Economic Questions (Calculation Based)

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TECON 480 – Class 5

August 7, 2019

Part 2 - Formulating the cost-benefit model

• Assignment #2 due Aug 16

• Instructions available on Canvas

Announcements / Reminders

Last Class

• Microeconomic concepts that are the foundation of CBA:

• Demand curve � willingness to pay

• Supply curve � opportunity cost

• Measuring and interpreting surplus:

• Consumers, producers, government

Today’s Class

• Discuss how to evaluate benefits in the primary market

affected by a policy/project

• When markets are efficient

• When markets are distorted

• This material relates to Chapter 4 in Boardman et al.

Introduction

• To perform a CBA, we need to measure the changes in

consumer, government and producer surpluses resulting from

a project or a policy

• We first discuss how we can estimate surpluses when market

demand and supply curves are known

Introduction

• We first consider primary markets

• Markets directly affected by the policy

• Example: For a new subway system, primary markets are the

market for public transportation and the market for material

used to build the subway system

• We will later consider secondary markets

• Markets indirectly affected by the policy

• Same example: The gasoline market (will some commuters

switch from cars to transit?) 6

Measures of Benefits & Costs

• Issue: practical vs. conceptually correct measures of benefits and

costs?

• For now, we will focus on “conceptually correct” measures of

benefits and costs

• These measures are not always used in practice for CBA studies

• Easier to use observed prices, which sometimes are not the

conceptually correct measures

• Observed prices in competitive markets tend to be correct measures

• Observed prices in distorted markets tend to be poor measures

• Distortions: monopoly, public goods, externalities, etc.

Measures of Benefits & Costs

• Better to use “shadow prices” to more accurately estimate

costs and benefits when:

• Prices do not reflect the accurate social value of a good

• There is no price for the good

Can you think of examples for these two scenarios?

• We will consider the evaluation of the benefits of a

project/policy

� As discussed, benefits are based on willingness to pay (WTP)

• For now: efficient markets with no market failure

Valuing Benefits in Efficient Markets

Recall the underlying assumptions of “efficient markets”

(i.e. perfect competition)

• When a policy affects the supply curve of a good in an efficient

market, the rule to evaluate the gross benefits of the policy is:

The gross social benefits equal the net government revenue

generated by the policy (after subtracting project costs) plus the

resulting changes in consumer surplus and producer surplus

Valuing Benefits in Efficient Markets

Two situations in which the rule is applicable:

1. A policy that directly affects the quantity of goods available

to consumers

• Example: A new publicly operated child care center shifts the

supply curve to the right

2. A policy that alters the costs of producing a good

• Example: Deepening a harbor will accommodate larger ships and

therefore decrease the transportation costs of producers 11

Valuing Benefits in Efficient Markets

Direct Increases in Supply Available to Consumers

• The next graph shows the gross benefits resulting from a

government project that increases the supply of a good in a

“well-functioning” competitive market

• Small quantity change � market price is unchanged

• Consumers do not actually benefit from this change

• Assumption: the increase in supply is provided by the

government

• A new publicly operated child care center would be a good

example 12

Can you think of other examples for this scenario?

• Supply curve shifts from S to S + q’

• Demand curve is horizontal

Direct Increases in Supply Available to Consumers

What is the

government

revenue?

• Government receives the price P0 for each new unit sold

• Revenue is R = P0 × �′

• Measured on the graph by the area of the rectangle ab�1�0

� must be taken into account

• It is also the cost for consumers to purchase the good, but it is

offset by consumers’ benefits of consuming it

� can be ignored

• Therefore, government revenue is the only gross benefit that

accrues from the project

Direct Increases in Supply Available to Consumers

• The next graph also shows the gross benefits resulting from a

governmental project that increases the supply of a good in a

“well-functioning” competitive market

• Large quantity change � market price changes

• Consumers will benefit from this change

• Assumption: the increase in supply is provided by the

government

Direct Increases in Supply Available to Consumers

• Supply curve shifts from S to S + q’

• Demand curve is downward sloping

• Price of the good falls from �0 to �1

Direct Increases in Supply Available to Consumers

What is the impact on:

• Consumers?

• Producers?

• Government?

