The problem most commonly faced by the cost-benefit analyst, however, is to evaluate the social cost of using labour

in a particular project when in the labour market as a whole there is unemployment but no systematic use of shadow prices. (the converse of this problem, which also is very common, is that of evaluating the saving to the community that results from employing less labour). It is tempting to deduce from figure 8.2 use if the wage is w3 and the number of men employed is n1, and if a project then provides a job for an additional worker, the value og the leisure that this worker forgoes is w1, the marginal value of leisure. This deduction would be correct if there were some mechanism to ensure that, when the number of people wishing to work exceeded the number of jobs available, jobs of leisure. In reality, however jobs may be allocated on other criteria such as first come, first served or knowing the right people. All that we can deduce immediately is that the social cost of labour is at least w0 (since no one who valued his leisure more less than this) and is no greater offer to work at the existing wage of w3). For the purposes of discussion,suppose that a project requires a small number of additional workers to be employed, and that the average valuation of leisure amongst the workers is known say, w*, which is less than the wage, w3. From the viewpoint of the organization that undertakes the project, the cost of labour is its financial cost,w3 per worker. But this partially offset by a benefit to the workers who are employed. Each worker receives w3 in return of giving up leisure which, on average, is valued at only w*. There is, then a benefit of (w3-w*) per worker. The net social cost of using labour is only w*. This is the valuation that would be used in a cost benefit analysis. 8.3 Taxation In a competitive economy, thre are two ways in which market prices are significant as measures of social value. If buyers are free to buy as much of a good as they choose at its market price, this price measure the goods marginal value to consumers. If producers are free to produce as much as they choose of the good for sale at its market price, this price measures the marginal cost of producing the good. (in the case of labour markets, the equivalent statement is that if workers are free to choose whether or not to work at the market wage rate, this wage rate measures the marginal value of leisure to workers). So fat wehave assumed that the price paid by buyers-the demand price-is the same as the price received by suppliers-the supply price. But frequently this is not so. The reason is that government rasise revenue by taxing goods. As a result, the buyer of a good pays a price which includes a tax payment ; he will buy the quantity that equates of the goods receives only the price paid by the buyer,net of tax. He will produce the quantity this equates the marginal cost of producing the good with its net-of-tax price. There are, then, two price of any taxed good, each of which carries some information for the cost benefit analyst. Suppose that some project requires one unit of a good (say,trucks) which is subject to indirect tax. The analysts problem is to evaluate the social cost of this unit. If the projects requirement is met entirely by an increase in the production of trucks, the net social cost is the marginal production cost, and this is measured by the net-of-tax supply price. The financial cost to the buyer is the gross of tax price, but the tax lement in this price is simply a transfer to the government, and hence, we may assume, to taxpayers in general.

Alternatively, the projects requirement might be met without there being any increase in the production of trucks. Instead,potential trucks user many have forgone the use of trucks to an extent equal to the project requirement. In this case, the social cost is the marginal value of the good to its consumers- that is the gross-of-tax price. This time the government makes no net gain which can be offset against the financial cost of trucks which is paid by whoever undertakes the project. (the government makes no net gain because the total consumption the taxed good remains unchanged). More generally, suppose that each extra unit of the good used by the project implies a decrease of a units in the consumption of the good outside the project and an increase of 1- units in the total production of the good. Clearly the social cost of each units of the good used in the project is. a(gross-of tax price) + (1- ) (net-of-tax price). The main remaining problem is to estimate, for any particular case, what the value of a will be. Consider figure 8.3. in this diagram, the curve s represents the supply of taxed good and the curve d, the initial demand for it. (both curves relate to the gross-of-tax price of the good). The market price initially is p1. Now suppose that a project requires of an additional unit of the good. This shifts the , to D2. The demand curve to the right by one unit. The result is an increase in the price to p2, a reduction of a units in the quantity demanded outside the project, and an increase of 1- units in the quantity supplied.

S P2 P1 D2 D1

Quantity of good per period (1-a)

The value of is determined by the slopes of the supply and demand curves in the relevant ranges. It is conventional to express to responsiveness to price of the quantity demanded of a good, and of the quantity supplied of a good, by use elasticities. If, given some initial combination of price and quantity demanded, and increase in the price by 1 per cent would induce a reduction of 2 per cent in the quantity demanded, the (price) elasticity of demand is-2. Similarly, if an increase in the price by 1 per cent would induce an increase of 3 per cent in the quantity supplied, the (price) elasticity of supply is 3. It is easy to show that

= 1-

-ed es

Where ed is the price elasticity of demand at the initial combination of price and quantity, and es is the price elasticity of supply. By slight revisions of the above argument it can be shown that, if a project produced one additional unit of the good (instead of requiring one additional unit), the resulting increase in the quantity consumed would be a units and the decrease in the quantity produced outside the project would be 1- units. ( has the same numerical value as before). Thus the social value of the unit of the good produced by the project would again be (gross of tax price) + (1- ) (net of tax price). Since this expression represent both the social value of producing an additional unit of the good and the social cost of using an additional unit (see Expression 8.1), it may be called the shadow price of the good. In a cost benefit analysis this shadow price would be used in place of financial valuations of the good. It is worth considering briefly two extreme assumptions that could be made about the elasticity of the supply curve, each of which is in some circumstances a good approximation to reality. First, consider the case of a good whose price elasticity of supply is zero. (this implies that the quantity supplied is independent of the price and that the supply curve is a vertical line). In this case = 1 and the correct shadow price for the good is its gross of tax price. Second, consider a good whose price elasticity of supply is infinite. (this implies that producers would not require any increase in the price of the good to induce them to produce greater quantities; the supply curve is a horizontal line). In this case =0 and the correct shadow price for the good is its net of tax price. The arguments of this section have been made in relation to taxes on goods. But since labour is itself a good, the same arguments can be applied to income taxes. An income tax is, in effect , a tax on the good labour. Our conclusions can be reinterpreted quite simply so as to relate to income taxes, provided only that we are considering a labour market in which wages are determined by the forces of competition ( and thus in which there is no involuntary unemployment). An employer will buy labour up to the point at which the value of the additional output that would be achieved by employing an additional worker (the marginal product of labour) is equal to the gross wage. A worker will offer his labour if the net of tax wage is high enough to compenstate him for forgoing his leisure. If a project requires one worker and this requirement is met by some other employer forgoing a worker, the social cost of labour is measured by the gross wage. If instead the requirement is met by an additional worker entering the labour market, the social cost of labour is measured by the net of tax wage. Throughout this section it has been assumed that the good with which we were dealing at any time was the only one subject to tax. This asumption allows the analysis to be made relatively simple, but it is hardly realistic. In an appendix to this chapter we show how a shadow price can be derived for a taxed good in an economy where many goods are also subject to tax.

8.4 Producers market power and public control of prices At various point in this chapter it has been argued that the supply price received by the producers of a good measures the marginal serial cost of producing it. The logic of this argument, it will be remembered, is that if the marginal cost were greater than the price, producers would want to produce less, whilst if marginal cost were less than price producers would want to produce more.