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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 planning benefit cost analysis

Civil Systems PlanningBenefit/Cost Analysis

Scott Matthews

12-706/19-702 / 73-359

Lecture 9

monopoly the real game
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
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

12-706 and 73-359

monopoly analysis
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
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 cont1
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
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 monopoly1
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 monopoly2
Natural Monopoly

Forcing the price P*

Means that the social surplus is increased.

DWL decreases from abc to dec

Society gains adeb

a

Pm

d

P*

AC

b

e

MC

c

D

Qm

Q*

Q0

MR

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monopoly
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

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referent groups rg

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
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
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 avoid1
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 water1
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 water2
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 water3
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 water4
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

administrative costs of program

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distorted market vouchers
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
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
Social Surplus - locals

Make decisions based on S-v, Dm

What about others in society,

e.g. neighbors?

P

P

S

S-v

P1+v

C

A

P0

B

E

P1

DS

Because of vouchers,

Residents buy Q1

DM

Q

Q0

Q1

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nearby residents
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
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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notes about public spending
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)

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opportunity cost land
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 land1
Opportunity Cost: Land

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)

Price

S

b

P

D

0

Q

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example change in demand for concrete dam project
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
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?

Price

D+q’

D

S

P1

P0

a

Q1

Q2

Q0

Quantity

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another example change in demand1
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
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
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
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
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

12-706 and 73-359