AGEC 608: Lecture 5

1. AGEC 608: Lecture 5 • Objective: Outline approach for valuing benefits and costs in secondary markets (those indirectly affected by policy) • Readings: • Boardman, Chapter 5 • Homework #2: Chapter 3, problem 1 Chapter 3, problem 2 Chapter 4, problem 3due: March 13

2. Valuation in Secondary Markets A primary market is a market directly affected by the policy change. A secondary market is a market indirectly affected by the policy change. Example: The government provides bus service (primary market). The demand for automobile repairs goes down (secondary market).

3. Valuation in Secondary Markets General perspective is that, in the absence of market distortions, impacts in secondary markets should be ignored (more later). But, this perspective depends on one’s view of geographical standing. Local impacts may not be important within a broader “national” perspective (due to shifts across categories), but in some cases local impacts may be of interest.

4. Complements vs. substitutes Complement As price of good x falls, demand for good y goes up. Example: Government stocks a lake with fish (x). Demand for fishing equipment (y) goes up.

5. Complements vs. substitutes Substitute As price of good x falls, demand for good y goes down. Example: Government stocks a lake with fish (x). Demand for golf clubs (y) goes down.

6. Complements vs. substitutes Most goods have a very large number of complements and substitutes. As a result, most government projects have numerous impacts in secondary markets. However, government provision of a good may or may not change prices in secondary markets. Furthermore, as long as markets are not distorted, measurements in primary markets generally capture full effects of secondary markets.

7. Case 1a: efficient secondary market with no price effects Assumptions: 1. price in primary market equals MC of good 2. MC in primary market is constant 3. project causes MC in primary market to fall 4. demand for complement good increases 5. change in demand is small relative to marketKey insights: 1. change in consumer surplus is gross benefit 2. all benefits arising in secondary market go into the construction of the primary market demand curve 3. if primary market can be measured directly, then adding secondary market effects is double counting.

8. Price P0 P1 Price c e P0 f d a b MC0 MC1 D D0 D1 q1 q0 Quantity Quantity Case 1a: no price effects q0 q1 Primary market (fishing) Secondary market (equipment)

9. Case 1b: efficient secondary market with price effects Assumptions: 1. price in primary market equals MC of good 2. MC in primary market is constant 3. project causes MC in primary market to fall 4. demand for substitute good falls 5. change in demand is large relative to marketKey insights: 1. change in consumer surplus is gross benefit 2. net loss in social surplus in secondary market 3. net gain in primary market is typically underestimated, but by an amount roughly equal to net loss in the secondary market.

10. Price P0 P1 Price S a b MC0 e g f h P0P1 MC1 D0 D1 D q1 q0 Quantity Quantity Case 1b: price effects g1 g0 Primary market (fishing) Secondary market (golfing)

11. Case 1b: price effects Price P0 P1 D* D0 and D1 hold prices “constant” These are typically difficult to estimate Instead D* is the “observed” demand curve (after adjustment) But D* under states gain in social surplus by the amount abc. a b c MC0 MC1 D0 D1 q1 q0 Quantity Primary market (fishing)

12. Price P0 P1 Price D* abc = efg S a b c MC0 e g f h P0P1 MC1 D0 D1 D0 D1 q1 q0 g1 g0 Quantity Quantity Primary market (fishing) Secondary market (golfing) Case 1b: price effects

13. Additional issues • distorted markets • taxes and deadweight losses • Local perspectives • local benefits vs. national transfers • surplus to non-local residents • if local prices rise, PS increases, CS falls • local “capture” rates tend to be low

14. Measurement issues • How to measure these effects in practice? • Multipliers.xls