Transcript Market Failure Stakeholder Analysis (Who Wins, Loses) Monopoly

Civil Systems Planning
Benefit/Cost Analysis
Scott Matthews
12-706 / 19-702
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Announcements
HW 2 returned
Install Decision Tools Suite ASAP (in case there
are problems)
Installation in CEE cluster done
(Group) Project 1 due Friday
Revision posted - Questions?
HW 3 Out
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Three Legs to Stand On
Pareto Efficiency
Make some better / make none worse
Kaldor-Hicks
Program adopted (NB > 0) if winners COULD
compensate losers, still be better
Fundamental Principle of CBA
Amongst choices, select option with highest
‘net’ benefit
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Welfare Economics
Concepts
Perfect Competition
Homogeneous goods.
No agent affects prices.
Perfect information.
No transaction costs /entry issues
No transportation costs.
No externalities:
Private benefits = social benefits.
Private costs = social costs.
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Profit Maximization under Perfect
Competition
P
P
S = MC
S
D
p
p = MR
D
q
Q
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Q
5
Benefits with WTP
Price
A
B
P*
0
1
2
3
4
Q*
Quantity
 Total/Gross/User Benefits = area under curve or
willingness to pay for all people = Social WTP = their
benefit from consuming = sum of all WTP values
 Receive benefits from consuming this much
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regardless of how much they pay to get it
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Net Benefits
Price
A
A
B
P*
B
0
1
2
3
4
Q*
Quantity
Amount ‘paid’ by society at Q* is P*, so total
payment is B to receive (A+B) total benefit
Net benefits = (A+B) - B = A = consumer
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surplus (benefit received
- price paid)
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Market Supply Curves
• 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
Supply=MC
Price
P*
PS*
P1
PS1
TVC1
Producer Surplus = Economic Profit
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TVC*
Q1
Q*
Quantity
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Social Surplus
Social Surplus = consumer surplus + producer surplus
Is difference between areas under D and S from 0 to Q*
Losses in Social Surplus are Dead-Weight Losses!
P
S
P*
D
Q*
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Q
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Allocative Efficiency
Allocative efficiency occurs when MC = MB (or S = D)
Equilibrium is max social surplus - prove by considering Q1,Q2
Price
S = MC
b
P*
D = MB
a
Q1
Q*
Q2
Is the market equilibrium Pareto efficient?
Yes - if increase CS, decrease PS and vice versa.
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Quantity
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Further Analysis
Price
A
CS1
P2
P*
0
1
2
C
B
Q2
Q*
Old NB: CS2
New NB: CS1
Change:P2ABP*
Quantity
Assume price increase is because of tax
Tax is P2-P* per unit, tax revenue =(P2-P*)Q2
Tax revenue is transfer from consumers to gov’t
To society overall , no effect
Pay taxes to gov’t, get same amount back
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But we only get yellow
part..
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Deadweight Loss
Price
A
CS1
P2
B
P*
0
1
2
Q*
Q1
Quantity
Yellow paid to gov’t as tax
Green is pure cost (no offsetting benefit)
Called deadweight loss
Consumers buy less than they would w/o tax
(exceeds some people’s WTP!) - loss of CS
There will always12-706
be and
DWL
when tax imposed
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Net Social Benefit Accounting
Change in CS: P2ABP* (loss)
 Government Spending: P2ACP* (gain)
Gain because society gets it back
Net Benefit: Triangle ABC (loss)
Because we don’t get all of CS loss back
OR.. NSB= (-P2ABP*)+ P2ACP* = -ABC
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Types of Costs
Private - paid by consumers
Social - paid by all of society
Opportunity - cost of foregone options
Fixed - do not vary with usage
Variable - vary directly with usage
External - imposed by users on non-users
e.g. traffic, pollution, health risks
Private decisions usually ignore external
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Pollution (Air or Water)
P
Typically supply (MC) only private, not
social costs. Social costs higher
for each quantity
S#:marginal
Social costs
S*: marginal
Private costs
P#
What do these curves,
Equilibrium points
tell us?
