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Civil Systems Planning Benefit/Cost Analysis Chapters 3 and 4 Scott Matthews Courses: 12-706 and 73-359 Lecture 4 - 9/10/2003 1 Recap: Net Benefits Price A A B P* B 0 1 2 3 4 Q* Quantity 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 12-706 and 73-359 surplus (benefit received - price paid) 2 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 3 BCA Part 2: Cost Welfare 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 4 Supply/Marginal Cost Notes Demand: WTP for each additional unit Supply: cost incurred for each additional unit Price At any given price, determines how much output to produce to maximize profit Supply=MC P* Q1 12-706 and 73-359 Q* Q2 Quantity 5 Supply/Marginal Cost Notes Recall: We always want to be considering opportunity costs (total asset value to society) and not accounting costs Price Area under MC is TVC - why? Supply=MC P* Q1 12-706 and 73-359 Q* Q2 Quantity 6 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 TVC1 Producer Surplus = Economic Profit 12-706 and 73-359 TVC* Q1 Q* Quantity 7 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 8 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 9 Allocative Efficiency Allocative efficiency occurs when MC = MB (or S = D) Price S = MC b P* D = MB a Q1 Q* 12-706 and 73-359 Q2 Quantity 10 Social Surplus Social Surplus = consumer surplus + producer surplus Losses in Social Surplus are Dead-Weight Losses! P S P* D Q* 12-706 and 73-359 Q 11 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? Price S a d PT b P* D c Q* 12-706 and 73-359 QT Quantity 12 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? Price S a d PT b P* PD e D c Q* 12-706 and 73-359 QT Quantity 13 Subsidies/Target Pricing CS increases from aP*b (yellow) to aPDe (yellow+orange). What about PS? Price S a d PT b P* PD e D c Q* 12-706 and 73-359 QT Quantity 14 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)? Price S a d PT b P* PD c e D c Q* 12-706 and 73-359 QT Quantity 15 Subsidies/Target Pricing A cost to society (taxpayers) is the government subsidy So what is the overall net benefit to society? Price S a d PT b P* PD e D c Q* 12-706 and 73-359 QT Quantity 16 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 Q* 12-706 and 73-359 QT Quantity 17 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 18 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 positive12-706 or and negative 73-359 19 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 20 Surplus Food Example Initial equilibrium at P0, Q0 New eq’m at (lower)P1, (higher) Q1 What is change in CS? S S+q’ P a P0 b P1 D Q2 Q0 Q1 12-706 and 73-359 Q 21 Surplus Food Example Change in CS is P0abP1 (gain) What about PS? S S+q’ P a P0 b P1 D Q2 Q0 Q1 12-706 and 73-359 Q 22 Surplus Food Example P Change in PS is P0acP1 (loss) for the ‘original suppliers’ since they still Operate on supply curve ‘S’ What is social surplus? S S+q’ a P0 b P1 c D Q2 Q0 Q1 12-706 and 73-359 Q 23 Surplus Food Example Social surplus is net gain of CS+PS, Or the triangle abc - what is Net Social Benefit? S S+q’ P a P0 b P1 c D Q2 Q0 Q1 12-706 and 73-359 Q 24 Surplus Food Example Government gains revenue Q2cbQ1, so NSB = Q2cabQ1 S S+q’ P a P0 b P1 c D Q2 Q0 Q1 12-706 and 73-359 Q 25 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 26 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 27 Monopoly Analysis MC In perfect competition, Equilibrium was at (Pc,Qc) - where S=D. But a monopolist has a Function of MR that Does not equal Demand Pc So where does he supply? MR Qc 12-706 and 73-359 D 28 Monopoly Analysis (cont.) MC Pm Monopolist supplies where MR=MC for quantity to max. profits (at Qm) But at Qm, consumers are willing to pay Pm! Pc What is social surplus, Is it maximized? Qm MR Qc 12-706 and 73-359 D 29 Monopoly Analysis (cont.) MC What is social surplus? Orange = CS Yellow = PS (bigger!) Pm Grey = DWL (from not Producing at Pc,Qc) thus Soc. Surplus is not maximized Pc Qm MR Qc 12-706 and 73-359 Breaking monopoly D Would transfer DWL to Social Surplus 30 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 31 Natural Monopoly Faced with these curves Normal monop would Produce at Qm and Charge Pm. a Pm We would have same Social surplus. d P* b Qm MR e AC c MC Q* 12-706 and 73-359 But natural monopolies Are regulated. D What are options? 32 Natural Monopoly Forcing the price P* Means that the social surplus is increased. DWL decreases from abc to dec a Pm d P* b Qm MR e Society gains adeb AC MC c D Q* 12-706 and 73-359 Q0 33 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 34 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 35
