Foundations of CBA

LECTURE 2: APRIL 2, 2015 (RHP)

Foundation 1: The Policy

What policy(s) will you consider?
To what will you compare the policy?
What is the status quo? Is it an option? -> if yes, include the

SQ!
What are the relevant options?

Define the policy change sufficiently narrowly to allow

analysis
When will the policy change occur? Over what time period
are you interested in resulting costs and benefits?
-> CBA can be conducted ex ante, ex post, or in media
res; best practices vary between the three timing options

Foundation 2: The Universe

Generally, give everyone in society standing their costs
and benefits will be included in the analysis. Define society
geographically:
Global everyone
National everyone in a country
Regionally everyone in a state, metro area, county, city, etc.
Institutional everyone affiliated with an organization

Foundation 3: Estimate Costs &

Benefits
For each person / group with standing, determine:
Costs
Calculate as opportunity costs (value of the inputs if put to the next best use)
Market prices ok if markets are perfectly competitive

Benefits
How should we monetize benefits?
-> What would someone be willing to pay to ensure a policy change occurred?
Under most circumstances, changes in consumer surplus can appropriately be
used as reasonable approximations of societys willingness to pay for policy
changes (Boardman p. 51)
-> BUT consumer surplus is not willingness to pay! (more on this later)

Foundation 4: Choose Policy(s)

BUT: more complex in practice

Micro Review: CBA

Why CBA?
-> Applied systematically, choosing policies based on CBA should
result in increased economic efficiency policies are selected based
on net social benefits

Review:
Pareto efficiency & welfare theorems
Kaldor-Hicks & net benefits criterion
Distributional considerations

How should we make social

decisions?
Government policy is inherently a social question: we choose a single
policy, which individuals will value according to individual preferences.
How do we translate individual preferences into policy?

Unanimous voting if everyone in society prefers one policy, then so should society

Voting majority rule (ignores intensity of preferences)

Social welfare functions measure individual utility functions, combine with a social
welfare function to maximize welfare

Kaldor-Hicks efficiency choose Pareto improvements (implement transfers)

Compensation principle choose potential Pareto improvements (most CBA)

Arrows Impossibility Theorem: No reasonable mechanism exists for translating

individual ordinal rankings into a sensible social ranking

Review: Welfare Economics

Pareto Efficiency - resources are Pareto efficiently
allocated if there are no other ways to reallocate resources
to make any person better of without making anyone worse
off than before
Pareto Improving - an allocation is Pareto improving if it
makes any person better off while making no one worse off

First Welfare Theorem

When markets are in equilibrium under perfect
competition, the resulting resource allocation is Pareto
efficient.
Alternately, at competitive equilibrium,
total surplus (PS+CS) is maximized

Failure of First Welfare Theorem

When are the assumptions of the theorem violated?
Imperfect competition
Public goods
Externalities
Incomplete markets
Information failures
-> Government may be able to improve efficiency

Simple Model: Edgeworth Box

Suppose a 2-person (Bart & Lisa), 2-good endowment
economy
Trade allowed at mutually-agreed upon prices
Consume good 1 / good 2 bundles after trade

Simple Model: Edgeworth Box

Any point on the contract curve is Pareto
efficient even ones where either
party gets nothing! (Pareto-frontier in
figure 2.1 of text)
Suppose point E is the endowment
-> Any point on the contract curve
between X & Y is Pareto improving

Reality Check: Edgeworth Box

Suppose you are unable to reach
CE due to some market failure.
Should we adopt a policy that
moves us to W?
-> Pareto-efficient
-> NOT Pareto-improving (Bart is
worse off)
-> potentially Pareto-improving IFF Lisa compensates Bart

Kaldor-Hicks criterion
A policy should be undertaken of if the winners can IN
PRINCIPLE compensate the losers -> CBA decides in favor
of any policy that is POTENTIALLY PARETO IMPROVING
Put differently: If Net Benefits > 0, it should be possible to
construct transfers that would be Pareto-improving.
THUS, CBA recommends adopting policies that are potentially
rather than actually Pareto-improving
NOTE: Economists arent blind to the distributional problems of this
approach.
More on this later.