P*
D
Q#
Q*
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Q
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What is WTP by society to avoid?
P
Typically supply (MC) only private, not
social costs. Social costs higher
for each quantity
S#:marginal
Social costs
S*: marginal
Private costs
P#
P*
D
Q#
Q*
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Q
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What is WTP by society to avoid?
P
Differences in cost functions represent the
alternative ‘valuations’ of the product Thus difference between them
WTP to avoid costs
S#:marginal
Social costs
S*: marginal
Private costs
P#
P*
D
Q#
Q*
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Q
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Pollution (Air or Water)
P
Relatively too much gets produced,
At too low of a cost - how to
Reduce externality effects?
S#:marginal
Social costs
S*: marginal
Private costs
DWL
P#
P*
D
Q#
Q*
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Q
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Pollution (Air or Water)
P
Government can charge a tax ‘t’ on
Each unit, where t = distance between
What are CS, PS, NSB?
S#:marginal
Social costs
S*: marginal
Private costs
P#
t
P*
D
Q#
Q*
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Q
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Pollution (Air or Water)
P
CS = (loss) A+B
PS=(loss) E+F
S#:marginal
Social costs
S*: marginal
Private costs
P#
t
A
B
E
F
P*
P# - t
D
Q#
Q*
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Q
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Pollution (Air or Water)
P
Third parties: (gain) B+C+F
(avoided quantity between S curves)
Govt revenue: A+E
Total: gain of C
P#
C
A
B
E
F
S#:marginal
Social costs
S*: marginal
Private costs
t
C is reduced DWL
of pollution
eliminated by tax**
P*
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
P
Social
WTP
S-v
P0
P1
DM
Q0
Q1
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DS: represents
higher WTP
for rodent control
Q
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Social Surplus - locals
P
Make decisions based on S-v, Dm
What about others in society,
S
e.g. neighbors?
P
S-v
P1+v
P0
A
B
C
E
P1
DS
Because of vouchers,
Residents buy Q1
DM
Q0
Q1
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Q
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Nearby Residents
P
Added benefits are area between demand
above consumption increase
S
What is cost voucher program?
P
S-v
F
P1+v
P0
A
B
C
E
G
P1
DS
DM
Q0
Q1
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Q
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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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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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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
D+q’
S
P1
P0
a
Q0
Q1
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Quantity
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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
D+q’
S
P1
P0
a
Q2
Q0
Q1
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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+q’
D
S
P1
P0
A
B
C
E
G
G
Q2
F
G
Q0
Q1
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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+q’
D
S
P1
P0
A
B
C
E
G
G
Q2
F
G
Q0
Q1
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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
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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
MC
In perfect competition,
Equilibrium was at
(Pc,Qc) - where S=D.
But a monopolist has a
Function of MR that
Does not equal Demand
Pc
So where does he supply?
MR
Qc
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D
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Monopoly Analysis (cont.)
MC
Pm
Monopolist supplies
where MR=MC for
quantity to max.
profits (at Qm)
But at Qm, consumers
are willing to pay Pm!
Pc
What is social surplus,
Is it maximized?
Qm
MR
Qc
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D
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Monopoly Analysis (cont.)
MC
What is social surplus?
Orange = CS
Yellow = PS (bigger!)
Pm
Grey = DWL (from not
Producing at Pc,Qc) thus
Soc. Surplus is not
maximized
Pc
Qm
MR
Qc
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Breaking monopoly
D Would transfer DWL to
Social Surplus
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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.
a
Pm
We would have same
Social surplus.
d
P*
b
Qm
MR
e
AC
c
MC
Q*
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But natural monopolies
Are regulated.
D What are options?
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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*
b
Qm
MR
e
Society gains adeb
AC
MC
c
D
Q*
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Q0
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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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