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CHAPTER 8

COST-BENEFIT
ANALYSIS

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

Present Value R0 = RT/(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 )

8-4

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

8-5

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

Admissible

Year

R&D

Advertising

R=

R&D

Advertising

$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 )

Benefit-cost ratio = B/C


8-8

Problems with the Benefit-cost Ratio


Method

B/C

$250

$100

2.5

II

$200

$100

2.0

I: Subtract
$40 mistake
from B

$210

$100

2.1

I: Add $40
mistake to C

$250

$140

1.79
8-9

Discount Rate for Government Projects

Returns in Private Sector

Social Discount Rate

Concern for Future Generations

Paternalism

Market Inefficiency

Government Discounting in Practice

8-10

Market Prices

Adjusted Market Prices

shadow price

Monopoly

Taxes

Unemployment

Consumer Surplus

Price per pound


of avocados

Valuing Public Benefits and Costs

$2.89
$1.35

Sa
Sa

Da
A0

A1
Pounds of avocados
per year
8-11

Inferences from Economic Behavior

The Value of Time

The Value of Life

Lost earnings

Probability of Death

8-12

Valuing Intangibles

Subverting cost-benefit exercises

Reveal limits on intangibles

Cost-effectiveness analysis

8-13

Games Cost-Benefit Analysts Play

The Chain-Reaction Game

The Labor Game

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

Are Reductions in Class Size Worth It?

Discount rate

Costs

Benefits

The Bottom Line and Evaluation

8-17

Use (and Nonuse) by Government

Using Cost-Benefit Analysis

Not Using Cost-Benefit Analysis

Clean Air Act

Endangered Species Act

Food, Drug and Cosmetic Act

8-18

Utility

Calculating the Certainty Equivalent Value


U

U(E + y)
U*

U(E)

Certainty Equivalent

Expected income
E

I*

E+y

Income per year

8-19