civil systems planning benefit/cost analysis
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Civil Systems PlanningBenefit/Cost Analysis
Chapters 3 and 4Scott MatthewsCourses: 12-706 and 73-359Lecture 4 - 9/9/2002
12-706 and 73-359 2
Unifying Cost and Supply
Economists learn Supply and Demand Equilibrium: where S=D
In our case, substitute cost for supply Econ: S = MC under perfect competition Perfect competition => no profits Thus market price = cost of producing
Why cost? Need to trade-off DemandUsing MC is a standard method
12-706 and 73-359 3
Meaning of Cost Curves
Highway pricing p = f(fares, fees, travel times,
discomfort) p ~ AVC: manages usage of highway Price increase=> less users (BCA) MC pricing: more users, higher price
12-706 and 73-359 4
Welfare Economics Continued
The upper segment of a firm’s marginal cost curve correspondsto the firm’s supply curve. Again, diminishing returns occur.
Quantity
Price Supply=MCAt any given price, determineshow much output to produce tomaximize profit
12-706 and 73-359 5
Supply/Marginal Cost Notes
Quantity
Price Supply=MCAt any given price, determineshow much output to produce tomaximize profit
P*
Q1 Q* Q2
Demand: WTP for each additional unitSupply: additional cost incurred for each additional unit
12-706 and 73-359 6
Supply/Marginal Cost Notes
Quantity
Price Supply=MCArea under MC is TVC - why?
P*
Q1 Q* Q2
We always want to be considering opportunity costs (total asset value to society) and not accounting costs
12-706 and 73-359 7
Supply/Marginal Cost Notes
Quantity
Price Supply=MC
P1
Q1 Q*
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
P*
PS1
PS*
12-706 and 73-359 8
Equilibrium Example
Demand Function: p=4-3qSupply function: p=1.5qAssume equilibrium, what is p,q?Eq=> S=D; 4-3q=1.5q ; 4.5q=4 ;
q=8/9P=1.5q=1.5*(8/9)= 4/3CS = (0.5)*(8/9)*(4-1.33) = 1.19PS = (0.5)*(8/9)*(4/3) = 0.6
12-706 and 73-359 9
Allocative Efficiency
Allocative efficiency occurs when MC = MB
Q*
P*
S
D = MB
= MC
Q1 Q2
a
bPrice
Quantity
12-706 and 73-359 10
Social Surplus
Social Surplus = consumer surplus + producer surplusLosses in Social Surplus are Dead-Weight Losses!
Q
P
Q*
P*
S
D
12-706 and 73-359 11
Subsidies/Target Pricing
Q*
P*
S
D
QT
a
b
d
c
PT
Price
Quantity
Allocative efficiency can only be achieved when P=MC.Assume market for corn, in initial eq’m -> what happens when government guarantees PT to farmers?
12-706 and 73-359 12
Subsidies/Target Pricing
Q*
P*
S
D
QT
a
b
d
e
c
PD
PT
Price
Quantity
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 issubsidized by government policy. What is change in CS, PS?
12-706 and 73-359 13
Subsidies/Target Pricing
Q*
P*
S
D
QT
a
b
d
e
c
PD
PT
Price
Quantity
CS increases from aP*b (yellow) to aPDe (yellow+orange).
What about PS?
12-706 and 73-359 14
Subsidies/Target Pricing
Q*
P*
S
D
QT
a
b
d
e
c
PD
PT
Price
Quantity
PS also increases, from P*bc to PTdc. Is overall net benefit tosociety then positive (since PS and CS both increase)?
c
12-706 and 73-359 15
Subsidies/Target Pricing
Q*
P*
S
D
QT
a
b
d
e
c
PD
PT
Price
Quantity
The cost to society (taxpayers) is the government subsidy -So what is the overall net benefit to society?
12-706 and 73-359 16
Subsidies/Target Pricing
Q*
P*
S
D
QT
a
b
d
e
c
PD
PT
Price
Quantity
Overall net benefit to society is (Increased CS + Increased PS) -Costs = Orange + Yellow - Grey = Triangle bde (loss!).This is a DWL, orange and yellow areas are transfers!Leakage of program is Area bde/Area PTdePD
12-706 and 73-359 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 policySecondary: indirectly affectedExample: 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 19
Benefits in Efficient Market
NSB=CS+ PS + 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
See related problems on p. 73
12-706 and 73-359 20
Surplus Food Example
Q
P
Q0
P0
S+q’
D
S
P1
Q1
Initial equilibrium at P0, Q0New eq’m at (lower)P1, (higher) Q1What is change in CS?
a
b
Q2
12-706 and 73-359 21
Surplus Food Example
Q
P
Q0
P0
S+q’
D
S
P1
Q1
Change in CS is P0abP1 (gain)What about PS?
a
b
Q2
12-706 and 73-359 22
Surplus Food Example
Q
P
Q0
P0
S+q’
D
S
P1
Q1
Change in PS is P0acP1 (loss) for the‘original suppliers’ since they stillOperate on supply curve ‘S’What is social surplus?
a
bc
Q2
12-706 and 73-359 23
Surplus Food Example
Q
P
Q0
P0
S+q’
D
S
P1
Q1
Social surplus is net gain of CS+PS,Or the triangle abc - what isNet Social Benefit?
a
bc
Q2
12-706 and 73-359 24
Surplus Food Example
Q
P
Q0
P0
S+q’
D
S
P1
Q1
Government gains revenue Q2cbQ1, so NSB = Q2cabQ1
a
bc
Q2
12-706 and 73-359 25
Monopoly - the real game
One producer of good w/o substituteNot 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
MR D
MC
Qc
Pc
In perfect competition,Equilibrium was at (Pc,Qc) - where S=D.
But a monopolist has aFunction of MR that Does not equal Demand
So where does he supply?
12-706 and 73-359 28
Monopoly Analysis (cont.)
MRD
MC
Qc
Pc
Monopolist supplies where MR=MC for quantity to max.profits (at Qm)
But at Qm, consumersare willing to pay Pm!
What is social surplus, Is it maximized?
Qm
Pm
12-706 and 73-359 29
Monopoly Analysis (cont.)
MRD
MC
Qc
Pc
What is social surplus?Orange = CS
Yellow = PS (bigger!)
Grey = DWL (from notProducing at Pc,Qc) thusSoc. Surplus is not maximized
Breaking monopolyWould transfer DWL toSocial Surplus
Qm
Pm
12-706 and 73-359 30
Natural Monopoly
Fixed costs very large relative to variable costs Ex: public utilities (gas, power, water)
Average costs high at low outputAC usually higher than MCOne 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
MRDQ*
P*
Faced with these curvesNormal monop wouldProduce at Qm and Charge Pm.
We would have sameSocial surplus.
But natural monopoliesAre regulated, usuallyProduce where D=ACWhy?
Qm
Pm
MC
AC
a
bc
d
e
12-706 and 73-359 32
Natural Monopoly
MRDQ*
P*
Forcing the price P*Means that the social surplus is increased.
DWL decreases from abc to dec
Society gains adeb
Qm
Pm
MC
AC
a
bc
d
e
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