1. 1 Civil Systems Planning Benefit/Cost Analysis Chapters 3 and 4 Scott Matthews Courses: 12-706 and 73-359 Lecture 4 - 9/9/2002

2. 12-706 and 73-3592 Unifying Cost and Supply  Economists learn Supply and Demand  Equilibrium: where S=D  In our case, substitute cost for supply  Econ: S = MC under perfect competition  Perfect competition => no profits  Thus market price = cost of producing  Why cost? Need to trade-off Demand  Using MC is a standard method

3. 12-706 and 73-3593 Meaning of Cost Curves  Highway pricing  p = f(fares, fees, travel times, discomfort)  p ~ AVC: manages usage of highway  Price increase=> less users (BCA)  MC pricing: more users, higher price

4. 12-706 and 73-3594 Welfare Economics Continued The upper segment of a firm’s marginal cost curve corresponds to the firm’s supply curve. Again, diminishing returns occur. Quantity Price Supply=MC At any given price, determines how much output to produce to maximize profit

5. 12-706 and 73-3595 Supply/Marginal Cost Notes Quantity Price Supply=MC At any given price, determines how much output to produce to maximize profit P* Q1 Q* Q2 Demand: WTP for each additional unit Supply: additional cost incurred for each additional unit

6. 12-706 and 73-3596 Supply/Marginal Cost Notes Quantity Price Supply=MC Area under MC is TVC - why? P* Q1 Q* Q2 We always want to be considering opportunity costs (total asset value to society) and not accounting costs

7. 12-706 and 73-3597 Supply/Marginal Cost Notes Quantity Price Supply=MC P1 Q1 Q*  Producer surplus is similar to CS -- the amount over and Above cost required to produce a given output level  Changes in PS found the same way as before P* PS1 PS*

8. 12-706 and 73-3598 Equilibrium Example  Demand Function: p=4-3q  Supply function: p=1.5q  Assume equilibrium, what is p,q?  Eq=> S=D; 4-3q=1.5q ; 4.5q=4 ; q=8/9  P=1.5q=1.5*(8/9)= 4/3  CS = (0.5)*(8/9)*(4-1.33) = 1.19  PS = (0.5)*(8/9)*(4/3) = 0.6

9. 12-706 and 73-3599 Allocative Efficiency Allocative efficiency occurs when MC = MB Q* P* S D = MB = MC Q1Q1 Q2Q2 a b Price Quantity

10. 12-706 and 73-35910 Social Surplus Social Surplus = consumer surplus + producer surplus Losses in Social Surplus are Dead-Weight Losses! Q P Q* P* S D

11. 12-706 and 73-35911 Subsidies/Target Pricing Q* P* S D QTQT a b d c PTPT Price Quantity Allocative efficiency can only be achieved when P=MC. Assume market for corn, in initial eq’m -> what happens when government guarantees P T to farmers?

12. 12-706 and 73-35912 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity At P T, farmers want to supply Q T units. But at Q T, consumers only want to pay P D. This is effective market price. So P T -P D is subsidized by government policy. What is change in CS, PS?

13. 12-706 and 73-35913 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity CS increases from aP*b (yellow) to aP D e (yellow+orange). What about PS?

14. 12-706 and 73-35914 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity PS also increases, from P*bc to P T dc. Is overall net benefit to society then positive (since PS and CS both increase)? c

15. 12-706 and 73-35915 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity The cost to society (taxpayers) is the government subsidy - So what is the overall net benefit to society?

16. 12-706 and 73-35916 Subsidies/Target Pricing Q* P* S D QTQT a b d e c PDPD PTPT Price Quantity Overall net benefit to society is (Increased CS + Increased PS) - Costs = Orange + Yellow - Grey = Triangle bde (loss!). This is a DWL, orange and yellow areas are transfers! Leakage of program is Area bde/Area P T deP D

17. 12-706 and 73-35917 Changes in Demand  There is a difference in ‘change in quantity demanded’ and a ‘change in demand’.  If (only) the price of good changes  Change in qty demanded - move along D  If something other than price changes (e.g. demand more of good)  Then entire demand curve shifts  Same things true for supply

18. 12-706 and 73-35918 Types of Markets  Primary: directly affected by policy  Secondary: indirectly affected  Example: new highway  Primary: commuting, traffic, pollution  Secondary: change in repairs, gas  Efficient markets (as discussed)  Distorted markets: when external effects occur as a result of market  Could be positive or negative

19. 12-706 and 73-35919 Benefits in Efficient Market  NSB=  CS+  PS + Net Gov’t Revenues  Government adds large quantity of good to market to reduce price  Example: surplus food programs  Government intervenes by supplying q’ units into the market  See related problems on p. 73

20. 12-706 and 73-35920 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Initial equilibrium at P0, Q0 New eq’m at (lower)P1, (higher) Q1 What is change in CS? a b Q2

21. 12-706 and 73-35921 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Change in CS is P 0 abP 1 (gain) What about PS? a b Q2

22. 12-706 and 73-35922 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Change in PS is P 0 acP 1 (loss) for the ‘original suppliers’ since they still Operate on supply curve ‘S’ What is social surplus? a b c Q2

23. 12-706 and 73-35923 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Social surplus is net gain of CS+PS, Or the triangle abc - what is Net Social Benefit? a b c Q2

24. 12-706 and 73-35924 Surplus Food Example Q P Q0 P0 S+q’ D S P1 Q1 Government gains revenue Q 2 cbQ 1, so NSB = Q 2 cabQ 1 a b c Q2

25. 12-706 and 73-35925 Monopoly - the real game  One producer of good w/o substitute  Not example of perfect comp!  Deviation that results in DWL  There tend to be barriers to entry  Monopolist is a price setter not taker  Monopolist is only firm in market  Thus it can set prices based on output

26. 12-706 and 73-35926 Monopoly - the real game (2)  Could have shown that in perf. comp. Profit maximized where p=MR=MC  Same is true for a monopolist -> she can make the most money where additional revenue = added cost  But unlike perf comp, p not equal to MR

27. 12-706 and 73-35927 Monopoly Analysis MR D MC Qc Pc In perfect competition, Equilibrium was at (Pc,Qc) - where S=D. But a monopolist has a Function of MR that Does not equal Demand So where does he supply?

28. 12-706 and 73-35928 Monopoly Analysis (cont.) MR D MC Qc Pc Monopolist supplies where MR=MC for quantity to max. profits (at Qm) But at Qm, consumers are willing to pay Pm! What is social surplus, Is it maximized? Qm Pm

29. 12-706 and 73-35929 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

30. 12-706 and 73-35930 Natural Monopoly  Fixed costs very large relative to variable costs  Ex: public utilities (gas, power, water)  Average costs high at low output  AC usually higher than MC  One firm can provide good or service cheaper than 2+ firms  In this case, government allows monopoly but usually regulates it

31. 12-706 and 73-35931 Natural Monopoly MR D Q* P* Faced with these curves Normal monop would Produce at Qm and Charge Pm. We would have same Social surplus. But natural monopolies Are regulated, usually Produce where D=AC Why? Qm Pm MC AC a b c d e

32. 12-706 and 73-35932 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