Chapter 5: Efficiency CBA Part 1: Market failure and shadow-pricing

Question 1

In a perfectly competitive market economy, the allocation of factors will be…

Answer 1

Pareto Optimal

Question 2

Some conditions for a perfectly competitive market economy

Answer 2

• no monopoly or monopsony
• no distorting taxes or regulations
• profit maximising producers and utility maximising consumers
• a complete set of private property rights

Question 3

Pareto optimality

Answer 3

A situation where no reallocation of factors of production can make one person better off without making someone else worse off

Question 4

If we lived in a perfectly competitive market economy, the private sector would…

Answer 4

• Choose to undertake all projects that are efficient from an economic point of view (contribute to Pareto optimality)
• Never choose to undertake an inefficient project

Question 5

If we lived in a perfectly competitive market economy, would would the role of government be in promoting economic efficiency?

Answer 5

• There would be no role for government in promoting economic efficiency
• Public projects wouldn’t be required because all efficient projects are already being undertaken by the private sector
• Private projects would not require government approval because they always contribute to economic efficiency

Question 6

Would there by any role for government in a perfectly competitive market economy?

Answer 6

The government might want to redistribute income in a way that did not alter the efficiency of private resource allocation decisions

Question 7

Would there be any role for benefit-cost anlaysts in a perfectly competitive market economy?

Answer 7

No. There would be no public projects aimed at improving resource allocation, and private projects would not have to be appraised and approved by government regulators

Question 8

How do models of perfectly competitive market economies help?

Answer 8

They provide a standard of efficiency against which the performance of real-world economies can be assessed

Question 9

Is there an alternative to the theoretical model of the perfectly competitive economy?

Answer 9

• In principle: Yes. Resource allocation decisions could be made by economic planners rather than the market
• In theory: If planners had access to all relevant information, they could allocate resources efficiently

Question 10

The free market economy and the centrally planned economy are…

Answer 10

Theoretical extremes

Question 11

Efficiency CBA

Answer 11

• Deals with overall net benefits of a project, irrespective of who the gainers and losers are
• Measures the economic efficiency of the project
• Ignores distribution of net benefits

Question 12

If Efficiency CBA net benefit is positive…

Answer 12

The project brings about a more efficient allocation of resources than the alternative (the world “without” the project)

Question 13

Which groups will the net benefit of the project under the efficiency cba flow to?

Answer 13

• Private sector (profits)
• Public sector (taxes/charges)
• General public (employment benefits, rent, pollution costs, etc.)
• Residents of foreign countries

Question 14

Kaldor-Hicks Criterion

Answer 14

If the project is a potential Pareto improvement, it represents an increase in economic welfare

Question 15

Two problems we face when conducting efficiency cba

Answer 15

• Missing markets (e.g. pollution, recreational fishing)
• Markets in which market price does not measure the value to the economy (e.g. non-competitive markets, markets distorted by taxes/regulations)

Question 16

How do we deal with the problems we face when conducting efficiency CBA?

Answer 16

• Non-market valuation techniques

- Shadow-pricing techniques (adjusting observed market prices to make them reflect marginal benefit/cost to the economy)

Question 17

For what elements of a CBA do we create shadow prices?

Answer 17

• Material inputs/outputs (taxes, subsidies, regulations, market imperfections)
• Factor inputs (labour, land, capital, taxes, regulations)
• Cost of public funds
• Corrective taxes and subsidies

Question 18

Prices when markets are distorted

Answer 18

• When markets are distorted, there are two prices at Q*:
• Pb (reflecting demand conditions)
• Ps (reflecting supply conditions)

Question 19

Taxes and subsidies: Pb for ad velorem/specific taxes/subsidies?

Answer 19

Ad velorem tax: Pb = Ps(1+t)
Specific tax: Pb=Ps+t
Ad velorem subsidy: Pb=Ps(1-s)
Specific subsidy: Pb=Ps-s

Question 20

After tax/before tax prices

Answer 20

After tax price: Pb (the price the buyer payers)

Before tax price: Ps (the price the seller receives)

Question 21

After subsidy/before subsidy prices

Answer 21

Before subsidy price: Ps (the price the seller receives)

After subsidy price: Pb (the price the buyer pays)

Question 22

Shadow pricing: material inputs with indirect tax (e.g. GST)

Answer 22

• If input is sourced through additional supply, use Ps
• If input is diverted from other users, use Pb
• If output is replacing other suppliers, use Ps
• If output is satisfying additional demand, use Pb

Question 23

Shadow pricing: material imported input with tariff

Answer 23

• If input is sourced through additional imports, use Pw
• If input is diverted from other users, use Pb
• If output is replacing imports, use Pw
• If output is satisfying additional demand, use Pb

Question 24

Shadow pricing: material inputs with subsidy

Answer 24

With subsidy, buyers pay less than what sellers receive

• If input is sourced through additional supply, use Ps
• If input is diverted from other resources, use Pb
• If output is replacing other suppliers, use Ps
• If output is satisfying additional demand, use Pb

Question 25

Material inputs with Price > MC (e.g. economies of scale)

Answer 25

• If input is sourced through additional supply, use Pm (mc)
• If input is diverted from other users, use P
• If output replacing other suppliers, use Pm
• If output satisfying additional demand, use P

Question 26

Labour input: distortion? two prices at Q*?

Answer 26

• Distortion: minimum wage, results in excess supply of labour (unemployment)
• At Q*: two prices of labour:
• Price indicated by the demand curve (Wm, the minimum wage)
• Price indicated by the supply curve (Ws, the reservation wage - the wage required to induce an extra unit of supply)

Question 27

Shadow pricing: labour input with minimum wage

Answer 27

• If labour is diverted from other employers, use Wm (=VMPl)

- If labour is sourced from unemployed, use Ws (additional supply)

Question 28

Shadow pricing: labour input drawn from monopolist

Answer 28

• If labour is diverted from other employer/monopolist, use Wp (=VMPL), not market wage W

Question 29

Shadow pricing: labour input drawn from monopsonist

Answer 29

• If labour is diverted from other employer/monopsonist, use Wp = (VMPL), not market wage W

Question 30

What does the efficiency cba shadow pricing rule tell us?

Answer 30

Tells us which is the appropriate price to use to value project outputs/inputs in the cba (demand curve or supply curve price?)

Question 31

Efficiency cba shadow pricing rule

Answer 31

VALUED AT EQUILIBRIUM ON DEMAND CURVE (Pb):

• OUTPUT: satisfies additional demand (after tax; after subsidy)
• INPUT: sourced from an alternative market use (after tax; after subsidy)

VALUED AT EQUILIUBRIUM ON SUPPLY CURVE (Ps):
- OUTPUT: satisfies existing demand from an alternative source (before tax; before subsidy)
INPUT: sourced from additional supply (before tax; before subsidy)

Question 32

Logic of the pricing rule

Answer 32

• Sourced from an alternative market use (e.g. otherwise employed elsewhere) -> opp. cost is the value of output foregone in that use. If alternative use is in a competitive undistorted market, labour’s VMP in that use equals wage, measured by a point on the demand curve for labour
• Sourced from additional supply (e.g. otherwise unemployed) -> opp. cost is the value of leisure time (the reservation wage) measured by a point on the supply curve