in time)
• Some sort of policy and governance to enforce or stimulate choices
• Scarcity is a basic concept, when something becomes scarcer, its value increases
• Change as long as there are differences in marginal values
Economic approach (What are economic models?)
• Economic models show how people, firms, and governments make decisions about managing
resources, and how their decisions interact.
• Models are simplifications of complex problems
• A model is useful when it
o Makes clear assumptions
o Describes the real world accurately (as possible)
o Predicts cause and effect
• The main goal is to understand the world to make informed decisions, not to create theoretical
models for the sake of modeling.
Consumers’ choice firms’ choice
U, utility
Market Clearing
A market clearing price = equilibrium price
Two basic modeling assumptions
• Rational choice: each person tries to choose the best alternative available to him or her
• Market clearing: market price adjusts until quantity demanded equals quantity supplied.
Competitive markets take care of an efficient allocation of scarce mean through prices:
• The sum of consumer and producer surplus is maximal
o Maximization of welfare
• Or the marginal costs of production equal the marginal benefits
o not more, not less production
• private costs and benefits equal social costs and benefits
o externalities are absent
2
,Positivistic economics = aims to describe what was and what is (what will be)
• What are the costs and benefits of reducing emissions?
• How much does demand influence price?
Normative economics = deals with what we ought to be from a broad welfare perspective (what we
want)
• How much pollution should be allowed?
• Are market outcomes desirable, and if not, how can we correct them?
Typology of benefits and costs
Total benefits = sum of all benefits from carrying out an activity
Marginal benefit = the increase in total benefit that results from carrying out one additional unit of an
activity
➢ Often measured as maximum willingness to pay by consumers
Total costs = sum of all costs from carrying out an activity
Marginal costs = the increase in total costs that results from carrying out one additional unit of an
activity
➢ Often measured as financial and/or opportunity costs
The invisible hand of the market
• Adam Smith 1176: maximization of individual welfare contributes to maximization of social
welfare.
• Competitive markets takes care of an efficient allocation of scarce means through prices:
o The sum of consumer and producer surplus is maximal
▪ Maximization of welfare
o Or the marginal costs of production equal the marginal benefits
▪ Not more, not less production
o Private costs and benefits equal social costs and benefits
▪ Externalities are absent
Demand & supply, market price, consumer & producer surplus
WTP = willingness to pay
Consumer surplus = the difference between willingness to pay for a good and the price that
consumers actually pay for it.
o Each price along a demand curve also represents a consumer's marginal benefit of each unit of
consumption.
o The difference between a consumer's marginal benefit for a unit of consumption, and what
they actually pay, represents how much benefit a consumer gets from the price they are
paying.
Producer surplus = difference between the price a seller receives and their willingness to sell for each
quantity.
o Each price along a supply curve also represents a seller's marginal cost of producing each unit
of production.
o The difference between the price the seller gets for each unit, and what it costs for the seller to
produce that last unit, represents the seller's benefit from the price they are getting.
Total surplus = consumer surplus + producer surplus
3
, Demand curve
How much of a good does a person buy for a certain price?
• The points on the curve show the marginal benefit of each
unit.
• The slope reflects the price elasticity of demand:
o “The % change in quantity demanded that occurs in response
to a 1% change in the price”
o The higher the price elasticity of demand, the flatter the
demand curve
Price elasticity = The responsiveness of the quantity demanded or supplied of a good to a change in
its price.
o The percentage change in quantity demanded—or supplied—divided by the percentage
change in price.
o Elastic—or very responsive—unit elastic, or inelastic—not very responsive.
Supply curve (competitive market)
How much of a good is produced for a certain price?
The points on the curve show the marginal cost of each unit.
Area under a marginal curve measures
the TOTAL (costs in this case)
Grey area shows total production costs
of 5 units
Why supply curve upward sloping?
Increasing marginal costs of production
• Short run: Law of diminishing returns
• Medium run: In a competitive market the most productive firms produce first
Results in an upward sloping supply curve
• The market (firms) supplies more if the price is higher
Slope reflects the price elasticity of supply
• “The % change in quantity supplied that occurs in response to a 1% change in the price”.
• The higher this elasticity of supply, the flatter the supply curve
Diminishing returns = After some optimal level of capacity is reached, adding an additional factor of
production will actually result in smaller increases in output.
4
▪ H&R Chapter 3: The Theory of Environmental Externalities, pp. 42-85.
• How can pollution and environmental damage be represented in economics?
• What economic policies can be instituted to respond to environmental problems?
• How and when can property rights be relied upon to solve environmental problems?
Concepts
Negative externality = negative impacts of a market transaction affecting those not involved in the
transaction.
Positive externality = the positive impacts of a market transaction that affect those not involved in the
transaction.
Marginal cost = the cost of producing or consuming one more unit of a good or service. marginal
benefit the benefit of producing or consuming one more unit of a good or service.
Equilibrium price = the market price where the quantity supplied equals the quantity demanded.
Economic efficiency = an allocation of resources that maximizes net social benefits; perfectly
competitive markets in the absence of externalities are efficient.
Internalizing external costs = externalities using approaches such as taxation to incorporate external
costs into market decisions. External cost(s) is a cost, not necessarily monetary, that is not reflected in
a market transaction.
• Environmental impacts hard to internalize →
▪ H&R Chapter 4: Common Property Resources and Public Goods, only Section 4.2, pp. 100-103.
