Social welfare economics foundations for CBA

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Social welfare economics foundations for CBA. G. Mason Updated 2013. 24. 18. Price (\$/unit). Price (\$/unit). Price (\$/unit). D1. D1. 24. 36. Q1. Q2. Q = Q1 + Q2. (a). (b). (c). Generating the Market Demand Curve for a Private Good. - PowerPoint PPT Presentation

Text of Social welfare economics foundations for CBA

• Social welfare economics foundations for CBAG. MasonUpdated 2013

• To construct the market demand curve for a private good [panel (c)], we add the individual demand curves [panels (a) and (b)] horizontally.Generating the Market Demand Curve for a Private Good

996024=+=+D = D1 + D2 2012 McGraw-Hill Ryerson Limited Ch14 -*LO3: The Optimal Quantity of a Public Good

LO3: The Optimal Quantity of a Public Good

• To construct the demand curve for a public good [panel (c)], we add the individual demand curves [panels (a) and (b)] vertically.FIGURE 14.2: Generating the Demand Curve for a Public Good

8122412825169D = D1 + D212244236 2012 McGraw-Hill Ryerson Limited Ch14 -*LO3: The Optimal Quantity of a Public Good

LO3: The Optimal Quantity of a Public Good

• The optimal number of hectares of urban parkland is A*, the quantity at which the publics willingness to pay for additional parkland is equal to the marginal cost of parkland.

The Optimal Quantity of Parkland

A080140200A*MarginalcostDemand 2012 McGraw-Hill Ryerson Limited Ch14 -*LO3: The Optimal Quantity of a Public Good

LO3: The Optimal Quantity of a Public Good

• The Loss in Surplus from a Pay-per-View Fee

Twice as many households would watch the program if its price were zero instead of \$10. The additional economic surplus is the area of the blue triangle, or \$50 million.

2012 McGraw-Hill Ryerson Limited LO3: The Optimal Quantity of a Public Good

LO3: The Optimal Quantity of a Public Good

• Under consumption of public goodWhat examples exist of public goods you care that others under consume?What examples of public goods make no difference that others under-consume?

• Direct and inverse demandDirect demand views quantity as the dependent variable and price as the independent variable or the driver.QA = A0 - A1PAInverse demand, views price as a marginal utility and measure of the willingness to pay for a specific quantity.PA = A0 + A1QA

• Social welfare rulesFew actions by government make everyone better off; usually there are several winners and several losers.Who are the winners and losers in the following scenariosStreet repairsSubsidies to the arts and cultureMandatory vaccination of girls (under 12) for HPV (see facts sheets)

• Pareto Rules 1Program X improves the welfare of society if it makes at least one person better off without making anyone else worse off.Adler and Posner (reading cited in outline) identify several factors that prevent this rule for working.Un observability of states of welfareUn comparability of welfare among individualsDeclining marginal utility of money suggests that those who are well off, would be worsened, if many others who are poor are made better off.

• Pareto 2Assume a social preference function (aggregate demand for a public good) given by:U(X1,X2, XN).Also assume H households in a community, and a single road. Cyclists would like a bike path; council must decide.If the bike path is built, the average household will experience utility increase of U.Council has an easy decision if:Uh > 0 for all households and Uh > 0 for at least one household, or ifUh < 0 for at all one household and (Uh
• Pareto 3Most situations involve a mix of households that experience increases, neutral or negative utilities from a bike path (Who loses from a bike path?)Nave solution is add utilitiesUtot = U1 + U2 +. Uh Utility is an ordinal measure, not cardinalThat means we cannot compare utilities directly

• Willingness to PayCompensating VariationBeneficiaries of bike pathWhat is the maximum amount you are willing to pay to have the bike path constructed? Opponents of bike pathWhat is the minimum amount you are willing to accept of the bike path were constructed.This is a proxy for the change in utility from the perspective of adopting the new.For household h, if compensating variation is CVh >0, then Uh > 0; if CVh
• Willingness to PayEquivalent VariationBeneficiaries of bike pathWhat is the minimum amount you would accept to forgo the bike path?Opponents of the bike pathWhat is the maximum amount you would be willing to pay to stop the bike path?This is the proxy for utility from the perspective of preserving the old.For household h, if equivalent variation is EVh >0, then Uh > 0; if EVh
• Several methods exist to measure willingness to pay, including revealed preference (demand studies) and direct surveys. These will be reviewed in more detail, later in the course

BeneficiariesOpponentsCompensating VariationMove to New Payment to get projectPayment to accept projectEquivalent VariationMaintain the OldPayment received to forgo projectPayment to prevent bike path

• First compensation ruleIt may be tempting to conduct a survey and then add CVh across all households. If CVh > 0 this is the first compensation test in public policyIssuesTo ensure Pareto optimality, those whose welfare declines with the change must actually be compensated. (This raises mechanical issues of getting winners to pay losers). It also causes strategic biases if survey respondents raise price to get more money (ie., overstate their need for compensation)Marginal utility of income means that one can compare CV and EV only for those at the same income.

Key assumption of CBA Government uses tax and transfer policies to ensure an optimal distribution of income, such that the marginal utility of income is equivalent for all.

• Second compensation ruleIf EVh > 0 this is the second compensation test in public policy (subject to equal marginal utilities of income).This is the preservation scenario. If EV>0, then the minimum amount needed by cyclists to forgo the path, exceeds the maximum amount opponents would be willing to pay to preserve the status quo. This means the project proceedsIf EV
• Combining the rulesCV> 0, EV > 0 (proceed)Both compensation rules are satisfied. Winners can compensate losers if the project were build, and losers could not compensate winners if the project were not built. If path does not exist, build it; the path exists retain it.EV
• Consumer surplusAt P1, consumers are willing to buy X1. At smaller quantities, they are prepared to pay more, but not have to. a is the consumer surplus at P1When prices drop, consumer surplus rises to a+b+c

• Consumer surplus and CV,EVNormal goods EV>CS>CVInferior goods EV
• Changes due to price of substitutes and complementsAssume that X, Y and Z are three commoditiesY is substitute for X and Z is a complement of X.A price decrease in X, reduces demand for Y, and increases the demand for Z

• Price of X increases, reduces the demand for YPrice of X increases, increase the demand for zOverall income has not changed: Thereforeb+d+f+g+h = d+e+f+h+jRearrangingb = e g + jAnd therefore b+c = (c + e) g +j Refer to previous figure as well for b, c d, and eRecall that b+c was the increase in consumer surplus from a price reduction in x

• Change in undistorted marketsUndistorted means that P = MCPrice of X drops, but demand for the substitute Y falls and increases for the complementB=c+e-g+jW = B - C

• W = [c+e-g+j] [e-g+j], or market by marketW = [c+e-e] +[-g+g] + [j-j], x y z

• Distorted marketsThe economy has three goods J, K, L. L is a composite good representing all other goods except J and KThe price of J rises from P1 to P2. The demand drops for J, but rises for K and L.The price of K is distorted because it is less than its marginal cost.

J, K, and L are assumed to be substitutes when the price of J drops the demand for K and l increases.

• In market J, consumers lose k + mIn markets K and L, they receive n + r.B = n + r (k + m)The resource cost declines for J = m, increases for K (q + n) and L (r)W = B - W = q + n + r - m

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