Chapter 3

Microeconomic Foundations of
Cost-Benefit Analysis
Learning Outcomes
• Understand the origin of the Demand and Supple curves.

• Realize the difference between the demand and its inverse.

• Comprehend the meaning and implications of consumer, producer

and government surplus.

• Understand the distributional implications of projects and policies.

Origins of the Demand:
• In economics, an individual’s demand for a product refers to all the
different quantities that a consumer is willing and able to buy at all
alternative prices, at a given point in time and holding all else (other
than the price of the product) constant.

• Willingness to pay depends on the consumer’s preferences.

• Ability to pay depends on the price and the consumer’s income (or
budget).
Origins of the Demand:
• Fundamentally:

Subject to (constrained by)

• The solution to this optimization problem will be the consumption bundle, that the satisfies:

• This condition has two ways of interpretation:

1. The marginal utility of the last $ spent on good X equals the marginal utility of the last $ spent on
good Y.
2. The rate at which the consumer is WILLING to trade between goods X and Y (preferences) is equal to
the rate at which the consumer MUST trade between X and Y (prices).
Origins of the Demand:
𝑀𝑈 𝑋 𝑃 𝑋
Y >
• The unique bundle at which the optimization 𝑀𝑈 𝑌 𝑃 𝑌
conditions are both satisfied is B, where:

1. The MRS equals relative prices. 𝑰 𝑴𝑼 𝑿 𝑷 𝑿

𝑷𝒀 =
𝑴𝑼 𝒀 𝑷 𝒀
A
𝑴𝑼 𝑿 𝑷 𝑿
= Y3
𝑴𝑼 𝒀 𝑷 𝒀
B
2. The consumer spends her entire income. Y2
U3
𝑀𝑈 𝑋 𝑃 𝑋
Y1 C U2 <
𝑀𝑈 𝑌 𝑃 𝑌
U1
X
X1 X2 X3 𝑰
𝑷𝑿
 Y

Origins of the Demand: 𝑰

𝑷𝒀
• Assume the optimal point A, where a A
quantity of X1 is demanded at a price of P1, B
point A’ in the lower figure.
U’
U
• If the price falls to P2, the budget line will X
rotate counter clock-wise and reach another 𝑰 𝑰
P
tangency point, B. 𝑷 𝑿𝟏 𝑷 𝑿𝟐
A’
𝑷𝑿𝟏
• This results in point B’ in the lower figure,
where a higher quantity of X is demanded at 𝑷𝑿𝟐 B’
a lower price.
D
• The locus between point A’ and B’ is the X
inverse demand for good X. 𝑿𝟏 𝑿𝟐
The Demand versus X
A’
the Inverse Demand: 𝑿𝟐

• Originally, the demand is B’

𝑿𝟏
expressed as where quantities
of X demanded respond to D
changes in the price of X.
P
𝑷𝑿𝟐 𝑷𝑿𝟏
P
• But under the condition of
monotonicity and Alfred 𝑷𝑿𝟏 A’
Marshall’s convention:

𝑷𝑿𝟐 B’
• We often work with the inverse
demand for convenience. D

X
𝑿𝟏 𝑿𝟐
The Law of Demand:
• As the price of a product increases/decreases, the quantity demanded
decreases/increases, ceteris paribus.

• Why:
1. The income effect: As prices rise/fall, real income falls/rises. Hence the
quantities demanded fall/rise, all else constant.
2. The substitution effect: As the price of X rises/falls, it becomes relatively
more/less expensive. Hence, the quantities demanded fall/rise, all else
constant.
3. Diminishing marginal utility: As we consume more/less of a good, the marginal
utility falls/rises. Hence our willingness to pay falls/rises.
Willingness to Pay and Consumer Surplus:
P
Consider the demand function: 60

• The consumer would be willing to pay $45 per unit for 50
the first 2.5 units of good X. That is her marginal
BENEFIT for the first 2.5 units.
40
• For the second 2.5 units, she is willing to pay only $40.
A lower marginal benefit. (Why?)
30

• For the third 2.5 units, her willingness to pay falls to

$35. An even lower marginal benefit. 20
•…
10

• For the sixth 2.5 units, her willingness to pay is only

$20. 0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
Willingness to Pay and Consumer Surplus:
P
60
Now…
• If she actually has to pay $20, 50
then she will consume a total of
15 units. 40

30
• Her TOTAL benefit from
consuming 15 units is the 20
shaded area:
10

0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
Willingness to Pay and Consumer Surplus:
P
BUT… 60

• She has to pay $20 per unit, which is her

marginal cost. So, if she consumes a total of 15 50
units, her TOTAL COST is the red-shaded area:
40

• Therefore, her surplus (net benefits from

30
consumption) is green-shaded area:

20

10

• This is called her CONSUMER SURPLUS

0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
Willingness to Pay and Consumer Surplus:
P
60
• Consumer surplus is the difference
between consumers willingness to pay
and their de facto payments, for a 50
given quantity demanded.
40

• We may also find her surplus from

consuming any additional (marginal) 2.5 30
units we wish.
20

• For example, for the second 2.5 units,

she was willing to pay $106.25 but paid 10
$50. Hence her marginal benefit for the
extra 2.5 units is $56.25. 0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
Willingness to Pay and Consumer Surplus:
P
60
• In CBA, consumer surplus is used as a
reasonable measure of the benefit to
consumers of a given policy change. 50

40
• Assume a policy that results in a
decrease in the price from $20 to $10.
As a result, the quantity demanded will 30
be 20 units instead of 15 units.
20

• As a result of that policy, the consumer

surplus will change (increase) by a dollar 10
value equal to the blue-shaded area:
0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
 Willingness to Pay and Consumer Surplus:
• It may be that the demand is not linear, or not know at all. In that case, the change in the consumer
surplus may be approximated using the elasticity of demand BEFORE introducing the policy.
 Willingness to Pay and Consumer Surplus:
P
60
• Applying the approximation to the
previous policy:
50

40

30

20

10

0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
Willingness to Pay and Consumer Surplus:
P
60
• It is equally simple to assess the
consequence of a policy that causes
the price the rise from $20 to $30 50

• As a result, the quantity demanded

40
will be 10 units instead of 15 units.
30
• Hence, the consumer surplus will
change (decrease) by a dollar value 20
equal to the red-shaded area:
10

0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25
Willingness to Pay and Consumer Surplus:
• It may be that the demand is not linear, or not know at all. In that case, the change in the
consumer surplus may be approximated using the elasticity of demand AFTER introducing the
policy.
 Willingness to Pay and Consumer Surplus:
P
60
• Applying the approximation to this
policy:
50

40

30

20

10

0 X
0 2.5 5 7.5 10 12.5 15 17.5 20 22.5 25