The Firm: Objectives, Costs and RevenuesThe Objectives of Firms: Main aim is to maximise profits: MR=MC If MR>MC produce increase profit If MRAP At point C, MP=AP which is maximum average product of C If MP>AP, AP is rising If MP decreases, AP also decreases B = diminishing marginal returns sets in C diminishing average returns sets in

CBOutput

Long-run Production and Returns to Scale: Long run: The time period in which no factors of production is fixed Three possibilities: Increasing returns to scale An increase in the scale of all factors of production causes a more than proportionate increase in output Constant returns to scale An increase in the scale of all factors of production causes an exactly proportionate increase in output Decreasing returns to scale An increase in the scale of all factors of production causes a less than proportionate increase in output

Fixed and Variable Costs, Marginal, Average and Total Costs, Short-run and Long-run Costs:Fixed costs: Costs that do not vary with output. They must be pain the short run even if no output is produced Rent Variable costs: Costs that vary in proportion to output Electricity Gas When labour is the only variable factor of production, variable costs are simply wage costs. With increasing marginal labour productivity, the total variable cost of production rise at a slower rate than output. This causes the MC of production an extra unit of output to fall. However the law of diminishing marginal productivity sets in, marginal cost rises with output. Variable costs rise faster than output, so marginal costs also rise. Marginal costs: The additional cost of making one extra unit of outputAverage costs: Total costs: Total cost of production = total fixed costs + total variable costs Short run costs: In the short run, when the inputs divide into fixed and variable factors of production, the costs of production can likewise be divided into fixed and variable costs Total cost = total fixed cost + total variable cost Average total cost = average fixed cost + average variable cost As quantity increase, AFC decreases as it spreads the cost to products Shows how the firms average total cost is derived by adding the AFC and the AVC MCATCAFCAVC

Shows the ATC curve without AFC and AVC AC is U shaped showing that AC per unit of output fall then rise as output increases AC must eventually rise as at high levels of output, any further spreading of fixed costs is insufficient to offset the impact of diminishing returns upon variable costs

Long run average costs: If, as the firm increases its size or scale of factors of production, it benefits from increasing returns to scale, the LRAC curve falls Economies of scale Rising long-run average costs are known as diseconomies of scale AC3 represents the lowest unit cost and most productively efficient Optimum size of firm

Other types of LRAC curves: Minimum Efficiency Scale is sited at the point on the LRAC curve beyond which no more economies of scale are possible No diseconomies of scale, so all firms beyond MES are equally productively efficient

Economies of Scale: falling long-run average costs as the size or scale of the firm increasesInternal economies of scale: result from the growth of the firm itself and are usually categorised into technical, marketing, managerial, financial and risk-bearing economies.Plant level: Technical economies: relate to production and distribution process Larger firms can employ and combine specialist machinery that should reduce the average costs of production Within larger firms, there is also a greater scope for the specialisation of labour, reducing average costs Law of increased dimensions (doubling the height and width of a tanker can lead to a more than proportionate increase in the cubic capacity) Managerial economies: arise as a result of the application of the division of labour to management Larger supermarkets can afford to employ specialist buyers who can reduce buying costs Better use of equipment and management can raise productivity and reduce average costsMulti-plant: Occur when long-run average costs fall as a result of operating more than one plantFirm-level: Marketing economies: relate to buying and selling As a firm grows it can spread its advertising budget over a larger output, by can purchase its factor inputs in bulk at negotiated prices A firm may have monopsony power Financial economies: larger firms normally have greater access to credit facilities with favourable rates of borrowing in comparison to smaller firms Risk-bearing economies: as firms grow they are able to reduce costs by effectively self-insuring Product diversification reduces the risk associated with the failure of any one product because the firm can be sustained by more successful lines of output Learning effects: Workers trained to use machines Trained to be managerial

