2.modeling Market Process

Modeling the Market:
Review of the Basics

What is economics?
Economics and the Environment
What is economics?
Limited Resources Unlimited Wants
Efficient Resource Allocation
Use Marginal Analysis
Comparing Marginal Benefits (Return) vs Marginal Costs
© UPM
Why we need economics tools?
Economic theory explains and predicts

what we observe in reality
=> Thus, economic theory can be

used to analyze environmental issues
and problems
Applications
 Policy Analysis
 Prediction/Forecasting
….through modelling……
….through modelling……
Modelling…….which one?
St = f (Pt-i, Pct, Nt, Zt)
Dt = f (Pt, Pst, At, Tt, Xt )
Pt = f (Pt-1, It)
It = It-1 + St - Dt)
Policy Analysis.….
Ask five economists and you’ll get five
different answers – six if one went to Harvard.
Edger R. Fiedler
Prediction…..
What would be the effects of climate change
on the production of agricultural commodities
if there are no mitigation and adaptation
programs?
Forecasting…..
Any astronomer can predict just where every
star will be at half past eleven tonight; he can
make no such prediction about his daughter.
James T. Adams
The Theory
The Theory
The theory is simple…..
 Utility maximization for demand
functions
 Profit maximization or cost
minimization for supply and derived
demand functions
Must adhere to economic theory

The Theory
Example: Econometric Model
 A system of mathematical equations that
depict relationship in a commodity or an
economy
 Parameters in each equation that
influence how one economic variable is
related to another
 Positive or negative relationship
 Strong or weak relationship
The Theory
Model specification
Competitive Equilibrium
Economics
and the Environment
 Economic theory explains what we
observe in reality
 Economic theory can be used to
analyze environmental problems
 How?
 Through Market-based Instruments
Environmental Policy
 Government’s Overall Policy Approach

 Command-and-control Approach – regulates
polluters through the use of rules
 Market Approach – through Market-based

Instruments (MBI)with incentive policy that
encourages conservation or pollution reduction
• e.g. “Polluter-pays Principle” – polluter pays for the damage
caused
Market Models:
The Fundamentals
 Defining the Relevant Market
 Market – the interaction between consumers
and producers to exchange a well-defined
commodity
 Specifying the Market Model

 Form of the model varies with the objective
of the prospective study and its level of
complexity
The Model of Supply and
Demand: An Overview
 Decisions of sellers are modeled through
a supply function
 Decisions of consumers are modeled

