Cost Benefit Analysis Example for Test 2

8/10/2019 Cost Benefit Analysis Example for Test 2

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Complete Tables 1, 2, 3, 4, and 5 by typing youranswers directly into the respective boxes. When youare done, save the file and then email it to me at

[email protected] 11:59pm on Tuesday, Nov 11,2014.

There are questions throughout the explanation. Youdo NOT need to address those questions marks. Just

complete Tables 1, 2, 3, 4, and 5. Dont worry about the format. After typing in your

answers, a table might extend outside of the slide.Dont worry about it.
mailto:[email protected]:[email protected]


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We are going to do a complete cost benefit analysis of atariff on steel by the US government.

As explained in the last set of slides, we are going touse a table to make sure that we have accounted foreverything.

We will complete a series of 5 tables.

The following is the basic information we need tocomplete the tables.


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Before In the beginning the US does not have a tariff on steel.

Since there is no tariff, the US price of steel is the same

as the world price of steel. Say the price of steel was $9 per pound.

At $9 per pound, US users of steel bought 120 poundsof steel.

Where did these 120 pounds come from? 20 pounds were supplied by US producer of steel.

100 pounds were imported.


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After Now the US imposes a $5 per pound tax on imported

steel.

Because of the tariff, the US price of steel (inclusive ofthe $5 tariff) is going to be different from the worldprice of steel (exclusive of the tariff).


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What will be the world price of steel (exclusive of thetariff)? Will it remain at $9 per pound?

Potential pitfall number 6 reminds you not to assume

things to stay the same. If the US is a large buyer of steel, it is unlikely that theworld price of steel will remain at $9?

Is it going to go up or go down? It will go down. This is because the $5 tariff reduces the

demand for imported steel. When demand goes down,price goes down. (Just like when we dont demand cordedphones, the price of corded phone drops.)

Assume that it goes down to $8. So the new world price of steel is $8 exclusive of the tariff.


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What will be the US price of steel inclusive of thetariff?

It will be equal to the $8 world price of steel plus the $5tariff.

So the US price of steel (inclusive of the tariff) will be$13.


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How much will US users of steel buy? Will theycontinue to buy 120 pounds of steel?

No, US price of steel is now higher at $13 instead of $9.When price is higher, people buy less.

So US users of steel will buy less.

Assume that US users will now buy 110 pounds at $13

per pound. So US users will cut back on steel use by 10 pounds

(120 minus 110) due to the tariff.


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So when there is a tariff, US users will buy 110 pounds ofsteel?

Where do these 110 pounds come from?

Will US producers continue to supply 20 pounds?

No, US price is higher at $13 instead of at $9 so USproducers will supply more at the higher price.

Assume that US producers will now supply 50 pounds atthe higher price of $13 (compared to 20 pounds at the lowerprice of $9).

The remaining 60 pounds (110 minus 50) will be imported.


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The following table sums up all the

information we need.BeforeNo tariff on steel

After$5 per pound tariff on steel

US users bought 120 pounds Now they buy 110 pounds. They buy 10

pounds less than before.US producers supplied 20 pounds Now they supply 50 pounds. They

supply 30 pounds more than before.

Import is 100 pounds (120 minus 20) Import is 60 pounds (110 minus 50)

World price of steel was $9 World price of steel is $8

US price of steel was $9 US price of steel (inclusive of tariff) is$13


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To avoid potential pitfall number 2, we will account forall quantities by fully accounting for the 120 poundsoriginally bought by US users before the tariff.


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120 pounds bought by US users when there was no tariff

Table 120 poundssupplied by USproducers

100 pounds importedwhen there was no tariff

Table 2Additional 30pounds nowsupplied by US

producers whenthere is a tariff

Table 360 poundsimported whenthere is a tariff

Table 4US users cut backby 10 pounds

when there is a

tariff


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Table 1The 20 pounds of steel supplied by US producers both before and after the

tariff

Before After Gain(after minus before)

Loss(after minus before)

Net effect(+ is net

gain; - is netloss)

US producers Sold at $9per pound

Sold at $13per pound

Revenue from 20pounds of steel at$13 per poundminus revenue from20 pounds of steel

at $9 per pound = ?