External economies of scale: arise from the growth in the size of an industry as a whole Firms will experience a fall in long run average costs, especially if theyre clumped together Economies of concentration: When firms locate near each other mutual advantages (transport, storage, market outlets) Cluster effect Economies of information: Worthwhile for specialist firms to undertake research and provide information through technology and trade from which all firms can benefits Economies of disintegration: Vertically linked production processes can be provided more efficiently by independent specialist firms

Diseconomies of Scale: rising long-run average costs as the size or scale of the firm increases Control: Monitoring how productive each worker is in a modern corporation is both imperfect and costly Co-ordination: It is difficult to co-operate complicated production processes and they may break down Achieving flows of information in large businesses is expensive Co-operation: Workers in large firms may feel a sense of alienation If they do not consider themselves to be an integral part of the business, their productivity may fall

Total, Average and Marginal Revenue:Total revenue

Revenue: the income generated from the sale of a good or service. The revenue earned by a firm depends on the willingness of consumers to buy the product at any given price and therefore relates to demand. Total revenue: Total revenue = price x quantity Price increase depends on price elasticity of demand

PED>1 (elastic)PEDMC produce If firms produce higher than Q1, MRMC consumption is discouraged and allocative inefficiency occurs When P income effect Substitution effect < income effect Substitution effect = income effect

Income effect: As price of goods increases the real income of consumers decreases and they are not able to buy the same basket of goods as before Work is an inferior good therefore if wages increase income increases so there is less demand for work Non-monetary factors: Improvements in the occupational mobility of labour:For example if more people are trained with the necessary skills required to work in a particular occupation Non-monetary characteristics of specific jobs they include factors such as the level of risk associated with different jobs, the requirement to work anti-social hours or the non-pecuniary benefitsthat certain jobs provide includingjob security, opportunities for promotion and the chance to live and work overseas, employer-provided in-work training, employer-provided or subsidised health and leisure facilities and other in-work benefits including occupational pension schemes Net migration of labour A rising flow of people seeking work in the UK is making labour migration an important factor in determining the supply of labour available to many industries

Determination of relative wage rates and level of employment in perfectly competitive labour markets: Downward sloping demand indicates more labour will be demanded the lower the real wage rate Upward sloping supply indicates more labour is supplied if real wages increase Demand for labour increase: Productivity increases (technological change) Increase in selling price of product increase value of each workers output Price of capital increases leading to a substitution of labour Price of complements falls Supply of labour increase: Increase number of workers in population due to change in demographic changes Wages deteriorate in other industries Perfectly competitive labour market:Wage

W* SL = ACL = MCL Wage MPR = D

The employer employs up to where MC=MR Profit maximisation Why do wages differ? Labour is not homogenous: Age Sex Ethnicity Education Ability Workers to not necessarily seek to maximise wages aim to maximise net benefits Labour is not perfectly mobile Footballers and nurses: Supply of footballers is inelastic Barriers to entry for footballers are high due to the fact that natural ability is needed for football and few people possess talent Supply of nurses is elastic Wage differentials: Nursing has a non-monetary benefit Supply side reasons for wage differences is the larger pool of nurses that can be employed Demand for footballers is inelastic Demand determined by MRP Footballers = higher MRP Reflected by willingness and ability for people to pay to watch football Difficult to substitute as few people have the talent Demand for nurses is elastic Easier to substitute than footballers Wages take up NHS production costs Lower wages due to net MRP costs for training and so depresses wages NHS monopoly Economic rent and transfer earnings: Economic rent: the difference between what a person gets paid and what they could earn in their next best employment opportunity Tends to be greater the more inelastic the supply of labour is Transfer earnings: what they could earn in their next best occupation (footballer electrician) ER TE Electrician Footballer

Determination of relative wage rates and level of employment in imperfectly competitive labour markets: Immobility of labour: Occupational: When workers are prevented from moving between jobs Natural or artificial barriers Geographical: When factors such as family ties, finance costs etc. prevent a worker filling a job vacancy Trade unions: Role is to seek better payments for its members If a trade union is formed and bargains wages above market clearing wage (W1 to W2), L2 are employed rather than L1 and creates unemployment of L2-L3 SL becomes linked at XClosed shop: Compulsory union membership the firm will not receive a supply of labour until it accepts wage demands of the union

