Cost Benefit Analysis, Deadweight Loss - Math Problem Example

Econ 361 DE – Problem Set Two Questions Question a. Use a diagram to illustrate the deadweight loss that, in the absence of government intervention results from information asymmetry. Solution: A deadweight loss refers to specific forms of benefits that consumers or producers lose due to inefficiency within market operations. In most cases such inefficiencies are caused by monopoly pricing or taxation (Brent 89). In other words, a deadweight loss can be termed as the total surplus resulting from market distortion especially from the side of government regulations on prices and in most cases the levied taxes. Asymmetric information can lead to disappearance of markets or rather inefficient allocation of resources, which causes the deadweight loss (Brent 98). A deadweight loss can be illustrated on the basis of the following graph. In the absence of government interventions from asymmetrical information, the market is likely to be inefficient thus causing a consumer surplus gain represented by CFEG and a consumer surplus loss represented by DGB. The graph CFEG+GEB represents the producer surplus. Therefore, the deadweight loss in this respect will be represented by DGB+GEB. Therefore, in the absence of the government interventions in a market with asymmetrical information, there is likelihood that the market will experience a deadweight loss represented by the graph DGB+GEB. b. Briefly describe a policy that could partially or entirely eliminate the deadweight loss resulting from information asymmetry. Solution: Deadweight loss results from the inefficiencies within various markets especially with respect to asymmetrical information. Efficient markets need symmetrical information to both buyers and producers. In the event that one party has more information than the other then there is likely to be inefficiency within the market, which definitely leads to deadweight loss. Nonetheless, various government policies can be employed in order to eliminate the deadweight loss resulting from information asymmetry (Brent 79). One such government policy is provision of adequate information in various sectors through various interventions such as cost-subsidization policies. The cost-subsidization policy will assist in making sure that every individual buyer has adequate information and access to specific services. c. Use the diagram, indicate the benefits, costs, or transfers that would result from implementing your policy (show these areas on your graph) and describe discuss each. Solution: The government’s involvement in eliminating the deadweight loss is likely to yield to various benefits, costs, and possible transfers. Through cost-subsidization programmes, the government will enable the customers to achieve social benefits hence reducing costs in respect to acquisition of goods. The following diagrams illustrate how gained social surpluses will assist in eliminating deadweight loss caused by the information asymmetry. In the above figure, the involvement of the government through cost-subsidization has caused an increase in the social surpluses hence making it possible for the elimination of the deadweight loss within an inefficient market. Another graph illustrating the significance in terms of the costs, benefits, and transfers that consumers may derive from government inventions involving the cost-subsidization policy that aims at providing adequate information regarding the market is represented below. This graph provides an illustration of how consumers benefit from the government invention. The benefits are increase in government revenue on one hand and gain in the consumer surplus. However, the transfer experienced is the shift of surplus from consumers to producers hence bringing about loss or cost to producers as they lose their surpluses. d. Describe any benefits, costs, or transfers that do not show up in your diagram. Solution: Even though benefits, costs, and transfers are illustrated in the above graphs, there are some costs, benefits, and transfers that cannot be illustrated. Such costs, benefits, and transfers are attached to the social and economic aspects (Brent 102). Most social costs, benefits, and transfers are immeasurable in monetary form hence illustrating then on the graph becomes difficult. 2. Should all information asymmetry problems be eliminated through government intervention? If not, what types of information asymmetry should the government focus on and why? Solution: There is no doubt that information asymmetries cause inefficiency within markets thus causing deadweight loss. Moreover, it is indisputable that government plays an important part through specific policies that aim at reducing or eliminating the deadweight loss. However, it is not right to leave all the information asymmetry problems be eliminated through government interventions. There are various ways through which other stakeholders other than the government can employ in order to eliminate deadweight loss. For instance, in respect to signaling and screening should be interventions carried out by the other stakeholders and not the government (Brent 139). Both buyers and sellers need to be responsible enough in order to enable passage of information in respect to specific products. Even though the government is involved in eliminating the deadweight loss, its interventions