1. 1 Civil Systems Planning Benefit/Cost Analysis Chapter 4 Scott Matthews Courses: 12-706 and 73-359 Lecture 7 - 9/22/2004

2. 12-706 and 73-3592 Announcements  PS 2 will be posted this afternoon  Same Due Date  PS 1 looks good so far  Reminder: Project teams/ideas due next Wednesday

3. 12-706 and 73-3593 Monopoly Analysis (cont.) MR D MC Qc Pc What is social surplus? Orange = CS Yellow = PS (bigger!) Grey = DWL (from not Producing at Pc,Qc) thus Soc. Surplus is not maximized Breaking monopoly Would transfer DWL to Social Surplus Qm Pm

4. 12-706 and 73-3594 Natural Monopoly MR D Q* P* Forcing the price P* Means that the social surplus is increased. DWL decreases from abc to dec Society gains adeb Qm Pm MC AC a b c d e Q0

5. 12-706 and 73-3595 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Third parties: (gain) B+C+F (avoided quantity between S curves) Govt revenue: A+E Total: gain of C t P# - t B F C A E C is reduced DWL of pollution eliminated by tax** **This cannot be a perfect reduction in practice - need to consider administrative costs of program

6. 12-706 and 73-3596 Distorted Market - Vouchers  Example: rodent control vouchers  Give residents vouchers worth $v of cost  Producers subtract $v - and gov’t pays them  Likely have spillover effects  Neighbors receive benefits since less rodents nearby means less for them too  Thus ‘social demand’ for rodent control is higher than ‘market demand’

7. 12-706 and 73-3597 Distortion : p0,q0 too low Q P Q0 P0 S-v DMDM S D S: represents higher WTP for rodent control P1 Q1 What is NSB? What are CS, PS? Social WTP

8. 12-706 and 73-3598 Social Surplus - locals Q P Q0 P0 S-v DMDM S DSDS P1 Q1 B P E P1+v A C Make decisions based on S-v, Dm What about others in society, e.g. neighbors? Because of vouchers, Residents buy Q1

9. 12-706 and 73-3599 Nearby Residents Q P Q0 P0 S-v DMDM S DSDS P1 Q1 B P E P1+v A C Added benefits are area between demand above consumption increase What is cost voucher program? F G

10. 12-706 and 73-35910 Voucher Market Benefits  Program cost (vouchers):A+B+C+G+E ----  Gain (CS) from target pop: B+E  Gain (CS) in nearby: C+G+F  Producers (PS): A+C  ---------  Net: C+F

11. 12-706 and 73-35911 Notes about Public Spending  Resource allocation to one project always comes at a ‘cost’ to other projects  E.g. Pittsburgh stadium projects  “Use it or Lose it”  There is never enough money to go around  Thus opportunity costs exist  Ideally represented by areas under supply curves  Do not consider ‘sunk costs’  Three cases (we will do 2, see book for all 3)

12. 12-706 and 73-35912 Opportunity Cost: Land Q P D b Price Case of inelastic supply (elastic supply in book, trivial) Government decides to buy Q acres of land, pays P per acre Alternative is parceling of land to private homebuyers What is total cost of project? S Can assume quantity of land is fixed (Q)

13. 12-706 and 73-35913 Opportunity Cost: Land Q P D b Price Government pays PbQ0, but society ‘loses’ CS that they would have had if government had not bought land. This lost CS is the ‘opportunity cost’ of other people using/buying land. Total cost is entire area under demand up to Q (colored) S 0

14. 12-706 and 73-35914 Example: Change in Demand for Concrete Dam Project  If Q high enough, could effect market  Shifts demand -> price higher for all buyers  Moves from (P0,Q0) to (P1,Q1).. Then?? Q0 P0 D a Price Quantity D+q’ S P1 Q1

15. 12-706 and 73-35915 Another Example: Change in Demand  Original buyers: look at D(p1), buy Q2  Total purchases still increase by q’  What is net cost/benefit to society? Q0 P0 D a Price Quantity D+q’ S P1 Q1 Q2

16. 12-706 and 73-35916 Another Example: Change in Demand  Project spends B+C+E+F+G on q’ units  Project causes change in social surplus!  Rule: consider expenditure and social surplus change Q0 P0 D Price Quantity D+q’ S P1 Q1 Q2 E B C FA G G G

17. 12-706 and 73-35917 Dam Example: Change in Demand  Decrease in CS: A+B (negative)  Increase in PS: A+B+C (positive)  Net social benefit of project is B+G+E+F Q0 P0 D Price Quantity D+q’ S P1 Q1 Q2 E B C FA G G G

18. 12-706 and 73-35918 Final Thoughts: Change in Demand  When prices change, budgetary outlay does not equal the total social cost  Unless rise in prices high, C negligible  So project outlays ~ social cost usually  Opp. Cost equals direct expenditures adjusted by social surplus changes Quantity

19. 12-706 and 73-35919 Price Floors (e.g. Min. Wage)  Labor market example (tricky)  Supply and demand ‘reversed’ - ideas of ‘consumer’, ‘producer’ switched  In labor market, workers are ‘producers’  Companies are ‘consumers’ of labor  A ‘price floor’ is a guaranteed wage rate level that must be kept  Good for some workers, bad for others

20. 12-706 and 73-35920 Price Floor (e.g. Min Wage) L=num of workers P Ld Pm S D Pe Le Pr D+L’ LsLt

21. 12-706 and 73-35921 Problem 4-2 from Book  Done on Board

22. 12-706 and 73-35922 Monopoly Project - What is NSB? MR1D MC Q1 P1 P2 Q3Q2 Q’ D+Q’ MR2

23. 12-706 and 73-35923 Monopoly Project - Agency Cost MR1D MC Q1 P1 P2 Q3Q2 Q’ D+Q’ MR2 C E A A AA A A G G G Agency Cost is A+C+G+E

24. 12-706 and 73-35924 Monopoly Project - PS (2 parts) MR1D MC Q1 P1 P2 Q3Q2 Q’ D+Q’ MR2 C E A A AA A A G G G PS is price effect + Quantity effect = B+C+G+E C+G+E is transfer B

25. 12-706 and 73-35925 Monopoly  Easy to see loss in CS is B+C. Thus:  Original Buyers lose B+C  Monopolist gains B+C+G+E  Project Costs A+C+G+E  --  NSB = (loss) A+C  Budgetary outlays larger than Social costs

26. 12-706 and 73-35926 Secondary Markets  There are always secondary effects  When secondary markets affected  Can and should ignore impacts as long as primary effects measured and undistorted secondary market prices unchanged

27. 12-706 and 73-35927 Primary: Fishing Days Q1 P D Price Government decides to buy Q acres of land, pays P per acre What is total cost of project? b a Q0 MC0 MC1

28. 12-706 and 73-35928 Primary: Fishing Days Q1 P0 D Price Government puts more fish in lake for fishermen Makes local lake more attractive, lowers travel/access costs Number of fishing days increases in quantity Change in CS is trapezoid P0-a-b-P1 b a Q0 MC0 MC1 P1

29. 12-706 and 73-35929 Secondary Market: Equipment P0 D0 D1 q0q1 Elastic Supply No Price Effect Do we count CS Increase or not? Consider cases of fishermen with and without equipment prior to policy.

30. 12-706 and 73-35930 When to Consider Secondary Markets  We should ignore impacts in undistorted secondary markets as long as:  We measure change in social surplus in primary market  Secondary prices do not change… OR  OR When we measure benefits in primary market with demand schedules that do not hold secondary market prices constant  Measuring both usually leads to double counting (since primary markets tend to show all effects)