Measuring Costs and Benefits

1. 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)

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

3. 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

4. Measuring Benefits Individual Demand Curve Price P0 X0 P1 X1 D Q0 Q1 Quantity Consumed

5. 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

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

7. Market demand curves Individual 1 Individual 2 Market P P DM D1 D2 Q Q Q q1 q2 q1+q2

8. 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.

9. Measuring Benefits Price Market Equilibrium WTP0 S CS Pe Actual Expenditures D Q0 Quantity Qe

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

11. Measuring Benefits Price Market Equilibrium Consumer Surplus WTP0 S Pe Actual Expenditures WTP D Q0 Quantity Qe

12. Price S0 S1 CS0 ∆CS D Quantity WTP0 ∆WTP

13. 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

14. Mozambique market for electricity DM DSA PSA QD0 QS0 QS1

15. 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)

16. Local Market for Cable Connections D (Marginal WTP) A (CS0) C (CS) P* B (EXP0) D (EXP) Q0 Q1

17. 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)

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

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

20. 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

21. Social Surplus S CS Pe PS D Qe

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

23. 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

24. Review Boardman Figure 4.3

25. Local Market for Cable Connections CS CS P* PS  PS D S0 S1

26. 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)

27. Mozambique market for electricity DM S0 S1 CS DSA PSA PS ∆PS ∆FX FX QD0 QS0 QS1 With international trade, need to add changes in Foreign exchange (FX) flows

28. 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)