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Efficiency and Surplus

Efficiency and Surplus. How can economics help determine the optimal size of a project or extent of a regulation?. A few examples. What should be the CO concentration standard in tailpipe emissions? How large should the Channel Islands marine reserve be?

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Efficiency and Surplus

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  1. Efficiency and Surplus How can economics help determine the optimal size of a project or extent of a regulation?

  2. A few examples • What should be the CO concentration standard in tailpipe emissions? • How large should the Channel Islands marine reserve be? • Can we measure loss to recreationists of the Forest Adventure Pass? • Add another lane to Hwy 101? • Close Mission Canyon to cyclists?

  3. “Efficiency” • Usually talking about whether sum of benefits outweigh sum of costs. • Distribution often not the focus – if gains outweigh losses, can redistribute to achieve desired distribution (but can measure and value who wins and loses). • If evaluating multiple projects, efficiency is met only by one with highest net “surplus”.

  4. “Species distributions, land values, and efficient conservation” • J = {1,2,…,n} sites, cost cj • I = {1,2,…,m} candidate species • Ni = subset of J that contains species i • xj = 1 if site selected; 0 otherwise

  5. Cost effectiveness vs. CBA • Is the species conservation question a cost effectiveness or benefit cost question? • Doesn’t ask how many species should be saved, does plot # species vs. cost. • Muti-criteria analysis: want to focus in on 2 or 3 important variables • E.g. monetary benefits, species protected

  6. CBA: main principle • Quantify all costs and benefits in a common measure (usually $) • Note that we have ways of quantifying non-market, even non-use values. • Project size, Q. • Benefits = B(Q), Costs = C(Q). • Maximize B(Q)-C(Q)…set derivative = 0.

  7. $ Q* is where TB-TC is maximized. Also where MB=MC. TB(Q) TC(Q) Q Q* $ MC(Q) MB(Q) xC Q

  8. $ One view of this problem: Maximize TB-TC TB(Q) TC(Q) Q Q* $ TB(Q)-TC(Q) Q

  9. Discrete sized projects • If deciding between projects A, B, C • Pick one with highest net benefits (TB-TC), provided net benefits > 0. • May have values that are difficult to quantify. • Quantify values you can, then compare projects along as few dimensions as possible (“multi-criteria analysis”); examine tradeoffs between alternatives.

  10. How are benefits calculated? • Demand, D(x), measures MB. • Consumers Surplus is the total benefit to consumers minus their cost.

  11. Consumers Surplus (CS) $ CS(q) p D(x) x q

  12. How are costs calculated? • Supply, S(x), is same thing as MC. • Producer Surplus is the total revenue to producers minus their cost.

  13. Producer Surplus (PS) $ MC(x) PS(q) p x q

  14. Where is CS+PS maximized? $ Tension: Too little produced At too high price. CS low, PS high CS p Supply, S(x) PS Demand, D(x) x q1 q*

  15. If captured all costs & benefits • Then we want to maximize CS + PS which would occur where Supply = Demand. • Challenge is to capture all costs and benefits to accurately measure MC & MB. • Common challenges w/ env. goods: • Externalities • Public Goods

  16. Externality • When one “agent” takes an action that affects well-being of another agent. • E.g. Hydro-power dams • How integrated into analysis? • Include a “marginal externality cost” (MEC) • Add vertically with existing MC. • Economic theory predicts: Free market overproduces negative externalities.

  17. Including an externality cost S(x)+MEC(x) $ Reflects all Social costs Reflects the “external” Costs of producing power MEC(x) S(x) Reflects the “internal” Costs of producing power D(x) x1 x* Megawatts, x

  18. Public Goods • A good that is both non-rival and non-exclusive • Non-rival: My use doesn’t diminish your use • Non-exclusive: People cannot be excluded from using the good. • E.g.’s: views, air quality, biodiversity, city parks, flood control, lighthouses.

  19. Demand for Public Goods • 2 people, DS(x) and DC(x) • Aggregate demand if x is private good: • Aggregate demands horizontally • Because we cannot both use the same Altoids: At a price of p, how many tins will Scott demand, how many tins will Chris demand? • Aggregate demand if x is public good: • Aggregate demands vertically • Because both enjoy the same park: Park is 20 ac., how much is Scott WTP, how much is Chris WTP?

  20. Aggregate demand: Public Goods $ D(x) In a free market, Chris will Try to free-ride off of Scott S(x) Economic theory says This is optimal park size DS(x) DC(x) Park size (acres) xC xS x*

  21. The “free-rider” problem • If rely on private market to provide public goods, often get “free riders”. • If I pay for some of the good, you can use it for free, don’t cough up any money…you are a free-rider. • Economic theory predicts: public goods will be systematically underprovided by free market.

  22. Potential problems with CBA • Recall “Cookbook” steps to CBA • Potential problems include: • Omission of some costs or benefits • Often ignores distribution (who wins, loses) • Moral dimension may be omitted • Some values difficult to quantify (e.g. nonmarket goods) • Economics has answers to some of these problems, some remain unanswered.

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