3 Cost – Benefit Analysis OutlineDefinitionPrinciples of applied welfare economicsa) Welfare measurement for individualsb) Aggregated welfare measurementWelfare measurement in a closed economya) without state intervention: technological progressincrease of real incomeb) with state intervention: taxes/subsidiesWelfare measurement in an open economy
4 Cost-benefit analysis -what is it about?- Government must make decisions regarding the adoption of public policies and projects. The branch of economics that deals with how to evaluate proposed policies/projects is known as cost-benefit-analysis or applied welfare economics
5 Cost-Benefit-Analysis or Applied Welfare Economics Objective How to use resources optimally to achieve the maximum well-being for the individualls in society or more simply to help society make better choices
6 Principles of applied welfare economics I “Welfare economics is the study of how the allocation of resources affects economic well-being” (Mankiw, 2004, p. 138).Assumptions:welfare increases with an increase of the consumtionthe social welfare is the sum of the welfare of all individualsutility can be measured cardinally and the utility of individuals can be comparedallocation of resources depends on the followed policyconsumer sovereigntypartial analysis
7 Principles of applied welfare economics - Starting points -perfect competitionno external effectsKaldor-Hicks criterion (compensation test):„State B is preferred to state A if at least one individual is made better off without making anyone worse off – not that all individuals are actually worse off – by some feasible redistribution (compensation) following the change. (Just et al., 2004, p. 32)the Pareto criterion is not used(„if it is possible to make at least one person better off when moving from state A to state B without making anyone worse off, state B is ranked higher by society than state A“ Just et al., 2004, p. 15)a reference system is used
8 Welfare measurement of a single consumer I Conditions:utility is difficult to be observed and to be measuredapproximation for the measurement of utility: monetary unitsbut: income and consumption decisions at various prices are observed and based on that money-based measurements of welfare effects are measured (Just et al., 2004, p. 98) !!!!!!
9 Four possible Buyers’ Willingness to pay JohnPaulGeorgeRingo100807050
10 The Demand Curve Quantity of Albums Price of Album (€) Demand Willingness to pay John10080Willingness to pay Paul70Willingness to pay George50Willingness to pay Ringo1234Quantity of Albums
11 Measuring Consumer Surplus with the Demand Curve Price of Album (€)(a) Price = € 80DemandJohn’s Consumer Surplus(€ 20)1008070501234Quantity of albums
12 Measuring Consumer Surplus with the Demand Curve Price of Album (€)(b) Price = € 70DemandConsumer Surplus John(€ 30)100Consumer SurplusPaul (€ 10)8070Total Consumer Surplus (€ 40)501234Quantity of Albums
13 How the Price Affects Consumer Surplus Consumer Surplus at different PricesPriceABCDemandInitial Consumer SurplusConsumer Surplusto New ConsumersAdditional Consumer Surplus to Initial ConsumersP1Q1DEFP2Q2Quantity
18 Welfare measurement of a single consumer II Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it.Consumer surplus measures the benefit buyers get from participating in a market.Consumer surplus can be computed by finding the area below the demand curve and above the price.
19 Production Costs of Four Possible Sellers Maria900Luise800Georgine600Grandmother500
24 How the Price Affects Producer Surplus (a) Producer Surplus at Price P1PriceSupplyBCAP1Producer SurplusQ1Quantity
25 How the Price Affects Producer Surplus (b) Producer Surplus at Price P2PriceAdditional producersurplus to initial producersSupplyDEFP2Q2Producer surplusto new producersBP1CInitial producersurplusAQ1Quantity
29 Welfare measurement of a single producer Producer surplus equals the amount sellers receive for their goods minus their costs of production.Producer surplus measures the benefit sellers get from participating in a market.Producer surplus can be computed by finding the area below the price and above the supply curve.
30 Welfare measurement of a single producer and consumer
31 Principles of applied welfare economics -aggregation over individuals-
32 Principles of applied welfare economics -aggregation over individuals-
34 Social Welfare -the willingness to pay concept-
35 Social Welfare -the willingness to pay concept-
36 Social Welfare -the willingness to pay concept-
37 Social Welfare -the surplus and the willingness to pay concept-
38 Both concepts should give the same result! Social WelfareWillingness to Pay concept(direct)W = WtP – VCW WelfareWtP Willingness to Pay(„Nutzen“)VC variable costsSurplus concept(indirect)W = CS + PSW welfareCS consumer’s surplusPS producer’s surplusBoth concepts should give the same result!