Consumers

• Because consumers face lower prices, there is a gain in

consumer surplus:

• CS before the policy = triangle f�0a

• CS after the policy = triangle f�1b

� Trapezoid �0ab�1 is the gain to consumers

Direct Increases in Supply Available to Consumers

Producers

• Private producers still represented by the supply curve S

• Units provided by the government not counted here

• Producer surplus decreases because:

(1) quantity sold by the private sector falls from �0 to �2 (2) the price decreases

• PS before the policy = triangle �0ea

• PS after the policy = triangle �1ec

� Trapezoid �0ac�1 is the loss to producers

Direct Increases in Supply Available to Consumers

Government

• The government receives the price P1 for each new unit sold

• The revenue is R = P1 × �′

� Measured on the graph by the area of the rectangle cb�1�2

Direct Increases in Supply Available to Consumers

Society

• If accounting only for consumers and producers:

� Net gain in surplus equals the light grey triangle abc

� Gain to consumers outweighs loss to producers

• If we aggregate private and governmental gains:

� Total gross benefits from the project equals area cab�1�2

Direct Increases in Supply Available to Consumers

Note that these are gross benefits

� haven’t calculated the cost of the government increasing the supply of the good

Reduction in Producer Costs

• Now suppose there is a reduction in the cost of inputs

� It costs less to produce a given quantity of output

� The “private” supply curve shifts right

• Assumption: There is no supply of output provided by the

government

21Can you think of examples for this scenario?

• Supply curve shifts from S to S + q’

• Demand curve is downward sloping

• Price of the good falls from �0 to �1

Reduction in Producer Costs

What is the impact on:

• Consumers?

• Producers?

• Government?

Consumers

• Because consumers face lower prices, there is a gain in

consumer surplus:

• CS before the policy = triangle f�0a

• CS after the policy = triangle f�1b

� Trapezoid �0ab�1 is the gain to consumers

� Outcome the same as the previous case 23

Reduction in Producer Costs

Producers

• Producers now represented by the supply curve S + q’

• Producer surplus changes due to the policy:

• PS before the policy = triangle �0ea

• PS after the policy = triangle �1db

� Difference between area ecdb and area �0ac�1 is the gain (or loss) to producers

� Producers receive a lower price per unit, but sell more units

Reduction in Producer Costs

Society

• If we take into account consumers and producers, net gain in

surplus equals:

∆CS + ∆PS = (area �0ab�1 ) + (area ecdb - area �0ac�1 )

= (area �0ac�1 + area abc) + (area ecdb - area �0ac�1 )

= area abc + area ecdb

= area abde

� Total gross benefits resulting from the project = area abde 25

Reduction in Producer Costs

Note: gross benefits to society differ between these two projects

(does this make sense intuitively?)

Gross benefits if q’ provided by government: cab�1�2

Gross benefits if input costs decrease: abde

• Please answer the 11 questions on the handout provided

Survey

• We now turn to measuring benefits in distorted markets

• In distorted markets, projects still evaluated by changes in social surplus plus net revenues

• However, determining the social surplus changes is more complicated

• We will consider four prevalent types of market failures:

1. Monopoly

• Classic and Natural

2. Information asymmetry

3. Externalities

4. Public goods

Valuing Benefits in Distorted Markets

Monopoly

• Monopoly: a market with a single firm providing a product

without close substitutes

• Demand curve that the monopolist faces is the market demand

curve

• All consumers must buy from the monopolist

• Market demand curve slopes downward

• In order to sell one more unit, monopolist must decrease the price

� decreasing marginal revenue

• Marginal revenue = additional revenue for each additional unit of

output produced/sold

Can you think of any examples for this scenario?

Monopoly

Note that PS ≠ profits

when there are fixed

costs

Monopoly

• Monopoly quantity of output Qm determined by intersection

of the marginal cost and marginal revenue curves:

MR = MC

• Monopoly price Pm determined by the value of the market

demand curve at the monopoly quantity:

� the WTP of consumers for the monopoly quantity

• The monopoly is able to maximize its profit by setting its price 31

Monopoly

• Social surplus determined by the output sold:

SS = CS + PS

• CS is the area between the demand curve and the monopoly

price, up to the quantity purchased

• “Light” grey area

• PS is the area between the monopoly price and the marginal

cost curve, up to the quantity sold

• “Medium” grey area 32

Monopoly

• Market power of a monopoly is considered a market failure

Market failure ↔ deadweight loss (DWL)

