Cost benefit analysis lecture 3

• Valuing impacts in the output markets – distorted markets

• Valuing impacts in the input markets

Distorted markets
• Estimating the changes in surplus gets complicated if the market is distorted
• Examples of market distortion:
1. Information asymmetry
2. Externalities
3. Public goods
4. Addictive goods
(monopoly/oligopoly)
1. Information asymmetry
• One side of the market knows more information than the other
• Firms may know the true quality of the product which may be hidden from the consumers
e.g., prescription drugs
• Employees may know their true productivity/ability which may be hidden from the
employers
• This moves the market away from competitive equilibrium
• Government intervention reducing information asymmetry may decrease the dead-weight
loss
• However, government intervention may be costly
• Justified depending on the nature of the good
– search goods e.g., notebook, umbrella
– experience goods e.g. clothes, restaurants, hotels
– post-experience goods e.g. surgeries, new medicines, automobiles

Suppliers side - d0 full information, d1 without full information (diagram) demanded less with
full information. How social surplus has changed = Producer surplus ADP0 vs AEP1
Consumer surplus P0DC vs imperfect information At point E consuming Q1 paying P1*Q1 -
net benefit is equal to +P’CG - GEF; losing because of less information. DEF is the net loss
of social surplus. Government provides information that can move from E to D, avoiding
losses.

2. Externalities
• Unintentional effect of production or consumption on third parties
• There is no market for externalities
• Negative externality generates social cost e.g., pollution caused by factories
• Positive externality generates social benefit e.g., utility generated by neighbour’s garden

Negative externalities = supply curve without negative externalities is below supply curve
with negative externalities. Price is P0 which is more expensive than P1
CS= P0DEp1 PS = p0DCEp1 > including social costs
Deadweight loss as a result - not accounting for externalities.
3. Public goods
• Goods that are shared with the entire population are public goods e.g. public statues, clean
air, etc.
• Non-excludable and Non-rivalrous
• Compare with apples which is a private good
• Publicness of a good cause market failure due to a free-rider problem
• No incentives for firms to produce such goods, so usually supplied by the government

Maximum willingness to pay - kinked demand curve - person 1 demand is 0 at Pa price

above demand curve market demand is 0. (private good diagram)

Quantity supplied Q*, Person 1 willing to pay p1 person 2 willing to pay p2

Vertical sum - kinked demand curve other way around, kink at P1 - after the kink person 2
will benefit and be more than satisfied, leaving person 1 just satisfied (public good diagram)
if someone else pays you don’t have to = free-rider

4. Addictive goods
• Goods for which today’s consumption increases the future consumption e.g., tobacco,
gambling, sugar, etc.
• Rational addiction: when consumers take “addiction” into account when making choices
• When “addiction” is not taken into account, consumers create negative externality on their
future selves
• Addiction results in loss of consumer surplus

Demand increases in the future. Externalities not taken into account.

Demand of unaddicted person below addicted person
Addicted person = P*DB - BCQ1A
Shaded area = loss of surplus (diagram)

Valuing impacts in the input markets

• Assume efficient market
• For simplicity, let MCPF = 1
• Suppose government increases demand for an input which it needs for a project e.g. hiring
labor, buying land or equipments

Chapter 6
Any government policy will have impacts on primary and secondary markets. input=cost
output=benefit
Demand curve shifts d to d+q’ (diagram) as government demands raw materials
Impact = change in social surplus = price increased from P0 to P1 decreasing consumers
demand, reduced consumer surplus. Producers selling more receive higher prices.
Government paying and consuming - total expenditure is EDQ1Q2
Opportunity cost = EDB
Homework
• What would be the total change in social surplus if the government demand q ′ units in the
following two extreme scenarios:
1. when supply is perfectly elastic (horizontal supply curve)
2. when supply is perfectly inelastic (vertical supply curve)
• Post your answers in the CBA - homework padlet

Distorted markets
• Estimating the changes in social surplus gets complicated if the market is distorted
• Examples of market distortion:
1. fixed supply
2. unemployed labour
3. purchasing from a monopolist

2. Hiring unemployed labor

• If market is efficient, market clearing ensures that there are no unemployed labor
• Unemployed labor may exist in the presence of minimum wage laws, union bargaining, etc.
• Government may wish to employ such unemployed labor

3. Purchases from a Monopoly

• If government has to buy the inputs from a monopolist, then expenditures overestimate the
opportunity cost
• In case of monopoly, prices overstate social cost of producing the input

Summary
• Expenditures incurred in purchasing the input may differ from the social opportunity cost if
– prices are affected (in efficient markets)
– market is distorted