Environmental EconomicsEcon 260Benefits and Costs, Supply and DemandCh.03

IntroductionIn this chapter, we will review the basic ideas behind demand and supply curves. They are the basic tools we use in economics to understand how market functions and how policies can influence the market outcomes.

Both demand and supply curves are relationships about price and quantity of goods or services. Demand curve is the relationship between price and quantity as consumers see it. Supply curve is the relationship between price and quantity as producers see it. The main difference is how consumers and producers interpret prices.

It is also important to see demand and supply curves as marginal benefit and marginal cost curves.

Over the next several slides, we will review important aspects of demand and supply curves.

Willingness to PayWillingness to Pay (WTP) for a good is related to the value a consumer attaches to it. Higher the value or benefit a consumer attaches to a good, higher the WTP for it. WTP information has to be inferred and is based on ability to pay.

Normally the WTP (for additional unit) changes with consumption level. As the number of units consumed increases, the WTP for additional units of that good declines. The additional WTP for one more unit of a good or service is termed as marginal WTP.

Marginal WTP (MWTP) at various consumption level is what we will be focusing on as we study demand curve. Now consider Fig. 3-1 and Fig. 3-2.

In these figures, height of the graph represents MWTP and area under it represents total WTP. Total WTP for a given consumption level refers to the total amount a person would be willing to pay to attain that consumption level rather than go without the good entirely.

Fig. 3-1 & Fig. 3-2

MWTP curve as demand curveRecall that an individual demand curve shows the quantity of a good or service that the individual in question would buy or consume at any particular price.

Note that a demand function has quantity on the left hand side. An inverse demand function has price on the left hand side. If we replace price by MWTP in this relationship, then we get MWTP curve. Graph for demand curve is actually based on the inverse demand function.

We are often interested in demand curve for many consumers. This is called aggregate or market demand curve. An aggregate demand curve for a market good is the horizontal summation of the demand curves of all the people.

Fig. 3-4 and Tab. 3-1 help us understand the mechanics of deriving aggregate demand curve from individual demand curves.

Fig. 3-4 and Tab.3-1

BenefitsWe can use area under aggregate MWTP curve or demand curve to measure benefits consumers get from their consumption. Fig. 3-5 shows that, when quantities increase from q1 to q2, consumers benefits increase by b under aggregate demand curve D2 and a + b under curve D1 .

Cost The remaining slides will focus on cost concepts associated with production. When we consider cost of production in economics, we are generally thinking about opportunity cost.

The opportunity cost of producing something consists of the maximum value of other outputs we could and would have produced had we not used the resources to produce the item in question.

To measure opportunity cost, we need to not only consider direct/monetary costs involved but also other indirect costs. In other words, opportunity costs and monetary (accounting) costs of production are not always the same.

We will now discuss cost curves ( marginal cost and total cost curves) and derive aggregate supply from individual supply curves.

Cost CurvesWe will use the concepts of marginal costs and total costs to summarize production cost information.

Marginal costs (MC) measure the amount by which total costs increase as output is increased by one unit.

Total costs (TC) are the costs of producing the total amount of output.

Consider Figure 3-6 in the next slide. The graphs are based on the following cost information. Unit1st2nd3rd4th5th6thCost1.672.002.332.673.003.33 These are marginal costs. When the second unit is produced, the total cost increases by $2.00 . In graphs of Figure 3-6, the height represents marginal costs and the area under graph represents total costs.

Figure 3-6

Marginal Cost and Supply, Aggregate SupplyA firms supply curve is its marginal cost curve. To see it clearly, you just need to replace marginal costs (MC) by price (P). This gives a relationship between price and quantity of production, just as you would expect in a supply information.

We are often interested in aggregate supply (quantity supplied by many firms at various prices). The aggregate supply curve for firms producing the same output is the horizontal summation of the individual supply curves of all the firms in the group.

The next couple of slides derive an aggregate supply curve graphically and algebraically.

Fig 3-7

Table 3-2

TechnologyTechnological change over time affects shapes and positions of cost curves. In other words, supply changes as a result of technological changes. Technology improves when firms invest in research and development (R&D). Figure 3-8 illustrates this.

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