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Civil Systems Planning Benefit/Cost Analysis

Civil Systems Planning Benefit/Cost Analysis. Scott Matthews 12-706/19-702 / 73-359 Lecture 8. Admin. HW 2 returned. Avg 42 (76%) HW 3 due next Wednesday. Office Hours - I am out of town Monday (back tues). Social Surplus. Social Surplus = consumer surplus + producer surplus

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Civil Systems Planning Benefit/Cost Analysis

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  1. Civil Systems PlanningBenefit/Cost Analysis Scott Matthews 12-706/19-702 / 73-359 Lecture 8

  2. Admin • HW 2 returned. Avg 42 (76%) • HW 3 due next Wednesday. • Office Hours - I am out of town Monday (back tues). 12-706 and 73-359

  3. Social Surplus Social Surplus = consumer surplus + producer surplus Is difference between areas under D and S from 0 to Q* Losses in Social Surplus are Dead-Weight Losses! P S P* D Q* Q 12-706 and 73-359

  4. Allocative Efficiency Allocative efficiency occurs when MC = MB (or S = D) Equilibrium is max social surplus - prove by considering Q1,Q2 S = MC Price b P* D = MB a Q1 Q* Q2 Quantity Is the market equilibrium Pareto efficient? Yes - if increase CS, decrease PS and vice versa. 12-706 and 73-359

  5. Net Social Benefit Accounting • Change in CS: P2ABP* (loss) • Government Spending: P2ACP* (gain) • Gain because society gets it back • Net Benefit: Triangle ABC (loss) • Because we don’t get all of CS loss back • OR.. NSB= (-P2ABP*)+ P2ACP* = -ABC 12-706 and 73-359

  6. Types of Costs • Private - paid by consumers • Social - paid by all of society • Opportunity - cost of foregone options • Fixed - do not vary with usage • Variable - vary directly with usage • External - imposed by users on non-users • e.g. traffic, pollution, health risks • Private decisions usually ignore external 12-706 and 73-359

  7. Pollution (Air or Water) Typically supply (MC) only private, not social costs. Social costs higher for each quantity P S#:marginal Social costs S*: marginal Private costs P# P* What do these curves, Equilibrium points tell us? D Q Q# Q* 12-706 and 73-359

  8. What is WTP by society to avoid? Typically supply (MC) only private, not social costs. Social costs higher for each quantity P S#:marginal Social costs S*: marginal Private costs P# P* D Q Q# Q* 12-706 and 73-359

  9. What is WTP by society to avoid? Differences in cost functions represent the alternative ‘valuations’ of the product - Thus difference between them WTP to avoid costs P S#:marginal Social costs S*: marginal Private costs P# P* D Q Q# Q* 12-706 and 73-359

  10. Pollution (Air or Water) Relatively too much gets produced, At too low of a cost - how to Reduce externality effects? P S#:marginal Social costs S*: marginal Private costs DWL P# P* D Q Q# Q* 12-706 and 73-359

  11. Pollution (Air or Water) Government can charge a tax ‘t’ on Each unit, where t = distance between What are CS, PS, NSB? P S#:marginal Social costs S*: marginal Private costs P# t P* D Q Q# Q* 12-706 and 73-359

  12. Pollution (Air or Water) CS = (loss) A+B PS=(loss) E+F P S#:marginal Social costs S*: marginal Private costs P# t A B P* F E P# - t D Q Q# Q* 12-706 and 73-359

  13. Pollution (Air or Water) Third parties: (gain) B+C+F (avoided quantity between S curves) Govt revenue: A+E Total: gain of C P S#:marginal Social costs S*: marginal Private costs P# t C A B C is reduced DWL of pollution eliminated by tax** P* F E P# - t D Q Q# Q* **This cannot be a perfect reduction in practice - need to consider administrative costs of program 12-706 and 73-359

  14. Distorted Market - Vouchers • Example: rodent control vouchers • Give residents vouchers worth $v of cost • Producers subtract $v - and gov’t pays them • Likely have spillover effects • Neighbors receive benefits since less rodents nearby means less for them too • Thus ‘social demand’ for rodent control is higher than ‘market demand’ 12-706 and 73-359

  15. Distortion : p0,q0 too low What is NSB? What are CS, PS? S Social WTP P S-v P0 P1 DS: represents higher WTP for rodent control DM Q Q0 Q1 12-706 and 73-359

  16. Social Surplus - locals Make decisions based on S-v, Dm What about others in society, e.g. neighbors? P P S S-v P1+v C A P0 B E P1 DS Because of vouchers, Residents buy Q1 DM Q Q0 Q1 12-706 and 73-359

  17. Nearby Residents Added benefits are area between demand above consumption increase What is cost voucher program? P P S S-v F P1+v C A G P0 B E P1 DS DM Q Q0 Q1 12-706 and 73-359

  18. Voucher Market Benefits • Program cost (vouchers):A+B+C+G+E ---- • Gain (CS) from target pop: B+E • Gain (CS) in nearby: C+G+F • Producers (PS): A+C • --------- • Net: C+F 12-706 and 73-359