Possible Decision Rules

Net Benefits Rule:
Benefit/Cost Ratio Rule:

Net Benefits > 0

Benefit-Cost Ratio > 1

Internal Rate of Return Rule: IRR > Social Discount Rate

Example: Mutually Exclusive

Projects
You can build one dam on a river should it be big or small
(or not built)?
You can build one overflow reservoir for storm water
should it be expanded to a large one from the current small
one?
You can choose one of two curricula for early reading
instruction in Head Start programs in Chicago.
Maximize Net Benefits

Example: Mutually Exclusive

Policies
Suppose you could
choose policies that
resulted in Q=20,
Q=30, or Q=50.
Using the BCR, you get
it WRONG!

What if Projects Arent Mutually

Exclusive?
Adopt all projects with positive net benefits!

Reality Check: Resource

Constraints
In practice, options are often constrained by financial
considerations.
-> For mutually exclusive projects, choose project with highest NB
within the constraint
-> For other projects, start with the project with the highest BCR,
and keep adopting additional projects until all money is spent.
The goal is always to maximize net benefits, within
constraints!

Example:
Project

Benefits

Costs

A
B
C
D
E

$150
$150
$400
$90
$650

$100
$200
$300
$100
$500

Net
Benefits
$50
-$50
$100
-$10
$150

BCR
1.50
0.75
1.33
0.90
1.30

Which project(s) should you adopt if:

Mutually Exclusive?
M.E. with $400 budget cap?
Not M.E., no resource limits?
Not M.E. with $400 cap?

Example:
Project

Benefits

Costs

A
B
C
D
E

$150
$150
$400
$90
$650

$100
$200
$300
$100
$500

Net
Benefits
$50
-$50
$100
-$10
$150

BCR
1.50
0.75
1.33
0.90
1.30

Which project(s) should you adopt if:

Mutually Exclusive? E M.E. with $400 budget cap? C
Not M.E., no resource limits? A, C, E Not M.E. with $400 cap? ???

What about scale?

In the previous example, it depends whether projects can
be divided / partially implemented and still achieve the
same (scaled) NB
-> Sometimes OK, sometimes not
If project E is divisible (you can adopt part but not all of it),
do 4/5th of the project, since it has the highest BCR. If
not.

What about scale?

In the previous example, it depends whether projects can be
divided / partially implemented and still achieve the same
(scaled) NB
-> Sometimes OK, sometimes not
If projects can be EXPANDED (scaled up) and still achieve the
same BCR (scaled NB), then we might want to pick the single
project with the largest BCR and expand it, spending up to the
resource constraint. From the example, do project A repeatedly.
Note: the assumption that the BCR doesnt change with scale is
nontrival!

Reality Check: Resource

Constraints
In practice, options are often constrained by financial considerations.
-> For mutually exclusive projects, choose project with highest NB
within the constraint
-> If projects can be scaled up, pick the highest BCR and expand; If
projects are divisible, do a fraction of the last best project
-> For other projects, start with the project with the highest BCR, and
keep adopting additional projects until all money is spent.
The goal is always to maximize net benefits, within
constraints!

Not mutually exclusive, $400 resource

constraint, projects divisible but not
scaleable up.

Example:
Project

Benefits

Costs

A
B
C
D
E

$150
$150
$400
$90
$650

$100
$200
$300
$100
$500

Net
Benefits
$50
-$50
$100
-$10
$150

BCR
1.50
0.75
1.33
0.90
1.30

Ranked by NB: E,C,A -> Do 4/5th of project E. NB = $120

Ranked by BCR: A,C,E -> Do A, C. NB = $150
BCR rule seems attractive.

BCR: Issues of Reliability

While BCR is sometimes helpful, it can be unreliable
depending on how we think about costs and benefits:
Suppose project A is a criminal justice policy expanding the use
of jury trials, with the following on the benefits side:
$500 gain for defendants from speedy trials
$150 in
$350 loss for jurors in time and wages benefits
Should the $350 be a NEGATIVE BENEFIT or a COST?

BCR: Issues of Reliability

Project

Benefits

Costs

A (old)
A (new)
B
C
D
E

$150
$500
$150
$400
$90
$650

$100
$450
$200
$300
$100
$500

NB rule is unaffected -> NB = $120

BCR: C, 20% of E -> NB = $130

Net
Benefits
$50
$50
-$50
$100
-$10
$150

BCR
1.50
1.11
0.75
1.33
0.90
1.30

BCR: Issues
Note the BCR rule still did better in terms of maximizing
total net benefits, but issues of negative benefits or
positive costs should be examined closely before applying
the rule
Unlike the case of a firm costs = $ out, benefits = $ in
CBA often deals with flows between members of society
with standing, making it hard to categorize things clearly as
costs or benefits
BCR can be complicated by the inherent lumpiness of
projects and policies, where questions of scaleability (up or
down) constrain choices

Internal Rate of Return

Basic rule: do a project if its IRR exceeds the social

discount rate.

