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Civil Systems Planning Benefit/Cost Analysis

Civil Systems Planning Benefit/Cost Analysis. Chapters 3 and 4 Scott Matthews Courses: 12-706 and 73-359 Lecture 4 - 9/10/2003. Price. A. B. P*. 0 1 2 3 4 Q*. Quantity. Recap: Net Benefits. A. B.

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Civil Systems Planning Benefit/Cost Analysis

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  1. Civil Systems PlanningBenefit/Cost Analysis Chapters 3 and 4 Scott Matthews Courses: 12-706 and 73-359 Lecture 4 - 9/10/2003

  2. Price A B P* 0 1 2 3 4 Q* Quantity Recap: Net Benefits A B • Amount ‘paid’ by society at Q* is P*, so total payment is B to receive (A+B) total benefit • Net benefits = (A+B) - B = A = consumer surplus (benefit received - price paid) 12-706 and 73-359

  3. Short Run vs. Long Run Cost • Short term / short run - some costs fixed • In long run, “all costs variable” • Difference is in ‘degree of control of plans’ • Generally say we are ‘constrained in the short run but not the long run’ • So TC(q) < = SRTC(q) 12-706 and 73-359

  4. BCA Part 2: CostWelfare Economics Continued The upper segment of a firm’s marginal cost curve corresponds to the firm’s SR supply curve. Again, diminishing returns occur. Price At any given price, determines how much output to produce to maximize profit Supply=MC AVC Quantity 12-706 and 73-359

  5. Supply/Marginal Cost Notes Demand: WTP for each additional unit Supply: cost incurred for each additional unit Supply=MC Price At any given price, determines how much output to produce to maximize profit P* Q1 Q* Q2 Quantity 12-706 and 73-359

  6. Supply/Marginal Cost Notes Recall: We always want to be considering opportunity costs (total asset value to society) and not accounting costs Supply=MC Price Area under MC is TVC - why? P* Q1 Q* Q2 Quantity 12-706 and 73-359

  7. Market Supply Curves  Producer surplus is similar to CS -- the amount over and Above cost required to produce a given output level  Changes in PS found the same way as before Supply=MC Price P* PS* P1 PS1 TVC* TVC1 Quantity Q1 Q* Producer Surplus = Economic Profit 12-706 and 73-359

  8. Unifying Cost and Supply • Economists learn “Supply and Demand” • Equilibrium (meeting point): where S = D • In our case, substitute ‘cost’ for supply • Why cost? Need to trade-off Demand • Using MC is a standard method 12-706 and 73-359

  9. Example • Demand Function: p = 4 - 3q • Supply function: p = 1.5q • Assume equilibrium, what is p,q? • In eq: S=D; 4-3q=1.5q ; 4.5q=4 ; q=8/9 • P=1.5q=(3/2)*(8/9)= 4/3 • CS = (0.5)*(8/9)*(4-1.33) = 1.19 • PS = (0.5)*(8/9)*(4/3) = 0.6 12-706 and 73-359

  10. Allocative Efficiency Allocative efficiency occurs when MC = MB (or S = D) S = MC Price b P* D = MB a Q1 Q* Q2 Quantity 12-706 and 73-359

  11. Social Surplus = consumer surplus + producer surplus Losses in Social Surplus are Dead-Weight Losses! P S P* D Q* Q Social Surplus 12-706 and 73-359

  12. Subsidies/Target Pricing Allocative efficiency only achieved when P = social MC. Assume market for corn below in initial eq’m -> what happens when government guarantees PT to farmers? S Price a d PT b P* D c Q* QT Quantity 12-706 and 73-359

  13. Subsidies/Target Pricing At PT, farmers want to supply QT units. But at QT , consumers only want to pay PD . This is effective market price. So PT-PD must be subsidized by government policy. What is change in CS, PS? S Price a d PT b P* PD e D c Q* QT Quantity 12-706 and 73-359

  14. Subsidies/Target Pricing CS increases from aP*b (yellow) to aPDe (yellow+orange). What about PS? S Price a d PT b P* PD e D c Q* QT Quantity 12-706 and 73-359

  15. Subsidies/Target Pricing PS also increases, from P*bc to PTdc. So is overall net benefit to society then positive (since PS and CS both increase)? S Price a d PT b P* PD e D c c Q* QT Quantity 12-706 and 73-359

  16. Subsidies/Target Pricing A cost to society (taxpayers) is the government subsidy - So what is the overall net benefit to society? S Price a d PT b P* PD e D c Q* QT Quantity 12-706 and 73-359

  17. Subsidies/Target Pricing Overall net benefit to society is (Increased CS + Increased PS) - Costs = Orange + Yellow - Grey = Triangle bde (loss!). This is a DWL, increases in CS, PS are transfers! Efficiency Measure: Leakage = Area bde/Area PTdePD Price S a d PT b P* PD e D c Quantity Q* QT 12-706 and 73-359

  18. Changes in Demand • There is a difference in ‘change in quantity demanded’ and a ‘change in demand’. • If (only) the price of good changes • Change in qty demanded - move along D • If something other than price changes (e.g. demand more of good) • Then entire demand curve shifts • Same things true for supply 12-706 and 73-359

  19. Types of Markets • Primary: directly affected by policy • Secondary: indirectly affected • Example: new highway • Primary: commuting, traffic, pollution • Secondary: change in repairs, gas • Efficient markets (as discussed) • Distorted markets: when external effects occur as a result of market • Could be positive or negative 12-706 and 73-359

  20. Benefits in Efficient Market • NSB=DCS+ DPS + Net Gov’t Revenues • Government adds large quantity of good to market to reduce price • Example: surplus food programs • Government intervenes by supplying q’ units into the market • Supply curve moves out (right) - more supplied at each price point 12-706 and 73-359

  21. Surplus Food Example Initial equilibrium at P0, Q0 New eq’m at (lower)P1, (higher) Q1 What is change in CS? S P S+q’ a P0 b P1 D Q Q2 Q0 Q1 12-706 and 73-359

  22. Surplus Food Example Change in CS is P0abP1 (gain) What about PS? S P S+q’ a P0 b P1 D Q Q2 Q0 Q1 12-706 and 73-359

  23. Surplus Food Example Change in PS is P0acP1 (loss) for the ‘original suppliers’ since they still Operate on supply curve ‘S’ What is social surplus? S P S+q’ a P0 b P1 c D Q Q2 Q0 Q1 12-706 and 73-359

  24. Surplus Food Example Social surplus is net gain of CS+PS, Or the triangle abc - what is Net Social Benefit? S P S+q’ a P0 b P1 c D Q Q2 Q0 Q1 12-706 and 73-359

  25. Surplus Food Example Government gains revenue Q2cbQ1, so NSB =Q2cabQ1 S P S+q’ a P0 b P1 c D Q Q2 Q0 Q1 12-706 and 73-359

  26. 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

  27. Monopoly - the real game (2) • Could have shown that in perf. comp. Profit maximized where p=MR=MC • 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. Pricing Strategies • Highway pricing • If price set equal to AC (which is assumed to be TC/q then at q, total costs covered • p ~ AVC: manages usage of highway • p = f(fares, fees, travel times, discomfort) • Price increase=> less users (BCA) • MC pricing: more users, higher price • What about social/external costs? • Might want to set p=MSC 12-706 and 73-359

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