  19. Notes about Public Spending • Resource allocation to one project always comes at a ‘cost’ to other projects • E.g. Pittsburgh stadium projects • “Use it or Lose it” • There is never enough money to go around • Thus opportunity costs exist • Ideally represented by areas under supply curves • Do not consider ‘sunk costs’ • Three cases (we will do 2, see book for all 3) 12-706 and 73-359

  20. Opportunity Cost: Land • Case of inelastic supply (elastic supply in book, trivial) • Government decides to buy Q acres of land, pays P per acre • Alternative is parceling of land to private homebuyers • What is total cost of project? Price Can assume quantity of land is fixed (Q) S b P D Q 12-706 and 73-359

  21. Opportunity Cost: Land Government pays PbQ0, but society ‘loses’ CS that they would have had if government had not bought land. This lost CS is the ‘opportunity cost’ of other people using/buying land. • Total cost is entire area under demand up to Q (colored) Price S b P D 0 Q 12-706 and 73-359

  22. Example: Change in Demand for Concrete Dam Project • If Q high enough, could effect market • Shifts demand -> price higher for all buyers • Moves from (P0,Q0) to (P1,Q1).. Then?? Price D+q’ D S P1 P0 a Q1 Q0 Quantity 12-706 and 73-359

  23. Another Example: Change in Demand • Original buyers: look at D, buy Q2 • Total purchases still increase by q’ • What is net cost/benefit to society? Price D+q’ D S P1 P0 a Q1 Q2 Q0 Quantity 12-706 and 73-359

  24. Another Example: Change in Demand • Project spends B+C+E+F+G on q’ units • Project causes change in social surplus! • Rule: consider expenditure and social surplus change Price D D+q’ S P1 C A F B P0 G E G G Q1 Q2 Q0 Quantity 12-706 and 73-359

  25. Dam Example: Change in Demand • Decrease in CS: A+B (negative) • Increase in PS: A+B+C (positive) • Net social benefit of project is B+G+E+F Price D D+q’ S P1 C A F B P0 G E G G Q1 Q2 Q0 Quantity 12-706 and 73-359

  26. Final Thoughts: Change in Demand • When prices change, budgetary outlay does not equal the total social cost • Unless rise in prices high, C negligible • So project outlays ~ social cost usually • Opp. Cost equals direct expenditures adjusted by social surplus changes Quantity 12-706 and 73-359

  27. Secondary Markets • When secondary markets affected • Can and should ignore impacts as long as primary effects measured and undistorted secondary market prices unchanged • Measuring both usually leads to double counting (since primary markets tend to show all effects) • Don’t forget that benefit changes are a function of price changes 12-706 and 73-359

  28. Monopoly - the real game • One producer of good w/o substitute • Not example of perfect comp! • Deviation that results in DWL • There tend to be barriers to entry • Monopolist is a price setter not taker • Monopolist is only firm in market • Thus it can set prices based on output 12-706 and 73-359

  29. Monopoly - the real game (2) • Could have shown that in perf. comp. Profit maximized where p=MR=MC (why?) • Same is true for a monopolist -> she can make the most money where additional revenue = added cost • But unlike perf comp, p not equal to MR 12-706 and 73-359

  30. Monopoly Analysis In perfect competition, Equilibrium was at (Pc,Qc) - where S=D. But a monopolist has a Function of MR that Does not equal Demand So where does he supply? MC Pc Qc MR D 12-706 and 73-359

  31. Monopoly Analysis (cont.) Monopolist supplies where MR=MC for quantity to max. profits (at Qm) But at Qm, consumers are willing to pay Pm! What is social surplus, Is it maximized? MC Pm Pc Qm Qc D MR 12-706 and 73-359

  32. Monopoly Analysis (cont.) What is social surplus? Orange = CS Yellow = PS (bigger!) Grey = DWL (from not Producing at Pc,Qc) thus Soc. Surplus is not maximized Breaking monopoly Would transfer DWL to Social Surplus MC Pm Pc Qm Qc D MR 12-706 and 73-359

  33. Natural Monopoly • Fixed costs very large relative to variable costs • Ex: public utilities (gas, power, water) • Average costs high at low output • AC usually higher than MC • One firm can provide good or service cheaper than 2+ firms • In this case, government allows monopoly but usually regulates it 12-706 and 73-359

  34. Natural Monopoly Faced with these curves Normal monop would Produce at Qm and Charge Pm. We would have same Social surplus. But natural monopolies Are regulated. What are options? a Pm d P* AC b e MC c Qm Q* D MR 12-706 and 73-359

  35. Natural Monopoly Forcing the price P* Means that the social surplus is increased. DWL decreases from abc to dec Society gains adeb a Pm d P* AC b e MC c D Qm Q* Q0 MR 12-706 and 73-359

  36. Monopoly • Other options - set P = MC • But then the firm loses money • Subsidies needed to keep in business • Give away good for free (e.g. road) • Free rider problems • Also new deadweight loss from cost exceeding WTP 12-706 and 73-359

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