boardman_im_ch03

# boardman_im_ch03 - CHAPTER 3: BASICS OF COST BENEFIT...

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CHAPTER 3: BASICS OF COST BENEFIT ANALYSIS Purpose: To review the microeconomic underpinnings of CBA (assuming perfect competition). DEMAND CURVES Among the important properties of demand curves are: (1) their downward slope, which is due to diminishing marginal utility, and (2), the fact that they indicate willingness to pay (WTP) for various quantities of the good. Consumer surplus can be derived from a demand curve. The area under the market demand curve (i.e., the horizontal sum of the individual demand curves) is society's WTP for good X (see Figure 3.1 ). This area, WTP, is defined as the gross benefits of society for consuming X* amount of the good. If one has to pay P* for X* amount of the good, then the rectangle bounded by P* and X* is the aggregate cost. The net benefits, therefore, are the gross benefits minus the costs (the area between the demand curve and the P* line). The net benefits are called the consumer surplus (CS). The reason consumer surplus is important to CBA is that changes in CS can be viewed as close approximations of the WTP for (or benefits of) a policy change. Changes in Consumer Surplus If the price increases (decreases), less (more) of a good is demanded and the CS changes [see Figures 3.2 (a) and 3.2(b) ]. If the change in price and quantity are known and the demand curve is linear, Equation 3.1 can be used to solve for changes in CS. If the change in quantity is not known, the price elasticity of demand may be used to approximate it (see Equation 3.3 ). If the price change is due to a tax, the lightly shaded rectangle in Figure 3.2 is a transfer and the dark1y-shaded triangle is deadweight loss. SUPPLY CURVES The upward sloping segment of a firm’s marginal cost curve above its average variable cost curve is the supply curve (below the average variable cost, the firm would shut down). The marginal cost curve is the additional cost to produce each additional unit of the good. The area under the curve represents the total variable cost of producing a given amount of the good. The variable costs that are of concern in CBA are opportunity costs (i.e., the value of goods and services that the resources could have produced in their next best use). What is counted as variable costs should be appropriate to the policy in question and could cover the short run (labor varies and capital is fixed) or the long run (all inputs vary). The market supply curve

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## This note was uploaded on 01/26/2011 for the course ECON 1111 taught by Professor Fertar during the Spring '10 term at Memorial University.

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boardman_im_ch03 - CHAPTER 3: BASICS OF COST BENEFIT...

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