Basic Economic Concepts. OBJECTIVE: The student will become familiar with the following items:...
Transcript of Basic Economic Concepts. OBJECTIVE: The student will become familiar with the following items:...
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Basic Economic Concepts
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OBJECTIVE: The student will become familiar with the following
items:
• Economic Fundamentals– Scarcity– Choices– Basis of Benefits Estimates
• Types of Costs• Equivalence of Money Values• Evaluation Tools
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SCARCITY:
Limited Resources+
Unlimited Wants and Needs=
The Fundamental Economic Problem
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SCARCITY:
• Virtually no resource is available in limitless supply
• Tendency to view everything as an “indispensable necessity”
• We can’t do everything
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Choices:
• Limited resources with unlimited wants and needs forces decisions
• Choosing one thing means giving up another (opportunity cost)
• Economics examines the logic of choices among available possibilities
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Choices:
• Optimal decisions select the most desirable option among the possibilities that the resources permit
• Choices have costs
• They cost us the opportunity to do something else.
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Basis of Benefits:
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Demand PR
ICE
QUANTITY
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DemandPR
ICE
QUANTITY
P1
P2
Q1 Q2
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DemandPR
ICE
QUANTITY
Area Under Demand Curve is Total Willingness to Pay (TWTP)
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Area Under Demand CurvePR
ICE
QUANTITY
P
Q
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Area Under Demand CurvePR
ICE
QUANTITY
P
Q
Amount Paid for Q Quantity
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Area Under Demand CurvePR
ICE
QUANTITY
P
Q
Amount Paid for Q Quantity
Area You Did Not Have to Pay
Q1
P1
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Consumer SurplusPR
ICE
QUANTITY
P
Q
Amount Paid for Q Quantity
Consumer Surplus
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Example of Consumer Surplus Benefits:
PR
ICE
QUANTITY
P1
P2
Q1 Q2
A plan reduces the price from P1 to P2: Initial Consumer Surplus (CS) at Price P1 is Yellow Area
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Example of Consumer Surplus:
PR
ICE
QUANTITY
P1
P2
Q1 Q2
A plan reduces the price from P1 to P2: Consumer Surplus gain from Yellow Area to net gain in Blue Area.
Consumer Surplus Gain
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Summary: Estimating Benefits
• These concepts guide our thinking.• We rarely have demand or supply
curves.• Use your basic economic models to
think about situations.• We devise clever ways to
approximate these areas.
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Willingness To Pay Benefit Estimation - Approaches
• Actual or simulated market price• Change in net income• Cost of the most likely alternative• Administratively established values
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Costs:
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Opportunity Cost:
• The cost of forgoing certain opportunities or alternatives in favor of pursuing others.
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Opportunity Cost:
Job Search
• You currently earn $50,000• You start a business and earn
$40,000 profit• How are costs defined?
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Opportunity Cost:
• $40,000 accounting profit• $10,000 economic loss
• The cost of opening the business is the forgone opportunity to make $50,000
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Opportunity Cost:
• Explicit Cost– Out-of-pocket cost
• Implicit Costs– Non-cash costs
• Opportunity Costs = Explicit + Implicit
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Other Costs:
• Incremental Costs– Costs that change due to a decision– Only relevant costs of the decision
• Sunk Costs– Do not vary across alternatives
(including without project)– Do not influence optimal choice
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Associated Costs:
• The costs of measures needed over and above project measures to achieve the benefits claimed during the period of analysis.
• For example: irrigation water supply laterals, electric transmission lines
• Should be included in the net benefits and benefit to cost ratio
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Economic vs. Financial Costs
• Economic = Opportunity Costs– Explicit and Implicit Costs
• Financial or Accounting Costs– Explicit or Actual Cost
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IDC:Interest During Construction
• Conceptually, is compounding pre-base year costs forward to account for time value of money
• Only an economic cost
• Sample calculations in your notebook
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Equivalence of Money:
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Equivalence of Money:
Sums of money that occur at different points in time cannot be directly compared to one another.
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Equivalence of Money:
Price Level
Time Value
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Price Level:
• The same price levels should be used at each point in time
• Select a common point in time as reference (base year)
• Resulting in:– Constant relative prices– Real prices
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Price Level:One ton of Reinforcing Steel
• Selected price level does not matter
• Consistency matters
• Such values can be found industry sources (ENR, Dodge, USACE CCWCI)
Year Price
1951 19.0$ 1961 22.0$ 1971 30.0$ 1981 67.0$ 1991 101.0$ 2001 138.0$
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Price Level:
• Costs occur at different times– Construction costs are pre-base year
and base year – O&M costs are post-base year
• Benefits can occur throughout the analysis
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Time Equivalence:
$ $ $
Time Base Year
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Time Equivalence:
• Pre-base year values are brought forward in time by compounding.
• Post-base year values are brought back in time by discounting.
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Time Equivalence: Example
Cost Schedule
1997 $100 Compound
2002 $100 Constant
2007 $100 Discount
2002 Price Levels
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Time Equivalence:
1997 Compounding
$100 x (1.1)5 = $100 x 1.61 = $161
$100 spent in 1997 grows to $161 by 2002
Calculations with 10% interest rate
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Time Equivalence:
2007 Discounting
$100 x (1.1) -5 = $100 x 0.62 = $62
$100 expected expenditures in 2007 shrinks to $62 by 2002
Calculations with 10% interest rate
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Time Equivalence:
Project Costs2002 Prices
1997 + 2002 + 2007 = Total Costs
161 + 100 + 62 = $ 323
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Time Equivalence:
• Changes in purchasing power are irrelevant to Corps planning.
• Discounting done to account for time value, not for inflation.
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Average Annual Costs (AAC)
• All costs (and benefits) over time are put in same price level and time and summed (total present worth)
• Corps of Engineers evaluate on an average annual basis (AAC)
• Done by applying factor based on appropriate Federal interest rate
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Decision Criteria
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Benefit to Cost Ratio (BCR)
• Computed by dividing the Average Annual Benefits by Average Annual Costs
• Reflects the efficiency of a project• Not the Federal selection criteria
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Net National Economic Development (NED) Benefits
• The total NED average annual benefits minus the NED average annual costs
Net NED Benefits = AAB – AAC
• Used as the selection criteria, the project with highest net NED benefits
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Review:
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Review: Basics of Economics
• Fundamental economic problem?Scarcity
• Basis of economic benefits?Consumer Surplus
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Review:
• Costs
– Costs are important
– Different types of costs are used at different points in the process
– Economists care about opportunity and incremental costs
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Review:
• Time Equivalence of Money
– Price Levels• Values expressed in any common point in
time
– Time Value• Discount and escalate values to bring to
the base year
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Review:
• Benefit to Cost Ratio (BCR) = ratio of AAB/AAC
• Net NED Benefits = AAB – AAC
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Discussion