Civil Systems Planning Benefit/Cost Analysis

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

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### Civil Systems PlanningBenefit/Cost Analysis

Scott Matthews

12-706/19-702 / 73-359

Lecture 9

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

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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

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Monopoly Analysis

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?

MC

Pc

Qc

MR

D

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Monopoly Analysis (cont.)

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?

MC

Pm

Pc

Qm

Qc

D

MR

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Monopoly Analysis (cont.)

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

MC

Pm

Pc

Qm

Qc

D

MR

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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

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Natural Monopoly

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?

a

Pm

d

P*

AC

b

e

MC

c

Qm

Q*

D

MR

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Natural Monopoly

Forcing the price P*

Means that the social surplus is increased.

DWL decreases from abc to dec

a

Pm

d

P*

AC

b

e

MC

c

D

Qm

Q*

Q0

MR

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Monopoly
• Other options - set P = MC
• But then the firm loses money
• Subsidies needed to keep in business
• Free rider problems
• Also new deadweight loss from cost exceeding WTP

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### Referent Groups (RG)

C: RG NB

At non-

Market price

A = RG

NB @

Market

prices

B: non-RG

NB at market

prices

D: non-RG

NB at non-

Market price

Pollution (Air or Water)

Typically supply (MC) only private, not

social costs. Social costs higher

for each quantity

P

S#:marginal

Social costs

S*: marginal

Private costs

P#

P*

What do these curves,

Equilibrium points tell us?

D

Q

Q#

Q*

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What is WTP by society to avoid?

Typically supply (MC) only private, not

social costs. Social costs higher

for each quantity

P

S#:marginal

Social costs

S*: marginal

Private costs

P#

P*

D

Q

Q#

Q*

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What is WTP by society to avoid?

Differences in cost functions represent the

alternative ‘valuations’ of the product -

Thus difference between them

WTP to avoid costs

P

S#:marginal

Social costs

S*: marginal

Private costs

P#

P*

D

Q

Q#

Q*

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Pollution (Air or Water)

Relatively too much gets produced,

At too low of a cost - how to

Reduce externality effects?

P

S#:marginal

Social costs

S*: marginal

Private costs

DWL

P#

P*

D

Q

Q#

Q*

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Pollution (Air or Water)

Government can charge a tax ‘t’ on

Each unit, where t = distance between

What are CS, PS, NSB?

P

S#:marginal

Social costs

S*: marginal

Private costs

P#

t

P*

D

Q

Q#

Q*

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Pollution (Air or Water)

CS = (loss) A+B

PS=(loss) E+F

P

S#:marginal

Social costs

S*: marginal

Private costs

P#

t

A

B

P*

F

E

P# - t

D

Q

Q#

Q*

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Pollution (Air or Water)

Third parties: (gain) B+C+F

(avoided quantity between S curves)

Govt revenue: A+E

Total: gain of C

P

S#:marginal

Social costs

S*: marginal

Private costs

P#

t

C

A

B

C is reduced DWL

of pollution eliminated by tax**

P*

F

E

P# - t

D

Q

Q#

Q*

**This cannot be a perfect reduction in practice - need to consider

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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’

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Distortion : p0,q0 too low

What is NSB? What are CS, PS?

S

Social

WTP

P

S-v

P0

P1

DS: represents

higher WTP

for rodent control

DM

Q

Q0

Q1

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Social Surplus - locals

Make decisions based on S-v, Dm

e.g. neighbors?

P

P

S

S-v

P1+v

C

A

P0

B

E

P1

DS

Because of vouchers,

DM

Q

Q0

Q1

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Nearby Residents

Added benefits are area between demand

above consumption increase

What is cost voucher program?

P

P

S

S-v

F

P1+v

C

A

G

P0

B

E

P1

DS

DM

Q

Q0

Q1

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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

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• Resource allocation to one project always comes at a ‘cost’ to other 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)

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Opportunity Cost: Land

• 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?

Price

Can assume quantity

of land is fixed (Q)

S

b

P

D

Q

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Opportunity Cost: Land

Government pays PbQ0, but society ‘loses’ CS that they

CS is the ‘opportunity cost’ of other people using/buying land.

• Total cost is entire area under demand up to Q (colored)

Price

S

b

P

D

0

Q

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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??

Price

D+q’

D

S

P1

P0

a

Q1

Q0

Quantity

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Another Example: Change in Demand
• Total purchases still increase by q’
• What is net cost/benefit to society?

Price

D+q’

D

S

P1

P0

a

Q1

Q2

Q0

Quantity

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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

Price

D

D+q’

S

P1

C

A

F

B

P0

G

E

G

G

Q1

Q2

Q0

Quantity

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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

Price

D

D+q’

S

P1

C

A

F

B

P0

G

E

G

G

Q1

Q2

Q0

Quantity

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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

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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)
• Don’t forget that benefit changes are a function of price changes (Campbell pp. 167)

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Primary: Fishing Days

Government decides to buy Q acres of land, pays P per acre

What is total cost of project?

Price

a

MC0

b

MC1

P

D

Q0

Q1

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