1. 1 Civil Systems Planning Benefit/Cost Analysis Scott Matthews 12-706/19-702 / 73-359 Lecture 9

2. 12-706 and 73-3592 Revisiting HW 2, Question 2 (Dam)  Thanks to Ryan and Jenny..  Their argument “should stop doing the project when the yearly PV goes negative”; year 45 instead of 66  This is a “social cash flow” problem  Should use continuous discounting, but that’s not concern here  Part a (no concerns) show to keep adding rows until NPV (cumulative) goes to 0  Use cumulative NPV to automate/avoid doing 25 separate NPV worksheets  But in reality, what the cumulative says is what NPV “up to year n” would have been had we done a separate worksheet  Our rule is “select project as long as NPV > 0”

3. 12-706 and 73-3593 HW 2, Q2 (cont)  Part b just has different discount rates.. (no big deal)  Still - same basic framework applies. Finding NPVs to use our “rule”, but using cumulative NPV to help see when it would have gone to zero (if had done 45-66 separate worksheets)

4. 12-706 and 73-3594 Revisiting old problem.. I changed At cash streams to be non-uniform, and decreasing Would we do this project with information above? Eg 5 years? Does the fact that PV “goes negative” in year 4 matter?

5. 12-706 and 73-3595 Last thoughts  Had we done separate worksheets to test NPV for each year 25 to 66, we would have found a positive NPV.  That is our decision rule for accepting projects.

6. 12-706 and 73-3596 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

7. 12-706 and 73-3597 Monopoly - the real game (2)  Could have shown that in perf. comp. Profit maximized where p=MR=MC (why?)  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

8. 12-706 and 73-3598 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?

9. 12-706 and 73-3599 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

10. 12-706 and 73-35910 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

11. 12-706 and 73-35911 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

12. 12-706 and 73-35912 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. What are options? Qm Pm MC AC a b c d e

13. 12-706 and 73-35913 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

14. 12-706 and 73-35914 Monopoly  Other options - set P = MC  But then the firm loses money  Subsidies needed to keep in business  Give away good for free (e.g. road)  Free rider problems  Also new deadweight loss from cost exceeding WTP