8. Municipal water supplies are often managed by a government agency. Typically,

Question

8. Municipal water supplies are often managed by a government agency. Typically, government agencies are not allowed to ‘make a profit.’ a. Assuming supply and demand behave ‘normally,’ graphically illustrate the implications of a governmental ‘cost recovery’ mandate on the water market. b. Precisely identify the welfare effects of water management under these conditions relative to profit maximization. Use the concepts of Marginal Cost, Marginal Benefit, Average Cost, Average Benefit, Total Cost and Total Benefit in your answer. (20 points)

Explanation / Answer

Municipal water supplies are usually managed by a government agency. Its objective is to maximize welfare of the society. In order to achieve this objective, government will always look into the cost of production of one extra unit. If marginal cost of producing one extra unit is lower than the marginal benefit that society will receive from its use, then it will be produced. Thus government will stop production, where marginal benefit and marginal costs are equal. Thus equlibrium is observed where marginal benefit is at par with marginal cost.

Marginal benefit of an unit produced, is available from demand curve of the product. It indicates how much money users are ready to pay to get one extra unit. So long the demand curve is above MC curve, the government will continue supply. It will be stopped where these two intersect. It is shown below.

In the diagram,, for simpicity, MC of each unit produced is taken as constant. So MC curve is horizontal. Demand curve on the other hand is downward sloping in nature. It imlpes that MR is decreasing as more and more water is supplied. Government attains equilibrium, where MC has intersected demand curve. Price is set at this level.

In this diagram, if cost recovery is made, then government will supply OQ1 units of water. If no such recovery was made,. then water supply will continue upto OQ2 units until benefit received from one extra unit is zero. Thus impact of cost recovery mandate is reduction of water supply by Municipal in the economy.

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2. Welfare effect vs profit maximization effect:

A profit maximizer will try manufacture a quantity where profit is maximized. It is the gap between total cost and total revenue/benefit. But a welfare manufacturer will go on producing it until total benefit is rising and is above total cost.

In the diagram abovegap between TC and TB curve is maximized if Q1 units is produced. So a profit maximizer will stop here. But a welfare maximizer will contiue production until Q2 units are produced. Here total cost is just eqal to total benefit.

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Finally consider the understated diagram. A profit maximzer will maximize profit where marginal benefit curve has intersected margial cost curve. Price charged is on the basis of average benefit. Thus OQ0 units will be supplied at OP0 price.

But a profit maximizer will go on supplying until average benefit curve has intersected AC curve. So OQ1 uits will be supplied at OP1 price.

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