Consumer and Producer Surplus in Benefit-Cost Analysis
So far in this book it has been assumed that undertaking a proposed project would have no effect on the market prices of goods and services. However, since the market economy consists of a complex network of inter-related output and input markets, it is possible, in principle, that undertaking the project will have wide-ranging effects on market prices. If the project's output or input quantities are small relative to the amounts traded in the markets for these goods and services, the effects on market prices will be small enough to be ignored, on the grounds that including them would have no bearing on the outcome of the analysis. While this [small project assumption] is a reasonable one for many of the projects which the analyst will encounter, it is necessary to be able to identify circumstances in which price changes are relevant, and to know how to deal with them in the benefit-cost analysis.
A project increases the aggregate supply of the output produced by the project, and increases the aggregate demand for the inputs used in the project. Significant changes in market supply or demand can result in changes in market prices. A significant change in supply or demand is one that is large relative to the quantity that would be bought and sold in the market in the absence of the project being undertaken. It is evident that there is little chance of such a change occurring where the output or input in question is traded on international markets, as will be discussed in Chapter 8. Few countries, let alone individual projects, have the capacity to alter world prices by changing their levels of supply of, or demand for, goods and services.
Where non-traded goods are concerned, a project can cause a change in the market price of its output or its inputs where the level of output or input is large relative to the total quantity exchanged in the domestic market. This is most likely to occur where the relevant market is local or regional, rather than national in extent. Examples are local markets in transport services or irrigation water, and regional labour markets. Such goods and services have, at a national level, some of the characteristics which make commodities non-tradeable at the international level – principally relatively high transportation costs.
If a project is large enough at the local or regional level to cause changes in the market prices of goods and services it produces as outputs, or consumes as inputs, these price changes may affect the prices of complementary or substitute products traded in other markets. For example, a project which provides a new route into the city through provision of a bridge may result in increased demand for apartments in the area served by the bridge. Given a relatively inelastic supply of apartments, the increase in demand for this service, which is complementary to the service provided by the bridge, will result in a price increase. Apartments which are