Today

• Chapter 2 in the textbook

• Problem Set 1 on Ted (due October 8th)

• TA session 1:Carlo: Thursday 10/3, 7-8pm (Cog Sci 002)Marina: Monday 10/7, 7-8pm (Cog Sci 002)

Reading for Thursday

• Chapter 3 and start Chapter 4 of the textbook

Net Benefits

• Net benefits are just what is left over after all the costs have been incurred and benefits realized, i.e. benefits minus costs

• Works like most other decisions in economics

Example from the book

• Economist goes on vacation:

Option Price (cost) Enjoyment (benefit)

Net benefit

Tent 400 550 150

Cabana 600 900 300

Cabana+ 850 1100 250

Deluxe 1250 1250 0

Back to the environment• We’ll frame the question in terms improvements in

environmental quality

• Reduction (“abatement”) of emissions

• 0 reduction = the base case (often the status quo)

• reduction > 0 = various policy cases we might consider

• 100% reduction = no pollution (the strongest possible policy case)

• Example: protection of land to varying degrees

• What does 0 abatement represent? What about 100%?

• Benefits come via improved environmental quality

• Costs come from things we give up, and effort we have to make, in order to abate emissions or protect land

Total Abatement Cost

Why do we think this is usually convex as drawn?

Total Benefit

Why do we think this is usually concave as drawn?

Net Benefits

Net benefits =B(X)-C(X)

Define:XMAX?X*?

Graph the vacation choice

• Graph the costs and benefits

• What is the “base” case here? What are costs and benefits in the base?

• Indicate “X*”

• Are the costs, benefits concave or convex?

Option Price (cost)Enjoyment (benefit)

Net benefit

Tent 400 550 150

Cabana 600 900 300

Cabana+ 850 1100 250

Deluxe 1250 1250 0

Corner solutions

• Draw a case where X* = XMAX

• Draw a case where X* = 0

• Think of environmental examples where one of these is a good economic model of the problem

• Is more likely to represent costs or benefits in the standard model?

• What about

Algebra

Linear Costs and Benefits

• If total costs and benefits are straight lines at least one (and maybe both!) of the following are true:

X* = 0 X* = XMAX

• Make a logical argument that proves the statement above.

• When are both equalities true? This is a case where total net benefits are maximized for any value of X.

Analysis on the Margin

• What do we mean by marginal effects?

• It’s what happens when you do just a little more of something (e.g. one more unit of pollution reduction)

• Marginal cost is the cost of one more unit of reduction (abatement)

• Marginal benefit is the benefit of one more unit of reduction (abatement)

• Convex total costs imply increasing marginal cost

• Combined, the largest net benefit X* will occur where MB(X) crosses MC(X) from above

• To the left of X*, marginal benefits are larger than marginal costs -- one more unit of pollution reduction produces more benefit than it costs

Total ___ is the Area Under Marginal ___

• Remember this as a general rule for graphical analysis in this course

• It applies to costs of reduction, environmental benefits, and later in the course also to things like producer and consumer surpluses

• It is true anywhere we want to relate total and marginal values

The Dynamic Problem

• So far we have looked at the “static” problem, just a one-time measurement of costs and benefits with no attention to timing

• How should we think about dynamics, costs or benefits that come in the future?

• Very important for lots of environmental problems -- what are some examples?

Discounting

• In cases where costs and benefits occur at different times we still need a way to compare them in order to maximize net (present) benefit

• Idea is to first place all costs and benefits in the same terms (usually we use value in the present day). Then return to the simple cost-benefit

• The key relation is:

Discounting

• Use the relation between values across time to turn everything (i.e. all the various costs and benefits at different times) into present value

• Once everything is in the present, we are just back to static analysis

• Can ask: From today’s (present) perspective, does something pass a cost-benefit test, have we maximized net benefits?

Example: Marginal Analysis

• Suppose the marginal benefit from abatement (saving water in this case) is constant at $8 per acre-foot and the marginal cost is increasing, given by 2⋅X (where X is number of acre-feet saved).

• Is total benefit concave, convex, or linear? Total cost?

• Sketch the total cost, marginal cost, total benefit, and marginal benefit curves

• What is the amount of water-savings that maximizes net benefits?

Marginal Abatement Cost Curve (U.S. CO2, through 2030)

• Sketch the total cost curve that corresponds to McKinsey’s analysis

• If the marginal benefits of CO2 reduction are MB = $25, what is X* (approximately)?

• What is X* if there is no climate change and no benefit at all to abating carbon? (i.e. MB = 0)

Questions:

Energy Paradox

• The case on the last slide is paradoxical in the sense that total costs and benefits do not start at zero when there is no policy. (In the book and most of my examples they both have to start at 0 by definition.)

• Sometimes also called an “energy-efficiency gap,” this sort of argument often appears in the political dialog

• In what sense is it a paradox?

• Can we still use cost-benefit analysis to make decisions in a world like McKinsey’s? How?