Cost of producing20 pounds whenprice is $13 minuscost of producingthe same 20 pounds

when price is $9 = ?

?

US users Bought at$9 perpound

Bought at$13 perpound

Value of 20 poundsof steel to userswhen price is $13minus value of thesame 20 pounds ofsteel when price is

$9 = ?

Payment for 20pounds of steel at$13 per poundminus payment for20 pounds of steelat $9 per pound = ?

?

US govt Notinvolved

Notinvolved

? ? ?

US as a whole ?


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Table 2The 30 pounds increase in production by US producers due to the tariff



Net effect(+ is net gain;- is net loss)

US producers Notproduced

Sold at $13 perpound

Revenue from 30pounds of steel at $13per pound minusrevenue from zeropounds of steel at $9per pound = ?

Estimated cost ofproducing 1 poundof steel times 30pounds = ?See Box Aexplanation.

?

US users Bought at$9 perpoundfromabroad

Bought at $13per pound fromUS producers

Value of 30 poundsof steel to userswhen price is $13minus value of thesame 30 pounds ofsteel when price is $9= ?

Payment for 30pounds of steel at $13per pound minuspayment for 30pounds of steel at $9per pound = ?

?

US govt Notinvolvedbecausethere wasno tariff

Not involvedbecause these30 pounds arenot imports

? ? ?

US as awhole

?


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Box A explanation The loss in Box A is the cost of producing 30 pounds of

steel.

Do we know the cost of producing 30 pounds of steel?We dont know the exact cost.

However, we can form a reasonable estimate based ontwo observations.


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Box A explanation continued Observation 1:

US producers are producing and selling 30 pounds

more of steel when the price is higher at $13 after thetariff.

Observation 2:

US producers were not producing and selling these 30

pounds of steel when the price was lower at $9 beforethe tariff.


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Box A explanation continued Observation 2:

US producers were notproducing and selling these 30

pounds of steel when the price was lower at $9perpound before the tariff.

What does this tell you about the minimum (average)cost of producing 1 pound of steel?

The (average) cost is at least $9.


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Box B explanation In Box B we see that the US as a whole has a loss of $?. Here is an intuitive explanation of this loss. Before the tariff, the US was paying $9per pound to import

these 30 pounds of steel from abroad. After the tariff, the US was producing these 30 pounds of

steel at home at an average cost of $?. So the US is paying $? more per pound ($? minus $9). $? more per pound times 30 pounds is $?.

This explanation is intuitive and is a short-cut. There is still value in doing the long table. We are sure that

we have accounted for everything and that we have not leftanything out.


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Box B explanation continued The technical name for the $? loss in Box B is:

Change in producer surplus.

It is also called the deadweight loss due to productiondistortion.

With a tariff, the US is over-producing steel by 30pounds. Those 30 pounds should have been imported

at $9 per pounds instead of being produced at home at$? per pounds. We call this over-production aproduction distortion.


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Box B explanation continued The $? loss can also be calculated as the area of a (right-

angle) triangle.

The base is the increase in US production of steel due tothe tariff.

The height is the increase in US price of steel due to thetariff (from $9 to $13).

The area of this triangle is base times height divided by 2 =30 times ? divided by 2 = ?

So the deadweight loss is also called a deadweight losstriangle.

Base is30 pounds

Height is$?


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Table 3The 60 pounds of steel imported by the US after the tariff



Net effect(+ is net

gain; - is netloss)

US producers Notinvolved

Notinvolved

? ? ?

US users Bought at$9 perpoundfromabroad

Bought at$13 perpoundfromabroad

Value of 60 poundsof steel to userswhen price is $13minus value of thesame 60 pounds ofsteel when price is$9 = ?

Payment for 60pounds of steel at$13 per poundminus payment for60 pounds of steelat $9 per pound = ?

?

US govt Notinvolvedbecausethere wasno tariff

$5 perpoundtariff

$5 per pound tariffrevenue times ?pounds = $?increase in tariffrevenue

? ?

US as a whole ?


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Note that from Table 3, the US government collects $?of tariff revenue.

However, these $? does not represent a net gain to theUS from the 60 pounds of steel import.

This is because US users pay $? more for these 60pounds of steel than before the tariff.

