Economic Questions (Calculation Based)
TECON 480 – Class 7
August 12, 2019
Part 2 - Formulating the cost-benefit model
• Assignment #2 due Aug 16
• Instructions available on Canvas
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Announcements / Reminders
Last Class
• Discussed how to evaluate costs in the primary market
affected by a policy/project
3
Today’s Class
• Begin discussing how to evaluate benefits and costs in
secondary markets affected by a policy/project
• This material relates to Chapter 5 in Boardman et al.
• Introduce the timing of costs and benefits of a project
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Primary vs. Secondary Markets
Primary markets
• Markets directly affected by the policy
• Example: What are the primary markets
for an expansion of the Tacoma Dome?
Secondary markets
• Markets indirectly affected by the policy
• Example: What are the secondary markets
for an expansion of the Tacoma Dome?
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Valuing Benefits & Costs in Efficient Secondary Markets
• Secondary markets are affected because prices change in
primary markets
• These changes in primary markets have consequences on the
demand for the complements and substitutes of the primary
market goods
• These complements and substitutes are exchanged in
secondary markets
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Complements & Substitutes
• When a fall in the price of one good increases the demand for another good, the two goods are called complements
• Complements are goods that are purchased and used with another good
• Examples: milk and cereal, gas and cars
• When a fall in the price of one good decreases the demand for another good, the two goods are called substitutes
• Substitutes are goods that can be used instead of another good
• Examples: tea and coffee, buses and cars
• The effect in the primary market may or may not affect the price in secondary markets
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Example
• How would we determine the benefits of a transit trip,
thinking about primary and secondary markets?
• Are we avoiding double-counting benefits?
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Efficient Market Effects Without Price Changes
• When can we ignore secondary market effects?
• We can ignore impacts in undistorted secondary markets as
long as:
1. Changes in social surplus in the primary market resulting from a
government project are measured
and
2. Prices in the secondary markets do not change 9
• Why would secondary effects be ignored in this case?
� Those impacts are already measured as a social surplus
change in the primary market
• Measuring impacts in primary and secondary markets would
result in double counting effects 10
Efficient Market Effects Without Price Changes
• Example: A nearby lake is stocked with fish
� effective price of fishing days decreases
� number of fishing days increases
• Consider the following graph:
• Assume a constant marginal cost
• MCF0 is the marginal cost prior to the stocking
• MCF1 is the marginal cost after the stocking
• DF is the demand for fishing days 11
Efficient Market Effects Without Price Changes
• Primary Market: market for fishing days
• Increase in social surplus = PF0 abPF1
12
Efficient Market Effects Without Price Changes
• Now consider a secondary market: the market for fishing
equipment (a complement)
• The price decrease of fishing days shifts the demand curve for
fishing equipment to the right
• From DE0 to DE1
• Because the local market is only a small portion of national
demand, this demand shift does not affect the price of fishing
equipment
� Supply is perfectly elastic
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Efficient Market Effects Without Price Changes
• Secondary Market: market for fishing equipment
14
Efficient Market Effects Without Price Changes
• Any increase in CS resulting from the increased value that
people place on fishing equipment is already reflected in the
demand curve in the primary market
• People will use fishing equipment to fish
� This is taken into account in their WTP for fishing days
• Can therefore ignore secondary markets without price
changes if the social surplus in the primary market is already
measured 15
Efficient Market Effects Without Price Changes
• The situation is more complex when the price in the
secondary market changes
• Price changes when the supply curve is upward-sloping
• Consider another secondary market in the fishing example:
• The market for golf (a substitute)
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Efficient Market Effects With Price Changes
• Recall the primary market: market for fishing days
• Increase in social surplus = PF0 abPF1
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Efficient Market Effects With Price Changes
• Price of fishing days
decreases
• Causes demand for golf
to shift left
• From DG0 to DG1
• Secondary Market: market for golf
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Efficient Market Effects With Price Changes
• Price decrease in the market for fish days causes the
equilibrium to move from point g to point f
• The price decreases from PG0 to PG1
• The quantity decreases from qG0 to qG1
• Gain in consumer surplus represented by PG0 ��PG1
• Important: the area between the demand curves is not a loss
� The price changes makes consumers willing to switch consumption
• Loss in producer surplus represented by PG0 g�PG1
• Result: net social loss in the secondary market = triangle ��� 19
Efficient Market Effects With Price Changes
• Should we take this loss into account?
