Environmental Economics

Econ 260
Benefits and Costs, Supply and
Demand
Ch.03

Introduction
In 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 Pay
Willingness 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 curve

Recall 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

Benefits
We 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 Curves
We 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.
Unit 1st
2nd
3rd
4th
5th
6th
Cost 1.67
2.00
2.33
2.67
3.00
3.33
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

Supply

A 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

Technology
Technological 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.