Economic Concepts and Analysis

REVIEW

Economic Concepts and Analysis

Benjamin Franklin, London, September 19, 1772Benjamin Franklin, London, September 19, 1772

In the affair of so much importance to you, wherein you ask my advice, I cannot, for want of sufficient premises, advise you what to determine, but if you please I will tell you how. When those difficult casesoccur, they are difficult, chiefly because while we have them under consideration, all the reasons pro and con are not present to the mind at the same time; but sometimes one set present themselves, and at other times another, the first being out of sight. Hence the various purposes or inclinations that alternately prevail, and the uncertainty that perplexes us. To get over this, my way is to divide half a sheet of paper by a line into two columns; writing over the one Pro, and over the other Con. Then, during three or four days consideration, I put down under the different heads short hints of the different motives, that at different timesoccur to me, for or against the measure. When I have thus got them all together in one view, I endeavor to estimate their respective weights; and where I find two, one on each side, that seem equal, I strike them both out. If I find a reason pro equal to some two reasons cons, I strike out three. If I judge some two reasons con, equal to some three reasons pro, I strike out five; and thus proceeding I find at length where the balance lies; and if, after a day or two of further consideration, nothing new that is of importance occurs on either side, I come to a determination accordingly. And, though the weight of reasons cannot be taken with the precision of algebraic quantities, yet when each is thus considered, separately and comparatively, and the whole lies before me, I think I can judge better, and am less liable to take a rash step, and in fact I have found great advantage from this kind of equation, in what may be called

moral or prudential algebra.

CONCEPTUALLY BCA IS SIMPLECONCEPTUALLY BCA IS SIMPLE

1. Decide whose benefits and costs count (standing).2. Select the portfolio of alternative projects.3. Catalogue potential (physical) consequences and select

measurement indicators.4. Predict quantitative consequences over the life of the project.5. Monetize (attach dollar values to) all consequences .6. Discount for time to find present values.7. Sum: Add up the benefits and costs.8. Perform sensitivity analysis.9. Recommend the alternative with the largest net benefit

THE REALITIES OF DOING BCATHE REALITIES OF DOING BCA

• Decide whose benefits and costs count.Contentious whether global, national, state, or local

perspective is appropriate.• Select the portfolio of alternative projects.

Potentially infinite, the analyst must select a reasonable subset.

• Catalogue potential (physical) consequences and select measurement indicators.Difficult to identify specific consequences where

unresolved scientific or biological processes are involved.True consequences may be unobservable.


• Predict quantitative consequences over the life of the project.

Prediction is difficult, especially over long periods for complex systems.

• Monetize (attach dollar values to) all consequences (W2P).

Where there are no appropriate market values, one needs “catalogues” that rarely exist. Often the most important benefits are the most difficult to measure.

• Discount for time to find present values.Different theories suggest different social discount rates.


• Sum: Add up the benefits and costs.• Perform sensitivity analysis.

Potentially infinite—analyst has to choose a reasonable subset.

• Recommend the alternative with the largest net social benefits.

This is usually easy! It normally does not present any practical analytical difficulties, just political

ones.The one exception is where sensitivity analysis shows

that NPV estimates are very uncertain.

Linear functionLinear function

Nonlinear functionNonlinear function

● Law of Demand: the inverse relationship between the price of a good and the quantity consumers are willing to purchase.

● As price of a good rises, consumers buy less.

● The availability of substitutes (goods with similar functions) explains this negative relationship.

Law of Demand

Demand

Cell phone service price(monthly bill)

Cell phone subscribers

(millions)

$ 124 3.5 $ 92 7.6$ 73 16.0 $ 58 33.7

Market Demand Schedule

$ 46 55.3 $ 41 69.2

120

100

80

40

0 20 30 40 50

Price(monthly bill)

Quantity(millions of subscribers)

60

60 7010

120

100

80

40

0 20 30 40 50

Market Demand SchedulePrice(monthly bill)


60

60 7010

Demand

• Notice how the law of demand is reflected by the shape of the demand curve.• As the price of a good rises … consumers buy less.

120

100

80

40

0 20 30 40 50



60

60 7010

Demand

• The height of the demand curve at any quantity shows the maximum price that consumers are willing to pay for that additional unit.• Here, for the 16th unit … consumers are only willing to pay up to $73 for it.• While they would be willing to pay up to $92 for the 7.6 (millionth) unit.

• Consider the market for cellular phones service again. This time we will assume that the demand for cell service is more linear and that the market price is $100. 140

120

100

80

60

5 10 15 20 25

Demand

• If the market price is $100, then the 30th unit will not sell because those who demand it are only willing to pay $60 for cellular phone service.

• At $100, the 17th unit will sell because those who demand it are willing to pay up to $100 for cellular phone service.

• At $100, the 5th unit will sell because those who demand it are willing to pay up to $133 for cellular phone service.

Market price = $100

Market Demand Schedule

Price(monthly bill)


30

140

120

100

80

60

5 10 15 20 25

Demand

Market price = $100



30

• For all those goods under 17 units, people are willing to pay more than $100 for service.