Union membership in the UK: Factors explaining decline in union membership: Government policy: Reducing union power was one of the key supply side policies of the conservative government. TU were views as a major obstacle to labour flexibility Policies to decrease TU power: Making secondary picketing illegal Requiring secret ballots of workers Making closed shop agreements Restructuring of economy Decline in heavy industry where TU were strong Labour more dispersed in service sector harder for TU to organise Increasing product market pressure Benefits of a trade union: Reduce wage discrimination by collective negotiations Reduce exploitation Raise standards of health and safety Train and development for workers FACTS AND FIGURES: 33 million in workforce 7 million in TU (20%) 15% in private sector 60% in public sector

Monopsony: A sole employer in a market Occurs as a result of lack of competition on the demand side of the market

Monopsony without trade union: Not a wage taker If it wishes to employ an extra worker, it must offer higher wages MCL>ACL as increased wage must be paid to not just the extra worker but all the other workers Monopsonist will hire an extra worker if MRP>MCL

Monopsony with trade union: Labour supply is perfectly elastic when trade unions withhold labour (when wages offered less than target) monopsonist becomes a wage taker MCL is constant In order to combat a monopsony, a monopoly will form (TU) It uses collective bargaining and the threat of industrial action to bargain wages up Any point above Wm and below Wx the actions of the TU result in more workers employed than before the TU DWL of ABC is reduced in size

National minimum wage:ForAgainst

NMW will help alleviate poverty for those who receive itRaising wages leads to a contraction of labour demand and creates unemployment

The morale boost from higher wages could lead to a productivity boostAny unemployment created will disproportionately affect the young

NMW should help reduce labour turnover at companies, lowering recruitment and training costsNMW raises costs of firms and may make them uncompetitive

Firms paying more to their workers have a stronger incentive to train them raising MRPNMW is potentially inflationary

NMW can help counter the power of monopsonist employers Fails to take into account the regional differences in the cost of living

Recipients of the NMW are disproportionately female Not well targeted. May recipients are second wage earners not in poverty

NMW offers a greater incentive to workMany recipients are employed by the state, affecting public sector finances

Reduces male-female differentials Tax and welfare benefits more effective

Introduced April 1999 6.08: 21+ 4.98: 18-20 N1

3.68: 16-17 2.60: apprentice rate (first year of apprenticeship) If minimum wage is set below market wage it will have no impact on the labour market When NMW is at Wm the employer will employ labour at N1 lower than competitive market so higher the NMW the lower employment will be

The distribution of income and wealth:Wealth: the stock of assets (house, cars) with a marketable value Income: the flow concept measured over a given period

The Lorenz curve:AB

A representation of inequality Plots the percentage of a nations income that is enjoyed by the poorest x per cent of the population Diagonal = complete equality The further away from the diagonal, the more unequal

Gini coefficient: Numerical representation of inequality Gini coefficient 0 = complete equality 1 = total inequality

Factors affecting distribution of income:1) Wage differentials High levels of qualifications or people in inelastic supply tend to generate high MRP 2) Differences in income earned from assets The most important are financial assets such as savings 3) Age Earning potential peaks in 40s and 50s 4) Influence of government policies Governments operate progressive systems of taxation Means tested benefits have the greatest effect on distribution of income but universal benefits also have an impact Factors affecting distribution of wealth:1) Inherited wealth 2) Asset prices increase faster than incomes 3) Less easy to distribute

Poverty: Absolute poverty: when income is below a particular level when living on $2 a day Relative poverty: when income is below a specified proportion of average income when household income is below 60% of median income Water poverty: spending more than 3% of disposable income on water bills Fuel poverty: a household which spends more than 10% of its income on fuel Causes of poverty: Low wages Unemployment Illness/disability Poor parents Racial discrimination Single parenthood

