Measuring Costs and Benefits Measuring Benefits and Costs

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Measuring Costs and Benefits • Measuring Benefits and Costs (See Chap 4): – Consumers’

Measuring Costs and Benefits • Measuring Benefits and Costs (See Chap 4): – Consumers’ Willingness to Pay (WTP) – Consumer Surplus (CS) – Producers’ Surplus (PS) – Social Surplus (SS) – Review discussion of Fig. 4. 2; 4. 3 • Measuring Benefits in Secondary Markets (See Chap 5)

Measuring Benefits Utility Theory Utility Assumption: Diminishing Marginal Utility Quantity Consumed

Measuring Benefits Utility Theory Utility Assumption: Diminishing Marginal Utility Quantity Consumed

Measuring Benefits • Diminishing marginal utility • What evidence do we have that individuals’

Measuring Benefits • Diminishing marginal utility • What evidence do we have that individuals’ utilities have this property? • “Revealed preferences” – At lower prices, people consume more. – As prices increase, the amount people consume decreases

Measuring Benefits Individual Demand Curve Price P 0 X 0 P 1 X 1

Measuring Benefits Individual Demand Curve Price P 0 X 0 P 1 X 1 Q 0 Q 1 D Quantity Consumed

Measuring Benefits • Demand curve shows actual expenditure behaviors of individuals – When goods

Measuring Benefits • Demand curve shows actual expenditure behaviors of individuals – When goods are scarce, people willing to pay high price – When goods are abundant (people are already consuming a lot), people willing to pay only a lower price • Measured in monetary terms • Note: Consumers’ expenditure behaviors are constrained by their budgets! • Demand response has both substitution (pure preferences) and income effects

Market demand curves • Market demand curve is (horizontal) sum of individual demand curves

Market demand curves • Market demand curve is (horizontal) sum of individual demand curves

Market demand curves Individual 1 P Individual 2 Market P D 1 q 1

Market demand curves Individual 1 P Individual 2 Market P D 1 q 1 DM D 2 Q q 1+q 2 Q

Measuring Benefits • Demand curve – Willingness to pay for different quantities • In

Measuring Benefits • Demand curve – Willingness to pay for different quantities • In market exchanges, consumers to not actually pay all that they would be willing to pay. • Producers are not able to discriminate prices charged for each unit sold.

Price Measuring Benefits Market Equilibrium WTP 0 S CS Pe D Actual Expenditures Q

Price Measuring Benefits Market Equilibrium WTP 0 S CS Pe D Actual Expenditures Q 0 Qe Quantity

Measuring Benefits • Difference between WTP and actual expenditures is Consumer Surplus CS. •

Measuring Benefits • Difference between WTP and actual expenditures is Consumer Surplus CS. • WTP is theoretically correct measure, and of benefits from an activity. – Includes transfers (to producers) • CS is measure of “net” benefits – widely used in empirical studies – Based on estimated market demand curves

Price Measuring Benefits Market Equilibrium WTP 0 S Consumer Surplus Pe WTP D Actual

Price Measuring Benefits Market Equilibrium WTP 0 S Consumer Surplus Pe WTP D Actual Expenditures Q 0 Qe Quantity

Price S 0 S 1 CS 0 ∆CS D WTP 0 ∆WTP Quantity

Price S 0 S 1 CS 0 ∆CS D WTP 0 ∆WTP Quantity

Measuring Benefits • WTP and CS do not change if market price does not

Measuring Benefits • WTP and CS do not change if market price does not change, and • Perfectly elastic demand curve • Example – Expanding electricity production in Mozambique

Mozambique market for electricity DM DSA PSA QD 0 QS 1

Mozambique market for electricity DM DSA PSA QD 0 QS 1

Measuring Benefits • WTP and CS do change if market price does not change

Measuring Benefits • WTP and CS do change if market price does not change and • Constant, or administratively controlled price (and shift in supply) • Example: increase in local cable distribution capacity (cable access price determined in national market)

Local Market for Cable Connections D (Marginal WTP) P* A (CS 0) C (

Local Market for Cable Connections D (Marginal WTP) P* A (CS 0) C ( CS) B (EXP 0) D ( EXP) Q 0 Q 1

Measuring Costs • Area under supply curve (MC curve) • Analogous to consumer, in

Measuring Costs • Area under supply curve (MC curve) • Analogous to consumer, in market exchanges, producers’ revenues are greater than minimum necessary to meet their production costs • Assumptions: – Perfect competition – Profit-maximization (MR = MC)

Measuring Costs Total Revenue, Cost TC TR TRe Profit TCe Qe Quantity

Measuring Costs Total Revenue, Cost TC TR TRe Profit TCe Qe Quantity

Measuring Costs Marginal Revenue, Cost S=MC P=MR Profit Quantity

Measuring Costs Marginal Revenue, Cost S=MC P=MR Profit Quantity

Measuring Costs • What factors may cause supply curve to shift? – Technological change

Measuring Costs • What factors may cause supply curve to shift? – Technological change – Prices of inputs • May change due to infrastructure invesments – Government policies – taxes/subsidies

Social Surplus S CS Pe PS D Qe

Social Surplus S CS Pe PS D Qe

Social Surplus • Social Surplus = Consumer surplus + Producer Surplus • Social surplus

Social Surplus • Social Surplus = Consumer surplus + Producer Surplus • Social surplus is maximized in competitive markets – Assuming no market imperfections! – Assuming no externalities!

Change in Social Surplus • Annual policy: ∆W = ∆CS + ∆ PS +

Change in Social Surplus • Annual policy: ∆W = ∆CS + ∆ PS + ∆GS + ∆EE CS = Consumer Surplus PS = Producer Surplus GS = Government Surplus EE = External Effect • Investment project: ∆W = -[Initial Investment] + ∑i(∆CSi+∆PSi+∆GSi+∆EEi) Over i years of useful life of the investment

Review Boardman Figure 4. 3

Review Boardman Figure 4. 3

Local Market for Cable Connections CS PS PS P* S 0 D S 1

Local Market for Cable Connections CS PS PS P* S 0 D S 1

Local Market for Cable Connections Net Benefit = - [Initial investment] + ∑i{dfi(∆CSi +

Local Market for Cable Connections Net Benefit = - [Initial investment] + ∑i{dfi(∆CSi + ∆PSi)} ∆PS and ∆PS summed over the i years of the useful life of the investment (discounted by discount factor dfi)

Mozambique market for electricity DM S 0 CS PSA S 1 DSA PS ∆PS

Mozambique market for electricity DM S 0 CS PSA S 1 DSA PS ∆PS FX QD 0 ∆FX QS 0 QS 1 With international trade, need to add changes in Foreign exchange (FX) flows

Mozambique market for electricity Net Benefit = - [Initial investment] + ∑i{dfi(∆PSi + ∆FXi)}

Mozambique market for electricity Net Benefit = - [Initial investment] + ∑i{dfi(∆PSi + ∆FXi)} ∆PS and ∆FX summed over the i years of the useful life of the investment (discounted by discount factor dfi)