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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. 38-47) Homework #1: Chapter 1, problem 1 Chapter 2, problem 2 Chapter 2, problem 4 due: today
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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. 38-47) • Homework #1: Chapter 1, problem 1 Chapter 2, problem 2 Chapter 2, problem 4due: today • Homework #2: Chapter 3, problem 1 Chapter 3, problem 2 Chapter 4, problem 3due: March 13
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.
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).
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
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)
Price P0 S S + q' D gross benefit = gain in consumer surplus q1 q0 Quantity Case 1a: good provided free, no price effects
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)
Price P0 S S + q' D consumers gain this, but must pay it to the gov’t as revenue; this revenue is the measure of gross benefit q1 q0 Quantity Case 1b: good provided at market price, no price effects
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
net gain in consumer surplus for old consumers = gain in CS – loss in PS Price P0 P1 S S + q' D loss in producersurplus for existingproducers gain in consumer surplus for new consumers q2 q1 q0 Quantity Case 2a: good provided free, market price changes
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 (=q2cabq1)
net gain in consumer surplus for old consumers = gain in CS – loss in PS Price P0 P1 S S + q' a c b D loss in producersurplus for existingproducers gain in government revenue from sales q2 q1 q0 Quantity Case 2b: good provided at market price, market price changes
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).
Price P0 P1 S gross surplus = abde S + q' a c b old PS = eP0a new PS = dP1b Δ PS= dP1b – eP0a gain in CS = P0abP1 D ed no change in government revenue (consumers pay producers) q2 q1 q0 Quantity Shift in supply curve due to lowering of private marginal cost
Price P S D + q' D q1 q0 Quantity Valuing Inputs: Opportunity Costs Perfectly elasticsupply schedule: cost of government purchase (p x q') equals the social opportunity cost of resources
S D q Quantity Valuing Inputs: Opportunity Costs Perfectly inelasticsupply schedule: cost of government purchase (p x q) ignores lost consumer surplus(triangle = Pab) Price a P b
Price P1 P0 A B C F E G G G S D + q' D q2 q1 q0 Quantity Valuing Inputs: Opportunity Costs With price effects: social cost of q' equals B + G + E + FC is gain in social surplus and must be “netted” out.