Poverty trap and marginal tax rates: Disincentive to work Affects those in poverty and is created by: Means tested benefits Progressive taxation Those on low incomes may face effective marginal tax rates of greater than 100% If unemployment benefit is high, replacement ratio may be close to greater than one incentive to work is reduced Poverty trap could be government failure from a conflict of objectives between equity and efficiency

Measures to tackle poverty: Withdraw benefits Universal not means tested (family allowances) Withdrawing means tested as income is earned Progressive tax Transfers to the poor Tax credits (negative income tax) NMW Government intervention redistribution of income: Effect on incentives Targeting Expense Take up rates Stigma

Means tested benefits:Advantages: They allow money to be targeted to those who need it most. E.g. family tax credit or pension credit. It is cheaper than universal benefits and reduces the burden on the tax payerDisadvantages: Often unpopular because people are branded as being poor May create a disincentive to earn a higher wage, because if you do get a higher paid job you will lose at least some of your benefits and pay more tax. This is known as the benefit trap or the poverty trap Some relatively poor may fall just outside the qualifying limit Not everyone entitled to means tested benefit will collect them because of ignorance or difficulties in applying The government used to prefer universal benefits because it avoided the above problem, and people feel if they contribute towards taxes they deserve their benefits regardless of their wealth

Government Intervention in the Market Market failure: when a market fails to reach an optimal allocation of resources for society due to the market mechanism performing unsatisfactorily Monopoly: market outcome is both allocatively and productively inefficient Missing market: when the incentive function breaks down Goods: Pure public goods: ones which are non-excludable and non-rival Thames Barrier - cannot be restricted to those who have paid for the service and the consumption of the service by one household will not reduce its availability to others If left to the free market mechanism, no public goods would be provided and, as a result, there would be a clear market failure. No individual consumer would pay for a product that could be consumed for free if another household decided to purchase it Non pure public good (Quasi good): ones with elements of both public and private goods These are products that are essentially public in nature, but do not exhibit fully the features of non-excludability and non-rivalry The road network in the UK is currently available to all, but could be made excludable via a system of electronic road pricing. There is also non-rivalry in consumption, but only up to an extent Once roads are congested rival Exam Question: How does imperfect information lead to market failure for the provision of merit and demerit goods? (15 marks) Market failure: inability to reach societys optimal allocation of resources Information failure: where differences arise from perceived and actual benefits/costs meaning there isnt a perfect market Consumer/producers arent fully aware of the costs/benefits of a good So they are under/over consumed Imperfect information may arise leading to under consumption/production of a good that might generate positive externalities Arent fully aware of the benefits the good provides E.g. Education Some wont continue education in sixth form Arent fully aware of the benefits in the long run under consumption diagram E.g. Engineering Too little is produced by universities with preferences to foreign students shortage of engineers who are needed to help the UK improve infrastructure But externalities are difficult to measure universities arent aware of the issue (dont take into account benefits to third parties) Unaware of costs to society and negative externalities Signalling function broken down good is over consumed/produced arent enough regulations imposed making the good too cheap E.g. smoking Long term negative effect on third parties Costs arent taken into account despite tariffs

Environmental market failure: relate to land (factor of production) MSB = MPB + negative externality ABMPB C

1) Resource depletion When there are fewer natural resources available compared to the previous time periods non renewable Negative externality with future generations being the third party 2) Resource degradation When natural resources are rendered less productive than it was in previous periods Result of air/water pollution Negative externality with future generations being the third party 3) Public good aspects of environment Air can be seen as a public good (non-rivalrous, non-excludable and non-rejectable) Government intervention is necessary if clean air is desired 4) Negative externalities Pollution Overprovided in market 5) Positive externalities Planting trees Under produced in market Indirect taxation/regulation/pollution permits

