Civil Systems Planning Benefit/Cost Analysis

1. Civil Systems PlanningBenefit/Cost Analysis Scott Matthews 12-706/19-702 / 73-359 Lecture 9

2. 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 12-706 and 73-359

3. 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 12-706 and 73-359

4. Monopoly Analysis 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? MC Pc Qc MR D 12-706 and 73-359

5. Monopoly Analysis (cont.) 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? MC Pm Pc Qm Qc D MR 12-706 and 73-359

6. Monopoly Analysis (cont.) 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 MC Pm Pc Qm Qc D MR 12-706 and 73-359

7. 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 12-706 and 73-359

8. Natural Monopoly 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? a Pm d P* AC b e MC c Qm Q* D MR 12-706 and 73-359

9. Natural Monopoly Forcing the price P* Means that the social surplus is increased. DWL decreases from abc to dec Society gains adeb a Pm d P* AC b e MC c D Qm Q* Q0 MR 12-706 and 73-359

10. 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 12-706 and 73-359

11. Referent Groups (RG) C: RG NB At non- Market price A = RG NB @ Market prices B: non-RG NB at market prices D: non-RG NB at non- Market price

12. Pollution (Air or Water) Typically supply (MC) only private, not social costs. Social costs higher for each quantity P S#:marginal Social costs S*: marginal Private costs P# P* What do these curves, Equilibrium points tell us? D Q Q# Q* 12-706 and 73-359

13. What is WTP by society to avoid? Typically supply (MC) only private, not social costs. Social costs higher for each quantity P S#:marginal Social costs S*: marginal Private costs P# P* D Q Q# Q* 12-706 and 73-359

14. What is WTP by society to avoid? Differences in cost functions represent the alternative ‘valuations’ of the product - Thus difference between them WTP to avoid costs P S#:marginal Social costs S*: marginal Private costs P# P* D Q Q# Q* 12-706 and 73-359

15. Pollution (Air or Water) Relatively too much gets produced, At too low of a cost - how to Reduce externality effects? P S#:marginal Social costs S*: marginal Private costs DWL P# P* D Q Q# Q* 12-706 and 73-359

16. Pollution (Air or Water) Government can charge a tax ‘t’ on Each unit, where t = distance between What are CS, PS, NSB? P S#:marginal Social costs S*: marginal Private costs P# t P* D Q Q# Q* 12-706 and 73-359

17. Pollution (Air or Water) CS = (loss) A+B PS=(loss) E+F P S#:marginal Social costs S*: marginal Private costs P# t A B P* F E P# - t D Q Q# Q* 12-706 and 73-359

18. Pollution (Air or Water) Third parties: (gain) B+C+F (avoided quantity between S curves) Govt revenue: A+E Total: gain of C P S#:marginal Social costs S*: marginal Private costs P# t C A B C is reduced DWL of pollution eliminated by tax** P* F E P# - t D Q Q# Q* **This cannot be a perfect reduction in practice - need to consider administrative costs of program 12-706 and 73-359

19. 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’ 12-706 and 73-359

20. Distortion : p0,q0 too low What is NSB? What are CS, PS? S Social WTP P S-v P0 P1 DS: represents higher WTP for rodent control DM Q Q0 Q1 12-706 and 73-359

21. Social Surplus - locals Make decisions based on S-v, Dm What about others in society, e.g. neighbors? P P S S-v P1+v C A P0 B E P1 DS Because of vouchers, Residents buy Q1 DM Q Q0 Q1 12-706 and 73-359

22. Nearby Residents Added benefits are area between demand above consumption increase What is cost voucher program? P P S S-v F P1+v C A G P0 B E P1 DS DM Q Q0 Q1 12-706 and 73-359

23. 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 12-706 and 73-359

24. 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) 12-706 and 73-359

25. Opportunity Cost: Land • 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? Price Can assume quantity of land is fixed (Q) S b P D Q 12-706 and 73-359

26. Opportunity Cost: Land 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) Price S b P D 0 Q 12-706 and 73-359

27. 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?? Price D+q’ D S P1 P0 a Q1 Q0 Quantity 12-706 and 73-359

28. 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? Price D+q’ D S P1 P0 a Q1 Q2 Q0 Quantity 12-706 and 73-359

29. 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 Price D D+q’ S P1 C A F B P0 G E G G Q1 Q2 Q0 Quantity 12-706 and 73-359

30. 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 Price D D+q’ S P1 C A F B P0 G E G G Q1 Q2 Q0 Quantity 12-706 and 73-359

31. 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 12-706 and 73-359

32. 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 (Campbell pp. 167) 12-706 and 73-359

33. Primary: Fishing Days Government decides to buy Q acres of land, pays P per acre What is total cost of project? Price a MC0 b MC1 P D Q0 Q1 12-706 and 73-359