1. Introduction to Economics of Water Resources Lecture 5

2. Some Economic Indicators/Criteria
NPV (net present value)
Internal Rate of Return (IRR)
Interest Rate where NPVcost=NPV benefits
Economic Efficiency
Marginal Cost = Marginal Benefits

3. Economic Efficiency P

4. Cash Flow Example Year 1 2 3 4 5 6 7 8 9 10 Investment Cost 100000
Investment Cost
100000
50000
O&M Cost
10000
Cost
NPVc
45455
41322
7513
6830
6209
5645
5132
4665
4241
227012
Revenues
NPVr
37566
34151
31046
28224
25658
23325
21205
201174
Interest rate
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.1
264476
259285
254400
249797
245455
241353
237473
233799
230317
329781
311034
293632
277462
262421
248415
235361
223181
211807

5. IRR
IRR=0.068

6. Costs / Benefits Direct Cost / Benefit Indirect Cost / Benefit
Easily measured, allocated to a specific production and consumption
Indirect Cost / Benefit
Difficult to be measured, indirectly related to production and consumption
Fixed Cost
Do not vary with the quantity of output (capital / investment costs)
Variable Cost (is it same as recurrent cost ??)
Related to quantity (raw material, chemicals, labors, fuel, etc.)
Incremental cost / benefit
Compare the situation with or without introducing new components to a project
Opportunity Cost
The cost of foregoing the opportunity to earn a return

7. Some Economic Indicators
NPV
Strong:
Choosing among mutually exclusive projects
Decide if the project can be funded
Weak:
Sensitive to interest rate
No information about degree of acceptability
Internal Rate of Return (IRR)
Maximize the return when we have Limited fund
Used to rank projects
No information on the size of the project

8. Some Economic Indicators
B/C ratio
Strong:
Rank projects according to degree of acceptability
Decide if the project can be funded
Weak:
Sensitive to interest rate

9. Free Market System
Competitive system: Allocation of resources with maximum efficiency
Consumers must be consistent and independent
Producers must operate with the goal of profit maximization
No price regulations or constraints by the government, labors, business, etc
Goods, services, and resources must be mobile free to move from market to another
Buyers and sellers must be aware of the prices instantaneously
Commodities must be sufficiently divisible
All resources must be fully employed

10. Market Demand
People will buy less at higher prices provided that income, tastes, prices of substitutes remains constant
Price elasticity of the demand:
Shifts in Demand:
Customer preferences
Number of customers
Customer income
Price of related goods
Availability of alternatives Q P

11. Market Demand Price elasticity of the demand: Example:
More elastic at high prices
Rigid at low prices
Perfectly elastic when E=infinity, means no one will buy if the price increases
Example:
Calculate E at different locations on the curve assuming a unit change in price will result in a unit change in the demand. Q P 1 5 3
E=-5
E=-1
E=-0.2

12. Market Supply
Market supply: the amount that producers are willing to sell/produce at different prices
Shifts in supply curve:
Technological advances
Favorable production conditions
Lower input cost Q P

13. Market Equilibrium Market equilibrium:
the minimum that customer can pay for certain quantity and the maximum that suppliers can receive for the same quantity
Automatic way for allocation
Represent the customers willingness to pay
Economic efficiency Q P
Demand
supply
surplus
shortage

14. Economic Efficiency P Rising limb = supply curve Optimality Condition
Below the falling part of AC
Higher the rising part of AC
Affected by variable costs
Optimality Condition
= Demand Curve
= Benefits associated with
One Unit increase in output

15. Definitions
Total cost curve: variation in total production cost (Fixed costs + variable costs) with the level of production
Total benefit curve: variation in the resulting benefits with the level of production
Average cost curve : total cost divided by the level of production
U shape
Decrease first because of economies of scale
Marginal cost curve: the slope of the total cost curve, represent the change in total cost associated with a unit increase in output
Supplier will not produce an extra unit unless the price exceeds the marginal cost
The rising limb represent the supply curve
Marginal benefit curve: the slope of the total benefit curve, represent the change in total benefit associated with a unit increase in output
Represent the demand curve

16. RESULTS: M&I Demand Curve

17. RESULTS: M&I Supply Curve

18. RESULTS: 2010 Equilibrium Point

19. Irrigation Water Prices in Israel