This material is concerned with the effect imperfection in market structure has on the cost benefit analysis of a project. The basic problem is that the increase in the production of a commodity that results from a project may not be the same as the increase in consumption of that product. The reason that a possible difference between project production and the increase in consumption is that the other producers of the product may reduce their production in reaction to the project's output.
As an extreme example of the problem consider a project in Arizona that will produce cotton using irrigation water from a project. The levels of production of many crops in the U.S. are set by the U.S. Department of Agriculture rather than the market. Thus if the project in Arizona got permission to produce cotton it would be at the expense of production quotas elsewhere in the U.S., say Mississippi. Thus, despite the fact that the project produces cotton the net change in U.S. production of cotton would be zero and therefore there would be no social benefit.
Consider the case of a market in which there is monopolistic control through some mechanism of restricted entry or a cartel arrangement among producers. A protected monopoly makes excess profits by restricting production to maintain a higher price than would occur under competition. If a public project put output on the market the reaction of a protected monopoly would be to cut back production to reduce the impact of the project's sales on market price. The amount the protected monopolist would cut back its production would depend upon its marginal costs and the elasticity of demand. The net increase in market production and consumption would be less than the project's output. For a monopolist whose marginal costs are constant and the demand curve is a straign then the protected monopolist will cut back its production by exactly one half of the project's production so the net increase in consumption due to the project will be exactly one half of the project's output.
In the above diagram the black lines represent the situation faced by the monopoly without the project. It chooses its level of output and price indicated by the black Qm and Pm. The project produces some level of output of the product which when placed on the market takes away some of the level of demand previously faced by the monopolist. In effect, the projects production shift the demand curve faced by the monopolist to the left by the amount of the project output (shown in the diagram in red). Faced with the new effective demand curve the monopolist choses a level of output and price indicated by the red Qm and Pm. As can be seen from the diagram the monopoly reduces its output by an amount equal to one half of the project output. Therefore the increase in consumption is the project output minus one half of project output which is equal to one half of the project output.
The case of oligopoly is murky because there is no generally accepted model of oligopists' behavior. There are many models. The Cournot model would suggest some reduction in the oligopolists' outputs. In the simple case of constant marginal costs and a straight line demand curve if there were N oligopolists oligopolist would cutback production by 1/(N+1)th of project's production so the net increase in production and consumption due to the project would be N/(N+1) of the projct's production. As N increases the net effect of the project's output approach 100% of the project's output.
In the limit pricing model of oligopoly the dominant firm in the industry sets a price that is just under the lowest entry price of potential entrants. If the project puts some not-too-large amount on the market the limit pricing oligopolist would restrict its production by some amount that achieves the highest profit given the project's marketing.
The benefit of a project's output is then the area under the range of consumptions from what consumption would be without the project to what consumption would be with the project, but that range is not necessarily equal to the level of production of the project.