Some More Micro-Foundations for CBA

1. Some More Micro-Foundations for CBA

2. Consumer Surplus • Consumer Surplus • The difference between what consumers would have been willing to pay and what they actually did pay. • Economic surplus gained by the buyers of a product. • Measured by the cumulative difference (adding up over all consumers) between their reservation price for each unit of the good, and the price they pay . LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

3. Producer Surplus • Producer Surplus • The difference between what producers do get for output and the minimum price they would have been willing to accept. • Economic surplus gained by the sellers of a product. • Measured by the cumulative difference (adding up over all producers) between the price they receive and their reservation price for each unit of the good. LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

4. Consumer and Producer Surplus S Consumer surplus Producer surplus D LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

5. : How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction S $0.75 1.25 $0.25 D • At a market price of $1/litre, the most intensely dissatisfied buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.

6. How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction At a market price of $2/litre, dissatisfied sellers can produce an additional litre of milk at a cost of only $1, which is $1 less than a buyer would be willing to pay for it. If the buyer pays the seller $1.75 for an extra litre, the buyer gains an economic surplus of $0.25 and the seller gains an economic surplus of $0.75. S $0.25 1.75 $0.75 D Market Equilibrium and Mutually Beneficial Exchange

7. Public vs. private goods Private goods – demand sums horizontally MB is the marginal social benefit Consumer A demand falls to 0 Public goods – demand sums vertically

8. 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)

9. 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 scenarios • If goods are distributed free the increase in consumer surplus is cbq1q0 and the total is area abc + cbq1q0 • If good goes to consumers without charge, some receive the product who would not have purchased at P1. • 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.

10. 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

11. 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

12. 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 PuPicato the seller from the buyer, and the deadweight loss is acd. • Policies • Caveat venditorand caveat emptor • Private market (Consumer Reports) • Public provision of information)

13. Negative 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.