Chapter 3 - Economics Foundations of Cost-Benefit Analysis
from PART II - FUNDAMENTALS OF CBA
Summary
Microeconomic theory provides the basic technical foundations for CBA. This chapter begins with a review of the major concepts of microeconomic theory as they apply to the measurement of social costs and benefits. Most of these concepts should be at least somewhat familiar from your previous exposure to economics. After that we move to welfare economics, which concerns the normative evaluation of markets and of policies. We explain how to use microeconomic theory to assess benefits, costs, and net social benefits in CBA.
For purposes of simplicity, we assume the presence of perfect competition throughout this chapter. Specifically, we assume that there are so many buyers and sellers in the market that no one can individually affect prices, that buyers and sellers can easily enter and exit the market, that the goods sold are homogeneous (i. e., identical), that there is an absence of transaction costs, that information is perfect, and that private costs and benefits are identical to social costs and benefits (i. e., there are no externalities). Chapter 4 considers how to measure benefits and costs when some of these assumptions do not hold; that is, various forms of market failure are present.
DEMAND CURVES
An individual's ordinary demand curve (schedule) indicates the quantities of a good that the individual wishes to purchase at various prices. The market demand curve is the horizontal sum of all individual demand curves. It indicates the aggregate quantities of a good that all individuals in the market wish to purchase at various prices.
In contrast, a market inverse demand curve, which is illustrated by line D in Figure 3-1, has price as a function of quantity. The vertical axis (labeled Price) can be interpreted as the highest price someone is willing to pay for an additional unit of the good. A standard assumption in economics is that demand curves slope downward. The rationale for this assumption is based on the principle of diminishing marginal utility; each additional unit of the good is valued slightly less by each consumer than the preceding unit. For that reason, each consumer is willing to pay less for another unit than for the preceding unit. Indeed, at some point, each consumer would be unwilling to pay anything for an additional unit; his or her demand would be sated.
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- Cost-Benefit Analysis , pp. 52 - 77Publisher: Cambridge University PressPrint publication year: 2017