Methods of internalising externalities:1) Taxation (Pigovian tax making polluter pay) Creates incentive for less of the negative externality to be produced Negative externality in productioni. Tax BC which could create compulsory employers liability insurance (if a worker was injured, they have property rights by law to remain healthy firm has to provide safety) Negative externality in consumption i. Tax BC so reduce benefit (demerit good) Problem when consumption of demerit goods forms a higher proportion of spending in lower income households than in higher income householdsi. Cigarettes and alcohol: taxed regressively and lead to increased inequality 2) Subsidy Positive externality in production i. Subsidise AC Opportunity cost of government funding Lack of or reduction in profit motive: a subsidised producer may allow other costs to rise (productive inefficiency), fail to produce enough of the good to a high enough standard (allocative inefficiency) or fail to innovate (dynamic in efficiency) 3) Regulation Banning Quantity controls Minimum standards for health and safety 4) Pollution permits Assumes technology is fixed in short run, government aims to maximise societys welfare Ps MSC = MPC + negative externality MPC MPB = MSBABC Qs Qp Pp

Involves regulation: imposition of maximum limit on amount of pollution Main advantage over regulation i. Costs should be lower Firm wants to produce at Qp but government wants to produce at Qs Government issues Qs of pollution permits firms then trade permits Thus societys welfare is maximised Advantages:i. More efficient wat of reaching desired level of pollution ii. Trade schemes or caps can address international distribution of income. If poor countries are allocated sufficient permits, they can sell them to richer countries iii. Externality has been internalised and those who pollute have to pay Disadvantages:i. Scheme doesnt require a judgment to be reached about the optimal level of pollution. Not sufficient information to reach judgement accurately ii. New market in pollution permits can lead to market failure iii. Trading permits affects geographical distribution of pollution some pollutants may cause more damage if they are in a concentrated areas Kyoto Protocol:i. Set up in January 2005ii. 15 member states of EU participating iii. Covers almost 46% of EUs carbon dioxide emissions 5) Property rights If property rights are fully assigned and parties can negotiate at low cost with one another they will arrive at efficient solutions to problems caused by externalities without the need for explicit government intervention in the form of regulation or taxation E.g. water companies can seek compensation from companies/individuals who pollute rivers Absence can lead to consequences: i. Opportunismmay be encouraged, with individuals or groups exploiting the lack of private ownership. With moderntechnology, itis easily possible to copy CDs without paying for them another example of thefree rider problem, which means that the price mechanism is less effective at pricing goods that can easily be stolenii. Misuseof scarce resources suchas dropping litter on pavements, or deliberately spilling oil in the sea. This problem is made worse is accompanied bymoral hazard, assuming that someone else will pick up the litter, or clean the seasiii. Over-useof resources such as the depletion of rain forests,over-fishing, and traffic congestion, can also result in the general exhaustion

Government failure:Causes: High administrative costs resulting from government intervention Competition policy carries a significant administration cost Inadequate information Regulators may make wrong decision if they have insufficient information Unintended consequences Side effects may be harmful (tightening enforcement of underage drinking laws by raiding pubs more frequently may reduce alcohol problems in pubs but may lead to more illegal drinking) Regulation to prevent overfishing has caused fishermen to throw fish back into sea even though they are dead Conflict between objectives Potential for an equity-efficiency trade off Taxes on petrol Competition policy: When concentrated markets fail to produce efficient outcomes, government intervention is likely Involves government intervention to regulate markets to help them operate more efficiently Aims: Encourage business start ups Encourage entry into markets by removing barriers Take actions against anti-competitive practices Prevent firms from abusing monopoly power Has to power to: Fine firms Force firms to remove barriers Make firms sell off assets Introduce price controls Stop collusion Block mergers Advantages: Low prices for all:the simplest way for a company to gain a high market share is to offer a better price. In a competitive market, prices are pushed down. Not only is this good for consumers - when more people can afford to buy products, it encourages businesses to produce and boosts the economy in general. Better quality:Competition also encourages businesses to improve the quality of goods and services they sell to attract more customers and expand market share. Quality can mean various things: products that last longer or work better, better after-sales or technical support or friendlier and better service. More choice:In a competitive market, businesses will try to make their products different from the rest. This results in greater choice so consumers can select the product that offers the right balance between price and quality. Innovation:To deliver this choice, and produce better products, businesses need to be innovative in their product concepts, design, production techniques, services etc. Better competitors in global markets:Competition within the EU helps make European companies stronger outside the EU too and able to hold their own against global competitors.The rationale for competition policy: Monopoly equilibrium sees price forced above MC creating a misallocation of resources and deadweight welfare loss Perfectly competitive equilibrium MC=AR(P) allocatively efficient