39 Efficieny of the market equilibrium With the help of consumer and producer surplus we can answer the following question:is the allocation of resources through the market function somehow wished?The allocation of the resources is efficient when the maximum total surplus is achieved
41 Efficieny of the market equilibrium With the help of consumer and producer surplus we can answer the following question:is the allocation of resources through the market function somehow wished?The allocation of the resources is efficient when the maximum total surplus is achieved
42 Evaluation of the market equilibrium Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.This policy of leaving well enough alone goes by the French expression laissez faire.
43 Three Insights Concerning Market Outcomes Market EfficiencyThree Insights Concerning Market OutcomesFree markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.Free markets allocate the demand for goods to the sellers who can produce them at least cost.Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
44 Both concepts should give the same result! Social WelfareWillingness to Pay concept(direct)W = WtP – VC + (C)W = WtP – VC + (ER – IE)W WelfareWtP Willingness to Pay(„Nutzen“)VC variable costs(C Net foreign currency refundER Export RefundIE Import Expenditure)Surplus concept(indirect)W = CS + PS + StW welfareCS consumer’s surplusPS producer’s surplusSt Budget effects ortaxpayer’s effectsBoth concepts should give the same result!
45 Welfare effects of income increase price PS = b + c CS = + a – b W = + a csupply WtP = +a+c+d+e-[ VC = +d+e ] W = +a+cbD1D0quantity
46 Welfare effects of technological progress CS = +a+b+c PS = –a d+e W = +b+c+d+epriceS0S1 WtP = +c +e+f-[ VC = –b –d +f ] W =+b+c+d+eDfquantity
47 The deadweight loss of taxation - production tax as amount of tax per production unit-Producer iMarketquantitypricetMCiSi=2qQSiQSi,newMCi newSi new =2q+tS0S1DQS,DQS,DmewP0PDPSabcdΔCS=-a-bΔPS=-c-dΔSt=a+cΔW=-b-dP0
49 The Equilibrium without international trade Equilibrium Without TradeResults:Domestic price adjusts to balance demand and supply.The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive.
50 The determinants of trade Equilibrium Without TradeAssume:A country is isolated from rest of the world and produces steel.The market for steel consists of the buyers and sellers in the country.No one in the country is allowed to import or export steel.
51 Determinants of tradeWhat determines whether a country imports or exports a good?Who gains and who loses from free trade among countries?What are the arguments that people use to advocate trade restrictions?
52 The World Price and Comparative Advantage If the country decides to engage in international trade, will it be an importer or exporter?
53 The World Price and Comparative Advantage The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. The world price refers to the price that prevails in the world market for that good.
54 The World Price and Comparative Advantage If a country has a comparative advantage, then the domestic price will be below the world price, and the country will be an exporter of the good.
55 The World Price and Comparative Advantage If the country does not have a comparative advantage, then the domestic price will be higher than the world price, and the country will be an importer of the good.
59 How Free Trade affects welfare in an exporting country
60 The winners and losers from trade The analysis of an exporting country yields two conclusions:Domestic producers of the good are better off, and domestic consumers of the good are worse off.Trade raises the economic well-being of the nation as a whole.
61 The gains and losses of an importing country International Trade in an Importing CountryIf the world price of steel is lower than the domestic price, the country will be an importer of steel when trade is permitted.Domestic consumers will want to buy steel at the lower world price.Domestic producers of steel will have to lower their output because the domestic price moves to the world price.
66 How Free Trade affects welfare in an importing country
67 The winners and losers from trade How Free Trade Affects Welfare in an Importing CountryThe analysis of an importing country yields two conclusions:Domestic producers of the good are worse off, and domestic consumers of the good are better off.Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.
68 The winners and losers from trade The gains of the winners exceed the losses of the losers.The net change in total surplus is positive.
69 The effects of a tariffA tariff is a tax on goods produced abroad and sold domestically.Tariffs raise the price of imported goods above the world price by the amount of the tariff.
