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# CHAPTER 8

COST-BENEFIT
ANALYSIS

## Projecting Present Dollars into the Future

R0 = \$1000
R1 = \$1000*(1+.01) = \$1010
R2 = \$1010*(1+.01) = \$1020.10
R2 = \$1000*(1+.01)2 = \$1020.10
RT = R0*(1+r)T

8-2

## Projecting Future Dollars into the Present

R0 = \$1000
R1 = \$1000*(1+.01) = \$1010
R2 = \$1010*(1+.01) = \$1020.10
R2 = \$1000*(1+.01)2 = \$1020.10
RT = R0*(1+r)T

discount factor

discount rate
8-3

## Present Value of a Stream of Money

R1
R2
RT
PV R0

.
.
.

2
T
(1 r ) (1 r )
(1 r )

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Inflation

(1 ) R 1
(1 ) 2 R 2
(1 ) T R T
PV R0

. . .
2
2
(1 )(1 r ) (1 ) (1 r )
(1 ) T (1 r ) T

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## Private Sector Project Evaluation

B2 C2 B3 C3
BT CT
PV B1 C1

...
2
T
1 r
(1 r )
(1 r )
Annual Net Return

PV

Year

R&D

R=

R&D

\$1,000

-\$1,000

\$150

\$200

600

0.01

128

165

0.03

86

98

550

1,200

0.05

46

37

0.07

10

-21

Preferable
Present Value Criteria

8-6

## Internal Rate of Return

B2 C2 B3 C3
BT CT
PV B1 C1

...
0
2
T
1
(1 )
(1 )
Project

Year 0

Year 1

Profit

PV

-\$100

\$110

10%

\$4

3.77

-\$1,000

\$1,080

8%

\$20

18.87

8-7

Benefit-Cost Ratio

B1
B2
BT
B B0

...
2
T
1 r (1 r )
(1 r )
C1
C2
CT
C C0

...

2
T
1 r (1 r )
(1 r )

8-8

Method

B/C

\$250

\$100

2.5

II

\$200

\$100

2.0

I: Subtract
\$40 mistake
from B

\$210

\$100

2.1

mistake to C

\$250

\$140

1.79
8-9

## Concern for Future Generations

Paternalism

Market Inefficiency

8-10

Market Prices

Monopoly

Taxes

Unemployment

Consumer Surplus

\$2.89
\$1.35

Sa
Sa

Da
A0

A1
per year
8-11

## The Value of Life

Lost earnings

Probability of Death

8-12

Valuing Intangibles

## Reveal limits on intangibles

Cost-effectiveness analysis

8-13

## The Double-Counting Game

8-14

Distributional Considerations

## Hicks-Kaldor Criterion a project should be

undertaken if it has positive net present value,
regardless of distributional consequences

## Government costlessly corrects any

undesirable distributional aspects

Weighted benefits

8-15

Uncertainty
Project

Benefit

Probability

EV

\$1,000

1.00

\$1,000

0.50

\$2,000

0.50

\$1,000

Certainty Equivalent
8-16

Discount rate

Costs

Benefits

8-17

8-18

Utility

## Calculating the Certainty Equivalent Value

U

U(E + y)
U*

U(E)

Certainty Equivalent

Expected income
E

I*

E+y

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