Targets three practices: UK monopoly policy: abuse of monopoly power It is illegal for a dominant firm to exercise its market power in such a way as to reduce competition

OFT identifies the anti-competitive practices Excessively high prices Price discrimination Predatory pricing pricing set below own cost to prevent competitors entering Vertical restrains supplying firm imposes conditions on a purchasing firm Seeks to prevent firms from abusing monopoly power Targets behaviour not dominance UK restrictive practices policy: (cartels, horizontal collusion) Under the 2002 Enterprise Act it is a criminal offence to engage in cartel agreements irrespective of whether they are appreciable effects on competition Cartel agreements involve: Price fixing Limiting supply Each firm agreeing an output quota Collusive tendering UK merger policy: Seeks to prevent mergers that are likely to result in a substantial lessening of competition Need to be monitored as they could become a monopoly Horizontal mergers may allow economies of scale to be gained

UK competition policy: Based on 3 legislations 1998 Competition Act and 2002 Enterprise Act Office of Fair Trading Body charged with ensuring that prohibitions are carried out Can investigate any firms suspected of engaging in one or more of the prohibited practices Funded by government Competition Commission Charged with determining whether the structure of an industry or the practices of firms within it are harmful to competition Investigates monopoly situations

Privatisation, public ownership, regulation and de-regulation of markets:Privatisation: The transfer of assets from the public sector (government) to the private sector In the UK, state-owned enterprises now contribute less than 2% of GDP and less than 1.5% of total employment Nationalisation: when assents are taken back into state ownership Most recent examples in the UK are the re-nationalisation of Northern Rock and Network Rail Major privatisations in the UK British Airways in 1987 and BP in 1998 Has become more complex Focus has switched to breaking up existing statutory monopoly power through deregulation and liberalisation of markets Designed to introduce competition Huge rise in total public sector employment Public sector businesses: British Nuclear Fuels Network Rail Royal Mail Main arguments for privatisation: Private sector and discipline of the free market forces are a better incentive for businesses to be run efficiency and thereby achieve improvements to economic welfare Extra competition will lead to reductions in price level for consumers and improvements in dynamic efficiency Seen as a way of reducing trade union power and encouraging an increase in capital investment Businesses now free to raise extra financial capital through stock market Provides government with short term source of revenue reduction in public borrowing and state spending Improved efficiency Publicly owned companies have no incentive to cut costs X inefficiency Privatised firms have incentive to reduce cost due to higher profits so greater productive efficiency Lack of political interference Governments make poor economic managers - they are motivated by political pressures rather than sound economic and business sense Main arguments against privatisation: State owned enterprises faced competition when part of public sector Transfer of ownership merely replaced a public sector monopoly with a private sector State assets where sold off by governments at too low a price Decreased investment and employment as privatised businesses have sought to cut operating costs Increases monopoly abuse by transferring socially owned monopolies into weakly regulated monopolies Natural monopoly Occurs when the most efficient number of firms in an industry is one. E.g. Tap water has very significant fixed costs; therefore there is no scope for having competition amongst several firms. Privatisation would create a private monopoly which might seek to set higher prices which exploit consumers. Public Interest There are many industries which perform an important public service, e.g health care, education and public transport. In the case of health care, it is feared privatising health care would mean a greater priority is given to profit rather than patient care. Government loses out on potential dividends Many of the privatised companies in the UK are quite profitable. This means the government misses out on their dividends, instead going to wealthy shareholders. Problem of regulating private monopolies Privatisation creates private monopolies, such as the water companies and rail companies. These need regulating to prevent abuse of monopoly power.

