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COST BENEFIT ANALYSIS The fundamental concepts 1. BENIFITS AND COSTS 2. SOCIALLY DESIRABLE CHANGES 2.1 DAP and DAA 2.2 Net benefits 2.3 DAP and surplus of the user 2.4 Compensations and improvement 3. THE FUNDAMENTAL RULE 4.TEMPORAL PREFERENCE 4.1 Discount and actual value 4.2 VAN 4.3 The fundamental rule modification 5. THE COST RAPPORT – BENEFIT COST- BENEFITS ANALYSIS Based on the individual behavior, there is a tendency to act in a way to maximize the net BENEFIT of an action, or the difference between the profit and the applied cost Cost- benefit analysis tries to extend this logic of reasoning to the whole society. It is profit What satisfies a wish motivated by individual preference. The intensity of the individual preference for a product is measured by AVAILABILITY TO PAY (DAP) to get the product. The intensity of the individual non – preference is measured by the availability to pay not to have the product or from it AVAILABILITY TO ACCEPT (DAA ) a compensation Therefore: To get a BENEFIT To bear a COST DAP DAA The passage from a situation to another is socially acceptable if the sum of the paying ability of the interested person overcomes that of the individuals that are harmed from it Important: It is remarkable The maximum DAP While it is remarkable The minimum DAA P P q The DAP overcomes the real payment in presence of a consumer SURPLUS If really the damaged objects are compensated from those beneficiary on the basis of the DAP and DAA, an improvement will be realized for all FUNDAMENTAL RULE OF COST – BENEFIT ANALYSIS A change is socially desirable if the social net benefit calculated as addition of the individual net benefit is positive To keep track of the time preferences For many, the today’s EURO is better than tomorrow’s EURO! The costs are produced today and the benefits tomorrow, a positive net benefit could not be attractive… Now to DISCOUNT costs and benefits according to their temporal position. How much does one EURO be in 5 years? If we invested a sum X to the annual rate X, after 5 years it would be 1 EURO if And therefore = The recent value of a sum M in T years is therefore Where R is the rate of annual interest The recent value of a profit B in the time T is therefore While the recent value of a cost C in the time T is The calculation of the Net profit must take care of the discount relative to every period: The recent value of a profit / cost is very small as more as it is distant in the time! MODIFIED FUNDAMENTAL RULE A change is socially desirable if its net RECENT VALUE (VAN, or benefit –costs discounts) is positive. MODIFIED FUNDAMENTAL RULE If more alternative projects have a positive VAN, it is opportunity to choose that with the most elevated VAN