Highlights Chapter 4 & 5

Econ 4140

Greg Mason

Willingness to pay view of CBA

Benefits = willingness to pay to gain wanted outcomesCosts = 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 scenariosa.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

• 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.

P0

X

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 CostsConsumer 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

Public goods – demand sums vertically

Consumer A demand falls to 0

MB is the marginal social benefit

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.

• 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

General rule – opportunity cost of resources equals the expenditure on (-/+) any increase/decrease in social surplus in factor markets

Increase in producer surplus Reduction consumer surplus for buyers

Opportunity cost of inputs

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