• The area, represented by the distance above the actual price paid and below the demand curve, is called consumer surplus.

• This area represents the net gains to buyers from market exchange.

Consumer surplus

Summing Demand for a Private GoodSumming Demand for a Private Good

Summing Demand for a Private GoodSumming Demand for a Private Good

Qa = 20 – PQb = 25 – PQc = 15 – .5P

Summed Qa + Qb + Qc = 60 – 2.5P

• When the market price for gasoline rises from $1.25 to $2.00 a gallon, the quantity demanded in the market falls insignificantly from 8 to 7 million units per week.• In contrast, when the market price for tacos rises from $1.25

to $2.00, quantity demanded in

the market falls significantly from 8 to 4 million units per week.• As taco demand is highly sensitive to price changes, taco demand is described as elastic; as petrol demand is relatively insensitive to price changes, gasoline demand is described as inelastic.

Elastic and Inelastic Demand

$2.00

$1.25

D

Tacomarket

1 2 3 4 5 6 7 8 9

$1.00

Gasolinemarket

D

1 2 3 4 5 6 7 8 9

$2.00

$1.25$1.00

Quantity(tacos)

Quantity(gasoline)

Price

Price

ElasticityElasticity

Various Kinds of Demand SchedulesVarious Kinds of Demand Schedules

Demand for StuffDemand for Stuff

● Law of Supply: there is a positive relationship between the price of a product and the amount of it that will be supplied.

● As the price of a product rises, producers will be willing to supply a larger quantity.

The Law of Supply

SupplyCell phone

service supplied to market(millions)

$ 60 5.0 $ 73 11.0$ 80 15.1 $ 91 18.2 $ 107 21.0 $ 120 22.5

120

100

80

40

0 20 30 40 50

Price(monthly bill)


60

60 7010

Market Supply Schedule

Cell phone service price(monthly bill)

120

100

80

40

0 20 30 40 50

Price(monthly bill)


60

60 7010

Supply• Notice how the law of supply is reflected by the shape of the supply curve.• As the price of a good rises … producers supply

more.


120

100

80

40

0 20 30 40 50

Market Supply SchedulePrice(monthly bill)


60

60 7010

• The height of the supply curve at any quantity shows the minimum price necessary

to induce producers to supply that next unit to market.• Here, for the 11th unit … producers require $73 to induce them to supply it.• While they would require $91 to supply the 18.2 (millionth) unit.

Supply

• The height of the supply curve at any quantity also shows the opportunity cost of producing that next unit of the good.

• Consider the market for cellular phones service again. This time we will assume that the supply for cell phones is more linear and that the market price is $100.

140

120

100

80

60

5 10 15 20 25

• If the market price is $100, then the 30th unit will not be produced because the cost of supplying it exceeds the market price of $140.• At $100, the 17th unit will be produced because those who supply it are willing to do so for at least $100.• At $100, the 5th unit will be produced because those who supply it are willing to do so for at least $60.

Market price = $100

Price(monthly bill)


30


Supply

140

120

100

80

60

5 10 15 20 25

Market price = $100

Price(monthly bill)


30

• For market outputs of less then 17 units, producers are willing to supply the good for $100.• The area represented by the distance above the supply curve but below the actual sales price is called producer surplus.

• This area is the difference between the minimum amount required to induce producers to supply a good and the amount they actually receive.

Producer surplus

Supply


• When the market price for soft drinks increases from $1.00 to $1.50 a six-pack, the quantity supplied to the market

rises from 100 to 200 million units per week.• When the market price for physician services rises from $100 to $150 an office visit, the quantity supplied rises from 10 to 12 million visits per week.• As soft drink supply is very sensitive to price changes, soft drink supply is described as elastic; as physician services supply is relatively insensitive to price changes, physician services supply is described as inelastic.

Elastic and Inelastic Supply

$200

$150

S

Physician Services

market

100

$100

Soft drinkmarket

S

4 6 8 10 12

$2.00

$1.50

$1.00

Quantity(millionvisits)

Quantity(million 6-packs)

Price

Price

50 150 200

2 16 18 2014

quantity supplied of 600 … 7

89

10111213

Excess supply Downward

• This table & graph indicate demand and supply conditions of the market for pocket calculators.• Equilibrium will occur where the quantity demanded equals the quantity supplied. If the price in the market differs from the equilibrium level, market forces will guide it to equilibrium.• A price of $12 in this market will result in a quantity demanded of 450 …

resulting in an excess supply. • With an excess supply present, there will be downward pressure on price to clear the market.

Quantity demanded = 450

Quantity supplied= 600

Market Equilibrium

Price(dollars)

Quantitysupplied(per day)

Quantitydemanded(per day)

12 600 450

10 550 550

8 500 650

Conditionin the

market

Directionof pressure

on price

>

Price ($)

450 500 550 600 650Quantity

D

S

and quantity demanded of 650 … resulting in excess demand.

