Tools and Basic Concepts

The tool of demand, supply and market equilibrium mainly introduces us with the households and firms as the decision makers in the economy, and also the markets through which the decision makers of demand (households) and supply (firms) interact.

The law of demand states that a higher price leads to a lower quantity demanded and that a lower price leads to a higher quantity demanded.

`The principle of marginal utility` that explains the `law of demand`. As consumers enjoy increasing quantities of a certain product, the marginal benefit (utility) that the consumers enjoy from the extra unit of the product decreases. Here, `demand` as willingness to pay also leads to the interpretation that Price = Marginal Utility (Marginal Private Benefit, MPB). Hence, the maximum price that consumers are willing to pay for this extra unit, as compared to going without decreases. In summary, each unit price that we observe on the `demand curve` shows us the marginal (private) benefit that the consumers enjoy for the `last` unit of the product that they would like to buy.

Consumer surplus is the difference between the price that the consumers are willing to pay for each unit and the current market price.

Supply curve, is a graphic representation of the relationship between product price and quantity of product that a seller is willing and able to supply

The law of supply states that a higher price leads to a higher quantity supplied and that a lower price leads to a lower quantity supplied.

Producer surplus is the difference between the minimum price that producers are willing to accept and the price that prevails in the market.

The assumptions are:

• that the households and firms are self-interested and rational in their choices,
• that the decision makers of demand and supply have perfect information,
• that the markets work in a perfectly competitive environment: that both buyers and sellers are price takers,
• that resources of the economy can be transferred easily from one sector to the other,
• that ownership rights are clearly defined.

In a perfectly competitive market and under the set of certain assumptions the `price` of a good or service not only reflects what is `private`, but also reflects what is `social`.

As long as the equilibrium price PE is positive, it means that the `economic` value associated with the product under concern is also positive and that the equilibrium price is an indicator of the `relative scarcity` of the resources utilized for the production of the product under concern. Stable market equilibrium prices therefore, reflect the social, as well as the private cost of using resources (land, labor, capital etc.) to produce this particular product. Under these conditions, an intervention with the market equilibrium system would also mean misallocation of resources. So, for instance, if the government intervenes with the market through taxes, subsidies etc., it would create a distortion leading to a misallocation of resources in the economy. Hence, the social benefit would not be maximized.

For the market system to work efficiently, certain conditions related to ownership rights must be met, in addition to other assumptions such as self-interested rational decision makers, perfect information, perfectly competitive markets and flexibility in the transfer of resources. These conditions are as follows: • All the quantitative and qualitative features as well as the boundaries of the ownership are specified, • The rights are completely exclusive, • The rights are transferable, • The rights are enforceable by law. 

An externality is defined as a situation, either positive or negative, that occurs when the actions of some individuals affect the welfare (utility) of others who have no direct control over the activity in question. 

Because the decision makers do not account for the additional social costs in case of a negative externality (or benefit in case of a positive externality) and prices of the free market do not reflect these costs or benefits, there arises the problem of `misallocation` and `market inefficiency`.

Marginal Social Cost > Marginal Private Cost

                              = Marginal Private Cost + Marginal External Cost

with Marginal External Cost (MEC) > 0 in case of negative externality.

We define goods and services that exhibit the characteristics of being both non-rival and non-excludable as pure public goods. Clean air, stable climate conditions, clean oceans, optimal biodiversity, forests are examples of environmental goods and services that are non-rival and non-excludable, and are therefore considered pure public goods. Public goods are socially the most valuable, but unlike pure private goods (which are both rival and excludable, like a t-shirt you buy), they are almost never produced by the free market system.

Non-rivalry defines the situation that once they are produced the consumption of the good or service it is associated with does not reduce the availability, hence the utility to the others. So, one person consuming and benefiting the good or service does not prevent others from consuming and benefiting the same good/service.

Clean air, stable climate conditions, clean oceans, etc. are all examples of non-rival goods and services.

Ecology is “the study of the relationships between organisms and their environment. Some of the most pressing problems in human affairs—expanding populations, food scarcities, environmental pollution including global warming, extinctions of plant and animal species, and all the attendant sociological and political problems—are to a great degree ecological.”

Ecosystem, is “the complex of living organisms, their physical environment, and all their interrelationships in a particular unit of space.”

The ecological perspective highlights that human activities, such as extensive land use for settlements, large-scale production of toxic waste from industries, excessive exploitation of natural resources through extractive practices, and overuse of pesticides in agriculture, have resulted in significant ecological crises, including climate change and biodiversity loss, observed over the past decades.