• DWL is the part of the social surplus that would be created in

an efficient market (i.e. with perfect competition), but is not

created because of the monopoly

• DWL is the area that is vertically between the marginal cost

and the marginal benefit (the demand curve) and horizontally

between the monopoly quantity and the competitive quantity

(i.e. the units foregone due to market power)

• “Dark” grey area abc

Monopoly

Example:

• Suppose the government implements a policy that “breaks

up” a monopoly to create a market with many competing

firms

• Graphically depict the changes in CS, PS and SS

Natural Monopoly

• A natural monopoly has the following characteristics:

• Exhibits economies of scale over a wide range of output

• Has very large fixed costs relative to variable costs

� Consequently, it can provide a given amount of output at a

lower average cost than would two or more firms

• Examples of natural monopoly:

• Electricity or TV cable provider

• Public utilities, roads and bridges

Can you think of other examples for this scenario?

Natural Monopoly

How can we represent a natural monopoly?

• Large fixed costs make average costs (AC) very large at small

range of output and decreasing as output increases

• Average costs higher than marginal costs over a large range of

output

• Average costs continue to fall over the “relevant range of

output”

• The range between the first unit of output and the maximum

amount that consumers are willing to consume Q0 36

Natural Monopoly

What should the price be for a

natural monopoly?

Consider:

• Pm • Pr • PC • P0

Natural Monopoly

• The government accepts natural monopolies because it

requires less resources for them to produce the required level

of output than if there were more firms competing in such a

market

• However, the government must use one of the following

policies to regulate (or not regulate) the industry

Natural Monopoly

1. Do nothing and let the monopoly maximize its profits

• Price = Pm • It produces at the monopoly level (seen previously), Qm • This results in a deadweight loss (area abc)

2. Government can set the price where the average cost curve crosses the demand curve

• Price = Pr • Firm stay in the market but makes zero profit, producing Qr • Some surplus transferred from the monopoly to consumers

• DWL decreases (to area dec)

• Output and social surplus increases as a result

Natural Monopoly

3. Government can set the price where the marginal cost

curve crosses the demand curve

• Price = Pc

• DWL is eliminated and net social benefits are maximized, with

output Qc

• Firm makes negative profits and wants to exit the market since

revenues no longer cover costs

• To keep the firm in the market, tax money must be used to

subsidize this loss 40

Natural Monopoly

4. Government can allow free access (i.e. set price = P0 = 0)

• Example: roads

• DWL exists (ch�0) when �0 units are consumed

• Firm makes even more negative profits and wants to exit the

market

• To keep the firm in the market, tax money must be used to

subsidize this (larger) loss

Information Asymmetry

• Information asymmetry: occurs when information about a

product or a job is not equal on both sides of a market

• Examples:

• Sellers have more information than consumers about the quality

of a good

• Traditional example: used cars (i.e. lemons)

• Doctors know more than patients about required care

• Mechanics, contractors, etc. with specialized skills/knowledge

• Employers know more about job-related risks than the employees

Information Asymmetry

• Let’s focus on the case where the seller has more information

• To represent this situation, draw two demand curves

• One demand curve representing buyers as if they had perfect

information: Di (“informed”)

• One demand curve with buyers’ current knowledge: Du (“uninformed”)

• Assume that WTP of consumers would be lower if they had full

information

• If not, the sellers would share the information

Information Asymmetry

• The equilibrium with information asymmetry is (��; ��)

• Intersection of the supply curve S and the demand curve Du

• The equilibrium with perfect information is (��; ��)

• Intersection of the supply curve S and the demand curve Di

Information Asymmetry

• Equilibrium price and quantity are larger than what would

arise with perfect information

• Due to the price increase, part of the consumer surplus is

transferred to the sellers

• The light grey trapezoid area ��ac��

• Due to the increase in quantity, DWL is created

• The dark grey area abc 46

Information Asymmetry

• When should the government intervene to reduce information

asymmetry?

• It depends of the types of goods

• Goods can be:

• Search goods

• Experience goods

• Post-experience goods 47

Information Asymmetry

• Search goods: products with characteristics that consumers

can learn about by examining them prior to purchasing them

• Example:

• Clothing

• Able to go to the store to observe it, try it on, etc.