should only focus on areas where there are benefits that would accrue to the public. Such scenarios only apply if the government is the sole custodians of the needed information (Brent 137). Therefore, the government should only focus on correcting information asymmetries where there are public concerns and benefits on one hand and when it is only the government that has the required information on the other hand. 3. The liberals have won the federal election. They immediately impose a price floor of $300 on apartment rentals throughout the country in order to ensure a minimum return to landlords or owners of rental property. The demand curve for apartment rentals is QD = 4000-5p, while the corresponding supply curve is QS = 20p. (Remember that a price floor is a regulation that makes it illegal to trade at a price lower than the specified level). a. What is the equilibrium price and quantity in the absence of any price floor? Solution: Equilibrium price and equity are obtained at the point where the QS = QD. Therefore, QS = 20p needs to be equated to QD = 4000-5p Hence, 20p = 4000-5p 25p = 4000 Equilibrium Price, p = $160 From the price, the quantity can be obtained as follows: QS = 20p or QD = 4000-5p Which is given by 20*160 or 4000 – (5*160) = 3,200 quantity or 3,200 Therefore, the Equilibrium quantity = 3,200 units Equilibrium price and quantities are $160 and 3,200 units respectively b. Does the price floor result in any change to consumer and product surplus? Identify the exact components of any change (transfers, deadweight loss) and illustrate your answer graphically. Solution: A price floor refers to the lowest legal price upon which a commodity can be bought. In this scenario, the price floor set at $300 means that the rentals cannot be let at a lesser price other than $300. However, the equilibrium price in the market is $160. In most markets, the price floor usually acts as tax on the consumers whilst a subsidy to the producers. Therefore, the main impacts of price floor include excess supply, under-consumption in the market, decrease in the consumer surplus, and transfer of some consumer surplus to producer hence causing an increase in producer surplus. Consequently, this leads to a deadweight loss. The following two graphs show the changes that occur as a result of price floors and consequently deadweight loss. 4. Suppose construction of a new road will divert traffic from an older road, thereby driving some of the gas stations on to older road out of business. Discuss the factors that determine the extent to which this should be treated as a component of the cost of building the new road. Solution: Different investments and projects are usually carried out with the main aim of ensuring that there are adequate benefits to the people affected. In the scenario of constructing a new road that diverts traffic from an older road hence forcing some businesses out of business, there are specific factors to consider in determining the extent to which the project should be treated as a component of the cost of building the new road. The two main factors include social and economic benefits. If the making the gas stations to be out of business causes some social impact, then that should be considered cost of building the road. In addition, if there are economic benefits that the community will lose in the process of forcing out the gas stations out of businesses, then the component should be considered cost of building the new road. Therefore, the cost of building revolves around social and economic costs, which may arise due to loss of social and economic benefits respectively. 5. Suppose the government is considering an increase in the toll on a certain stretch of highway from $0.40 to $0.50. At present, 60,000 cars per week use that highway stretch; after the toll is imposed, it is projected that only 40,000 cars per week will use the highway stretch a. Assuming that the marginal cost of highway use is constant (i.e. the supply schedule is horizontal) and equal to $0.40 per car, what is the net cost to society attributable to the increase in the toll? (HINT: The toll increase will cause the supply schedule, not the demand schedule, to shift.) Solution: Since the marginal costs remains at $0.40, the net cost would be the marginal cost multiplied by the quantity. Given that the quantity has changed from 60,000 cars to 40,000 cars per week, the net cost would be $(0.40 * 20,000) = $8,000 b. Because of the reduced use of the highway, the government would reduce its purchases of concrete from 20,000 tons per year to 19,000 tons per year. Thus, if the prices of concrete were $25 per ton, the government’s cost savings would be $25,000. However, the government’s reduced demand for concrete causes its market price to fall from $25 per ton to $24.50 per ton. Moreover, because of this reduction in price, the purchases of concrete by non-government buyers increase by 300 tons per year. Assuming that the actor market for concrete is competitive, can the government’s savings of $25,000 be appropriately used as the measure of the social value of the cost savings that results from the government purchasing less concrete? Or would shadow pricing be necessary? Solution: Given that the actor market for concrete is competitive, any factor that shifts the equilibrium price and quantity should be considered in determining the social benefits of specific projects. In this scenario, the government’s reaction towards the use of a public good has caused a reduction in the prices of concrete. Given the competitiveness of the market, it is true that the factors that come into play should be considered whilst evaluating the social benefits attached to the public good. As a result, there is no need to attach monetary values to every asset through shadow pricing. 