� Often unnecessary
• Instead, can take into account a second effect in the market
for fishing days due to the price decrease in the golf market
20
Efficient Market Effects With Price Changes
• As mentioned, a price change makes consumers willing to
switch consumption
• Fishing and golf days are substitutes
• Price of golf has decreased
• Demand for fishing days decreases
• The substitute is relatively less expensive
• Therefore, the demand for fishing days shifts to the left
• From DF0 to DF1 21
Efficient Market Effects With Price Changes
• Primary Market: market for fishing days
• Increase in social surplus has been overstated
� is actually PF0 acPF1
22
Efficient Market Effects With Price Changes
• D* is the equilibrium demand schedule
• This curve indicates the demand for fishing days once prices in
other markets have fully adjusted to the original change in the
price for fishing days
• Therefore, D* is the curve more likely to be used in a CBA
• This curve, however, understates the true measure of the gain
in social surplus in the primary market
• But this understatement is a close approximation of the net loss
of social surplus in secondary markets due to price changes
• In other words, if changes in social surplus in secondary markets
are ignored and an equilibrium demand curve is used to measure
a change in social surplus in the primary market � errors tend to
offset each other
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Efficient Market Effects With Price Changes
• The equilibrium demand schedule is the demand that is
commonly empirically estimated
• It is what is actually “observed” in reality
• Consequently, the effects in undistorted secondary markets
should be ignored
• As long as benefits in the primary market are measured using
empirically measured "observed" demand curves that don't hold
prices constant in secondary markets
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Efficient Market Effects With Price Changes
Example: Externalities and Surplus Calculations
Suppose the market for auto travel currently has the following:
• Demand: P = 1000 – 10Q
• Marginal private cost: P = 100 + 2Q
• Marginal external cost: P = Q
where P is the monetary value or cost per trip and Q is the
number of trips
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Example: Externalities and Surplus Calculations
Determine the following:
• Current level of auto travel, Q = 75
• Efficient level of auto travel, Q* = 69.23
• Deadweight loss = 216.38 26
Note: we calculated these values last class
Example: Externalities and Surplus Calculations
Compare 2 possible policies on the deadweight loss in the auto
market:
1. Implementing a tax of 20 per auto trip
• Q = 73.33
• DWL = 150.33 (compare to value without tax)
2. A subsidy of public transit that causes auto demand to
change to P = 750 – 10Q
• Q = 54.17
• DWL = 112.94 (compare to value without subsidy)
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Valuing Benefits & Costs in Distorted Markets
• Distorted markets: price ≠ social marginal costs
• Common causes of distorted markets:
• Negative externalities
• Taxes
• This is often an important consideration
• Example: suppose that you are doing a CBA on the Pacific
Avenue BRT
28 Are there any (important) secondary markets that are distorted in this case?
Negative Externalities
• Return to the market for fishing equipment
• Assume that the price PE0 underestimates the marginal social
cost by $x per unit
• Lead sinkers, which are part of fishing equipment, can poison
some of the wildlife
• x represents the monetized value of the expected loss of wildlife
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• Secondary Market: market for fishing equipment
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Negative Externalities
• The increase in consumption involves
an extra cost of x times the increase in
quantity that should be included in a
CBA:
( ) 1 0 E E
x q q−
Negative Externalities
• Recall our earlier example of the effect on externalities in the
market for automobiles following an increase in public transit
service
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Taxes
• Another example is taxes
• Consider two substitute goods:
• Beef: not initially taxed
• Chicken: taxed
• Now, suppose that a tax tB per pound is imposed on beef
� This tax increases the price of beef 32
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Taxes
Market for beef Market for chicken
• Effects in the beef market are:
• Creation of DWL: B
• Tax Revenue: A
• Loss of consumer surplus: A + B
• The price increase in the beef market increases the demand
for chicken
• From DC0 to DC1
� Consumers substitute beef for chicken when beef becomes
relatively more expensive 34
Taxes
• Effects in the chicken market are:
• No change in CS (as discussed previously; price hasn’t changed)
• DWL changes from (U + N) to (M + N) � same amount
• Tax revenue changes from T to (T + U + V) � increases by U + V
• Total effects:
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Taxes
Benefits Costs
Consumers A + B
Government A + U + V
Society U + V B
Question: is (U + V) > B?
• All changes in CS take place in the primary market
• Increases in tax revenue occur in both markets
� Should take into account the secondary markets to fully
measure the variation of tax revenue
• However, price changes in secondary markets are usually small
� ignoring this impact would not be a significant concern
36
Taxes
Infrastructure Projects: Indirect Effects
• Public infrastructure projects that reduce transportation costs
may have indirect effects on the markets for consumption
goods.
• Examples of projects: road construction, harbor deepening
• Valid for goods that use inputs that are shipped by truck or boat
• If shipping firms reduce their prices and consequently firms
producing consumption goods transfer cost savings to consumers
in form of reduced prices
37
Infrastructure Projects: Indirect Effects
• Analysis of these indirect effects is similar to the analysis of
effects in secondary markets:
If the product markets in which the indirect effects occur are
undistorted, and the surplus changes that occur in the shipping
markets are fully measured, then the indirect effects can be
ignored
38
Secondary Market Effects
• Consider the perspective of local communities in evaluating a
project
• If the standing is restricted to the local area, should effects
from undistorted secondary markets be included as project
benefits?
