Chapter 3

Benefits and Costs,

Supply and Demand

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 Learning Objectives

1. Derive the demand curve for an individual from his

willingness to pay and show how to aggregate to a
market demand curve
2. Derive the supply curve for a firm using marginal cost
information and show how to aggregate to a market
supply curve
3. Illustrate the impact of technological progress on
marginal cost curves
4. Explain the equimarginal principle and apply it to
different situations of decision-making

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 Willingness to Pay (WTP)

• A fact: Individuals have preferences for goods and services

• One way to express abstract concept of preferences is to state how
much you are willing to sacrifice/pay for the good/service
• The value of a good to somebody is what that person is willing to pay
for it.
• Willingness to pay (WTP)
• is an operational measure of value
• is subjective
• reflects ability to pay – affected by wealth/affordability
• Diminishing WTP: As the number of units consumed increases, the
willingness to pay for additional units of that good normally goes
down.

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 FIGURE 3.1 The Concept of Willingness to Pay

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 Marginal WTP & Total WTP

• Marginal willingness to pay: the additional willingness to pay of a

person for one more unit, at a given consumption level.
• The height of the WTP curve shows the marginal WTP at each unit.

• Total willingness to pay for a given consumption level is the total

amount a person would be willing to pay to attain that consumption
level rather than go without the good entirely.
• The whole area under the WTP curve from the origin up to the
quantity in question represents the total WTP for all units.

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 Demand

• An individual demand curve shows the quantity of a good or service

that the person would demand (i.e., purchase and consume) at any
particular price - a way of summarizing personal consumption
attitudes and capabilities for that good.

• WTP curve coincides with demand curve

• Different concepts: WTP represents preferences only; demand is
the result of optimal choice given preferences and constraints
• Downward-sloping WTP => downward-sloping demand curve:
principles of diminishing WTP + maximization => law of
demand

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 FIGURE 3.2 Typical Demand/Marginal Willingness-to-Pay
Curves

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 Different Demand/MWTP curves – Panel (a)

• Panel (a) shows two demand curves, one steeper than the other. The
steeper one shows a situation in which marginal willingness to pay
drops off fairly rapidly as the quantity consumed increases; the flatter
one shows marginal willingness to pay that, although lower to begin
with, goes down less rapidly as quantity increases.
• These two demand curves could represent the case of one consumer
and two different goods or services, or the case of two different
consumers and the same good or service.

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 Different Demand/MWTP curves – Panel (b)

• The demand curve above and to the right shows a good for which the
marginal willingness to pay is substantially higher than it is for the
same quantity of the other good.
• Several factors could account for the difference:
• demand curves of two different people, with different tastes and
preferences;
• demand curves for the same person, the one on the right being
after an income rise;
• demand curves for the same person, before and after that person
receives more information about the good (for example, the
possible presence of pesticide residues in a food item).

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 Aggregate Demand/MWTP

• An aggregate demand curve represents demand/marginal

willingness to pay of defined groups of people
• It is the horizontal summation of individual demand curves:
summing together, at each price, the quantities that are demanded
by all individuals

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 FIGURE 3.3 Aggregate Demand/Marginal Willingness-to-Pay
Curves

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 Exercise

Individual demand for organic potatoes:

- Alice: Qd = 10 – 2P
- Bruce: Qd = 7 – P
Derive the aggregate demand equation and draw the demand curves.

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 Benefits

• The word benefits implies being made better off.

• If individuals are benefited by something, their position is improved
— they are better off. Conversely, if they are worse off, it must be
because benefits were somehow taken away from them.
• How do we confer benefits on people? We do this by giving them
something they value.
• How do we know that they value something? We know by the fact that
they are willing to sacrifice, or willing to pay, for it.
• According to this logic, then, the benefits that people get from
something are equal to the amount they are willing to pay for it:
WTP = value = benefit
• We can use ordinary demand curves to determine the benefits of
making various things available to people.

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 FIGURE 3.4 Willingness to Pay and Benefits

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 Marginal Benefit & Total Benefit

• Marginal Benefit = Marginal WTP: height of demand/MWTP curve

• Total Benefit = Total WTP: area below demand/MWTP curve up to
the last unit

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 Benefits in Environmental Economics

• Strength: based on a clear notion of the value that people place on

different things.
• Shortcomings:

1) Demand and therefore benefits are often very hard to measure

when it concerns environmental questions
2) Demand curves are critically affected by the ability to pay –
income. Environmental policies and programs affect people at
different income levels in different ways
3) People’s demand curves of the moment may not be true
expressions of the benefits of environmental actions – they are
constantly affected by knowing of new information and influence
of media, scientific press and politics; they are changing over time

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 Costs

• In economics, costs always mean opportunity costs.