Box 4.2 The nature of conservancy
- Voluntary donations cannot be relied on to provide an efficient level of public goods,
voluntary efforts can effectively supplement government efforts.
o Nature Conservancy, an environmental group that purchases land with donations.
o Uses a means for individuals to use the market to promote habitat conservation
Common property resource = a resource that is available to everyone (non-excludable), but use of
the resource may diminish the quantity or quality available to others (rival)
Nonexcludable good = good that is available to all users, under conditions in which it is impossible to
exclude potential users
Rival good = good whose use by one person diminishes the quantity/quality of the good available to
others
Open-access resources = a resource that offers unrestricted and unregulated access such as an ocean
fishery or the atmosphere
Free riders = individual / group that obtains a benefit from a public good without having to pay for it
Vertical addition = adding the price of more than one demand curve at the same quantity demanded
Social benefits = the market and nonmarket benefits associated with a good or service aggregated
across all members of a society
1
,Lecture 1: Fundamentals
Economics = study of allocating & managing scarce natural & environmental resources optimally
accounting for externalities
• Choices have to be made (consumption and production in time)
• Some sort of policy and governance to enforce or stimulate choices
• Scarcity is a basic concept, when something becomes scarcer, its value increases
• Change as long as there are differences in marginal values
Economic approach (What are economic models?)
• Economic models show how people, firms, and governments make decisions about managing
resources, and how their decisions interact.
• Models are simplifications of complex problems
• A model is useful when it
o Makes clear assumptions
o Describes the real world accurately (as possible)
o Predicts cause and effect
• The main goal is to understand the world to make informed decisions, not to create theoretical
models for the sake of modeling.
Consumers’ choice firms’ choice
U, utility
Market Clearing
A market clearing price = equilibrium price
Two basic modeling assumptions
• Rational choice: each person tries to choose the best alternative available to him or her
• Market clearing: market price adjusts until quantity demanded equals quantity supplied.
Competitive markets take care of an efficient allocation of scarce mean through prices:
• The sum of consumer and producer surplus is maximal
o Maximization of welfare
• Or the marginal costs of production equal the marginal benefits
o not more, not less production
• private costs and benefits equal social costs and benefits
o externalities are absent
2
,Positivistic economics = aims to describe what was and what is (what will be)
• What are the costs and benefits of reducing emissions?
• How much does demand influence price?
Normative economics = deals with what we ought to be from a broad welfare perspective (what we
want)
• How much pollution should be allowed?
• Are market outcomes desirable, and if not, how can we correct them?
Typology of benefits and costs
Total benefits = sum of all benefits from carrying out an activity
Marginal benefit = the increase in total benefit that results from carrying out one additional unit of an
activity
➢ Often measured as maximum willingness to pay by consumers
Total costs = sum of all costs from carrying out an activity
Marginal costs = the increase in total costs that results from carrying out one additional unit of an
activity
➢ Often measured as financial and/or opportunity costs
The invisible hand of the market
• Adam Smith 1176: maximization of individual welfare contributes to maximization of social
welfare.
• Competitive markets takes care of an efficient allocation of scarce means through prices:
o The sum of consumer and producer surplus is maximal
▪ Maximization of welfare
o Or the marginal costs of production equal the marginal benefits
▪ Not more, not less production
o Private costs and benefits equal social costs and benefits
▪ Externalities are absent
Demand & supply, market price, consumer & producer surplus
WTP = willingness to pay
Consumer surplus = the difference between willingness to pay for a good and the price that
consumers actually pay for it.
o Each price along a demand curve also represents a consumer's marginal benefit of each unit of
consumption.
o The difference between a consumer's marginal benefit for a unit of consumption, and what
they actually pay, represents how much benefit a consumer gets from the price they are
paying.
Producer surplus = difference between the price a seller receives and their willingness to sell for each
quantity.
o Each price along a supply curve also represents a seller's marginal cost of producing each unit
of production.
o The difference between the price the seller gets for each unit, and what it costs for the seller to
produce that last unit, represents the seller's benefit from the price they are getting.
Total surplus = consumer surplus + producer surplus
3
, Demand curve
How much of a good does a person buy for a certain price?
• The points on the curve show the marginal benefit of each
unit.
• The slope reflects the price elasticity of demand:
o “The % change in quantity demanded that occurs in response
to a 1% change in the price”
o The higher the price elasticity of demand, the flatter the
demand curve
Price elasticity = The responsiveness of the quantity demanded or supplied of a good to a change in
its price.
o The percentage change in quantity demanded—or supplied—divided by the percentage
change in price.
o Elastic—or very responsive—unit elastic, or inelastic—not very responsive.
Supply curve (competitive market)
How much of a good is produced for a certain price?
The points on the curve show the marginal cost of each unit.
Area under a marginal curve measures
the TOTAL (costs in this case)
Grey area shows total production costs
of 5 units
Why supply curve upward sloping?
Increasing marginal costs of production
• Short run: Law of diminishing returns
• Medium run: In a competitive market the most productive firms produce first
Results in an upward sloping supply curve
• The market (firms) supplies more if the price is higher
Slope reflects the price elasticity of supply
• “The % change in quantity supplied that occurs in response to a 1% change in the price”.
• The higher this elasticity of supply, the flatter the supply curve
Diminishing returns = After some optimal level of capacity is reached, adding an additional factor of
production will actually result in smaller increases in output.
4
