1. 1 Civil Systems Planning Benefit/Cost Analysis Chapters 4 and 5 Scott Matthews Courses: 12-706 and 73-359 Lecture 5 - 9/15/2003

2. 12-706 and 73-3592 Announcements  Homework 1 Due Today  Will insert 2 lectures (wed, next Monday)  Syllabus adjusted on web  Guest Lecturer next Wed

3. 12-706 and 73-3593 Externalities  Recall that external effects happen to third parties (non-consumers, producers)  Cause distortions in the market  Are by-products with no markets  Since number of externalities is large, CBA can/should be used before government intervenes to correct

4. 12-706 and 73-3594 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Typically supply (MC) only private, not social costs. Social costs higher for each quantity What do these curves, Equilibrium points tell us?

5. 12-706 and 73-3595 What is WTP by society to avoid? Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Typically supply (MC) only private, not social costs. Social costs higher for each quantity

6. 12-706 and 73-3596 What is WTP by society to avoid? Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Differences in cost functions represent the alternative ‘valuations’ of the product - Thus difference between them WTP to avoid costs

7. 12-706 and 73-3597 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Relatively too much gets produced, At too low of a cost - how to Reduce externality effects? DWL

8. 12-706 and 73-3598 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* Government can charge a tax ‘t’ on Each unit, where t = distance between What are CS, PS, NSB? t

9. 12-706 and 73-3599 Pollution (Air or Water) Q P Q# P# S*: marginal Private costs D S#:marginal Social costs P* Q* CS = (loss) A+B PS=(loss) E+F t P# - t AB E F

10. 12-706 and 73-35910 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

11. 12-706 and 73-35911 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’

12. 12-706 and 73-35912 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

13. 12-706 and 73-35913 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

14. 12-706 and 73-35914 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

15. 12-706 and 73-35915 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

16. 12-706 and 73-35916 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)

17. 12-706 and 73-35917 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)

18. 12-706 and 73-35918 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

19. 12-706 and 73-35919 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

20. 12-706 and 73-35920 Another Example: Change in Demand  Original buyers: look at D, 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

21. 12-706 and 73-35921 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

22. 12-706 and 73-35922 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

23. 12-706 and 73-35923 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

24. 12-706 and 73-35924 Secondary Markets  When secondary markets affected  Can and should ignore impacts as long as primary effects measured and undistorted secondary market prices unchanged  Measuring both usually leads to double counting (since primary markets tend to show all effects)

25. 12-706 and 73-35925 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