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

2. Announcements  HW 2 returned  Install Decision Tools Suite ASAP (in case there are problems)  Installation in CEE cluster done  (Group) Project 1 due Friday  Revision posted - Questions?  HW 3 Out 12-706 and 73-3592

3. 3 Three Legs to Stand On  Pareto Efficiency  Make some better / make none worse  Kaldor-Hicks  Program adopted (NB > 0) if winners COULD compensate losers, still be better  Fundamental Principle of CBA  Amongst choices, select option with highest ‘net’ benefit

4. 12-706 and 73-3594 Welfare Economics Concepts  Perfect Competition  Homogeneous goods.  No agent affects prices.  Perfect information.  No transaction costs /entry issues  No transportation costs.  No externalities:  Private benefits = social benefits.  Private costs = social costs.

5. Profit Maximization under Perfect Competition 12-706 and 73-3595 Q P S D Q P S = MC p D p = MR q

6. 12-706 and 73-3596 Benefits with WTP Price Quantity P* 0 1 2 3 4 Q* A B  Total/Gross/User Benefits = area under curve or willingness to pay for all people = Social WTP = their benefit from consuming = sum of all WTP values  Receive benefits from consuming this much regardless of how much they pay to get it

7. 12-706 and 73-3597 Net Benefits Price Quantity P* 0 1 2 3 4 Q* A B A B  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 surplus (benefit received - price paid)

8. 12-706 and 73-3598 Market Supply Curves 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* PS 1 PS* TVC 1 TVC* Producer Surplus = Economic Profit

9. 12-706 and 73-3599 Social Surplus Social Surplus = consumer surplus + producer surplus Is difference between areas under D and S from 0 to Q* Losses in Social Surplus are Dead-Weight Losses! Q P Q* P* S D

10. 12-706 and 73-35910 Allocative Efficiency Allocative efficiency occurs when MC = MB (or S = D) Equilibrium is max social surplus - prove by considering Q1,Q2 Q* P* S D = MB = MC Q1Q1 Q2Q2 a b Price Quantity Is the market equilibrium Pareto efficient? Yes - if increase CS, decrease PS and vice versa.

11. 12-706 and 73-35911 Further Analysis  Assume price increase is because of tax  Tax is P2-P* per unit, tax revenue =(P2-P*)Q2  Tax revenue is transfer from consumers to gov’t  To society overall, no effect  Pay taxes to gov’t, get same amount back  But we only get yellow part.. Price Quantity P2 0 1 2 Q2 Q* A B P* CS1 C Old NB: CS2 New NB: CS1 Change:P2ABP*

12. 12-706 and 73-35912 Deadweight Loss  Yellow paid to gov’t as tax  Green is pure cost (no offsetting benefit)  Called deadweight loss  Consumers buy less than they would w/o tax (exceeds some people’s WTP!) - loss of CS  There will always be DWL when tax imposed Price Quantity P2 0 1 2 Q* Q1 A B P* CS1

13. 12-706 and 73-35913 Net Social Benefit Accounting  Change in CS: P 2 ABP* (loss)  Government Spending: P 2 ACP* (gain)  Gain because society gets it back  Net Benefit: Triangle ABC (loss)  Because we don’t get all of CS loss back  OR.. NSB= (-P 2 ABP*)+ P 2 ACP* = -ABC

14. 12-706 and 73-35914 Types of Costs zPrivate - paid by consumers zSocial - paid by all of society zOpportunity - cost of foregone options zFixed - do not vary with usage zVariable - vary directly with usage zExternal - imposed by users on non-users ye.g. traffic, pollution, health risks yPrivate decisions usually ignore external

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* Typically supply (MC) only private, not social costs. Social costs higher for each quantity What do these curves, Equilibrium points tell us?

16. 12-706 and 73-35916 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

17. 12-706 and 73-35917 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

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* Relatively too much gets produced, At too low of a cost - how to Reduce externality effects? DWL

19. 12-706 and 73-35919 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

20. 12-706 and 73-35920 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

21. 12-706 and 73-35921 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

22. 12-706 and 73-35922 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’

23. 12-706 and 73-35923 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

24. 12-706 and 73-35924 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

25. 12-706 and 73-35925 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

26. 12-706 and 73-35926 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

27. 12-706 and 73-35927 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)

28. 12-706 and 73-35928 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

29. 12-706 and 73-35929 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

30. 12-706 and 73-35930 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

31. 12-706 and 73-35931 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

32. 12-706 and 73-35932 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

33. 12-706 and 73-35933 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

34. 12-706 and 73-35934 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

35. 12-706 and 73-35935 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

36. 12-706 and 73-35936 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?

37. 12-706 and 73-35937 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

38. 12-706 and 73-35938 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

39. 12-706 and 73-35939 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

40. 12-706 and 73-35940 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

41. 12-706 and 73-35941 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

42. 12-706 and 73-35942 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