Environmental Damage and Price Taking Behaviour by Firms and Consumers

Abstract

Integrated assessment models lack a microeconomic foundation in modelling environmental damages to the economy. To overcome this, damage coe¢ cients are incorporated in standard microeconomic models. Firms and consumers take both damages and prices as given. Demand, supply, pro…t and expenditure functions under damage coe¢ cients are derived that allow easy implementation in applied economic models through appropriate price distortions related to such coe¢ cients. For the consumer, Slutsky's equations are derived. The di¤erent speeds of equilibrium adjustment in economic and climate models is reconciled in the Recursive Equilibrium with Environmental Damages (REED). An exchange economy and Robinson Crusoe economy illustrate our approach.JEL Classi…cation: Q41, Q51, Q52, D11, D12, D51Keywords: environmental damage, substitution e¤ects, income e¤ects, Slutky's equations, equilibriumWe would like to thank Claudia Kempfert for her feedback during this project.