Measuring Costs and Benefits Measuring Benefits and Costs (See Chap 4): –Consumers’ Willingness to Pay (WTP) –Consumer Surplus (CS) –Producers’ Surplus (PS) –Social Surplus (SS) –Review discussion of Fig. 4.2; 4.3 Measuring Benefits in Secondary Markets (See Chap 5)

Measuring Benefits Utility Theory Quantity Consumed Utility Assumption: Diminishing Marginal Utility

Measuring Benefits Diminishing marginal utility What evidence do we have that individuals’ utilities have this property? “Revealed preferences” –At lower prices, people consume more. –As prices increase, the amount people consume decreases

Measuring Benefits Individual Demand Curve Quantity Consumed Price Q0Q0 P0P0 X0X0 Q1Q1 P1P1 X1X1 D

Measuring Benefits Demand curve shows actual expenditure behaviors of individuals –When goods are scarce, people willing to pay high price –When goods are abundant (people are already consuming a lot), people willing to pay only a lower price Measured in monetary terms Note: Consumers’ expenditure behaviors are constrained by their budgets! Demand response has both substitution (pure preferences) and income effects

Market demand curves Market demand curve is (horizontal) sum of individual demand curves

Market demand curves P Q P Q q1q1 q2q2 q 1 +q 2 Q Individual 1Individual 2 D1D1 D2D2 Market DMDM

Measuring Benefits Demand curve – Willingness to pay for different quantities In market exchanges, consumers to not actually pay all that they would be willing to pay. Producers are not able to discriminate prices charged for each unit sold.

Actual Expenditures Measuring Benefits QeQe PePe Q0Q0 WTP 0 Market Equilibrium Price D S Quantity CS

Measuring Benefits Difference between WTP and actual expenditures is Consumer Surplus CS. WTP is the theoretically correct measure, and of benefits from an activity. –Includes transfers (to producers) CS is measure of “net” benefits –widely used in empirical studies –Based on estimated market demand curves

WTP Consumer Surplus Actual Expenditures Measuring Benefits QeQe PePe Q0Q0 WTP 0 Market Equilibrium Price D S Quantity

WTP 0 Price D S0S0 Quantity S1S1 ∆WTP CS 0 ∆CS

Measuring Benefits WTP and CS do not change if market price does not change, and Perfectly elastic demand curve Example – Expanding electricity production in Mozambique

P SA Mozambique market for electricity DMDM D SA Q D0 Q S0 Q S1

Measuring Benefits WTP and CS do change if market price does not change and Constant, or administratively controlled price (and shift in supply) Example: increase in local cable distribution capacity (cable access price determined in national market)

P*P* Q0Q0 Q1Q1 A (CS 0 ) C (  CS) B (EXP 0 ) D (  EXP) D (Marginal WTP) Local Market for Cable Connections

Measuring Costs Area under supply curve (MC curve) Analogous to consumer, in market exchanges, producers’ revenues are greater than minimum necessary to meet their production costs Assumptions: –Perfect competition –Profit-maximization (MR = MC)

Measuring Costs QeQe TR TC TR e TC e Quantity Total Revenue, Cost Profit

Measuring Costs Profit P=MR S=MC Quantity Marginal Revenue, Cost

Measuring Costs What factors may cause supply curve to shift? –Technological change –Prices of inputs May change due to infrastructure invesments –Government policies – taxes/subsidies

Social Surplus S D PS CS QeQe PePe

Social Surplus Social Surplus = Consumer surplus + Producer Surplus Social surplus is maximized in competitive markets –Assuming no market imperfections! –Assuming no externalities!

Change in Social Surplus Annual policy: ∆W = ∆CS + ∆ PS + ∆GS + ∆EE CS = Consumer Surplus PS = Producer Surplus GS = Government Surplus EE = External Effect Investment project: ∆W = -[Initial Investment] + ∑ i (∆CS i +∆PS i +∆GS i +∆EE i ) Over i years of useful life of the investment

Review Boardman Figure 4.3

P*P* S0S0 S1S1 CS  CS D Local Market for Cable Connections PS  PS

Local Market for Cable Connections Net Benefit = - [Initial investment] + ∑ i {df i (∆CS i + ∆PS i )} ∆PS and ∆PS summed over the i years of the useful life of the investment (discounted by discount factor df i )

P SA Mozambique market for electricity DMDM D SA Q D0 Q S0 Q S1 S0S0 S1S1 CS PS FX ∆PS ∆FX With international trade, need to add changes in Foreign exchange (FX) flows

Mozambique market for electricity Net Benefit = - [Initial investment] + ∑ i {df i (∆PS i + ∆FX i )} ∆PS and ∆FX summed over the i years of the useful life of the investment (discounted by discount factor df i )