Highlights
Chapter 4 & 5
Econ 4140
Greg Mason
Willingness to pay view of CBA
Benefits = willingness to pay to gain wanted outcomes
Costs = willingness to pay to avoid unwanted outcomes
Valuation in efficient markets – no effect on price.
• Increase in supply has no effect
on price.
• Gross social benefits = net
government revenue generated by
the program + change in social
surplus.
• Supply shift to the right (publicly
provided good) increases benefits
to consumers (S → S+q’).
− The cost to the consumer of the
new amount (q’) is offset by the
benefits of consuming more
− Only benefit is the increased
revenue to supplier –
government or (abq1q0)
• Supply shifts due to cost
reduction which increases
benefits to producers.
− Benefit is the increase in
producer surplus (abde)
Valuation in efficient markets – supply reduces price
• Downward sloping demand
• Increase in supply cases price to
fall and change in social surplus is
abc.
Three scenarios
a. If goods are distributed free the
increase in consumer surplus is
cbq1q0 and the total is area abc
+ cbq1q0
b. If good goes to consumers
without charge, some receive
the product who would not have
purchased at P1.
c. Assume q due to increase in
supply arises from cost
reduction
−increase in consumer surplus
is P0P1ab
−change in producer surplus
is P0ae-P1bd or ecbd-P0abP1
• Note that that the last scenario is
the most realistic.
Valuation in inefficient markets – monopoly power
reduces price
P0
X
• Monopoly – market demand is the
revenue schedule
• Marginal revenue is lower than the
average revenue (MA<AR).
• Profit maximization at MC=MR
• Consumer surplus – P0Pma
• Producer surplus – Pmabx
• The social surplus under monopoly is
P0abx
• The social surplus under competition is
P0cX.
• The deadweight loss is the reduction in
social surplus due to monopoly.
Natural Monopoly
• Always defined by falling average cost over the
region where demand exists for any price >0
• Typical in capital intensive industries, or
industries with high entry/exit barriers, and
knowledge barriers
• Policies to deal with natural monopoly
− Ignore and accept deadweight loss
− Regulate (price so that price set at AC =
AR)
− Regulate (price so that MC=AR)
− Allow free access (accept social cost that
demand exceeds marginal cost)
• Natural monopolies usually erode due to
technical change – high profits create incentives
to innovate.
• Policy may create temporary monopolies to
induce innovation (e.g., pharmaceuticals).
Demand > 0, AC falling
Information asymmetry
•
•
•
•
•
Present in every market
Imbalance between information held by sellers and
buyers
− Buyers can have the edge in labour markets
(they know what the job truly entails)
− Sellers (job applicants) can have the edge if
they fabricate experience.
Where sellers have information, the presumption is
that the demand would fall as addition
product/service attributes become known to the
buyer (Du → Di).
The information asymmetry transfers PuPica to the
seller from the buyer, and the deadweight loss is
acd.
Policies
− Caveat venditor and caveat emptor
− Private market (Consumer Reports)
− Public provision of information)
Externality
Externalities create a divergence of
marginal private and marginal social costs.
• Negative externality MSC > MPC
• Positive externality MSC < MPC
• Negative externality reduces consumer
and producer surplus
• S# - S* = social costs = WTP to avoid the
costs.
• Market will under price good/service and
too much is produced.
• Taxation is the standard policy with the
level set “t”, price shifts to P# and
quantity drops to Q#.
Positive externalities work in reverse,
subsidies to increase consumption.
Benefits
Costs
Consumer
A+B
Producer
E+F
Third Parties
B+C+F
Gov. Rev.
A+E
Social Benefit
C
Externality
Make sure you can explain
the mechanics of a positive
externality
Public vs. private goods
Private goods – demand sums
horizontally
MB is the marginal
social benefit
Consumer A
demand falls to 0
Public goods – demand sums
vertically
Opportunity cost – no price effect.
When a program has a negligible effect on the demand for an
input, prices are not affected.
The amount paid for the inputs = social costs when input
markets are competitive and the amount demanded is small
in relation to the total market.
Opportunity cost – in elastic supply.
When a program has a major effect on the demand
for an input, prices are affected and prices face by
others will be affected.
Major spending (stimulus package) can have regional
impacts that are adverse. An opportunity cost exists
Keynesian macro policy, when factor markets are not
efficient.
Using national stimulus to increase demand to
address unemployment in the southern Ontario
market, can have an adverse impact on construction
markets in Saskatchewan that are fully employed.
Opportunity cost of inputs
• All resources have opportunity costs.
• Government (or anyone) entering the market will raise the
demand for resources.
• Price will rise as more is demanded.
• The non-project demand and supply produces P0 and q0 for
the inputs.
• The project shifts the demand by q’ with the resultant
increase in resource cost of B+C+G+E+F
Increase in producer surplus
Reduction consumer surplus
for buyers
General rule – opportunity cost of resources equals the
expenditure on (-/+) any increase/decrease in social surplus in
factor markets
Impact of a government project on labour
• The equilibrium wage is Pe, but a wage floor (Pm)
reduces demand and increases supply (Ld and Ls)
• Unemployment is Ls – Ld
• The project increases labour demand by L’
• At the price floor this reduces unemployment by Lt-Ls
• The shaded area measures the social cost of hiring
the unemployed workers which is less than the
private cost (abLtLe).
• The core idea is that in unemployed markets, the
social cost of the resource is less than the
private cost.
Opportunity cost in purchasing from a monopoly
• Monopoly will result in the cost of acquisition being
above the social cost.
• At equilibrium (MR=MC) before the project, quantity
purchased is Q1 at a price of P1.
• The project raises demand and price rises to P2 and
quantity Q2. The rise in price reduces private
demand and government purchases Q2-Q3.
• Total cost to government is A+C+G+E.
• The original buyers lose surplus = B+C
• Monopolist gains B+C+G+E
• Net social cost is A+C
General rule – since all factor markets have some degree of
market power, large projects (public and private) impose costs
on existing purchasers