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? Can we measure loss to recreationists of the Forest Adventure Pass? Add another lane to Hwy 101? Close Mission Canyon to cyclists?

“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”.

“Species distributions, land values, and efficient conservation” J = {1,2,…,n} sites, cost c j I = {1,2,…,m} candidate species N i = subset of J that contains species i x j = 1 if site selected; 0 otherwise

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

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.

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

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

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.

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

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

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

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

Where is CS+PS maximized? Demand, D(x) Supply, S(x) q1q1 q* p x $ CS PS Tension: Too little produced At too high price. CS low, PS high

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

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.

Including an externality cost Megawatts, x D(x) S(x) MEC(x) S(x)+MEC(x) x1x1 x* $ Reflects the “internal” Costs of producing power Reflects the “external” Costs of producing power Reflects all Social costs

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.

Demand for Public Goods 2 people, D S (x) and D C (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?

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

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.

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.