Skip to 0 minutes and 7 secondsEconomic models consist of building blocks. Remember the blocks we discussed to describe firm behaviour? In addition to these blocks, we need three more types of building blocks for our construction-- consumer behaviour, markets, and the natural environment. These blocks serve to connect the dots left open by our model of firm behaviour. Thus they have to be chosen so that they fit to each other and to the model of firm behaviour that we have selected. Let us start with building blocks describing consumer behaviour. In general, economic models describe consumers as choosing between different goods while being subject to a budget constraint.

Skip to 0 minutes and 55 secondsHowever, in environmental economic models, we focus on emissions so that the choice among different goods is not that important, but we rarely need much sophistication for the consumer side, and thus usually extend the model of firm behaviour in the simplest possible way. If we have selected the Emission Choice Model for firm behaviour, there is very little to do for depicting consumer behaviour. The Emission Choice Model describes only emissions, not the production of conventional goods. Thus, consumers are obsolete except for being subject to damage caused by emissions. Thus, in the case of the Emission Choice Model, we only add a damage function to our description of firm behaviour. If we selected the Output Abatement Choice Model, firms produce output and emissions.

Skip to 1 minute and 54 secondsOn the consumer side, we thus have to describe the well being derived from consuming the product and the damage caused by emissions.

Skip to 2 minutes and 6 secondsTo this end, we describe the benefit of consumption by the consumer end-- that is, the area below the demand curve-- and again use a damage function. In case of the Input Choice Model, we've also to describe where the inputs come from. Thus, we will usually need a model that describes labour supply, capital supply, and the supply of all other factors. In the simplest case, we take the supply as being exogenously given. For example, we could assume this there's a fixed amount of labour and capital available to the firms that we model. In addition, we need to describe the utility gained from consumption and the damage caused by emissions.

Skip to 2 minutes and 55 secondsBoth can be done in the same way as in the Output Abatement Choice Model. Finally, we have to describe markets and the natural environment. In most cases, we can use balancing equations to both ends. A market is modelled by assuming that what flows into the market-- that is, supply-- has to equal what is drawn from the market-- that is, demand. We already used this approach in our first example where we assumed that two firms on the permit market trade a fixed number of permits. Demand-- the sum of the permits used by both firms --equals supply --the number of permits available.

Skip to 3 minutes and 42 secondsThus, to model markets we set up a balancing equation for each good or factor that our models of firm and consumer behaviour describes. For each good or factor, the market has to clear. This shows why the Input Choice Model is so much more complex. We do not only have a more complex model of firm behaviour. We also have to model as many markets as we have inputs plus the market for the output. Usually we assume perfect competition on all markets. Thus, we derive consumer and firm behaviour for given, but not yet derived prices, and then use balancing equations to explain the market clearing prices.

Skip to 4 minutes and 31 secondsIn contrast, if we want to model imperfect competition, we could assume that a firm or a consumer anticipates his or her influence on the market viewing price. We will see an example of this in week six. To describe the natural environment we have to link the emissions of all firms to the total emissions that cause damage to consumers. In the simplest case of a perfectly mixing pollutant, the total emissions are simply the sum of individual emissions. However, we could also use a model where the total emissions are weighted sum of firm emissions with the weights corresponding to the distance between emitting firms and the location where people live. Finally, we often have to account for accumulation of emissions.

Skip to 5 minutes and 23 secondsFor example, climate change is not only caused by current, but also by past emissions. Thus, the damage is not a function of only current emissions, but rather a function of current and past emissions. With these building blocks we have everything that we need to build the main structure of a model. In the following step, we will go into somewhat more detail. In particular, we will discuss how to introduce policy instruments into a model and how to evaluate the consequences of environmental policy.

How to build a theoretical model II

Economic models consist of building blocks. In addition to these blocks, we need three more types of building blocks for our construction:

  • consumer behaviour
  • markets
  • natural environment

These blocks serve to connect the dots left open by our model of firm behaviour. They have to be chosen so that they fit to each other and to the model of firm behaviour that we have selected.

Consumer behaviour

In general, economic models describe consumers as choosing between different goods while being subject to a budget constraint. However, in environmental economic models, we focus on emissions so that the choice among different goods is not that important, but we rarely need much sophistication for the consumer side, and thus usually extend the model of firm behaviour in the simplest possible way.

If we have selected the Emission Choice Model for firm behaviour, there is very little to do for depicting consumer behaviour. The Emission Choice Model describes only emissions. Thus, in the case of the Emission Choice Model, we only add a damage function to our description of firm behaviour.

If we selected the Output Abatement Choice Model, firms produce output and emissions. On the consumer side, we thus have to describe the well-being derived from consuming the product and the damage caused by emissions.

In case of the Input Choice Model, we’ve also to describe where the inputs come from. Thus, we will usually need a model that describes labour supply, capital supply, and the supply of all other factors.

Markets and the natural environment

In most cases, we can use balancing equations to both ends. A market is modelled by assuming that what flows into the market has to equal what is drawn from the market. We already used this approach in our first example where we assumed that two firms on the permit market trade a fixed number of permits.

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This video is from the free online course:

Exploring Possible Futures: Modeling in Environmental and Energy Economics

University of Basel