through a demand function
Demand: An Overview
 The Purpose of the Model
 The primary objective of the supply and
demand model is to facilitate and analysis
of market conditions and any observed
change in price
 Conventional supply and demand model
must be modified to account for conditions
that weaken the operation of market forces
Demand: An Overview
 Building a Basic Model: Competitive
Markets for Private Goods
 Assumptions
• Large number of buyers and sellers with no
control over price
• Homogenous or standardized product
• Absence of entry barriers
• Perfect information
 Private good – a commodity that has two
characteristics, rivalry in consumption and
excludability
Market Demand
 Demand – the quantities of a good the
consumer is willing and able to purchase
at a set of prices during some discrete
time period
 Demand price is considered a measure
of the marginal benefit (MB) associated
with consuming another unit of the good
Market Demand
 The Law of Demand – There is an
inverse relationship between price and
quantity demanded of a good
 Modeling Individual Demand
 Deriving Market Demand from Individual
Demand Data
• Market demand for a private good – the
decisions of all consumers willing and able to
purchase a good, derived by horizontally
summing the individual demands
Individual Demand
Individual Consumer’s Demand (d) for Bottled Water
Market Demand
Market Demand (D) for Bottled Water
Market Supply
 Supply – the quantities of a good the
producer is willing and able to bring to
market at a given set of prices during some
discrete time period
 Variables that potentially affect the price-
quantity response of a firm:
 Production technology
 Input prices
 Taxes and subsidies
 Price expectations
Market Supply
 The Law of Supply – there is a direct
relationship between price and
quantity supplied of a good
 Modeling Individual Supply
 Deriving Market Supply from Individual
Supply Data
• Market supply of a private good – the combined
decisions of all producers in a given industry
derived by horizontally summing the individual
supplies
Individual Supply
Individual Producer’s Supply (s) of Bottled Water
Market Supply
Market Supply (S) of Bottled Water
Market Equilibrium
 Supply and demand must be
considered simultaneously to generate
a model of price determination
 The formal theory that price is
simultaneously determined by supply
and demand is one of the most
significant in all of economic analysis
Market Equilibrium
 Equilibrium Price and Quantity
 Equilibrium price – the point at which the
market system has no tendency to change
 Equilibrium quantity – the “market-
clearing” price associated with the
equilibrium quantity
Market Equilibrium
 Market Adjustment to Disequilibrium
 Disequilibrium – if the prevailing market price is at
some level other than the equilibrium level, the
market is said to be in disequilibrium
 Shortage – excess demand of a commodity equal to
(QD – QS), that arises if price is below its equilibrium
level
 Surplus – excess supply of a commodity equal to
(QS – QD), that arises if price is above its equilibrium
level
 Price movements serve as a signal that a shortage or
surplus exists, whereas stability or price suggest
equilibrium
Market Equilibrium
Equilibrium in the Market for Bottled Water:
Market Supply and Market Demand
Market Equilibrium
Price Quantity Quantity
Demanded/Month Supplied/Month
$5 6,000 10,000
$4 8,000 8,000
$3 10,000 6,000
$2 12,000 4,000
$1 14,000 2,000
•Graph the demand and supply curves
•What is the equilibrium price and equilibrium quantity?
•Suppose the price is currently at $5. What problem would exist in the economy? What would
you expect to happen to price?
•Suppose the price is currently $2. What problem exists in the economy? What would you
expect to happen to price?
Market Equilibrium
Economic Criteria of Efficiency
 Allocative efficiency – requires that
resources be appropriated such that the
additional benefits to society are equal
to the additional costs incurred
 Evaluating Resource Allocation at the Market
Level
• The value society places on the good is
equivalent to the value of the resources given
up to produce it
Economic Criteria of Efficiency
 Evaluating Resource Allocation at the Firm
Level
• Assumed motivation governing firm decision making is profit
maximization
• Total profit – total profit is equal to total revenue minus total
costs
• Decision making process relies on changes, the relevant
marginal variables are:
• Marginal Revenue
• Marginal Cost
• Marginal Profit
• Profit maximization – achieved at the output level where
marginal revenue equals marginal cost or where M∏ = 0
Profit Maximization
 In competitive industries, firms face constant
prices determined by the market, which means
P = MR
 Therefore the competitive market equilibrium
achieves allocative efficiency because:
  maximization requires: MR = MC
 Competitive markets imply: P = MR
 So  maximization in competition means:
 P = MC, which defines allocative efficiency
36
Profit Maximization
MC
2.50 P = MR
0.25
qE = 36 Quantity
37
Welfare Measures: Consumer
Surplus and Producer Surplus
 Consumer surplus – the net benefit to buyers
estimated by the excess of the marginal
benefit (MB) of consumption over market price
(P), aggregated over all units purchased
 Consumer surplus depends on two distinct notions
of price – one that measures a willingness to pay
and on that measures what is actually paid
 Any disturbance to market equilibrium will change
the size of consumer surplus
Welfare Measures:
Consumer Surplus
Consumer Surplus in the Competitive Market for Bottled
Water
 Producer surplus – the net gain to sellers
of a good estimated by the excess of the
market price (P) over marginal cost (MC),
aggregated by units sold
 Any market disturbance will change its
value and provide a way to assess any
associated welfare gain or loss to firms
Welfare Measures:
Producer Surplus
Producer Surplus in the Competitive Market for Bottled
Water
 The Welfare of a Society: Sum of
Consumer and Producer Surplus
 Society’s welfare – the sum of consumer
surplus and producer surplus
 Measuring Welfare Changes
 Deadweight loss to society – the net loss
of consumer and producer surplus due to
an allocatively inefficient market event
Deadweight Loss to Society Under a Pricing Regulation in
the Bottled Water Market

2.modeling Market Process

Uploaded by

Copyright:

Available Formats

2.modeling Market Process

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2.modeling Market Process

Uploaded by

Copyright:

Available Formats

Modeling the Market:

Review of the Basics

Limited Resources Unlimited Wants

Efficient Resource Allocation

Use Marginal Analysis

Comparing Marginal Benefits (Return) vs Marginal Costs

Economic theory explains and predicts

=> Thus, economic theory can be

Must adhere to economic theory

 Government’s Overall Policy Approach

 Market Approach – through Market-based

 Specifying the Market Model

 Decisions of consumers are modeled

 P = MC, which defines allocative efficiency

You might also like