• In this case, information asymmetry is not a problem

Information Asymmetry

• Experience goods: products about which consumers can obtain full knowledge, but only after purchasing and experiencing them

• Examples:

• Movie tickets

• Restaurant meals

• University professors

• etc.

• Often prompts third parties to provide information about goods for a reasonable fee

• Companies such as Consumer Reports

• Home inspections

• Online rating platforms (Yelp, Google, Ratemyprofessor.com, etc.)

Information Asymmetry

• Post-experience goods: products for which consumption does

not reveal information

• Examples:

• Adverse health effects associated with a prescription drug

• A new automobile with a defective part

• Government intervention may be required because:

• Consequences can be dramatic long-term effects such as death

• Information is often very costly to generate

• People may not be able or willing/able to pay for it

Externalities

• An externality is an effect on third parties resulting from

production or consumption activity

• Third parties: people not involved in the production or

consumption of the good

• Can be positive or negative

• (Negative) example: pollution caused by a factory

• Effect of an externality is that the market underestimates:

• The social costs with negative externalities

• The social benefits with positive externalities

Externalities

Negative externality

• To represent the negative externality on a graph, we need to

draw two supply curves

• The private supply curve (the “usual” one): S*

• The social supply curve that includes the cost for third parties of

the externality: S#

� Vertical distance between the supply curves multiplied by the

quantity of the good consumed is the cost of the negative

externality on third parties 52

Externalities

• If we consider only private incentives, the equilibrium is (�∗; �∗)

• Intersection of the supply curve S* and the demand curve D

• Considering the social interest, the equilibrium should be (�#; �#)

• Intersection of the supply curve S# and the demand curve D

Externalities

• Competitive market takes into account only private interest

and therefore sets:

• Equilibrium price that is too low in comparison with what would

be socially desirable: �∗ > �#

• An equilibrium quantity that is larger than what would be socially

desirable: �∗ < �#

� Causes DWL represented by the grey area C

• DWL created for each unit produced beyond the socially desirable

quantity of a good 55

Externalities

• What can government do in this case?

• The standard government action is to impose a tax on sellers

• Goal of the tax is to match social and private supply curve (the tax

shifts up the supply curve)

• Government would want to set a tax of t dollars per unit

• Price paid by consumers will be �# and the net price received by

sellers will be �# − �

• Quantity would be reduced to the socially desirable quantity �#

Externalities

• Note that pollution will not disappear but will be reduced to

the socially desirable level

• Is the implementation of the tax socially desirable?

• Yes � DWL is eliminated � a net social benefit arises

• However, must consider the distributional aspect as well

Externalities

1. CS decreases because they consume less and pay more

2. PS decreases because they receive a lower price per unit

and produce less

3. Third parties suffer lower external costs, since fewer units

are produced

4. Government receives the tax revenue

Externalities

Positive externality

• In this case, there is an external benefit to third parties

• Leads to different private and social demand curves

• Competitive market creates DWL by producing too little of this

good

• Possible corrective policy: a subsidy given directly to the

consumers 59

Can you think of an example for this scenario?

Can you graph this market outcome?

Public Goods

• Once produced, public goods are available for everyone:

• National Defense

• Flood control project

• Streetlight

• “Pure” public goods have two characteristics:

1. Non-excludable: cannot prevent others for consuming it

• Example: Free wifi

2. Non-rival: one’s consumption does not prevent others for

consuming it as well

• Example: Videos on YouTube

Public Goods

• The non-excludable characteristic causes a market failure

� “free-riding”

• As soon as the good is available, everybody can consume it for

free, even though there is a cost to provide it

• Consequently, private firms will not supply the good because

they would be unable to earn a profit

• The non-rival characteristic intensifies the free rider problem 61

Public Goods

• Public goods usually provided or subsidized by the

government to ensure they will be produced

• However, it is not very likely that the socially desirable

quantity is provided

• Efficient outcome: when MB and MC curves intersects

• Problem: MB curve is unknown in practice

Example for Assignment #2

• How would we measure the gross benefits of an investment in

public transit?

� Step 1: graph the market for transit travel

� Step 2: graph the market for auto travel