Lecture Notes for Economics 435: Economics of Resources
Prepared by Gunnar Knapp, Professor of Economics
January 30, 2001
ECONOMIC IMPACT AND ECONOMIC VALUE ANALYSIS
Cost-Benefit Analysis and Economic Impact Analysis
Two techniques used in the evaluation of public resource policies and projects are cost-benefit
analysis and economic impact analysis. It is important to understand the differences between
these two types of analysis.
Cost-benefit analysis (or benefit-cost analysis) involves the use of various economic techniques
to calculate the costs and benefits of a particular project or policy, and how these costs and
benefits affect different groups. By adding up total costs and benefits we can calculate the net
value of a project or policy. By comparing costs and benefits of different projects or policies, we
can figure out which projects or policies are relatively more efficient, and how the costs and
benefits fall upon different groups.
The explicit or implicit policy goal in cost-benefit analysis is efficiency: projects or policies
should only be undertaken if the benefits exceed the costs. However, cost-benefit analysis, if
well done, should also consider the distributional implications of projects or policies: who
enjoys the benefits and who pays the costs.
Economic impact analysis involves the use of various economic techniques to calculate how a
particular project or activity affects the economy of a particular region. Most commonly,
economic impact analysis uses measures of economic impact such as employment and income.
Economists often distinguish between the direct economic impacts of a project or activity (for
example, employment or income generated directly in the exploitation of a resource) and the
indirect economic impacts resulting from additional activity created by the project (such as the
income earned in restaurants or barbershops as workers in resource industries spend their
income).
Large economic impacts are often considered “good” for regions in need of jobs and income.
Note that large economic impacts do not necessarily imply that a project is efficient. The more a
project costs, the more jobs and income it is likely to generate. It is perfectly possible for a
project to generate lots of employment and income and at the same time have the costs exceed
the benefits.
Uses of Economic Impact and Economic Value Analysis
Economic impact analysis and economic value analysis are increasingly being used to
study the economic contributions of resources, or to help evaluate the consequences of
public policy decisions affecting resources. These kinds of analysis are being used to
make more informed decisions about the following kinds of issues (among others):
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•
Public funding for resources management and enhancement. Are the benefits
generated by resource management (National Parks, National Forests, fisheries) worth
the public costs? What levels of funding are justified?
•
Resource management strategies What kinds of management strategies will
produce the greatest economic benefit?
•
Resource allocation. How should fish be allocated between different commercial
gear groups, between different groups of sport fishermen, and between sport and
commercial groups? How should forests be divided up between wilderness and
logging uses?
•
Environmental protection. What are the economic benefits derived from
environmental measures, such as restrictions on logging or mining or hydroelectric
development? Do these benefits justify the reduction in these other economic
opportunities?
A more cynical view of economic impact and economic value analysis would be that the
analysis is not used to actually make these decisions, but rather used, where convenient,
to justify arguments of groups in favor of a particular decision.
For anyone involved in resources public policy, it is important to have an understanding
of at least the basics of economic impact and economic value analysis--the kinds of
questions which each type of analysis can and cannot address, the methods that are used
for each type of analysis, and some of the common mistakes associated with doing or
interpreting each kind of analysis.
“Economic Value” vs. “Economic Impacts”
Contrast the concepts of “economic value” and “economic impacts.” How is each
defined? For which public policy goals is each relevant?
Economic value (also referred to as “economic benefit,” “net economic value,” or “net
economic benefit”) measures how much an economic activity is worth to residents of a
specified geographic area. Net economic value is calculated by subtracting total costs
from total benefits. Total benefits can include both “market benefits” (which can be
observed from market transactions) as well as “non-market benefits” (benefits which are
received without having to pay for them).
Economic impacts are jobs, income or other measures of economic activity within a
specified geographic area associated with or generated by an economic activity. In
contrast to economic value, which has a very specific definition, there are many potential
measures of economic impacts (for example total jobs, total full-time jobs, total full-time
jobs for residents, etc.)
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Note that economic value analysis is the appropriate technique to use if you are interested
in the goal of “efficiency.” For this reason, economists are likely to argue that economic
value analysis is the “right” method to use in studying resource public policy issues.
Note that economic impact analysis is the appropriate technique to use if you are
interested in goals such as “jobs” and “economic growth.” For this reason, politicians
and interest groups often are more interested in--or more inclined to seize upon the results
of--economic impact analysis.
Contrast the treatment of expenditures in the calculation of “economic value” and
“economic impacts.”
