Cost-Benefit Analysis I
PAI 723 Economics for Public Decisions
11/19/2013
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Outline
• Introduction to Cost-Benefit Analysis
•
-
The First Three Steps in Cost-Benefit Analysis
Define the scope
Estimate the costs
Estimate the benefits
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Introduction: Why do we need costbenefit analysis?
• Cost-benefit analysis (CBA) can be used to
guide several decisions for public officials:
- Whether a project should be undertaken?
- Which of several alternatives should be
selected?
- What is the appropriate scale of the projects
to be undertaken?
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Introduction: Basic Logic
Basic Logic of CBA
• Calculate the economic benefits and economic costs of
each alternative.
• These costs and benefits are discounted over time to
reflect opportunity costs.
• Choose projects with the highest net benefit.
The ultimate goal of CBA
• To ensure that society’s resources are put to their most
highly valued uses.
- Scarcity is also a concern for government officials.
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Introduction: Roles of CBA in Policy
Analysis
• CBA required by federal law for evaluating
major rules since 1981 (Executive Order
12291)
• A tool of rational planning:
- To provide answers to which choice to select
- To provide a process to help decision making
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Steps to Performing CBA
1.
2.
3.
4.
5.
6.
7.
Define the situation
Estimate the costs
Estimate the benefits
Discounting
Interpret the results
Equity issues
Sensitivity analysis
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Step1 Define the Situation/Scope
• CBA looks at how a project will change the
community’s resources
1. What resources are at stake?
2. What jurisdiction should CBA be done for?
- One community? Its neighbors? A state?
whole country?
This is a political decision!
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Step 1 Define the Situation/Scope
Example: A PUBLIC SWIMMING POOL
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Step 2 Estimate the Costs
• Costs: resources that the community will use
to carry out the project.
• The PUBLIC POOL EXAMPLE
What are the possible costs for the city to
have the new public pool?
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Step 2 Estimate the Costs
• Types of Costs
1. Resources purchased for the project by the
government
- Costs of construction (materials, equipment, labor,
etc.)
- Costs of operating and maintenance
- Overhead costs (time and resources spent by park
and recreation dept., police etc.)
2. Resources owned or purchased by local residents
and firms
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Step 2 Estimate the Costs
• Types of Costs
1. Resources purchased for the project by the government
2. Resources owned or purchased by local residents
3. Opportunity costs
- For assets owned by the government (e.g. land): the value
of these assets in their next most valuable use
- For assets which are underutilized by the society (e.g.
labor): opportunity costs is not the full market price.
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Step 2 Estimate the Costs
• Types of Costs
1. Resources purchased for the project by the government
2. Resources owned or purchased by local residents
3. Opportunity costs
4. External costs (externalities): How to monetize them?
-
Environmental damage
-
Increased congestion or traffic in the neighborhood
-
Other social costs (e.g. increased crime)
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Step 2 Estimate the Costs – Shadow
Price
• In the public arena, the “price” mechanism often fails to
reflect the true social values or costs of a resource.
• Thus, we estimate the “shadow price” in order to
monetize the social costs and benefits of those resources.
• The shadow price of an input or output is its value to the
economy as a whole.
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Step 2 Estimate the Costs – Shadow
Price
• For inputs, the shadow price is the marginal
opportunity cost – the value of the best alternative
use of the input.
• Shadow prices are related to the market price, but
not exactly the same because of market
imperfections.
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Step 2 Estimate the Costs – Shadow
Price
• Monopoly (P>MC)
P
MC
Pm
D
Ps=MC
MR
Qm
Q
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Step 2 Estimate the Costs – Shadow
Price
• Tax (P>MC)
S’
P
S
Pm
D
Ps=MC
Qm
Q
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Step 2 Estimate the Costs – Shadow
Price
• Negative Externalities(P<MSC)
MSC = MPC+MEC
P
S=MPC
Ps
Pm
D
Q*
Qm
Q
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Source: Boardman, Greenberg, Vining and Weimer, 1997. “Plug-in Shadow Price Estimates
for Policy Analysis”. Annals of Regional Science, 31.
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Step 2 Estimate the Costs
• Distinguish between costs and transfers
- When resources are not used up nor created, but just
shifted from one set of individuals to another, we say
the resources are transferred.
e.g. Destiny USA
Increased property tax from houses near the pool
- A transfer does not change the total amount of
resources in a community. It just changes the
distribution of the resources.
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Step 3 Estimate the Benefits
• Benefits: new resources made available to the
community.
• Types of Benefits
1) Resources measurable in monetary terms: goods and
services sold in the market places Price
2) Resources measurable in physical units, but not in
monetary terms.
3) Resources valued by the community, but not measurable
by any means.
- The shadow prices of crimes in Vining and Weimer (2010)
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Step 3 Estimate the Benefits
• How to estimate the benefits?
- Measured by a community’s willingness to pay (WTP)
- WTP: the amount that individuals are willing to pay to
receive the benefits (or the costs they are willing to pay
to avoid negative effects).
- The demand curve tells us the marginal willingness to
pay for consumers. Total benefits are the area under the
demand curve.
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Step 3 Estimate the Benefits
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Step 3 Estimate the Benefits
• Estimate the benefits using WTP
The PUBLIC POOL EXAMPLE:
- Capacity=2000 visits/day
- The pool will open 6 days a week for 14 weeks during the
summer
- At a fee of $0.50, 2000 users
- At a fee of $2.50, 0 user
What is the total benefits of building the pool for the
community?
-- Total benefits are the area under the demand curve.
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Step 3 Estimate the Benefits
WTP
Total benefits/day = A+B
= (2.5 – 0.5)(2000)/2 + 0.5(2000)
= $3,000/day
$2.5
Demand
A
$0.5
Total benefits in a year:
$3,000 * 6* 14 = $252,000
B
2000
Visits/day
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Step 3 Estimate the Benefits
• How to get the demand/community’s WTP?
Approach 1: Surveys
- Ask people how much they are willing to pay for services
Approach 2: Use information on demand and prices from
neighboring communities
Approach 3: Use information on related markets
- Recreational services: differences of property values between
neighborhoods with and without the service
- Value of life?
Average salary*average life expectancy
People’s WTP on safety devices for automobiles (V=C/P)
C=$180, P=4 in 10,000, V= 180/0.0004 = $450,000
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Step 3 Estimate the Benefits
• Distinguish between benefits and transfers
The benefits should not reflect transfers from
one section of the population to another.
e.g. - Tax abatement for elderly people
- Creating jobs for pool construction and
operation
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Step 3 Estimate the Benefits
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Step 3 Estimate the Benefits
• Distinguish between benefits and transfers:
Are jobs a benefit?
- If the economy is at full-employment (which is
often the assumption of CBA), the opportunity
cost of using workers is that they are not used
somewhere else.
- Thus, the new jobs are simply a transfer of
workers from one sector to another.
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Step 3 Estimate the Benefits
• Distinguish between benefits and transfers: Are jobs
a benefit?
• At the local level, could there be net gains in
employment locally?
- Need to prove there’s significant unemployment in
the region and the project hires the unemployed
• A better way to deal with this issue is to adjust the
costs of labor.
- The unemployed faces lower opportunity costs
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