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Introduction to Economics of Water Resources Lecture 5

Introduction to Economics of Water Resources Lecture 5. Some Economic Indicators/Criteria. NPV (net present value) Internal Rate of Return (IRR) Interest Rate where NPV cost =NPV benefits Economic Efficiency Marginal Cost = Marginal Benefits. P. Economic Efficiency. Cash Flow Example.

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Introduction to Economics of Water Resources Lecture 5

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  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. P Economic Efficiency

  4. Cash Flow Example

  5. IRR IRR=0.068

  6. Costs / Benefits • Direct 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) Strong: • Maximize the return when we have Limited fund • Used to rank projects • Decide if the project can be funded Weak: • 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. P Q 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

  11. P 5 E=-5 E=-1 3 E=-0.2 1 Q 1 5 3 Market Demand • Price elasticity of the demand: • 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.

  12. P Q 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

  13. P Demand supply surplus shortage Q 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

  14. P Economic Efficiency Rising limb = supply curve 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

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