A critical difference between economic value analysis and economic impact analysis is
how they deal with expenditures. In calculating economic impacts, expenditures generate
jobs and income. Thus the more expenditures associated with an activity, the greater will
be the economic impacts. Put differently, expenditures are “good” for creating economic
impacts.
In calculating economic value, expenditures are a cost of using a resource. For example,
if a commercial fisherman hires crew, buys a boat, or buys fuel, these are costs--which are
subtracted from the value of the catch in order to calculate the net economic value of the
fishery. Put differently, expenditures are “bad” in the sense that the higher expenditures,
the lower will be net economic value.
Linking Economic Impact and Value Analysis
to Actual Public Policy Decisions
What basic rule of logic is important to remember when using economic impact or
value analysis for actual public policy decisions?
To use the results of any economic value or economic impact analysis for a public policy
decision, the economic value or economic impact analysis must be logically related to the
actual public policy decision. Surprisingly often, this is not the case.
Why is knowing the total value or total economic impacts of a resource often not
particularly useful?
Many studies have been done about the economic value or economic impacts associated
with various resources. In some cases, the results of these studies have been translated
into average economic value or average economic impacts “per fish” or “per acre”.
But knowing the total value or total economic impacts associated with a particular
resource may not be particularly useful if public policy decisions don’t involve decisions
about totally ending the resource benefits.
Care must be used in linking the results of these studies to actual public policy decisions.
It is not enough to know the total economic value or economic impacts. You must ask
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the question “what specific information about economic value or economic impacts is
relevant to the specific question I am trying to answer?” Often the total value is simply
not relevant. What is relevant is how the total value would change as a result of the
policy decision under consideration--and this may be very different than the total value,
and which may not be closely related to the “average value” either.
Here are some examples of incorrect and correct uses of analytical results for public
policy decisions involving fisheries:
IRRELEVANT: “The commercial fishery provides net benefits of $Y, and we spend $X
on fisheries management.” This is irrelevant because (usually) no one is proposing doing
away with all fisheries management. The actual public policy decision relates to
increasing or decreasing management expenditures by some amount.
RELEVANT: “Changing fisheries management expenditures by $Y would change net
benefits of the commercial fishery by $X.”
IRRELEVANT: “The net benefits generated by the Cook Inlet sport fishery are $Y,
while the net benefits generated by the Cook Inlet commercial fishery are $X.” This is
irrelevant because the public (usually) does not face an all or nothing choice between the
sport or commercial fishery.
RELEVANT: The proposed management action would change the net benefits of the
sport fishery by $Y while changing the net benefits of the commercial fishery by $X.
IRRELEVANT: “The trees proposed for harvest have a value of $Y, while the salmon in
the stream are worth $X.” This is relevant only if harvesting the trees would end all
salmon harvests in the stream.
RELEVANT: “The trees proposed for harvest have a value of $Y; harvesting them
would reduce the value of salmon harvests by $X.”
In practice, assessing the actual economic impacts or economic values relevant to specific
public policies can sometimes be very difficult, because it involves predicting the
consequences of specific management actions. Look at the examples above: in each
case, it would be a lot easier to calculate the numbers for the “irrelevant” than for the
“relevant” statement.
Sometimes it is even difficult to predict what the public policy actions might be that
would be carried out in response to a cut in management funding, or a change in
allocation between sport or commercial fisheries. This makes it even more difficult to
analyze the economic consequences.
But this difficulty is no excuse for sloppy logic. The most sophisticated analysis of
economic impact or economic value is worthless for a public policy decision unless it
relates (or can be related) to that actual decision.
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Average vs. Marginal Economic Value and Impacts
Contrast the concepts of marginal economic value and average economic value and
impacts. What is the definition of each? Which is likely to be larger? Which is more
likely to be relevant for public policy analysis?
The following definitions are stated in terms of fisheries, but can be applied to other
resources by substituting other measures (for example, acres) for number of fish.
Average economic value per fish is the total value divided by the number of fish.
Marginal economic value of a fish is the extra value derived from one more fish. Note
that most of the “irrelevant” examples above involved total or average value, while most
of the “relevant” examples above involved marginal value.
Average economic impact per fish is the total impact divided by the number of fish.
Marginal economic impact of a fish is the extra impact derived from one more fish.
The contrast between “average” and “marginal” is very important in many areas of
economics, including economic value and economic impact analysis. Economists usually
argue that marginal value or marginal impact is more relevant for most public policy
decisions. But it is often easier to calculate average values or impacts--and average
values and impacts are often an easier concept for the public to understand.
Average value may be very different from marginal value; average impacts may be very
different from marginal impacts. A common mistake is to assume that average and
marginal value or impacts are equal to each other.
