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COST BENEFIT ANALYSIS & PROJECT EVALUATION Social CBA References: Chapter 8 & 9, Social CBA and Economic Evaluation. Presenter: Dr Suzanne Bonner, School of Economics. 1. Identify economic efficiency and its challenges in practical applications. 2.Understand the role of shadow prices for economic efficiency in CBA. 3. Identify and utilise relevant shadow prices using adjusted observed prices in distorted markets. 4.Demonstrate the difference between corrective and distortionary taxes/subsidies. 5.Describe the distribution of costs and benefits from the social CBA. 6.Calculate the benefits and costs for those with standing in a CBA. Learning Objectives 2 • Social perspective is harder to implement in CBA. • Social benefits and social costs are harder to calculate. - Market prices often do not capture the social benefit and social costs associated with production or consumption of a good. • So why does economics focus on perfectly competitive markets? Especially because perfectly competitive markets are few and far between in the real world? Benchmark – identification of socially improving policies (week 5) Social Perspective in CBA. 3 Undistorted Market 4 Quantity Price S = MSC P* Q* D = MSB equilibrium Producer Surplus Consumer Surplus MSB=MSC What if the market was distorted? How do we choose the correct shadow price? • In competitive market equilibrium there is only one price as determined by the intersection of supply and demand curves • When markets are distorted there are two prices - one reflecting demand conditions (Pb) and one reflecting supply conditions (Ps). • Shadow - pricing - adjusting observed market prices to reflect marginal benefit or cost to economy in CBA evaluations. • Shadow Pricing in Social CBA - The CBA analyst has to decide whether Pb or Ps is the appropriate price to value output or input in the CBA. Shadow Pricing Decisions 5 1.Monopoly 2.Distortive Taxes 3.Distortive Subsidies 4.Information Asymmetries 5.Public Goods 6.Externalities 7.Corrective Taxes and Subsidies 8.Monopsony 9.Labour Markets with Minimum Wages Types of Distorted Markets 6 Output markets: - If the intervention causes the availability of the output to increase – use WTP - If the intervention decreases the availability of the output for use by others to (diverting use) – use OC Input Markets: - If the intervention causes the availability of the input to increases – OC - If the intervention decreases availability of the input for use by others (diverting use) - WTP Remember it is key to identify if it is an input or an output market under evaluation! General Rules 7 Material Inputs with Indirect Tax 8 • In a perfectly competitive market we would face supply curve S and demand curve D. • Equilibrium Price and Quantity would be P1 and Q1 respectively • Implementing an ad valorem (proportional tax) decreases the supply to Stax Quantity Price S P1 Q1 D PB Ps Stax Q2 T a x a m o u n t Material Inputs with Indirect Tax 9 Quantity Price S P1 Q1 D PB A B C D Ps Stax Q2 T a x a m o u n t • Per unit tax amount is Pb-Ps • The area of A + B is the revenue for the tax • C + D is the deadweight loss caused by the tax (hence distortionary) Material Inputs with Indirect Tax 10 Quantity Price S P1 Q1 D PB A B C D Ps Stax Q2 T a x a m o u n t • Depending on whether production is diverted the shadow price can be Pb or Ps • Which one ‘correct’ for Social CBA? • Consider whether it is a market for inputs or outputs. Material Inputs with Indirect Tax 11 Quantity Price S P1 Q1 D PB A B C D Ps Stax Q2 T a x a m o u n t • Input Market: • If the number of additional units sourced increases use Ps – the OC • If input diverted from use by other users, use Pb - the WTP Material Output with Indirect Tax 12 Quantity Price S P1 Q1 D PB A B C D Ps Stax Q2 T a x a m o u n t • Output Market: • If output satisfying additional demand, use Pb – the WTP • If output replaces other suppliers use Ps - the OC Material Inputs with Subsidy 13 The aim of a subsidy is to lower the market price. Supply curve S represents the marginal cost of producing the good or service The supply to customers is Ssubsidy which captures the cost of production minus the subsidy paid by the government Quantity Price S P1 Q1 D PS PB Ssubsidy Q2 Material Inputs with Subsidy 14 The area of A+B+C+D+E +F+G+H is the expenditure by the government E + F is social deadweight loss (market distortion) Again, the choice of Pb or Ps relies on whether it is an input or output market Quantity Price S P1 Q1 D PS A B C D PB Ssubsidy Q2 E F G H Material Inputs with Subsidy 15 Input Market: • If the production of the market increases to meet the additional demand, use use PS – the OC • If the availability of the input is diverted from other users, use PB - the WTP Quantity Price S P1 Q1 D PS A B C D PB Ssubsidy Q2 E F G H Material Output with Subsidy 16 Output Market: • If output increases such that it satisfies additional demand, use PB - the WTP • If output replacing other suppliers use PS – the OC Quantity Price S P1 Q1 D PS A B C D PB Ssubsidy Q2 E F G H • Taxes and subsidies drive a wedge between the price the buyer pays, , and the price the seller receives, : - For an ad valorem tax: = (1 + ), i.e. > - For a specific tax: = + , i.e. > - For an ad valorem subsidy: = (1 − ), i.e. = − , i.e. < - For a specific subsidy: = − , i.e. < Calculating Taxes and Subsidies 17 Monopoly output: - If the government is purchasing the good from the monopoly output market use Pm - If the government intervention increases the production of the monopoly output use P1 - In between Pm and P1 when production is increased but not by the full amount Other Distorted Markets 18 Quantity Price MC Pc Qc D PM A B C E F D QM MR P1 Quantity Price S =MPC P1 Q1 D =MB P2 A B C E D P3 Q2 Allocatively efficient MSC Market Equilibrium True Cost of Production MEC Other Distorted Markets Externalities: • Shadow price