1. 1 Civil Systems Planning Benefit/Cost Analysis Scott Matthews 12-706/19-702 / 73-359 Lecture 9

2. 12-706 and 73-3592 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

3. 12-706 and 73-3593 Monopoly - the real game (2)  Could have shown that in perf. comp. Profit maximized where p=MR=MC (why?)  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

4. 12-706 and 73-3594 Monopoly Analysis MR D MC Qc Pc 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?

5. 12-706 and 73-3595 Monopoly Analysis (cont.) MR D MC Qc Pc 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? Qm Pm

6. 12-706 and 73-3596 Monopoly Analysis (cont.) MR D MC Qc Pc 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 Qm Pm

7. 12-706 and 73-3597 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

8. 12-706 and 73-3598 Natural Monopoly MR D Q* P* 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? Qm Pm MC AC a b c d e

9. 12-706 and 73-3599 Natural Monopoly MR D Q* 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 b c d e Q0

10. 12-706 and 73-35910 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

11. 11 Referent Groups (RG) A = RG NB @ Market prices B: non-RG NB at market prices C: RG NB At non- Market price D: non-RG NB at non- Market price

12. 12-706 and 73-35912 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Typically supply (MC) only private, not social costs. Social costs higher for each quantity What do these curves, Equilibrium points tell us?

13. 12-706 and 73-35913 What is WTP by society to avoid? Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Typically supply (MC) only private, not social costs. Social costs higher for each quantity

14. 12-706 and 73-35914 What is WTP by society to avoid? Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Differences in cost functions represent the alternative ‘valuations’ of the product - Thus difference between them WTP to avoid costs

15. 12-706 and 73-35915 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Relatively too much gets produced, At too low of a cost - how to Reduce externality effects? DWL

16. 12-706 and 73-35916 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Government can charge a tax ‘t’ on Each unit, where t = distance between What are CS, PS, NSB? t

17. 12-706 and 73-35917 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* CS = (loss) A+B PS=(loss) E+F t P# - t AB E F

18. 12-706 and 73-35918 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Third parties: (gain) B+C+F (avoided quantity between S curves) Govt revenue: A+E Total: gain of C t P# - t B F C A E C is reduced DWL of pollution eliminated by tax** **This cannot be a perfect reduction in practice - need to consider administrative costs of program

19. 12-706 and 73-35919 Distorted Market - Vouchers  Example: rodent control vouchers  Give residents vouchers worth $v of cost  Producers subtract $v - and gov’t pays them  Likely have spillover effects  Neighbors receive benefits since less rodents nearby means less for them too  Thus ‘social demand’ for rodent control is higher than ‘market demand’

20. 12-706 and 73-35920 Distortion : p0,q0 too low Q P Q0 P0 S-v DMDM S D S: represents higher WTP for rodent control P1 Q1 What is NSB? What are CS, PS? Social WTP

21. 12-706 and 73-35921 Social Surplus - locals Q P Q0 P0 S-v DMDM S DSDS P1 Q1 B P E P1+v A C Make decisions based on S-v, Dm What about others in society, e.g. neighbors? Because of vouchers, Residents buy Q1

22. 12-706 and 73-35922 Nearby Residents Q P Q0 P0 S-v DMDM S DSDS P1 Q1 B P E P1+v A C Added benefits are area between demand above consumption increase What is cost voucher program? F G

23. 12-706 and 73-35923 Voucher Market Benefits  Program cost (vouchers):A+B+C+G+E ----  Gain (CS) from target pop: B+E  Gain (CS) in nearby: C+G+F  Producers (PS): A+C  ---------  Net: C+F

24. 12-706 and 73-35924 Notes about Public Spending  Resource allocation to one project always comes at a ‘cost’ to other projects  E.g. Pittsburgh stadium projects  “Use it or Lose it”  There is never enough money to go around  Thus opportunity costs exist  Ideally represented by areas under supply curves  Do not consider ‘sunk costs’  Three cases (we will do 2, see book for all 3)

25. 12-706 and 73-35925 Opportunity Cost: Land Q P D b Price Case of inelastic supply (elastic supply in book, trivial) Government decides to buy Q acres of land, pays P per acre Alternative is parceling of land to private homebuyers What is total cost of project? S Can assume quantity of land is fixed (Q)

26. 12-706 and 73-35926 Opportunity Cost: Land Q P D b Price Government pays PbQ0, but society ‘loses’ CS that they would have had if government had not bought land. This lost CS is the ‘opportunity cost’ of other people using/buying land. Total cost is entire area under demand up to Q (colored) S 0

27. 12-706 and 73-35927 Example: Change in Demand for Concrete Dam Project  If Q high enough, could effect market  Shifts demand -> price higher for all buyers  Moves from (P0,Q0) to (P1,Q1).. Then?? Q0 P0 D a Price Quantity D+q’ S P1 Q1

28. 12-706 and 73-35928 Another Example: Change in Demand  Original buyers: look at D, buy Q2  Total purchases still increase by q’  What is net cost/benefit to society? Q0 P0 D a Price Quantity D+q’ S P1 Q1 Q2

29. 12-706 and 73-35929 Another Example: Change in Demand  Project spends B+C+E+F+G on q’ units  Project causes change in social surplus!  Rule: consider expenditure and social surplus change Q0 P0 D Price Quantity D+q’ S P1 Q1 Q2 E B C FA G G G

30. 12-706 and 73-35930 Dam Example: Change in Demand  Decrease in CS: A+B (negative)  Increase in PS: A+B+C (positive)  Net social benefit of project is B+G+E+F Q0 P0 D Price Quantity D+q’ S P1 Q1 Q2 E B C FA G G G

31. 12-706 and 73-35931 Final Thoughts: Change in Demand  When prices change, budgetary outlay does not equal the total social cost  Unless rise in prices high, C negligible  So project outlays ~ social cost usually  Opp. Cost equals direct expenditures adjusted by social surplus changes Quantity

32. 12-706 and 73-35932 Secondary Markets  When secondary markets affected  Can and should ignore impacts as long as primary effects measured and undistorted secondary market prices unchanged  Measuring both usually leads to double counting (since primary markets tend to show all effects)  Don’t forget that benefit changes are a function of price changes (Campbell pp. 167)

33. 12-706 and 73-35933 Primary: Fishing Days Q1 P D Price Government decides to buy Q acres of land, pays P per acre What is total cost of project? b a Q0 MC0 MC1