2. 1 Civil Systems Planning Benefit/Cost Analysis Chapters 3 and 4 Scott Matthews Courses: 12-706 and 73-359 Lecture 4 - 9/10/2003

3. 12-706 and 73-3592 Recap: 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)

4. 12-706 and 73-3593 Short Run vs. Long Run Cost  Short term / short run - some costs fixed  In long run, “all costs variable”  Difference is in ‘degree of control of plans’  Generally say we are ‘constrained in the short run but not the long run’  So TC(q) < = SRTC(q)

5. 12-706 and 73-3594 BCA Part 2: Cost Welfare Economics Continued The upper segment of a firm’s marginal cost curve corresponds to the firm’s SR supply curve. Again, diminishing returns occur. Quantity Price Supply=MC At any given price, determines how much output to produce to maximize profit AVC

6. 12-706 and 73-3595 Supply/Marginal Cost Notes Quantity Price Supply=MC At any given price, determines how much output to produce to maximize profit P* Q1 Q* Q2 Demand: WTP for each additional unit Supply: cost incurred for each additional unit

7. 12-706 and 73-3596 Supply/Marginal Cost Notes Quantity Price Supply=MC Area under MC is TVC - why? P* Q1 Q* Q2 Recall: We always want to be considering opportunity costs (total asset value to society) and not accounting costs

8. 12-706 and 73-3597 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 73-3598 Unifying Cost and Supply  Economists learn “Supply and Demand”  Equilibrium (meeting point): where S = D  In our case, substitute ‘cost’ for supply  Why cost? Need to trade-off Demand  Using MC is a standard method

10. 12-706 and 73-3599 Example  Demand Function: p = 4 - 3q  Supply function: p = 1.5q  Assume equilibrium, what is p,q?  In eq: S=D; 4-3q=1.5q ; 4.5q=4 ; q=8/9  P=1.5q=(3/2)*(8/9)= 4/3  CS = (0.5)*(8/9)*(4-1.33) = 1.19  PS = (0.5)*(8/9)*(4/3) = 0.6

11. 12-706 and 73-35910 Allocative Efficiency Allocative efficiency occurs when MC = MB (or S = D) Q* P* S D = MB = MC Q1Q1 Q2Q2 a b Price Quantity

12. 12-706 and 73-35911 Social Surplus Social Surplus = consumer surplus + producer surplus Losses in Social Surplus are Dead-Weight Losses! Q P Q* P* S D

13. 12-706 and 73-35912 Subsidies/Target Pricing Q* P* S D QTQT a b d c PTPT Price Quantity Allocative efficiency only achieved when P = social MC. Assume market for corn below in initial eq’m -> what happens when government guarantees P T to farmers?

14. 12-706 and 73-35913 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity At P T, farmers want to supply Q T units. But at Q T, consumers only want to pay P D. This is effective market price. So P T -P D must be subsidized by government policy. What is change in CS, PS?

15. 12-706 and 73-35914 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity CS increases from aP*b (yellow) to aP D e (yellow+orange). What about PS?

16. 12-706 and 73-35915 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity PS also increases, from P*bc to P T dc. So is overall net benefit to society then positive (since PS and CS both increase)? c

17. 12-706 and 73-35916 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity A cost to society (taxpayers) is the government subsidy - So what is the overall net benefit to society?

18. 12-706 and 73-35917 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity Overall net benefit to society is (Increased CS + Increased PS) - Costs = Orange + Yellow - Grey = Triangle bde (loss!). This is a DWL, increases in CS, PS are transfers! Efficiency Measure: Leakage = Area bde/Area P T deP D

19. 12-706 and 73-35918 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

20. 12-706 and 73-35919 Types of Markets  Primary: directly affected by policy  Secondary: indirectly affected  Example: 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

21. 12-706 and 73-35920 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  Supply curve moves out (right) - more supplied at each price point

22. 12-706 and 73-35921 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Initial equilibrium at P0, Q0 New eq’m at (lower)P1, (higher) Q1 What is change in CS? a b Q2

23. 12-706 and 73-35922 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Change in CS is P 0 abP 1 (gain) What about PS? a b Q2

24. 12-706 and 73-35923 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Change in PS is P 0 acP 1 (loss) for the ‘original suppliers’ since they still Operate on supply curve ‘S’ What is social surplus? a b c Q2

25. 12-706 and 73-35924 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 is Net Social Benefit? a b c Q2

26. 12-706 and 73-35925 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Government gains revenue Q 2 cbQ 1, so NSB = Q 2 cabQ 1 a b c Q2

27. 12-706 and 73-35926 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

28. 12-706 and 73-35927 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

29. 12-706 and 73-35928 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?

30. 12-706 and 73-35929 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

31. 12-706 and 73-35930 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

32. 12-706 and 73-35931 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

33. 12-706 and 73-35932 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

34. 12-706 and 73-35933 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

35. 12-706 and 73-35934 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

36. 12-706 and 73-35935 Pricing Strategies  Highway pricing  If price set equal to AC (which is assumed to be TC/q then at q, total costs covered  p ~ AVC: manages usage of highway  p = f(fares, fees, travel times, discomfort)  Price increase=> less users (BCA)  MC pricing: more users, higher price  What about social/external costs?  Might want to set p=MSC