361 ch3 - find more resources at oneclass.com CHAPTER 3 ECONOMICS FOUDATIONS OF COST-BENEFIT ANALYSIS Purpose To review the microeconomic and welfare

361 ch3 - find more resources at oneclass.com CHAPTER 3...

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CHAPTER 3: ECONOMICS FOUDATIONS OF COST-BENEFIT ANALYSIS Purpose: To review the microeconomic and welfare economic underpinnings of CBA (assuming perfect competition). DEMAND CURVES Individual demand curves slope down (have a negative slope) due to diminishing marginal utility. The market demand curve is the horizontal sum of individual demand curves. It also slopes down.It is important to distinguish between an ordinary demand curve where q = f(p), and an inverse demand curve in which p = f-1(q). The inverse market demand curve can be interpreted as a (societal) marginal benefits (MB) curve: it indicates how much (actually the maximum) someone is willing to pay for an additional unit of a good – the marginal unit. Consequently the area under the market demand curve from the origin to X* (see Figure 3.1) measures the gross benefits to society of consuming X* units of the good.If one has to pay P* for X* units of the good, then the rectangle bounded by P* and X* is the aggregate cost to consumers. The net benefits to consumers are the gross benefits minus the consumers’ costs. The net benefits are called the consumer surplus (CS): it is the area between thedemand curve and the P* line—the light shaded area in Figure 3.1. Consumer surplus is important in CBA because changes in CS can be viewed as close approximations of the WTP for (the benefits of) a policy change.Changes in Consumer SurplusFigures Figures 3.2 (a) and 3.2(b)show the changes in CS due to a price decrease or increase, respectively. If the demand curve is linear, the change in CS is given by equation 3.2. This is a good approximation even if the demand curve is not linear.Sometimes the demand curve is not linear but the analyst knows the price elasticity of demand. In this case the change in CS may be computed using equation 3.4:Taxes are important in CBA because governments often raise funds for government projects through taxes. Unfortunately, taxes result in a reduction in CS, represented by the triangular area ABC in Figure 3-2b. This is an example of deadweight loss. The deadweight loss due to a tax is called the deadweight loss of taxation. For a unit tax, like an excise tax, it can be computed using equation 3.6:Leakageis the ratio of the deadweight loss to the total tax revenue raised; see equations 3.7 and3.8. Boardman, Greenberg, Vining, Weimer / Cost-Benefit Analysis, 4 th Edition Instructor's Manual 3-1 find more resources at oneclass.com find more resources at oneclass.com