70 The effects of an import tariff (small country) piacpwbdDqqwAqiAqiNqwNqiMqwM
71 The effects of an import tariff (small country) PS = + a CS = – a – b – c – d St = + c W = – b – dpiacpwbdDqqwAqiAqiNqwNqiMqwM
72 The effects of an export subsidy (small country) pipwabcdDqqiDqwDqwSqiSqwXqiX
73 The effects of an export subsidy (small country) pi PS = + a + b + c CS = – a – b St = - [b + c + d ] W = – b – dpwabcdDqqiDqwDqwSqiSqwXqiX
74 The effects of an export subsidy (small country) decrease of Willingness to PaySpiincrease of variable costspwDqqiDqwDqwSqiS
75 The effects of an export subsidy (small country) decrease of Willingness to PaySpiincrease of variable costspwincrease of export refundDqqiDqwDqwSqiS
76 What happens if a country is a big one and applies a foreign trade policy? Change of domestic price level due to import tariff and/or export subsidyChange of imported/exported quantities (i.e. lower quantity is imported and more is exportedIncrease of supply in the world marketsDecrease of world market prices!
77 Why does the higher export supply decrease the world market price? EA=Export Supply= (Exportangebot)IN=Import Demand=(Importnachfrage)Quantity
78 Welfare Effects of the guaranteed Price (Big exporting country) Assumption: The higher export supply leads to the decrease of the world market price from Pw to P`wΔCS = -b-cΔPS = b+c+dΔST = -(c+d+e+g+h+i)ΔW = -c-e-g-h-iAllocation TOTLosses LossesQuantity
79 SummaryThere are various arguments for restricting trade: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions.Economists, however, believe that free trade is usually the better policy.
80 References used, suggested reading Henrichsmeyer, W. and H. P. Witzke (1994). Agrarpolitik Band 2, Bewertung und Willensbildung. Stuttgart: Eugen Ulmer VerlagJust, R. E., Hueth, D. L. and A. Schmitz (2004). The Welfare Economics of Public Policy, A Practical Approach to Project and Policy Evaluation. Edward Elgar Publishing.Mankiw, N. G. (2004). Principles of Economics, 3rd Edition. Thomson South-Western.
82 Cost – Benefit Analysis OutlineRecap - Welfare measurement in an open economyExternal effectsa) negative externalitiesb) positive externalitiesMarket power and rent seeking: monopolySecond best theory: a) monopoly and negative ext. effectsb) price support and unemploymentWelfare measurement of multiple price changesEmpirical examples of cost-benefit Analysis
83 Welfare measurement of a single consumer priceConsumer surplus(CS)Consumer expenditure (CE)p*CS = WtP – CEDquantityq*
84 Welfare measurement of a single producer priceSproducer’s surplus (PS)Variable Costs (VC)p*PS = PR – VCquantityq*
85 Welfare measurement of single producers & consumers priceSconsumer’s surplusproducer’s surplusp*Dquantityq*
86 Both concepts should give the same result! Social WelfareWillingness to Pay concept(direct)W = WtP – VC + (C)W = WtP – VC + (ER – IE)W WelfareWtP Willingness to PayVC variable costsC Net foreign currency refundER Export RefundIE Import Expenditure)Surplus concept(indirect)W = CS + PS + StW welfareCS consumer’s surplusPS producer’s surplusSt Budget effects ortaxpayer’s effectsBoth concepts should give the same result!
87 Calculation of CS and PS ExerciseCalculation of CS and PSGiven a demand function: XD = 12 - p and a supplyfunction: XS = 2 p1. find p* and x * used in the demand or supply functions2. calculate the consumer surplus (CS)3. calculate the produce surplus (PS) and the total welfare
89 The deadweight loss of taxation - production tax as amount of tax per production unit-Producer iMarketquantitypricetMCiSi=2qQSiQSi,newMCi newSi new =2q+tS0S1DQS,DQS,DmewP0PDPSabcdΔCS=-a-bΔPS=-c-dΔSt=a+cΔW=-b-dP0
91 The effects of an import tariff (small country) PS = + a CS = – a – b – c – d St = + c W = – b – dpiacpwbdDqqwAqiAqiNqwNqiMqwM
92 Welfare Effects of the guaranteed Price (Big importing country) Assumption: The lower import demand leads to the decrease of the world market price from Pw to P`wPriceΔCS = -a-b-c-dΔPS = aΔST = c+eΔW = -b-d+eAllocation TOTLosses LossesQ
93 Welfare Effects of the guaranteed Price (Big exporting country) Assumption: The higher export supply leads to the decrease of the world market price from Pw to P`wΔCS = -b-cΔPS = b+c+dΔST = -(c+d+e+g+h+i)ΔW = -c-e-g-h-iAllocation TOTLosses LossesQuantity
94 ExternalitiesAn externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander (Mankiw, 2004)Case when an action of an economic agent affects the utility or production possibilities of another in a way that is not reflected in the market place (Just et al., 2004)
95 ExternalitiesAppear when there is influence of the economic activities of producer or consumers (economic units) over other economic units, they cause advantages or disadvantages without being evaluatedExternalities cause markets to be inefficient, and thus fail to maximize total surplusNegative externalities lead markets to produce a larger quantity than is socially desirable.Positive externalities lead markets to produce a smaller quantity than is socially desirable.