So the net gain to the US from these 60 pounds is $?($? gain to US government minus $? loss to US users).


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Table 4The 10 pounds decrease in purchase by US users of steel when price went

from $9 to $13 per pound due to the tariff



Net effect(+ is netgain; - is netloss)

US producers Notinvolved

Notinvolved

? ? ?

US users Bought at$9 per

pound

Not boughtat $13 per

pound

Expenditure wentdown by $9 per

pound. Total savingis $9 time 10 = $?

Estimated value of 1pound of steel times

10 pounds = ?See Box Cexplanation.

?

US govt Notinvolvedbecausethere was

no tariff

Notinvolvedbecausethese 5

pounds areno longerimported

? ? ?

US as a whole ?See Box Dexplanation.


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Box C explanation US users of steel cut back on their purchase of steel by

10 pounds when the price went up from $9 to $13 due tothe tariff.

When they do not buy these 10 pounds, users lose thevalue that could be obtained from steel. For example,the user could have used the steel to build a ship andsell the ship for a profit.

How much value do users lose?

We dont know the exactvalue.

However, we can form a reasonable estimate based ontwo observations.


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Box C explanation continued Observation 3:

US users are not buying these 10 pounds when theprice is higher at $13 after the tariff.

Observation 4:

US producers were buying these 10 pounds of steelwhen the price was lower at $9 before the tariff.


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US users are not buying these 10 pounds when theprice is higher at $13 after the tariff. What does this tellyou about the maximum (average) value of steel?

The (average) value is at most $13.


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US producerswere buying these 10 pounds of steelwhen the price was lower at $9before the tariff.

What does this tell you about the minimum (average)value of 1 pound of steel?

The (average) value is at least $9.


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Box C explanation continued So the maximum average value is $13.

And the minimum average value is $9.

A reasonable estimate of the average value is themiddle between the maximum and the minimum.

Therefore ($? + $?) divided by 2 = $? is a reasonableestimate of the average value.

The total value of 10 pounds is then $? times 10 = $?,which is in Box C.


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Box D explanation In Box D we see that the US as a whole has a loss of $?.

Here is an intuitive explanation of this loss. Before the tariff, the US was buying steel at $9 per pound but the

value is estimated to be $? per pound.

After the tariff, the US is not buying those 10 pounds. The US is

no longer paying $9 per pound so that is a saving. However, sincewe are not buying the steel, we also lose the $? value from steel.

So the net loss to the US is $2 per pound ($? value we are notgetting minus the $9 saving).

$? per pound times 10 pounds is $?.

This explanation is intuitive and is a short-cut.

There is still value in doing the long table. We are sure that wehave accounted for everything and that we have not left anythingout.


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Box D explanation continued The technical name for the $? loss in Box D is:

Change in consumer surplus.

It is also called the deadweight loss due toconsumption distortion.

With a tariff, the US is under-using steel by 10 pounds.Those 10 pounds should have been imported at $9 per

pounds to generate $11 per pound in value. We call thisunder-consumption a consumption distortion.


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Box D explanation continued The $? loss can also be calculated as the area of a (right-

angle) triangle.

The base is the decrease in US usage of steel due to thetariff.

The height is the increase in US price of steel due to thetariff (from $9 to $13).

The area of this triangle is base times height divided by 2 =10 times ? divided by 2 = ?

So the deadweight loss is also called a deadweight losstriangle.

Base is 10 pounds

Height is$?


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Now we can put the four tables together to get anoverall net gain/loss to the US as a whole.

Table 5Overall Net Effect on US as a Whole

Table 1 ?

Table 2 ?

Table 3 ?

Table 4 ?

Overall net effect of a tariff ?


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So in this example, the overall net effect on the US is a ? of$?. In this case, the tariff is ? for the US as a whole.

However, this will not always be the case.

Note that Table 1 will always show no gain or loss. Table 2 and 4 will always show a loss. That is why they are

called deadweight losses you cannot avoid them as longas there is a tariff.

The only gain comes from Table 3. If the gain in Table 3 islarge enough, it can offset the deadweight losses in Tables 2and 4. If the gain in Table 3 is small, a tariff will result in anoverall net loss to the US as a whole.

Cost Benefit Analysis Example for Test 2

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