12/10/2021 Cost benefit analysis Lecture 2 Toolkit for CBA · Microeconomic theory provides a basis for the valuation of social costs and benefits · Some assumptions - presence of perfect competition (price takers) - easy market entry and exit - homogenous goods (substitutes) - no information asymmetry - no transaction cost - no externalities Demand Curve: · Individual demand curve indicates the quantity individual wishes to consume as a function of market price · Market demand curve is the horizontal sum of all individual demand curves · Inverse demand curve gives the highest price someone is willing-to-pay for an additional unit of the good (more useful) consumer surplus = total benefits (WTP) - total expenditures Quality or service of a good determined by CS. Presence of externalities is why we need government intervention. Decrease in price = higher demand = increase in consumer surplus Tax imposed on market = price increased = demand decreases = lower consumer surplus = government revenue in area lost by consumer surplus (transfer) = Deadweight loss of surplus appears Supply curve: Supply curve indicates the marginal cost of each additional unit of the good produced Market supply is the horizontal sum of supply curves of all firms in the market Producer surplus is the supply side equivalent of consumer surplus. It is the benefit going to firms Without government intervention, social surplus = consumer surplus + producer surplus Represented by marginal cost curve - upward sloping, as you increase size of production MC increases. Lowest point of the AC curve meets the MC curve. Market supply curve is also upward sloping. Willingness to pay and opportunity cost. P*Q is net revenue Allocative efficiency · Demand curve reflects marginal benefit · Supply curve reflects marginal cost · At equilibrium, - demand equals supply - marginal cost equals marginal benefit . Net social surplus is maximized -> the outcome is Pareto-efficient . This is the first fundamental theorem of welfare economics -> a competitive equilibrium is economically efficient · In a perfectly competitive market, anything that interferes with the process will reduce allocative efficiency
. In most circumstances, the government must interfere only when the market is distorted · By reducing market distortions, the government can reduce the deadweight loss and increase the net social surplus Government restricts output below equilibrium quantity. = consumer surplus decreases, producer surplus rises further to where the consumer surplus used to be. But there is a deadweight loss due to the policy. Government surplus . Thus far, we focused only on consumers' and producers' surplus · To ease our analysis, it is useful to treat the government as a separate player · For a comprehensive analysis, CBA analyst should also include government surplus (GS) · SS = CS + PS + GS · To evaluate a policy, we calculate the change in social surplus · ASS = ACS + APS + AGS Target pricing = minimum price above price at equilibrium = willing to supply more = consumers less willing to