96 Negative external effects How can I show in this diagram the social effects?priceSMC privateWith the help of the damage function!Dquantity
97 Damage function= Relationship between production quantities and negative external effectsExternal effect in monetary unitsNegative external effect (NEE) =¼ q2quantityMarginal External Effect (MEE) =
99 Negative external effects (without trade) Reference system: qsocialpriceS*ΔVCsocial = ΔVCprivate + ΔVCext= c + d + d= c + d + a + bSMC privatepsocialthe social cost exist but nobody takes them into accountapprivatebMEEcdDqsocialqprivatequantity
100 Internalising an externality Altering incentives so that people take into account the externality and act analogous
101 The Types of Private Solutions Moral norms and social sanctionsVoluntary organizations (foundations and associations)Contracts between parties
102 Coase Theorem:The private economic actors can solve the problem of externalities among themselves. Whatever initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient.
103 Why private solutions do not always work? Transaction costsBreakdown of agreementsCoordination problem of the large number of interested parties
104 Internalising an externality Achieving the Socially Optimal OutputThe government can remedy an externality by Regulation, i.e. making certain behaviours either required or forbidden orby using market based policies like imposing a tax (or a subsidy) on the producer to reduce (or increase) the equilibrium quantity to the socially desirable quantity. Example Pigovian Taxes
105 Internalising an externality Pigovian taxesS* MC socialpriceΔCS = -a-b-cΔPS = -e-f-gΔST = a+b+e+fΔEA1 = g+c+dΔW = +dSMC privateP1dthe social cost exist but nobody takes them into accountIf we move more towards left (ban of production) then the utility gets reduced, but again we have very low variable costs. Nevertheless in total the welfare losses are higher than the savings from lower costs.An extreme case would be that the marginal external cost so high that the marginal social cost cuts the demand curve in the ypsilon axis where the quantity is zero. In this case the welfare optimum is reached with a ban of production (like nuclear energy, nuclear weapons)abcPogefP21 External AgentsDqsocialqprivatequantity
106 Positive external effects (with trade) Import tariff:priceSMC privateΔU = -d-e-(ΔVCs) = -(+c)-(ΔIE) = -(-b-c-e)ΔW = +b-dS*First best policy producer subsidy!But there is a difference for the country’s budget because with an import tariff the country benefits from a revenue, while the subsidy is an expenditure, so what to do??Maybe a country would prefer the option of the tariff and when this is the case it should see how to get the most out of it, thus set the tariff so high that areas b=d and this would be a second-best policyby-product distortionPiProducer subsidy:adΔU = 0-(ΔVCs) = -(+c)-(ΔIE) = -(-b-c)ΔW = +bPwbecDquantityqS,pqS,sqD,2qD,1
107 Monopoly D price Pcomp. qcomp. quantity The producers make a cartel (an association) and form a monopoly.No change in the technology thus no change in the marginal costDqcomp.quantity
108 D selling price function MonopolypricePmonPcomp.Thus to find the quantity the monopolist will produce we need the marginal revenue curve of the monopolist and with the help of the demand function we find the selling price that applies under the monopolyWHY is it so???D selling price functionqmon.qcomp.quantityMRmonopoly
113 D selling price function MonopolypricePmonabΔCS = -a-bΔPS = +a-cΔbudget= 0ΔW = -b-cPcomp.Reference system polypolyThese are the social costs of forming a monopoly.Nevertheless we show that the monopoly rent is area a, meaning that for the monopolist it worths operating so that a>c , or else it makes no sense for himRent seeking: seeking for distributions-profits, but that entails costs, like corrupting politicians so as to get the wished legislation etc.(!)These rent-seeking costs should no way exceed the area a or else the monopolist has no rent, and thus no benefit from being a monopolist!!!cD selling price functionqmon.qcomp.quantityMRmonopoly
114 Monopoly and negative external effects D selling price function SsocialSprivatePmon--Pcomp.In case though we have negative external effects,if we do not take them into account we will have losses of triangle XXXbut if a monopoly exists in the market then the welfare loses would be only as high as the triangle XX which is smaller, meaning that the welfare losses are lower and thus there is a gain for the society!D selling price functionqmon.qsqcomp.quantityMRmonopoly
115 Monopoly and negative external effects D selling price function SsocialSprivatePmonPcomp.In case though we have negative external effects, as shown in this graphic then,D selling price functionqmon.qsqcomp.quantityMRmonopoly