6. On the first assignment, you were asked to identify one topic in the Cost-Benefit Analysis: The Mystique versus the Reality article that you consider important to cost-benefit analysis and explain why. Given your CBA learning to-date, do you still believe the items you identified (in your paper) are still key to CBAs and why. A one paragraph answer will suffice. Please note that there is no right or wrong answer to this question –I am looking for your explanation of the topic and your reasoning for selecting the topic Solution: Definitely, the knowledge on Cost-Benefit Analysis enables an individual to make appropriate decisions especially with respect to social policies in a rational way. Nonetheless, the contemporary environment is experiencing significant changes especially with respect to technological advancements. Surprisingly, CBA goals, procedures, assumptions, and contemporarily developed applications are not congruent with the contemporary environment in respect to technology. The article is very important to CBA since it identifies the discrepancies between the goals, applications, procedures, and assumptions of CBA and the contemporary environment upon which social policy decisions are made. Indeed, based on the CBA learning to-date, it is still clear that such items are still key very significant in the perspective of CBA especially taking the note of changing environment. 7. A pool is being constructed in town of Smithville and as a result, the citizens of Smithville are purchasing more bathing suits and sun tan lotion than they would without the pool. Do these purchases need to be taken into account when estimating the benefits and costs of the pool? Explain any factors that might be important when determining whether or not the purchase needs to be taken into account. Solution: A social project is judged on the basis of both economic and social benefits that a given community receives. Since the bathing suits and sun tan lotions are bought courtesy of the new pool, it is important to include them whilst establishing the benefits and costs of the pool. Notably, the businesses around the pool never made many sales on the bathing suits and sun tan lotions. With construction of the pool, the businesses around are now benefitting as the sales increase. Therefore, there is no doubt that the pool has brought economic benefits to the businesses that operate around. Moreover, there is likelihood that region will experience more importation or production of more bathing suits and sun tan lotions. Consequently, these buying behaviors and decisions should be considered whilst establishing costs and benefits of the pool. Social and economic impacts are very vital in making social policy decisions in respect to projects. Other facts that need to be considered in determining the benefits and costs of the pool include the displacement impact, creation of public good, and the impact on the public revenue in respect to construction of the pool. All these factors directly relate to the construction of the pool project hence the need to be considered whilst establishing the benefits and costs of the pool. For instance, when many people are displaced then the cost of constructing the pool becomes very high. 8. Question a. State –via a one sentence explanation for each–the four simple methods that can be used to predict impacts when demand and supply curves are not available. Also, provide an example with each method. Solution: In the absence of demand and supply curves, there are various other methods that can be used in order to predict impacts. The methods vary from simple to complex. In addition, such methods are based on specific available data or information. Four simple methods include: Delphi method that seeks to develop a point of consensus amongst various prepositions from different experts. For instance, using the economics various views in coming up with the overall economic stand of a given project. Causal or associative methods, which explore the relationships between causes and effect based on leading indicators. For instance, predicting housing project based on appliance sales. Time series methods that assume same pattern in future. For instance, predicting the increase in the development of houses since it has been the pattern of late. The prediction of the creation of houses can be linked to the belief that the current pattern where there has been increased demand for houses will remain unchanged in future. Collaborative planning forecasting and replenishment (CPFR) methods that uses collaborative relationships between buyers and sellers thereby developing a joint plan to predict the future. For instance, the collaborative relationships can be used in predicting sales in the future. b. State –via a one sentence explanation–why complex methods even exist. Solution: Other than simple methods for predicting the future, there are complex methods that can be used when there are no demand or supply curves. One such method is the use of regression analysis. Complex methods such as regression analysis exist for the purposes of having an accurate and complex prediction. 