Example: Network Rail/Rail TrackPrivatised for these reasons: Loss making nature of British Rail Heavy dependence on external subsidies for rural and provincial services The need to see safety as an overriding priority Positive externalities of railways, - taking traffic off congested roads BR was an integrated national network with a complex systen of fares and railcards. Railways had an extensive national infrastructure

Arguments for rail privatisation: Increased efficiency through reducing costs and cutting waste Increased concern for consumer need less subsidy from government MBOs giving a market led service Arguments for rail privatisation: Rail is a natural Monopoly, therefore there is little scope for competition because duplication would lead to lower average costs Lack of organization of the national network It is not clear where responsibility for safety lies in a fragmented network. E.g. chairman of rail track stated that it is impossible to lower prices, increase investment for improved safety and meet targets for improved punctuality It has not been easy to cut subsidies, many argue the government needs to spend more subsidies to improve safety Less profitable services are always under threat Many fares have risenDeregulation: The process of removing controls To open up markets and encourage the entry of new suppliers E.g. Opening up of markets for household energy supplies Liberalisation of household mail services Financial deregulation affecting banks and building societies Designed to improve resource allocation Makes markets more contestable (forces incumbent firms to lower prices and increase output)

Notions of equity: Equity: fairness Involves a valued judgement Equality: equal Horizontal equity: Concerned with the fair treatment of people whose circumstances are the same People with a similar ability to pay taxes should pay similar amounts Vertical equity: The fair treatment of people whose circumstances differ People with a greater ability to pay taxes should pay more Cost-Benefit Analysis (CBA): The method used to appraise major investment projects Project is commercially viable if its private benefits exceed private costs CBA attempts to establish whether the project carries a net social benefit (social benefit-social costs) Governments may choose to carry out CBA to improve allocation of resources Examples: New line in London Underground New run ways Nuclear power station Projects have to have an efficient use of resources where MSB=MSC Method: Identify all costs and benefits Attach a monetary value to each cost and benefit Find social benefit and social cost using: Social benefit = private benefit + external benefit Social cost = private cost + external cost Subtract social cost from social benefit to find net social benefit Opportunity cost Look at alternative uses for the resources to establish if the project is the best use of the resources

Problems:1) Identifying all costs and benefits: Governments may not have the information to identify accurate costs and benefits 2) Putting a monetary value on costs and benefits Valued by market transactions and therefore may seem relatively easy to measure But future demands may be hard to estimate (costs may exceed budget) 3) Valuing costs or benefits that may/may not occur E.g. nuclear plant possibility of a nuclear accident should be considered Necessary to attach a probability to the cost/benefit concerned 4) Valuing costs or benefits that occur in the future Discount future costs and benefits to find their present value Difficult to choose appropriate rate of discount 5) The CBA may not cover everyone affected(i.e. all third parties) Inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential stakeholders who stand to be affected by the decision. CBA cannot hope to include all stakeholders there is a risk that some groups might be left out of the decision process6) Distributional consequences Benefits to the poor are usually worth more. Those receiving benefits and those burdened with the costs of a project may not be the same. The equity issue is as important as the efficiency argument.

7) Valuing the environment: How are we to place a value on public goods such as the environment where there is no market established for the valuation of property rights over environmental resources? How does one value nuisance and aesthetic values?

8) Valuing human life: Some people are against valuation of human life. This objection can be partly overcome if we focus instead on the probability of a project reducing the risk of death and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies.9) Attitudes to risk: E.g. a cost benefit analysis of the effects of genetically modified foodsi. Precautionary Principle: Assume toxicity until proven safe If in doubt, then regulatei. Free Market Principle: Assume it is safe until a hazard is identified If in doubt, do not regulate Exam Question: Evaluate the advantages and disadvantages of using CBA when deciding whether or not to invest in snow-clearing equipment. (25 marks) Advantages: Puts information in from of decision makers Encourages transparency about the claims that are made Disadvantages: Collects too much information Clouds the issue False objectivity Arguments that CBA could reveal in favour of investment: Prices Output Profits Earnings Employment Arguments against that CBA could reveal: Costs Taxes Government budgets Waste of resources