789

10111213


• A price of $8 in this market will result in quantity supplied of 500 …• With an excess demand present, there will be upward pressure on price to clear the market.

D

S

Quantity demanded = 650


Market Equilibrium

Price(dollars)



12 600 450

10 550 550

8 500 650

Conditionin the

market


on price

>

Price ($)

450 500 550 600 650Quantity

< Excessdemand Upward

and quantity demanded of 550 …

resulting in market balance.

• A price of $10 in this market results in a quantity

supplied of 550 …

789

10111213


• With market balance present, there will be an equilibrium present and the market will clear.

D

S

Market Equilibrium

Price(dollars)



12 600 450

10 550 550

8 500 650

Conditionin the

market


on price

>

Price ($)

450 500 550 600 650Quantity


= Balance EquilibriumQuantity demanded

= 550


Excess supply

Excess demand

789

10111213


• At every price below market equilibrium there is excess demand and there will be upward pressure on the price level.

D

S

Market Equilibrium

Price(dollars)



12 600 450

10 550 550

8 500 650

Conditionin the

market


on price

>

Price ($)

450 500 550 600 650Quantity


= Balance Equilibrium

• At every price above market equilibrium there is excess supply and there will be downward pressure on the price level.

• It is at equilibrium that prices will rest.

Equilibrium price

140

120

100

80

60

5 10 15 20 25

Market price = $100

Net Gains to Buyers and SellersPrice(monthly bill)


30

Supply

Demand

Equilibrium

• Return again to the market for cell phone service. When the market is in equilibrium – where supply just equals demand – price equals $100.

• If the area above the market price and below the demand curve is called consumer surplus … and the area above the supply curve but below the market price is called producer surplus … then the combined area is the net gains to buyers and sellers. It is here that all potential gains from production and exchange are realized.

Net gains tobuyers and

sellers

Natural Monopoly I Natural Monopoly I

Natural Monopoly II Natural Monopoly II

Monopoly RevenueMonopoly Revenue

Natural Monopoly IIINatural Monopoly III

Benefits from a SubwayBenefits from a Subway100K200K140K$1$2$1.60FareRiders per DayOld revenue = $224KOld consumers’ surplus = $98K

New revenue = $200KNew consumers’ surplus = $50K

DWL change = $50K -$18K =-$32K

SUBWAY OPTION

Consumers gain = +$150K

Benefits from a SubwayBenefits from a Subway100K200K140K$1$2$1.60FareRiders per DayOld net operating revenue = $224K - $140K = $84K + old CS ($98K) = $182K

New NOR = $100K + new CS ($50K) = $150


SUBWAY OPTION


Benefits from a SubwayBenefits from a Subway100K200K140K$1$2$1.60FareRiders per DayOld net revenue = $224K - $140K - fixed costs ($60K) = $24K + old CS ($98K) = $122K

New OR = $40K + new CS ($50K) = $90K


SUBWAY OPTION

Consumers gain = $150KTaxpayers lose = $75 K

Bus’ owners lose = $40KNET GAIN = $35K

Bus Fixed Cost = $60K per daySubway Fixed Cost = $75K per day

Benefits from a SubwayBenefits from a Subway100K200K140K$1$2$1.60FareRiders per DaySUBSIDIZED BUS OPTION

Consumers gain = $150KTaxpayers lose = $105 KBus’ owners gain = $5K

NET GAIN = $50K

Bus Fixed Cost = $60K per daySubway Fixed Cost = $75K per day

Assume the Bus Company’sOwners Could be Bribed to

Set the Fare at $1@ $105K

Benefits from a SubwayBenefits from a Subway100K200K140K$1$2$1.60FareRiders per DayOld revenue = $224

New revenue = $200K

DWL change = approx $32K

SUBWAY OPTION


300K

Private GoodPrivate Good

Q = 60 - 2.5P

Public Good IPublic Good I

Summing Demand for a Public GoodSumming Demand for a Public Good

Q a = 20 – P, Pa = 20 – QQ b = 25 – P, Pb = 25 – QQ c = 15 – .5P, Pc = 30 – 2Q

Summed Pa + Pb + Pc = 75 - 4Q

Public Good IIPublic Good II

P = 75 - 4Q

Public Good IIIPublic Good III

What Is a FAIR Tax/Price?What Is a FAIR Tax/Price?

IF THE LIGHTHOUSE

COST $12000?

● Equal share?

● Equal net benefit?

● Equal ratio of MC to MB

IF THE LIGHTHOUSE

COST $12000?

● Equal share?

● Equal net benefit?

● Equal ratio of MC to MB

IF THE LIGHTHOUSE COST $12000 & A + B EACH HAD A BENEFIT LEVEL OF $2000 AND C’s BENFIT WAS $2750?

IF THE LIGHTHOUSE COST $12000 & A + B EACH HAD A BENEFIT LEVEL OF $2000 AND C’s BENFIT WAS $2750?

Economic Concepts and Analysis

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