Consumer and Producer Surplus in Benefit-Cost Analysis (Campbell & Brown Chapter 7) Harry Campbell & Richard Brown School of Economics UQ, St. Lucia 2003 BENEFIT-COST ANALYSIS BENEFIT-COST ANALYSIS nancial and economic nancial and economic appraisal using spreadsheets appraisal using spreadsheets The market prices of project inputs or outputs will NOT change if: - the inputs or outputs are TRADED ie. price is determined in world markets) - the project is SMALL relative to the size of the economy in which is undertaken Examples of project outputs or inputs whose prices might change: - output: a bridge - price of trips across a river - input: wage of skilled labour in a local market eg. ICP case study (Ch.7, p.26) Suppose the market price of project output is predicted to fall from P 0 to P 1 as a result of the increase in quantity supplied from Q 0 to Q 1 (as in Figure 7.1). How do we value the additional output (Q 1 - Q 0 ) in a social benefit-cost analysis? Project Analysis: use P 1 Private Analysis: use P 1 Efficiency Analysis: use (P 0 +P 1 )/2 Referent Group Analysis: calculate the aggregate net benefits in the usual way How do we account for the fall in price of the original quantity of output, Q 0 ? Clearly consumers benefit by the amount (P 0 - P 1 )Q 0 . When will that represent a net benefit of the project? When the fall in price from P 0 to P 1 represents a fall in cost, as in the bridge example, the value (P 0 - P 1 )Q 0 is a net benefit which is included in the efficiency net benefits. When the fall in price 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 (P 0 - P 1 )Q 0 is simply a transfer from consumers to firms and it nets out in the efficiency benefit-cost analysis. Suppose that the fall in product price is not matched by a fall in production cost.What is the effect on aggregate referent group benefits of allowing for the change in output price, compared to the case in which there is no change in price? 1. Suppose that the private firm is not a member of the referent group (as in the ICP case study): efficiency net benefits fall but private net benefits fall even more, hence RG net benefits rise. Consumers benefit at the expense of the firm. 2. Suppose that the private firm is a member of the referent group. Then efficiency net benefits are the same as RG net benefits, and hence RG net benefits fall. The reason for the fall is the lower value placed on the extra output produced by the project. The social benefit-cost analysis implements the Kaldor- Hicks (K-H) criterion by assessing whether a project is a potential Pareto improvement. A potential Pareto improvement exists if the gainers from a project could compensate the losers and still be better off. Gains and losses are measured as COMPENSATING VARIATIONS. Compensating variations are measured as areas of consumer surplus under demand curves, or as areas of producer surplus above supply curves. Applying the Kaldor-Hicks criterion: suppose I said that I was going to change the lecture time from 4 pm to 8 am. That would suit some people (the gainers) and not suit others (the losers). To apply the K-H criterion, I ask each gainer to work out how much money I could take away from them and still leave them as well off as before the change. And I ask each loser to work out how much money I would need to pay to them to leave them as well off as before the change. These sums are the compensating variations (CVs). I ask each person to write their CV amount on a piece of paper (positive for gainers, negative for losers). I then pass the hat around: each person puts their piece of paper in the hat and if the net value of the aggregate CV is positive, the change is a potential Pareto improvement. . Lucia 2003 BENEFIT-COST ANALYSIS BENEFIT-COST ANALYSIS nancial and economic nancial and economic appraisal using spreadsheets appraisal using spreadsheets . Consumer and Producer Surplus in Benefit-Cost Analysis (Campbell & Brown Chapter 7) Harry Campbell