� Supporters of local projects often claim they should be
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“Stadiums”
• https://www.youtube.com/watch?v=xcwJt4bcnXs
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Example: Tourist Multiplier Effect
Reasons to be very careful about including these effects:
1. These effects are typically not incremental to the project; it is just a substitution of spending from one activity to another
2. From a broader perspective, the benefits are actually just a transfer from non-residents to residents
3. If standing is restricted to local area residents, benefits received by non-residents must be excluded
4. Even if the demand for local goods and services that are produced in secondary markets increases, suppliers only receive an increase in surplus if the price also increases
5. Possible multiplier effects would be small because non-residents often own local businesses, and many purchases by local businesses are outside the local area
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Secondary Market Effects
Rules for Measuring Social Benefits & Costs of
Government Interventions
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Rules for Measuring Social Benefits & Costs of
Government Interventions
If you could only have one of the two options, which would you
prefer?
a) $100 given to you today: 9
b) $105 given to you one year from today: 0
What information does this give us?
• The “social” discount rate is > 5%
46
Survey: Scenario #1
If you could only have one of the two options, which would you
prefer?
a) $100 given to you today: 8
b) $110 given to you one year from today: 1
What information does this give us?
• The “social” discount rate is > 10%
• Is this a reasonable assumption to make? 47
Survey: Scenario #2
If you could only have one of the two options, which would you prefer?
a) $100 given to you today: 3
b) $130 given to you one year from today: 6
What information does this give us?
• The “social” discount rate is difficult to estimate due to heterogeneous preferences across individuals
• Is it > 30% or < 30%? 48
Survey: Scenario #3
Would you accept a student loan for $12,000 to cover this year’s
education expenses, if you had to pay back $13,000 when you
graduate three years from now?
a) Yes: 7
b) No: 2
What information does this give us?
• The “social” discount rate is > 2.7%
49
Survey: Scenario #4
Would you accept a student loan for $12,000 to cover this year’s
education expenses, if you had to pay back $13,000 when you
graduate one year from now?
a) Yes: 1
b) No: 8
What information does this give us?
• The “social” discount rate is < 8.4%
50
Survey: Scenario #5
Compare this result with Scenario #2
Should the U.S. spend $8 billion in 2017 to research climate change, if the benefits are expected to be $20 billion, but these benefits would not be realized until 2117?
a) Yes: 4
b) No: 5
What information does this give us?
• Suggests the discount rate is ≤ 1%
• Again, compare to earlier scenarios � consistent? 51
Survey: Scenario #6
What is the highest annual interest rate that you would be
willing to accept for a 30-year home mortgage? (i.e. X% per
year)
_____ % per year
3, 3.5, 4, 4, 4, 4,
4.5, 5, 5-7
52
Survey: Scenario #7
Would you be willing to invest in an opportunity that cost
$10,000 today and would provide you with a guaranteed
payment of $11,000 one year from now?
a) Yes: 6
b) No: 3
What information does this give us?
• The “social” discount rate is ≤ 10%
53
Survey: Scenario #8
Again, compare this result with Scenario #2
Would you be willing to invest in an opportunity that cost
$10,000 today and would provide you with a 50% chance of a
gain of $22,000 one year from now and a 50% chance that you
would lose your entire investment?
a) Yes: 3
b) No: 6
What information does this give us?
• People tend to be risk averse 54
Survey: Scenario #9
Compare this result with Scenario #8
Suppose that you put $10 into the bank when you were 5 years
old. This account earns 3% interest per year. What is your best
guess about how much you would have in your account when
you retire at 65 years old, if you only deposited the initial $10?
(i.e. $X)
$_____
28, 30, 30, 40, 500, 3000, 5000, 10000, 110000
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Survey: Scenario #10
Answer: $58.91
Suppose that you have a credit card with an interest rate of
28.6% per year and you used it to pay for a trip to Cancun that
cost $2800. If you don’t make any payments on the credit card
for 5 years, how much money would you owe at that time? (i.e.
$X)
$_____
6,000 6,500 6,800 7,000 10,000 10,000
10,000 10,000 280,000
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Survey: Scenario #11
Answer: $9,849.37
Survey Takeaways
• Decisions based on intuition are often inconsistent/incorrect
when comparing costs and benefits that occur over different
time periods
• This is especially true when considering long time horizons
• It is challenging to define/quantify a social discount rate
• Should we trust the results of surveys of individuals?
• This survey is an example of a “stated preference technique”
(we will return to this concept later in the course)
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Education Timeline
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• Once we have identified the costs and benefits of a project
(Step 3), we must begin the process of quantifying these
effects over the life of the project
• To introduce this idea, let’s generate a timeline of the costs
and benefits to attending UWT
Assignment #2
59
• Questions?