Example: Using IRR

Year
Suppose the social discount rate is 10%.
0
The IRR rule suggests we should do this 1
2
project.
3
IRR

Project A
-1000
475
475
475
20%

Example: Using IRR

Year
0
1
2
3
IRR

Project
A
-1000
475
475
475
20%

Project
B
-500
256
256
256
25%

Suppose the social discount rate is 10%

Projects are mutually exclusive.

Example: Using IRR

Year
0
1
2
3
IRR
NPV

Project
A
-1000
475
475
475

Project
B
-500
256
256
256

Discoun
t
1
0.9091
0.8264
0.7513

IRR gets it WRONG! NPV(A) > NPV(B)

PV (A)

PV (B)

-1000
431.82
392.56
356.87
20%
$181.25

-500
232.73
211.57
192.34
25%
136.63

It preferences the smaller project with less initial outlay

Possible Decision Rules

Net Benefits Rule:
Benefit/Cost Ratio Rule:

Net Benefits > 0

Benefit-Cost Ratio > 1

Internal Rate of Return Rule: IRR > Social Discount Rate

CBA Decision Rules

Net Benefits Rule:
Net Benefits > 0
CBA prefers the Kaldor-Hicks rule, maximizing net
benefits
Rules based on BCR or IRR can be misleading.
Do not use if projects are mutually exclusive
BCR may be helpful, but use with caution when projects
are lumpy or if the categorization of items as costs vs.
benefits is somewhat arbitrary

Distributional Concerns

CBA recommends adopting policies that are

potentially rather than actually Pareto-improving

Imbedded assumptions in CBA

Notice
the following:

The status quo endowments are privileged, regardless of distribution

CBA uses monetized values NOT true utility
In order to be utility-maximizing, Kaldor-Hicks assumes money has
equal marginal utility for all individuals

While it might be possible to define a structural social welfare

function which would allow us to apply different marginal utilities for
different people, we cant measure utility directly so theres no
empirical foundation for testing the accuracy of the social welfare
function.

Distributional Issues
If a policy results in transfers between groups (where some win
and others lose), the CBA should often include an analysis of the
distributional impacts of the policy.
E.g. Consider impacts on low vs. high income groups. Why?
Diminishing marginal utility of money
Increased equality may improve social welfare
Democratic values (one person, one vote -> each individuals
preferences should have equal weight)
Altruism, existence value of equality, etc.

Distributional Weights
To integrate distributional considerations into a CBA, you
can use distributional weights simple numerical
multipliers to adjust the relative value of the costs and
benefits
groups. Proje
Proje
NBfor separate
NB
Aggreg
NB
NB
Aggreg
ct

Group Grou
1
p2
I
10
50
II
20
30
Weigh
1
1
t

ate NB
60
50

ct

Group Group
1
2
I
3(10)=3
50
0
II
3(20)=6
30
0
Weigh
3
1
t

ate NB
80
90

Distributional Weights
When policies may have substantially different impacts on
various groups, particularly when one group is relatively
disadvantaged, it may be utility-improving to adopt policies that
fail the NB rule or to rank policies using distributional weights.
Which policies?
-> efficient but unfair/inequitable
-> inefficient but fair / equitable
-> calculate the total NPV and the NPV for relevant subgroup
consider subgroups separately & consider weighting if efficiency and
equity move in opposite directions

Distributional Weights
When policies may have substantially different impacts on
various groups, particularly when one group is relatively
disadvantaged, it may be utility-improving to adopt policies
that fail the NB rule or to rank policies using distributional
weights.
What weights should you use?
-> good question, no easy answer
-> always display both weighted and unweighted values
-> compute internal weights (break-even weights)
how big
would the weights need to be to change the
policy
recommendation?

Example: MDRC Welfare-to-Work

The WV CWEP
program is efficient
but unfair
Would need to
weight participants
8.74 times as heavily
as nonparticipants to
reach break-even
NPV.

Distributional Concerns
In practice, CBAs should:
Identify to whom the various costs and benefits of the policy accrue
This includes transfers which are neutral with regards to the
calculation of net benefits but create winners and losers
For policies where distribution is a significant consideration, include
both unweighted and weighted calculations, and calculate breakeven weights to illustrate the relative weighting which would
change the policy recommendation