9. Assume a municipal government wants to measure the gross benefits of community tennis courts that it owns and operates. Currently the municipality does not charge an admission fee for playing on the tennis courts and receives 400 visitors per month. In a comparable municipality, a privately owned tennis club charges $10 for admission and receives 100 visitors per month. a. If we assume a linear demand curve passes through these two points– what is the estimated gross benefit of the municipal tennis courts –fully explain your calculation (use a diagram is you feel it will help your explanation). Solution: Demand curve passes through the points (400, 0) and (100, 10). The gradient of the linear demand curve can be obtained from the change in quantity over the change in prices. The gradient will be given by: (400-100) / (0-10) The gradient of the linear demand curve is -30 In this perspective, it means that the estimated gross benefit that the municipal will be represented by the area under the graph, that is, the area between 100 and 400 visitors. From the above graph, the gross benefit will be given by ?*300*10 Therefore, the gross benefit to the municipal council based on the tennis court will be $1,500. The gross benefit is given by the area under the graph that is controlled by the municipal council. Even though the council does not charge the court, the gross benefit is derived from other aspects that include both social and economic benefits as opposed to the private court, which only receives the private benefits obtained from the charges. Therefore, there is no doubt that the municipal council receives a much higher gross benefit in respect to both social and economic benefits as illustrated in the above graph. b. How reasonable is to envision the observed price and quantity at the private tennis courts arena as a point on the demand curve for the municipal tennis courts –explain your stance. Solution: The municipal council controls the overall demand within the market. Given that it does not have any charges in respect to using the tennis court, many people would prefer going to the municipal courts rather than the private courts. As a result, the municipal council commands the market of courts within the region. Besides, the number of visitors experienced within the environment is higher for municipal court than the private courts. Therefore, it is reasonable to envision the observed price and quantity at the private tennis courts arena as a point on the demand curve for the municipal tennis courts. 10. Consider a public project to improve the un-crowded shore of a small community by converting it into a public beach. The estimated cost of developing the beach is $150,000 and the future maintenance and operating costs are expected to be $15,000 annually for 30 years. When completed, the beach will be provided, free of charge, to an estimated 15,000 individuals per year. Currently 6,000 individuals enjoy the existing un-crowded shore facilities that are available –such as swimming and camping. These facilities are currently serviced by a near-by private business, who charges a $3 fee per visit, at cost of $2.50 to the private business –so the average profit made by the near-by private business is $.50 per visit. After construction of the new facility, an additional 9,000 individuals are expected to benefit from the facilities free of charge. As stated above, an initial investment cost is estimated at $150,000 with an expected lifetime of 30 years with annual maintenance and operating costs to be $15,000.The salvage value after 30 years, is estimated at zero. Determine if the project is feasible, using the NPV rule at a discount rate of 6%. Complete a supporting diagram (HINT: Place visitors on the x-axis and price on the y-axis). Show all your calculations and ensure to explain what components are within the cost and the benefit (of your calculations). Solution: Net Present Value analysis of the project: Initial investments = $ 150,000 Annual operating and maintaining costs = $15,000 Salvage Value = $0 Life Span of the investment = 30 years Discounting rate = 6% Year Cost Returns Net Returns 0 150,000 0 -150,000 1 15,000 45000 30,000 2 15,000 45000 30,000 3 15,000 45000 30,000 4 15,000 45000 30,000 5 15,000 45000 30,000 6 15,000 45000 30,000 7 15,000 45000 30,000 8 15,000 45000 30,000 9 15,000 45000 30,000 10 15,000 45000 30,000 11 15,000 45000 30,000 12 15,000 45000 30,000 13 15,000 45000 30,000 14 15,000 45000 30,000 15 15,000 45000 30,000 16 15,000 45000 30,000 17 15,000 45000 30,000 18 15,000 45000 30,000 19 15,000 45000 30,000 20 15,000 45000 30,000 21 15,000 45000 30,000 22 15,000 45000 30,000 23 15,000 45000 30,000 24 15,000 45000 30,000 25 15,000 45000 30,000 26 15,000 45000 30,000 27 15,000 45000 30,000 28 15,000 45000 30,000 29 15,000 45000 30,000 30 15,000 45000 30,000 NPV Value $248,061.26 From the above NPV analysis, the project is viable since the NPV is positive. Therefore, the public project to improve the un-crowded shore of a small community by converting it into a public beach is viable and should be carried out. Work Cited Brent, Robert. Applied cost-benefit analysis. Northampton, MA: Edward Elgar Publishing Limited, 2008. Print. Read More