that should be used is the one that captures the true value of the good or service • Negative Externality: In this instance it would be the point where $MSC=MB$ (shown in graph →) • Positive Externality: In this instance it would be the point where $MC=MSB$ Asymmetric Information: • Market prices value for outputs (or inputs) inaccurately in a cost- benefit analysis. • The type of asymmetric information will determine the shadow price used. - Search and experience goods can be resolved at P1 - Credence goods are complicated. - Search costs can be calculated. Other Distorted Markets 20 Quantity Price S P1 Q1 Dsym P2 A B Q2 Dasym • Let’s look at a useful example of distorted markets. • A minimum wage (eg. an award wage) creates a market distortion which results in excess supply of labour (unemployment) – see over next slide for a diagram • The market equilibrium is determined by the quantity of labour demanded at the minimum wage. At this equilibrium quantity there are, in effect, two prices of labour: - the price indicated by the demand curve (PM the minimum wage) - the price indicated by the supply curve (POC the reservation wage - the wage required to induce an extra unit of supply) Labour Input with Minimum Wage 21 • Due to the higher wage Pm • only Qd is demanded • Qs is supplied by workers • The difference between Q2 and Q3 is unemployment (involuntary) • If a firm higher workers at Pm it affects their value of marginal product of labour (VMP) Labour Input with Minimum Wage 22 Quantity Price Q1 D S P1 (a) (c) Q2 Q3 POC 0 PM (b) • What wage do we use in the social CBA? • We need to look at the opportunity costs – the value of the labour in the next alternative use • If the workers are hired from the pooled of unemployed people POC is an appropriate shadow price Labour Input with Minimum Wage 23 Quantity Price Q1 D S P1 (a) (c) Q2 Q3 POC 0 PM (b) • If the labour was employed elsewhere • Use wage Pm as it is the opportunity cost of the next best alternative use. • If the labour is receiving unemployment benefits the shadow price should capture • Poc - the opportunity cost to the economy • The subsidy received to the worker (in the form of the benefit) Labour Input with Minimum Wage 24 Quantity Price Q1 D S P1 (a) (c) Q2 Q3 POC 0 PM (b) • Taxes and subsidies change economic behaviour: - A tax (subsidy) on a commodity reduces (increases) quantity traded in the market place. - The effect of a tax or subsidy is usually seen as distorting economic behaviour ie. moving the economy further away from the point at which MSB = MSC. However, some taxes are corrective (known as Pigovian taxes) - Taxes are designed to counter the negative effects on the efficiency of resource allocation resulting from missing or incomplete markets ~ eg. taxes on alcohol and tobacco are intended to discourage over-consumption from a social point of view. ~ Other examples are the petrol excise, the carbon tax, subsidies on flu vaccinations etc Corrective Taxes Vs Distortionary Taxes 25 • When a project output increases in availability, or when a project input is diverted from current uses, the appropriate price is a point on a demand curve. - A point on a demand curve is the supply price plus indirect tax (ie. the after tax price -the price paid by the buyer), or the supply price less subsidy (ie. the after subsidy price - the price paid by the buyer). • When a project output diverts the consumption of the output by others, or when a project input increases the availability, the appropriate price is a point on a supply curve. - A point on a supply curve is the demand price less indirect tax (ie. the before tax price - the price received by the seller), or the demand price plus the subsidy (ie. the before subsidy price - the price received by the seller) Summary of Distortionary Taxes and Subsidies 26 • We usually consider taxes and subsidies to be distortionary unless we have specific information to the contrary. • These rules apply to distortionary taxes. What happens if the indirect tax or subsidy is a corrective tax or subsidy? • A corrective tax (subsidy) is intended to discourage (encourage) an activity that is at too high (low) a level as a result of market forces. Example: a tax on tobacco or a subsidy on vaccinations. • A different procedure is followed when corrective taxes or subsidies are present. Corrective Taxes Vs Distortionary Taxes 27 • If the corrective tax is set at the efficient level it is equal to the marginal external cost. The following shadow price rules apply: - In input markets a corrective tax should use Pb (e.g. petrol) - In output markets a corrective tax should be Ps (e.g. tobacco) Corrective Tax 28 Quantity Price S = MPC P1 Q1 D PB A B C D Ps Stax = MSC Q2 MEC = tax How to calculate amount of indirect tax in market price • Market price (incl. GST/VAT) = $1500 • t = tax rate (7%) • T= amount of tax • T= t * Ps How to Calculate the Amount of an Indirect Tax 29 • If the corrective subsidy is set at the efficient level it is equal to the marginal external benefit. The following shadow price rules apply: - In input markets a corrective tax should use Ps - In output markets a corrective tax should be Pb Corrective Subsidy 30 Quantity Price S P1 Q1 D= MPB PS A B C DPB Ssubsidy Q2 E F G MEB = Subsidy MSB ✓ Identify economic efficiency and its challenges in practical applications. ✓ Understand the role of shadow prices for economic efficiency in CBA. ✓ Identify and utilise relevant shadow prices using adjusted observed prices in distorted markets. ✓ Demonstrate the difference between corrective and distortionary taxes/subsidies. ✓ Describe the distribution of costs and benefits from the social CBA. ✓ Calculate the benefits and costs for those with standing in a CBA. Learning Objectives 31 Case Study Worked Example on Solar Farms For students who are looking for more practice questions – refer to the online textbook activities. Putting it into Practice!