• 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.
• The opportunity cost idea is relevant in any situation in which a
decision must be made about using productive resources for one
purpose rather than another: consumers, producers, public
agencies
• In practice, opportunity costs are measured by the market value of
inputs used up in production.
• We need to not only consider out-of-pocket direct/monetary costs
but also indirect/implicit costs of using the resources.

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 Private and Social Costs

• The private costs of an action are the costs experienced by the party
making the decisions leading to that action.
• The social costs of an action are all of the costs of the action, no
matter who experiences them.
• Social costs include private costs, but also may include much more in
certain situations – external costs

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 Cost Curves

• To summarize cost information, we use cost curves, which are

geometric representations of the costs of producing something.
• Just as in the case of willingness to pay, we differentiate between
marginal costs and total costs.
• Marginal cost (MC) is the added cost, the amount by which total cost
increases, when output is increased by one unit.
• Shown by the height of MC curve
• Total cost (TC) is the cost of producing the total amount of output.
• Total cost is the summation of marginal costs of all units.

• Measured by the area below MC curve up to the last unit

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 FIGURE 3.5 The Concept of Marginal Cost

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 The Shapes of Cost Curves

• The height and shape of the marginal cost curve for any production
process will differ from one situation to another, based on several
underlying factors:
• Technology utilized in production: technological progress => MC
curve shifts downward
• The price of inputs: input prices increase => MC curve shifts
upward.
• Time (short run or long run) - the amount of time that a firm has
to adjust to changes in its rate of output. (From now on we will
assume that we are working with long-run marginal cost curves.)

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 FIGURE 3.6 Typical Marginal Cost Curves

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 Technology

• The most important factor affecting the shapes of marginal cost

functions is the technology of the production process - the inherent
productive capabilities of the methods and machines being employed.
• This concept of technology is vitally important in environmental
economics because technological change can provide ways to
produce goods and services with fewer environmental side effects and
also better ways of handling the quantities of production residuals that
remain.
• Technical advancement shifts marginal cost curves downward:
Technological progress makes it possible to produce a given increase
in output at a lower marginal cost and total cost.
• Technological change does not normally happen without effort; it
normally requires research and development (R&D). Cost savings
caused by technological change represent the incentive of R&D
investment.

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 FIGURE 3.7 Technological Improvement

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 The Equimarginal Principle

• Consider a firm producing a certain product and assume that the

firm’s operation is divided between two different plants with different
technology levels (MC)
• How many units should it produce in each plant in order to produce
the 100 units at the least total cost?
• As long as the marginal costs in the two plants differ from one another,
we can continue to reallocate production — away from the high-
marginal-cost plant and toward the low-marginal-cost plant — and get
a reduction in total cost.
• The total costs of producing the 100 units in the two plants will be at a
minimum (i.e., total cost cannot be reduced further by reallocation)
only when the marginal costs of the two plants are equal, hence the
“equimarginal principle.”

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 FIGURE 3.8 The Equimarginal Principle

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 General applications of Equimarginal Principle

• If you have multiple sources to produce a given product or achieve a

given goal, and you want to minimize the total cost of producing a
given quantity of that output, distribute production in such a way as to
equalize the marginal costs between the production sources.
• If you have given resources and you want to maximize the total
amount produced, distribute total production among the sources in
such a way as to equalize marginal costs.
• This principle will be very valuable when we take up the issue of
getting maximum emissions reductions from given amounts of
resources.

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 Exercise

A firm has 2 plants with different functions:

- Plant 1: MC = 20 + Q
- Plant 2: MC = 5 + 2Q
How to allocation output between the 2 plants to minimize total cost of
producing 45 units of output? What is the minimum total cost?

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 Marginal Cost and Supply

• Under prefect competition, the marginal cost curve of a firm acts

essentially as a supply curve, showing the quantity of the good the
firm would supply at different prices.
• Increasing MC + profit maximization => upward-sloping supply
curve
• The aggregate supply curve of a group of firms is the horizontal
summation of the individual supply curves of all the firms in the group.

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 FIGURE 3.9 Marginal Cost and Supply

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 FIGURE 3.10 Derivation of Aggregate (Market) Supply from
Individual Firm Supply Curves

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 Exercise

Individual supply for organic potatoes:

- Farm 1: Qs = 2P – 6 => MC =
- Farm 2: Qs = P – 2 => MC =
Derive the aggregate supply equation and MC equation, and draw the
supply curves.

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