116 Price support and unemployment SprivatePi--Pwquantity
117 Price support and unemployment SprivateΔU = -b-e-(ΔVC) = -(+g)ΔER = e+f+g-(ΔIE) = 0ΔW = -b+fSsocialWhen there is unemployment and assuming that the opportunity costs of labour are zero, then the extra resources (labour)that are required so as to produce more can come from the unemployed and in this case it is as if we are in the case of a internalising a positive externality!PiabcdPwfegquantity
118 Welfare measurement of multiple price changes Input (factor) marketOutput marketwagepriceS(W0)aSo far what we have done is to measure welfare in the output market. But there are cases that changes occur but we cannot measure them because of lack of data, but it can be that we have enough data to measure the derived demand in an intermediate market. For example it can be possible to estimate the demand for iron at the industry level but not the marginal cost curve for steel production for an individual firm. In such a case it would be great if we could measure the welfare effects in the input market and this exciting thing is what we are going to do now!A profit maximising firm would have to consider how to get the highest profit, so when deciding how many workers to employ should consider how much profit each worker will bring in. Marginal profit of an additional worker is the worker’s contribution to the revenue minus his wage and this is the value of the marginal product.Producer surplus in the input market: = total revenue – variable costTotal revenue is the product of labour and is thus the area between the axes and the value of marginal product curveThe variable cost is the wage multiplied with the hours of labour (i.e. unit to measure the quantity of labour)At first assume thatW0Value of marginal product(demand curve for labor)L0hrs of labourquantityPS = total revenue – variable cost= value of product – wage= a
119 Welfare measurement of multiple price changes a) Factor price changes (falls), by constant output pricesInput (factor) marketOutput marketwagepriceS(W0)a_What have I achieved with that? Well usually it is very difficult to obtain data and define the functions and it is assumed that the behaviour of the actors is like in middle areas, the exteme areas is very difficult to define , meaning that areas y and x cannot be measure.Moreover the deviations in the costs of a firm in the reality are influenced by more variables than the price of the output and the quantityTherefore it is easier to measure the welfare where the prices change but not where the curves shift!W0S(W1)P0zbycxW1dDquantityL0hrs of labourL1q0q1ΔPS = b+c = z
120 Welfare measurement of multiple price changes b) Output price changes (increases), by constant input pricesInput (factor) marketOutput marketpricewageS(W0)P1_baHere simpler is the welfare measurement in the output market!W0P0D (P1)D (P0)quantityL0hrs of labourL1q0q1ΔPS = a = b
121 Welfare measurement of multiple price changes c) Simultaneous changes of input & output prices, 1 variable factorInput (factor) marketOutput marketpricewageS(W0)P1xavbW0S(W1)P0zyD (P1)cdW1D (P0)hrs of labourquantityL0L1ΔPS = x+y+zΔPS = a+b+d
123 Empirical Measurement of Economic Policies Numeric equilibrium models have been developed to evaluate ex ante effects of economic policies: Policy Impact StudiesGeneral Equlibrium Models explain the whole economies, whereas the Partial Equlibrium Models are usefull for more elaborate sectoral analysisComparative static-DynamicOne product-multi productOne region-multi regionHomogenous goods-heterogenous goodsHere simpler is the welfare measurement in the output market!
124 Computable General Equilibrium (CGE) The General Equilibrium models consist of a system of equations, which cover all the money and goods flows in an economyFor the calculation of General Equilibrium Models variables must be determined eather as the model-endogenous or exogenousBy recursive iteration all markets are simultaneously being brought into the equilibrium.Therefore, wages, prices, investment and growth, state budget, export and import volumes, interest rates and other variables can be determined.Here simpler is the welfare measurement in the output market!
125 Social accounting Matrix SAM A SAM is a square matrix in which each transaction is recorded only once in a cell of its own – it is conventionally agreed that the entries made in rows represent incomes or receipts, whilst the entries made in columns represent outlays or expenditures - so, for each row there is a corresponding column, i.e. for every income there exists a corresponding expenditure, with their totals being equal.Here simpler is the welfare measurement in the output market!
126 Thank you for your attention! Here simpler is the welfare measurement in the output market!
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