AGEC 608 Lecture 04, p. 1 AGEC 608: Lecture 4 Objective: Outline approach for valuing benefits and costs in primary markets (directly affected by policy) Readings: –Boardman, Chapter 4 –Kankakee, Section IV (pp ) Homework #1: Chapter 1, problem 1 Chapter 2, problem 2 Chapter 2, problem 4 due: today Homework #2: Chapter 3, problem 1 Chapter 3, problem 2 Chapter 4, problem 3 due: March 13

AGEC 608 Lecture 04, p. 2 Valuation in Primary Markets A primary market is a market directly affected by the policy change. Example: The government decides to build low- income housing. The primary markets are those for housing and building materials.

AGEC 608 Lecture 04, p. 3 Valuation in Efficient Markets General rule is that gross social benefit equals net revenue of project plus any change in social surplus. We ignore for now the cost of providing the goods. Important caveat: Typically we use observed prices to value goods, but these may not be good indicators of social values, especially if markets are characterized by monopoly, externalities, or asymmetric information. In these cases, we need to use “shadow” prices (more later).

AGEC 608 Lecture 04, p. 4 Direct reduction in cost to consumers Focus on direct movements in the supply curve due to policy or project that directly affects the supply of a good. Two possible cases: price not affected price is lowered for all consumers

AGEC 608 Lecture 04, p. 5 Case 1a: good provided free, no price effects Assumptions: 1. project increases available supply in a well- functioning market by a small amount 2. additional units of good are given away 3. increase in supply too small to affect market price Key insights: 1. demand schedule is horizontal; supply shifts down 2. consumer benefit is the measure of gross benefit 3. Net benefit depends on cost of provision (later)

AGEC 608 Lecture 04, p. 6 Case 1a: good provided free, no price effects Price P 0 Quantity D S S + q' q0q0 q1q1 gross benefit = gain in consumer surplus

AGEC 608 Lecture 04, p. 7 Case 1b: good provided at market price, no price effects Assumptions: 1. project increases available supply in a well- functioning market by a small amount 2. additional units of good are sold at market price 3. increase in supply too small to affect market price Key insights: 1. demand schedule is horizontal; supply shifts down 2. consumer benefit is transferred to government as revenue, no double counting! 3. Net benefit depends on cost of provision (later)

AGEC 608 Lecture 04, p. 8 Case 1b: good provided at market price, no price effects Price P 0 Quantity D S S + q' q0q0 q1q1 consumers gain this, but must pay it to the gov’t as revenue; this revenue is the measure of gross benefit

AGEC 608 Lecture 04, p. 9 Case 2a: good provided free, market price changes Assumptions: 1. project increases available supply in a well- functioning market by a large amount 2. additional units of good are given away 3. increase in supply leads to drop in market price Key insights: 1. existing consumers gain surplus and existing producers lose surplus (net impact is abc) 2. new consumers gain additional surplus 3. gross surplus is the combined impact, but may be overstated since good is provided free

AGEC 608 Lecture 04, p. 10 Case 2a: good provided free, market price changes Price P 0 P 1 Quantity D S S + q' q0q0 q1q1 gain in consumer surplus for new consumers net gain in consumer surplus for old consumers = gain in CS – loss in PS loss in producer surplus for existing producers q2q2

AGEC 608 Lecture 04, p. 11 Case 2b: good provided at market price, market price changes Assumptions: 1. project increases available supply in a well- functioning market by a large amount 2. additional units of good are sold at market price 3. increase in supply leads to drop in market price Key insights: 1. existing consumers gain surplus and existing producers lose surplus (net impact is the area abc) 2. new consumers transfer additional surplus to gov’t 3. gross surplus is the combined impact (=q 2 cabq 1 )

AGEC 608 Lecture 04, p. 12 Case 2b: good provided at market price, market price changes Price P 0 P 1 Quantity D S S + q' q0q0 q1q1 gain in government revenue from sales net gain in consumer surplus for old consumers = gain in CS – loss in PS loss in producer surplus for existing producers q2q2 a c b

AGEC 608 Lecture 04, p. 13 Indirect reduction in cost to consumers due to direct reduction in cost to suppliers Focus on movements in the supply curve that arise due to policy or project that has impacts on the private producers of a good. Once again, we ignore the cost of the government intervention (i.e. this is a measure of gross surplus).

AGEC 608 Lecture 04, p. 14 Shift in supply curve due to lowering of private marginal cost Price P 0 P 1 Quantity D S S + q' q0q0 q1q1 no change in government revenue (consumers pay producers) gain in CS = P 0 abP 1 old PS = eP 0 a new PS = dP 1 b Δ PS = dP 1 b – eP 0 a q2q2 a c b e de d gross surplus = abde

AGEC 608 Lecture 04, p. 15 Valuing Inputs: Opportunity Costs Perfectly elastic supply schedule: cost of government purchase (p x q') equals the social opportunity cost of resources Price P Quantity S D D + q' q0q0 q1q1

AGEC 608 Lecture 04, p. 16 Valuing Inputs: Opportunity Costs Perfectly inelastic supply schedule: cost of government purchase (p x q) ignores lost consumer surplus (triangle = Pab) Price a P b Quantity S D q

AGEC 608 Lecture 04, p. 17 Valuing Inputs: Opportunity Costs With price effects: social cost of q' equals B + G + E + F C is gain in social surplus and must be “netted” out. Price P 1 P 0 Quantity S D D + q' q0q0 q1q1 A B C F E G G G q2q2