1. 1 Civil Systems Planning Benefit/Cost Analysis Scott Matthews 12-706/19-702 / 73-359 Lecture 8

2. 12-706 and 73-3592 Admin  HW 2 returned. Avg 42 (76%)  HW 3 due next Wednesday.  Office Hours - I am out of town Monday (back tues).

3. 12-706 and 73-3593 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

4. 12-706 and 73-3594 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.

5. 12-706 and 73-3595 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

6. 12-706 and 73-3596 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

7. 12-706 and 73-3597 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?

8. 12-706 and 73-3598 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

9. 12-706 and 73-3599 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

10. 12-706 and 73-35910 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

11. 12-706 and 73-35911 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

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* CS = (loss) A+B PS=(loss) E+F t P# - t AB E F

13. 12-706 and 73-35913 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

14. 12-706 and 73-35914 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’

15. 12-706 and 73-35915 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

16. 12-706 and 73-35916 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

17. 12-706 and 73-35917 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

18. 12-706 and 73-35918 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

19. 12-706 and 73-35919 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)

20. 12-706 and 73-35920 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)

21. 12-706 and 73-35921 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

22. 12-706 and 73-35922 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

23. 12-706 and 73-35923 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

24. 12-706 and 73-35924 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

25. 12-706 and 73-35925 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

26. 12-706 and 73-35926 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

27. 12-706 and 73-35927 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

28. 12-706 and 73-35928 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

29. 12-706 and 73-35929 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

30. 12-706 and 73-35930 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?

31. 12-706 and 73-35931 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

32. 12-706 and 73-35932 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

33. 12-706 and 73-35933 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

34. 12-706 and 73-35934 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

35. 12-706 and 73-35935 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

36. 12-706 and 73-35936 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