Chapter 7: Consumer and Producer Surplus Flashcards
The market prices of project inputs/outputs will not change if:
- the project output (input) satisfies existing demand from an alternative source (is sourced from an alternative market use)
- the inputs/outputs are traded in world markets
- the project is small relative to the size of the economy in which it is undertaken
Examples of project outputs/inputs where prices might change
- Output: a bridge - price of trips across a river
- Input: wage of skilled labour in a local market
An increase in consumer surplus represents…
Benefits received by the consumer as a result of a fall in price
- when price falls the consumer benefits by the amount of the price decrease for each unit of good originally purchased
- as price falls, consumer purchases more as the good provides more utility than the market price
When will a fall in the price of a good represent a net benefit of the project?
When a fall in price (P0 to P1)
- represents a fall in cost, then the value (P0-P1)Q0 is a net benefit which is included in the efficiency net benefits
- does not represent a fall in cost, one group is better off (consumers) and another group is worse off (firms) by the same amount. The amount (P0-P1)Q0 is simply a transfer from consumers to firms and it nets out n the efficiency CBA
Measuring changes in economic welfare: K-H criterion
- CBA implements the Kaldor-Hicks criterion by assessing whether adopting a project constitutes a potential pareto improvement (gains to gainers > losses to losers)
- Gains and losses are measured as compensating variables
Compensating variations
Measured as areas of consumer surplus under demand curves, or as areas of producer surplus above supply curve
Compensating variations: applying the K-H criterion
- Ask each gainer to work out how much could be taken away from them and still leave them as well off as before the change
- Ask each loser to work out how much would need to be given to them to leave them as well off as before the change
- These sums are the compensating variations (CVs)
- If the net value of the aggregate CB is positive, the change is a potential pareto improvement
The income effect
When price falls, the individual experiences an increase in purchasing power that is similar to an increase in income
- when income increases, the consumer will increase consumption of all normal goods
The substation effect
If price calls and purchasing power is held constant, then the consumer can increase their welfare by increasing the consumption of the cheaper good while simultaneously decreasing the quantity consumed of other goods/services
Fall in Price and Increase in Quantity: Implications in Efficiency and Referent Group CBA (1. Consumers)
Consumers benefit by additional consumer surplus from additional output plus additional consumer surplus from lower price for the original level of output
Fall in Price and Increase in Quantity: Implications in Efficiency and Referent Group CBA (2. The Firm)
The firm benefits by the difference between additional revenue and the additional cost associated with the project output (adjusted for tax and financing flows)
Fall in Price and Increase in Quantity: Implications in Efficiency and Referent Group CBA (3. Firms in the wider economy)
Firms in the wider economy may suffer a loss depending upon whether the fall in price from P0 to P1 represents fall in unit cost of production:
- if the fall in price from P0 to P1 represents a fall in unit cost of production then costs and revenues fall by the same amount and there is no net effect;
- if the fall in price from P0 to P1 does not represent a fall in unit cost of production then the fall in revenues is not matched by a fall in costs and there is a loss to firms equal to (P0 to P1)Q0
Fall in Price and Increase in Quantity: Implications in Efficiency and Referent Group CBA (4. Referent Group Analysis)
The effects described in 2 and 3 will only be entered in the Referent Group Analysis if the firms are part of the referent group
How is additional output (Q1-Q0) valued in a CBA?
- Market analysis: use P1
- Private analysis: use P1
- Efficiency Analysis: use (P0+P1)/2
- Referent Group Analysis: calculate the aggregate net benefits in the usual way. Consumer benefits will be included as a category of Referent Group Benefits
Why is it important to identify pecuniary vs real effects?
- price changes can sometimes be ignored in efficiency CBA and sometimes not
- can be ignored if there are only pecuniary effects - where gains to one stakeholder = losses to another
- these still have to be considered in referent group analysis
- they cannot be ignored if there are real benefits
