Question

In valuing the opportunity cost for a project input or resource, when the market of the input or resource is efficient but purchases of the resources will have a noticeable effect on prices, budgetary outlays or expenditures often slightly overstate project opportunity cost. Is this statement true or false? Clearly explain with a diagram.

Answer 1

Public policies often requires input which is used to produce other goods or services and all public policies incur opportunity costs.The opportunity costs is equal to the value of goods and services that would have been produced if the resources or inputs used in the project been used instead alternatively.

The opportunity costs are what must be given up today and in the future,not what has already been given up. The latter is sunk costs and it should be excluded while measuring the cost of the project.

The area under the supply curve represents opportunity cost and this area is used to measure the costs of the inputs however, the most efficient way to measure the value of inputs used by a project is the budgetary outlay which is needed to purchase the inputs and it is usually used in three situations:

-when the market for a resource is efficient and purchase of the resource for the project will have a negligible effect

-when the market for the resource is efficient,but purchase will have a noticeable effect on prices, and

-when the market for the resource is inefficient,purchases may substantially overstate or understate the prices.

The above statement is true and so, we are only going to study the second condition which is that, when the market for the resource is efficient,but purchases will have a noticeable effect on prices, budgetary outlays often only slightly overstate project opportunity costs.

When a large quantity of the resource is purchased,its price will increase, even if it is purchased in an efficient market which will result in upward sloping supply curve for the resource.

Let's look at the below diagram:

The price increase causes the buyer to decrease their demand from Q0 to Q2 but, total purchases made by the project expands from Q0 to Q1. Thus, the Q' units of the resource purchased by the project will be from units bid away from their previous buyers and additional units sold in the market.

The price change is taken account while measuring the opportunity cost.

Note-

General rule- opportunity cost = expenditure incur - or + any increase or (decrease) in social surplus occuring the factor market. In other words, expenditures do not accurately represent opportunity costs when purchase cause social surplus changes in factor markets.And,

Basic Point- when prices change,budgetary outlays do not equal social costs Unless, the rise in prices is quite substantial,however, the change in social surplus will be small relative to total budgetary costs, so in many cases, budgetary outlays will provide a very close approximation of true social cost.

If prices go up substantially,however,budgetary costs need to be adjusted for cost benefit analysis purpose.

If the demand and supply curves are linear or is assumed to be linear, the amount of this adjustment can be calculated as the amount of the factor purchased for the product, Q' multiplied by 1/2(P1-P0)

The opportunity cost of purchasing the resource for the project can also be measured directly by multiplying the amount purchased by the average of the new and old prices-1/2(P1+P0)Q'

The average of the new and old prices is shadow price which reflects the social opportunity cost of purchasing the resource more accurately than the old and new price.

Now, coming back to the diagram, as prices rises from P0 to P1, Producer surplus increases by the area P1ECP0, the increase in the area below price and above the supply curve.

At the same time, consumer surplus decreases by the area P1DCP0, the decrease in the area above price and below the demand curve.

Subtracting, we get a net gain of social surplus in the factor market which is the area CDE.If we subtract this social surplus gain from the expenditure on the Q' units of factor of needed for the project yields the opportunity cost represented by the whole shaded area denoted by letter G which represents the area of opportunity cost.