Benefit-Cost Analysis

A set of practical procedures for guiding

public expenditure decisions.
It is a tool to apply decision-making rule,
specifically it is a method to evaluate public
programs in terms of benefits and costs.
Issue
 Implicitly, government should undertake
spending to correct externalities, provide public
goods, provide social insurance, etc.
 How should government decide what and how
much to spend? → B/C analysis
 There is a stream of benefits (B) over time: B0,
B1, … BT.
 There is a stream of costs C over time: C0, C1, …
CT’.
 Note: T may not be equal as T’.
Issue Cont’d
 We need to be able to:
 Measure (BT, CT)
 Make (BT, CT) that occur at different time,
comparable.
 Apply criterion of B/C.
Criterion
 Net Present Value (NPV)

NPV 
T  Bt  Ct 
t  0 1  r 
t

NPV  B0  C0  
 B1  C1  B2  C2 
  ... 
 BT  CT 
1  r  1  r 2
1  r T
Criterion Cont’d
 Invest if NPV > 0 (Admissibility Condition)
If NPV < 0, we don’t get much of the
project as it costs → the resources should
be put anywhere else.
 Choose the project with higher NPV, if two
or more projects have NPV > 0.
If NPV > 0, you add more value to
society.
Higher NPV → higher value to society.
Criterion Cont’d
 As long as NPV > 0, it’s conceivable that
gainers from project can compensate the
losers and still will gain → “Compensation
Test”.
Criterion Cont’d
Internal Rate of Return (IRR)
Set:

