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ECON7740
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!