Chapter 4 – Valuing Impacts from Observed Behavior: Direct Estimation of Demand Schedules

- Key Concept of Valuing Policy Impacts: change in social surplus

o Changes in surplus represented by areas (triangles/trapezoids), bounded by supply and demand
schedule
- Focus on estimating demand curves because:
o Both short-term and long-term demand curves tend to be upward-sloping, long-term supply curves
tend to be perfectly elastic
 There is neither producer surplus in pre-policy market nor change in producer surplus
o For ex post CBA, changes in producer surplus can be computed easily from changes in profits,
which can be obtained directly from affected firms
- To measure social surplus gain, know the demand curve for refuse disposal
Linear Demand Curve
- Market demand curve for a good indicates how many units of goods do consumers wish to purchase at
each price
- Linear functional form = linear relationship between quantity and price
o Written as
 Q = Quantity Demanded at Price (P)
 = Quantity Demanded if Price = 0
 = Change in Quantity Demanded if Price increases in one-unit
- Price Elasticity Estimate
o Measures responsiveness of quantity demanded to changes in prices

o For linear demand, price elasticity of demand is written as:

 It is always negative because and p & q > 0
 Non constant because it varies with both price and quantity
o If there is an estimate of price elasticity and know the price and quantity, it will be written as:

- Construction of linear demand curve to measure changes in social surplus requires either direct estimate of
the slope itself or estimate of price elasticity of demand and price and quantity at which elasticity was
estimated
- In using slope/elasticity estimate, validity is important
o Internal Validity: involves evaluation design issues, and issues related to proper use of econometric
techniques
o External Validity: involves appropriateness of using estimates derived from data collected at other
times, places, and populations
Constant Elasticity
- Market demand curve may not be linear
- Many goods have constant elasticity demand curve
o Elasticity of demand does not change as price and quantity change
o Written as
 Q = Quantity Demanded at Price (P)
 Bo & B1 = Parameters
 To interpret B1 = natural logarithm, denoted by 1n
 o
 B1 = Slope of Demand Curve
 Ed = Price Elasticity of Demand, does not depend on
price/quantity because it comes from constant elasticity
demand curve
 B1 = Ed

- Formula of area under constant elasticity demand curve from quantity Qo to Q1:
- Complication: using elasticity demand from constant elasticity functional form to predict effect of raising a
price from zero to some positive level
- Constant Elasticity Demand Curve
o Has inconsistent observation of zero price
o No full satisfactory way to make use of elasticity estimate
o Should be an informed guess that serves as starting point for sensitivity analysis
Extrapolating from Few Observations
- The further analysts extrapolate from past experience, the more sensitive are their predictions to
assumptions about functional form
- Analysts can derive two functional forms
o Absence of theoretical guidance or empirical evidence
o No basis for choosing between two predictions
Econometric Estimation with Many Observations
- If observations of quantities demanded at different prices are available, it is possible to use econometric
techniques to estimate demand functions
- Linear Regression Model
o Serves as starting point
- Model Specification
o Starting point for econometric estimation of demand functions
o Specifies independent variables (e.g. price and income)
 Affects Qd and functional form the relationship

 Q = Demand of a particular good
 P = Price of a Good
 I = Income
 T = Temperature
 F = Functional Form, may be linear, linear in logarithms, have some other form
o Should include all variables that affect demand in theory
 There may be no substantive interest in some explanatory variables (e.g. temperature), it
still should be included to control the effects of dependent variables
 Independent Variables (e.g. price and income)
o Set of included explanatory variables is limited for four reasons:
 measures of variables may not be available at reasonable cost
 some variables have relatively small expected effects
 variable may be excluded because it is too highly correlated with other explanatory
variables
  problem of multicollinearity
 number of observations may be small
 additional variables reduce degrees of freedom that help determine precision
estimates
o Seriousness of excluding theoretically important variable depends on two factors:
 Depends on the degree to which the excluded variable is correlated with an included
variable of interest
 one whose coefficient we require for predicting policy effects.
 The higher the correlation, the greater is the bias in the estimated coefficient of
the included variable
 it depends on the true coefficient of the excluded variable if it were included
 If coefficient is very small, then the bias from excluding it is likely to be small
o Assuming model has linear functional form:
 = error term that captures effect of unmeasured variables on q
 Can be estimated by Ordinary Least Squares (OLS) – assuming no simultaneity problem
o Constant Elasticity Functional Form model:

o Natural Logarithm of Both Sides of equation:

 “linearized” model
 Can be estimated by OLS with lnq as dependent variable
 Lnp, InI, lnT = explanatory variables
Types of Data
- Data availability is limiting factor in estimating demand curves
- Resource limitations forces to rely on convenience samples
o data that is available at acceptance cost
- Level of Aggregation
o First major consideration is level of aggregation
o Individual-level data measure behavior of consuming units
o Aggregate-level data measure combined behavior of groups of consumers
- Cross-sectional Data vs Time Series Data
o Second major consideration in selecting data is the choice between cross-sectional data and time
series data
o Prone to different types of econometric problems and yield coefficient estimates that have different
interpretations
o Cross-section data
 Involves observations on number of comparable units at same point in time
 Generally provide estimates of long-run elasticities
o Time series
 Involves making repeated observations on same unit at several points in time
 Provide estimates of short-run elasticities
- Identification
o Determining whether we are estimating a demand curve or a supply curve is one example of
problem
 o Endogenous Variables: occurs in multiple equation models in which some variables (e.g. price and
quantity) are determined simultaneously
o Exogenous Variables: variables are fixed or determined outside of the model
o Identification of Demand Curves
 Tends to less of a problem in markets typically of interest in cost-benefit analysis than in
markets generally
 Identification problem does not arise in markets where price is exogenously
- Confidence Intervals
o Standard errors of estimated coefficients of model can be used to construct confidence intervals for
coefficients
o 95% confidence interval is interpreted as 95% chance that true value of coefficient lies within the
interval = incorrect interpretation
 Correct interpretation = to repeat the estimation procedure many times, with new data
sample for each repetition, estimated confidence intervals would contain true value of
coefficient in 95% of repetitions
Chapter 5 – Valuing Impacts in Outputs Markets
- Change in allocative efficiency due to new project or change in government policy:

o = changes in social surplus occurring in output, input, and secondary

markets
- Change in Social Surplus in output market equals:
o /_\ R = change in government revenues from policy
o /_\ E = change in government expenditures on policy
o Government revenues as occurring in output markets because that is where they are collected and
government expenditures as occurring in input markets because that is where money is spent
o /_\CS and /_\PS = changes in consumer surplus and producer surplus in output markets
o Yg = one plus the marginal excess tax burden

References
Anthony , B., David, G., Aidan, V., & David, W. (2018). Cost-Benefit Analysis: Concept and Practice.
United States of America: Sheridan Books, Inc.