In fisheries, for example, in the sport fishery, the marginal value associated with one
more fish is likely to be less than the average economic value. This is because of the
principle of “declining marginal utility”--we get less enjoyment from the fifth fish that we
catch than from the first fish that we catch. To see this, assume that there are no costs in
catching sport fish (often a very incorrect assumption). If you get $50 worth of
enjoyment from catching one fish, and $75 worth of enjoyment from catching two fish,
then the average value net economic value per fish (when you catch two fish) is $37.50,
but the marginal value of the second fish is only $25.
In contrast, in the commercial fishery, the marginal economic value may exceed the
average economic value. This can occur if the costs of commercial fishing are fixed,
regardless of the size of the catch (for example if the only cost of fishing were the boat).
In this case, the more fish you catch, the more fish the fixed costs are spread over. To see
this, suppose you have a fishery that catches 100,000 fish worth $1 per fish, with a total
fixed cost of $50,000. The average net economic value per fish is (total benefits-total
costs)/(number of fish) = ($100,000-50,000)/100,000 = $.50. But the marginal value of
an extra fish is (increase in total value)-(increase in total costs) = $1-$0 =$1.
Marginal economic impacts are likely to be smaller than average economic impacts in
both the commercial and sport fisheries. The reason is that even if you spend a lot of
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money per average fish caught, you don’t necessarily increase your spending by very
much to catch more fish. If all sport anglers went from catching one fish per day to
catching two fish per day, they would still be paying almost the same amount for travel,
food, lodging, tackle, and guide services.
Economic Impact Analysis
Contrast “direct” and “indirect” economic impacts.
Economic impact analysis traces the effects of expenditures as they wind their way
through the economy. An initial expenditure circulates through the economy and creates
and chain reaction of additional expenditures. Economists generally refer to the effects of
the initial expenditures as “direct” economic impacts and the effects of the additional
expenditures as “indirect” economic impacts. Total economic impacts are the sum of the
direct and indirect impacts.
What is an economic multiplier? How is the multiplier related to the size of the region
being studied?
Economists sometimes say that the direct economic impacts are “multiplied” through
their indirect economic impacts. The ratio of the total (direct + indirect) economic
impacts to the direct economic impacts is frequently referred to as the “economic
multiplier.” The “employment multiplier” is the ratio of total employment to direct
employment. The “income multiplier” is the ratio of total income to direct income
created. (Sometimes the term “multiplier” is referred to the ratio of the indirect impacts
to the direct impacts.)
In general, the smaller the region which you are studying, the faster expenditures are
likely to “leak out” of the region, and the smaller the employment and income multipliers
are likely to be. In Alaska spending “leaks out” of the economy fairly rapidly because a
large share of expenditures go outside the state. For this reason, the employment and
income multipliers for the Alaska economy tend to be smaller than for the U.S. economy
as a whole. Probably these multipliers are both less than 2.5 for the Alaska economy. Be
suspicious of claims that “each job created in Alaska by the (sport or commercial) fishery
creates another six jobs.” Be especially skeptical of this claim when it is made for a
specific community.
“Input-output analysis” is a method commonly used for economic impact analysis. This
method traces how expenditures in one sector generate household income as well as
expenditures in other sectors, and calculates the total expenditures and income generated.
Why is the loss in jobs in an economy that would result from ending the exploitation of
a resource not necessarily the same as the number of jobs created by that resource?
A common but very important logical flaw in the application of economic impact analysis
to resources is the assumption that the jobs or income created by the resource would
disappear from the economy if the fishery didn’t exist. While this may sound like a
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reasonable assumption, it “ain’t necessarily so.” For example, expenditures on fishing
create jobs and income. But if the fishery didn’t exist, then many of the expenditures that
were made in the fishery might be made in another part of the economy--creating other
jobs and income. Thus the actual net change in total jobs and incomes might be much
less than would be expected based on economic impact analysis.
For example, there is no question that Alaska residents spend a great deal on sport
fishing, and that this spending creates many jobs for sporting goods store clerks, gas
station attendants, fishing guides, charter pilots, and so forth. But if all Alaska sport
fisheries were shut down then Alaskans wouldn’t just bury all their money. They would
instead spend it on something else. To the extent that they spent their money in Alaska, it
might create more jobs for restaurant waiters, bowling alley attendants, hunting guides,
and so forth.
However, it is very difficult to actually trace how changes in resource management might
change expenditures in other areas of the economy--which is why this very important
issue is often simply ignored. Another, more cynical interpretation is that it is convenient
to ignore changes in other expenditures because this tends to exaggerate the extent to
which an economy depends on a resource.
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