0  B0  C0  
 B1  C1  B2  C2 
  ... 
 BT  CT 
1    1   2
1   T
Criterion Cont’d
 Solve λ for NPV = 0 →IRR
 Choose higher IRR
Criterion Cont’d
 B/C Ratio
Invest if B/C > 1.
Ignore the scale of the project.
What Discount Rate Shall We Choose?
 If r ↑, the longer the project, the less the value
(projects whose benefit is way off in the future
looks unattractive).
 Therefore, choice of interest is important.
 If the government project to be justified → use
low r.
 Use social discount rate that is reflected in the
market interest rate but takes into account other
consideration:
 concerns for future generation.
 market imperfection.
What Discount Rate Shall We Choose?
 When market prices exist, and they are
accurate:
 P = MPC = MPB = MSC = MSB
 When market prices exist, but they are
inaccurate, then we have to adjust them.
 When market prices do not exist, use
contingent valuation.
Cost Effectiveness Analysis (CEA)
 Cost effectiveness analysis (CEA) is a
subset of benefit-cost analysis (CBA). CBA
includes impact assessment, risk
assessment, and cost-effectiveness.
 In CEA, policy outcome is treated as
exogenous and the task of decision maker
is to identify the least cost means to
obtain the given outcome. In CEA, costs
are measured as the money spent,
whereas effectiveness is measured as the
change in agents’ behavior.
Cost Effectiveness Analysis (CEA)
Cont’d
 In public health, CBA is less commonly used due to the
disagreement over the validity of the monetary values of
health states and life. CEA is more commonly used in public
health because it does not need to assign the value of
health states and life.
 If the valuation of non-market goods such as the value of
life is not involved, then CBA is better used. CBA is not
complete for regulatory impact analysis, especially with
respect to nonquantitative values. In this case, CEA is more
appropriate to use.
 To sum up, CEA is used where the goal of the program is
implementing a specified environmental, health, or safety
objective at the most effective cost, while cost benefit
analysis is used where the goal is to determine an action
and its level that obtains the highest net economic benefit
or is the most economically efficient outcome.
Some Examples
 Example of market imperfection where
price does not reflect market price:
monopoly.
In this case, we should use price at the
competitive market since it reflects the
true social cost.
 Other examples: the presence of taxes,
quota, externalities, unemployment. We
want P that reflects the true social cost.
Some Examples Cont’d
 Use the ‘adjusted’ market price → shadow market
price. P at the competitive market is the shadow
price for the monopoly market.
 If there is no market price (for example, the
value of time saved), we can use:
 wage, since it reflects the opportunity cost.
 Contingent Valuation Method (CVM), to ask
people the value of time saved.
 Revealed Preference.
Some Examples Cont’d
 For value of life, we can use:
 wage (net wage)
 Use CVM: what is the value if we can
decrease the probability of you are dying
by 1/1000?
Some Common Errors in B/C Analysis
 The Chain-Reaction Game. Counting
secondary profits make the project can
have positive present value. However,
secondary profits may only represent
transfers, not represent net benefit of the
project. If secondary benefits are counted,
secondary losses should be counted as
well.
Some Common Errors in B/C Analysis
Cont’d
 The Labor Game. There has been a
common error that the project should be
implemented because it creates
employment. The wages of the workers
employed in the project are viewed as
benefits. However, wages should be
viewed as costs, although if workers are
involuntarily unemployed, their social cost
is less than their wage.
Some Common Errors in B/C Analysis
Cont’d
 The Double Counting Game. Example: in
an irrigation project, the project’s benefits
are the sum of the increase in land value
and the present value of the stream of net
income obtained from farming it. In fact, a
farmer cannot do both simultaneously.
Some Examples of Valuation Problem
 Dooley and her nine friends are eating dinner at a
restaurant in Downtown. To simplify the task of
paying for their meal, they have agreed in
advance to split the cost of their meal equally,
with each paying one-tenth of the total check.
Having cleared the entrée dishes, the waiter
arrives with the dessert menu, on which are
Dooley’s two favorite desserts: cheese cake
(price = $10) and tiramisu (price = $6). Dooley’s
reservation prices for these items are $4 (cheese
cake) and $3 (tiramisu).
Some Examples of Valuation Problem
Cont’d
 If Dooley were dining alone, would she
order either dessert?
 In the group of ten people, will Dooley
order dessert? If so, which one (assume if
she were to eat dessert, she would only
eat one)?
Some Examples of Valuation Problem
Cont’d
 Sam and Alex are the only two people who value
a nonrival and nonexcludable public good. If the
private marginal benefit of one more unit of the
good is $500 for Sam and $800 for Alex, the
social benefit of providing one more unit of the
public good is:
A. $500, because the benefit will go to the person
who values it least.
B. $800, because the benefit will go to the person
who values it most.
C. $1300, because the benefit of one more unit
goes to both individuals.
D. $0, because neither Sam nor Alex will have an
incentive to provide the good on their own.
Some Examples of Valuation Problem
Cont’d
 Samantha and Swarupa are the only residents of their
village. Samantha earns $5000/year and Swarupa earns
$10000/year. Each resident has an equal area of forest on
her property. Samantha values her forest for its scenic view
at $15 and values Swarupa’s forest for its scenic view at
$10. Being wealthier, Swarupa values the scenic value of
forest more than Samantha: she values her forest for its
scenic view at $50 and values Samantha’s forest for its
scenic view at $35. Cutting the forest for agriculture is the
next best alternative use of the forest. Samantha can cut
her forest and use it for agriculture, earning $35 in profits.
Swarupa can cut her forest and receive $55 in profits. If
both agents make decisions rationally (and independently
of what the other person does), what will be the land use
outcome and what will be the total surplus earned from this
outcome?
Some Examples of Valuation Problem
Cont’d
 Suppose, both Samantha and Swarupa cut the
forest, then the following figures hold:
 Variable Samantha Swarupa
 Income 5000 10000
 Own forest 15 50
 Other’s forest 10 35
 π (cutting forest) 35 55
 Land use 35 55
 Surplus 35-15-10 = 10 55-50-35 = -30
 Therefore, Total Surplus = 10 – 30 = -20
Some Examples of Valuation Problem
Cont’d
 Meanwhile, if Swarupa cuts the forest and
Samantha does not, the following figures will
hold:
 Variable Samantha Swarupa
 Income 5000 10000
 Own forest 15 50
 Other’s forest 10 35
 π (cutting forest) 35 55
 Land use 15 50
 Surplus 15+10-35 = -10 50+35-55 = 30
 Therefore, Total Surplus = -10 + 30 = 20
Some Examples of Valuation Problem
Cont’d
 If Samantha cuts the forest and Swarupa does
not, the following figures will hold:
 Variable Samantha Swarupa
 Income 5000 10000
 Own forest 15 50
 Other’s forest 10 35
 π (cutting forest) 35 55
 Land use 35 50
 Surplus 35-15+10 = 30 50-35-55 = -40
 Therefore, Total Surplus = 30 - 40 = -10
Some Examples of Valuation Problem
Cont’d
 And if both of them do not cut the forest, the
following figures will hold:
 Variable Samantha Swarupa
 Income 5000 10000
 Own forest 15 50
 Other’s forest 10 35
 π (cutting forest) 35 55
 Land use 15 50
 Surplus 15+10-35 = -10 50+35-55 = 30
 Therefore, Total Surplus = -10 + 30 = 20
Some Examples of Valuation Problem
Cont’d
 Therefore, the highest surplus is achieved
when both Samantha and Swarupa do not
cut the forest. Therefore, the socially
optimal outcome will be achieved if both
agents do not cut the forest. The total
land use outcome will be 65 and the total
surplus will be $20.