MICROECONOMIC FOUNDATIONS
OF COST-BENEFIT ANALYSIS
Townley, Chapter 4
Review of Basic Microeconomics
• Slides cover the following topics from
textbook:
– Input markets.
– Decision making on the margin.
– Pricing mechanisms.
– Opportunity cost
Competitive Markets
•
•
•
•
•
•
•
Assume inputs are bought in input
markets.
Some projects will also produce
goods that are sold in output
markets.
Assume both of these markets are
perfectly competitive, this requires:
Good or service is homogenous.
There are many firms producing the
good or service so no firm can
dominate the market (firms are price
takers, i.e. no monopolists).
Households, firms, and consumers
are price takers (i.e. no one
dominates demand, so no
monopsonist).
No barriers to entry and firms earn
zero economic profits in LR
equilibrium.
– Total revenue for quantity of good sold in the
market is TR=P*Q
– Economists summarize sensitivity of quantity to
changes in price with elasticities:
• If elasticity of demand curve >1, then demand is elastic
and a fall in the price increases TR.
• If elasticity of demand curve <1, then demand curve is
inelastic and a fall in prices reduces TR.
• If elasticity =1, no change in TR if prices change.
– Elasticities also tell us about slopes of demand (as
well as supply curve).
• Elastic demand curves
are flatter.
• Inelastic demand curves
are steeper.
•
•
•
•
Another use of demand curve:
At 𝑃′ , the demand curve represents
the consumer’s marginal benefit, i.e.
most they would be willing to pay for
that unit. E.g. if had 𝑄′ −1units the
most one would pay for the 𝑄′ 𝑡ℎ unit
would be 𝑃′ . If household is
consuming 𝑄′′ −1 units, the most
that they would pay the unit would
be 𝑃′′ .
Marginal benefit declines as
consumption of the good increases
because of diminishing marginal
utility; as household consumes more
and more of a good or service so
extra units are worth less to it.
Demand curve is also sometimes
called a marginal benefits curve.
Supply, Marginal Cost and
Opportunity Cost:
• Supply curve shows the quantity of a good producers are willing to
produce and sell at each price.
• Upward shape indicates that producers will only expand production
if they are given incentives of a higher price.
• In perfect competition, firms earn zero economic profits in LR
equilibrium.
• How producers respond to price changes is measured by the
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑆
commodity price elasticity of supply =
•
𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
A profit maximizing firm will expand production as long as the price
exceeds marginal cost (increases profits).
• The price of the last unit produced will be exactly equal to marginal
cost.
Opportunity Cost
• What are the resource costs
associated with an input.
– In equilibrium S=D and 𝑃𝑒
and 𝑄𝑒 are equilibrium price
and quantity.
– D measures Marginal Benefit
– The maximum consumers will
be willing to pay for all the
units up to 𝑄𝑒 will be ORE𝑄𝑒
– S measures Marginal Cost (for
industry, industry supply
curve is sum of individual
supply / marginal cost
curves).
– Cost of producing units is
measured by the area
under the supply curve .
– The difference between
the maximum
consumers are willing to
pay and minimum firms
are willing to accept for
producing than is given
by RET, called the social
surplus.
• Social surplus can be split
into two pieces:
– Consumer Surplus –
Difference between
maximum they are willing to
pay, ORE𝑄𝑒 , and what they
actually pay O 𝑃𝑒 E𝑄𝑒 is 𝑃𝑒 RE.
– Producers Surplus –
Difference between what
producers receive O 𝑃𝑒 E𝑄𝑒
and minimum they are willing
to receive O 𝑇E𝑄𝑒 is 𝑃𝑒 𝑇E.
• Sum of Producers and
Consumers Surplus = Social
Surplus.
• Competitive markets maximize the sum of producer
and consumer surpluses.
• Competitive markets maximize social surplus because
they accommodate all transactions that are mutually
advantageous and reject any that are not.
• In other words, competitive equilibrium is optimal.
• Alternatively, equilibrium exhibits allocative efficiency
or it is efficient. An allocation of resources is Pareto
optimal (efficient) if it is impossible to find another
allocation (level of output) such that at least one
economic agent is made better off and no economic
agent is made worse off.
• The above analysis
applies to both output
market (for finished
goods) and input
markets (labour).
• Market equilibrium
reflects market clearing
at a particular point in
time, but sometimes
factors affect
equilibrium.
Demand Shifts
• Population may have
increased.
• Government may require
more of an input.
• Price of a substitute good may
have decreased / increased.
• Price of a complementary
good may have decreased /
increased.
• Consumer’s preferences may
have changed.
• If a normal good, demand
increases if income increases.
• If an inferior good, demand
decreases if income increases.
Supply Shifts
• Increase in number of firms,
attracted by positive profits.
• Increases in supply may have
been produced by a newly
constructed government
project.
• Price of a product that is a
substitute in production may
have decreased.
• Government may legislate
subsidies or taxes.
• Technology changes.
• Agricultural products (change
in climate).
• SR economic profits can be positive or
negative.
• In LR economic profits are zero, firms enter
and leave market.
Market Failure
• Markets don’t always work properly.
• Might be monopolies who produce less than
optimal amount of output.
• Might also be problems with information,
insurers may not always be able to judge risks
associated with someone who wants
insurance.
• More specific problems.
Externalities
• Consumers purchase additional units of a good as
long as their private marginal benefits exceed the
price they pay.
• People are motivated by their self-interest only;
they don’t care if their consumption makes
someone worse off. E.g. smoking – negative
effects on non-smokers; gardens – positive effects
on all.
• In producer markets, pollution may be an issue.
• Why do externalities make a difference?
• The classic example is the firm that pollutes.
•
•
•
•
•
•
•
•
•
P subscript private cost; S subscript social.
private supply curve (sum of individual
curves).
Private costs are only measured in 𝑆𝑝 ,
𝑀𝐶𝑝 .
Private and external costs are measured in
𝑆𝑆 , 𝑀𝐶𝑠 .
From societies perspective we should
produce this good until the MB to society
equals the marginal cost point where
D=𝑆𝑆 .
Social optimum will have less output than
perfectly competitive output, 𝑄𝑐 .
Cost to society of extra units is area under
between these two output levels .
Net welfare loss RTB.
Can eliminate this distortion by imposing a
tax so that producers will account for
externalities.
Public Goods
• Some goods have benefits which can only be
consumed by one person other goods may
have benefits which don’t exclude multiple
economic agents from consuming it, e.g.
street lights, national defence.
• For a public good produce it as long as the
marginal benefit society derives from it
exceeds marginal cost or producing it.
• Coming up with demand curves is different.
• Why is it different?
• Public goods are non-rival. Just because I
consume it does not take any away from you.
• Take vertical sum, not horizontal sum.