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Efficiency, Surplus and Doing Benefit-Cost Analysis
How can economics help determine the optimal size of a project or extent of a regulation?
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Motivating Group Project
2001 Actual Group Project (Advisors—Profs. McAusland and Kendall):
A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties
2001 Actual Group Project (Advisors—Profs. McAusland and Kendall):
A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties
2001 Actual Group Project (Advisors—Profs. McAusland and Kendall):
A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties
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A few other examples
What should be the CO concentration standard in tailpipe emissions?
What is the appropriate level of GHG emission reduction worldwide?
How large should the Channel Islands marine reserve be?
Can we measure loss to recreationists of the Forest Adventure Pass?
Add another lane to Hwy 101? Close Mission Canyon to cyclists? What habitat to buy to protect endangered
species (eg, Least Bell’s Vireo – bird)
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Generic Problem
Characterize an Environmental Policy or Action (or multiple policies or actions)
Estimate the Consequences of that policy or action
Estimate the pluses (benefits) and minuses (costs) of that policy or action
Reach conclusions
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CBA: main principle
Quantify all costs and benefits in a common measure (usually $)
Common metric need not be $ eg, health- health analysis, with health as metric
• Benefits directly measured in terms of lives saved• Costs indirect: costs increase deaths since
• Regs make people poorer• lower incomes lead to higher mortality ($13 million in extra
costs results in 1 statistical death)• Eg, Compare risks in lower and higher income countries
• Compare projects based on net effects on health.
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What others method to use?
Cost-effectiveness Analysis Weighted cost-benefit analysis Multigoal analysis
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Basic measure of value is willingness-to-pay
Demand curve is marginal willingness to pay
Quantity of water
MWTP First units very valuable
Last units less valuable
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Consumers Surplus (CS)
D(x)
x
$
q
p
CS(q)
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Calculating benefitsfrom MWTP
Demand, D(x), measures MB.Consumers Surplus is the total benefit
to consumers minus their cost.
q
pqdxxDqCS0
)()(
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Example – gross value of water from new dam (excluding costs)
Acre-feet of water
Price
Demand for water
New dam
. . .
. . . . . . .
. . . . .. .
. . . . . . .
Add’l Value
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What about nonmarket goods?
Air quality
Price
Suppose there were a market:
Demand for air quality
BUT, NO MARKET: price similar to MWTP
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Environmental goods
Demand for env goods just as real as demand for market goods – just harder to measure
Demand is a measure of intensity of preferences
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Costs are simpler
Some units are cheap to produce “Marginal” units are most expensive Costs consist of
Fixed costsMarginal costs
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Marginal costs plus fixed costs add up to total costs
Quantity
MC
First units cheapest
Last units pricey
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Producer Surplus (PS)
x
$
p
q
PS(q)
MC(x)
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How are costs calculated?
Supply, S(x), is same thing as MC.Producer Surplus is the total revenue
to producers minus their cost.
q
dxxSpqqPS0
)()(
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Put it together
Q
P
. . .
. . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . .
Total Surplus
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Where is CS+PS maximized?
Demand, D(x)
Supply, S(x)
q1 q*
p
x
$CS
PS
Tension: Too little producedAt too high price. CS low, PS high
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Suppose goods supplied in fixed amount
Land
Price Supply of land
Producer surplus (goes to land owners)
Consumer surplus
Demand for land
MarketPrice
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Example: Add a dam
Q Water
Price
Status quo water availability
XXXXXXXXXXXX ##################
PS: Before: # and X After:
CS: ??
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Example: Add a dam
Q Water
Price
Supply of water increases; price falls.What happens to PS? CS?
XXXXXXXXXXXX $$$$$##################
PS: Before: # and X After: X and $
CS: ??
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If captured all costs & benefits
Then we want to maximize CS + PS which would occur where Supply = Demand.
Challenge is to capture all costs and benefits to accurately measure MC & MB.
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Costs come in different flavors:Private, external and social
In principle, need to capture all costs and benefits.
Social costs may exceed private costs.
Difference is the “external cost” – the monetized cost of the externality.
$/gal
GallonsOf Gasoline
MPC
Q0
P0
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Social vs. Private Costs
In principle, need to capture all costs and benefits.
Social costs may exceed private costs.
Difference is the “external cost” – the monetized cost of the externality.
$/gal
GallonsOf Gasoline
MPCMEC
Q0
P0
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Social vs. Private Costs
In principle, need to capture all costs and benefits.
Social costs may exceed private costs.
Difference is the “external cost” – the monetized cost of the externality.
$/gal
GallonsOf Gasoline
MSC
MPCMEC
Q*
P*
Q0
P0
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First Theorem of Welfare Economics
In a competitive marketSurplus is maximized at a market equilibrium
ImplicationsCan rely on market if we are sure of
competitive market
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Implicit Assumptions: Distribution
Distributional consequences ignored Compensation Principle
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Implicit Assumptions: Income
Restaurant meals
Price
Y=$30,000 per year
Y=$50,000 per year
Demand and thus surplus depend on income distribution
Therefore: Change in income distribution will change results of CBATO USE CBA, MUST BELIEVE INCOME DISTRIBUTION IS OK
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Implicit Assumptions: Completeness
What happens with difficult to monetize benefits?Eg, clear view of Santa Cruz Islands
Difficult to monetize benes often omitted
Results in bias against env. benes
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Implicit Assumptions: Other
Moral and political dimensions omittedShould we do a cost-benefit analysis
on executing someone who has committed a crime?
Are there other issues when lives are at stake?
Are intergenerational issues adequately treated by CBA?
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Ten Steps to doing and using a CBA
1. Decide whose benefits and costs count 2. Select the portfolio of alternative projects3. Catalog potential physical impacts and determine how they are
measured4. Predict quantitative physical impacts over life of project5. Monetize all impacts6. Discount for time to find present values7. Sum: add up all benefits and costs8. Perform sensitivity analysis9. Choose alternative with largest social benefits10. Make policy recommendation, using CBA only as part of guidance