Cost and valuation exercises work best when competitive markets exist. Even when markets are distorted, they provide some useful information. This section offers brief insights into how the elements described can be applied in these situations.
Deadweight loss is a measure of the value of aggregate economic welfare that is lost when marginal social opportunity cost does not equal marginal social benefit. Aggregate economic welfare can be regarded as the sum of the total benefit derived from consuming a specific quantity of a specific good, net of the total opportunity cost of its production. Aggregate welfare is maximized in a competitive market. Deadweight loss therefore can be computed as the difference between economic welfare generated in a distorted market and economic welfare attained at the social optimum of a competitive market. More specifically, it is estimated as the area under a demand curve that reflects marginal social benefits and above a supply curve that reflects marginal social cost between the observed or anticipated outcome and the social optimumthe outcome that would equate marginal social costs and benefits. Moreover, changes in deadweight loss can be deduced by computing the appropriate areas even if the social optimum cannot be identified. In either case, deadweight loss simply is the sum of a change in private benefits, differences between social and private benefits, a change in private costs, and differences between social and private costs.
Market-based exercises that evaluate the costs and benefits of change must carefully account for preexisting distortions in markets. In the presence of one distortion, in fact, creation of another might actually improve welfare. Changes may or may not work to reduce preexisting distortions, so they actually can produce benefits that would be missed entirely if analyses were confined to competitive conditions. Goulder and Schneider (1999), for example, have noted that preexisting subsidies to conventional energy industries reduce the costs of climate policies but that preexisting subsidies to alternative energy industries would increase costs. Moreover, they point out that the opportunity costs of research and development (R&D) could be reduced or even reversed if there were an ample supply of R&D providers rather than a scarcity.
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