COST – BENEFIT ANALYSIS
(CBA)
OMKAR APHALE
• We want our environment to be clean and safe.
• But ‘how much’ clean and safe ?
• How to measure environmental benefits and
costs ?
• There is no free lunch.
Most Efficient
Resource
Distribution
Total Cost
Total Benefit
Maximum Net
Benefit
Q0
Q1
Q*
Q2
• Our aim is to
attain the
‘most efficient’
resource
distribution.
•We will select
the option
with the
‘maximum’ net
benefit
Technical Evaluation
• Net Present Value (NPV)
NPV =
n
( b – c )t
t=1
( 1 + r )t
∑
• Internal Rate of Return (IRR)
n
Ct
t= 1
( 1 + i )t
∑
=
n
( b – c )t
t= 1
( 1 + i )t
∑
Technical Evaluation continued ….
• Benefit – Cost ration (BCR)
n
( b – c )t
t=1
( 1 + r )t
∑
BCR
=
n
Ct
t= 1
( 1 + i )t
∑
Cost Benefit Analysis (CBA)
• CBA aims to value the effects of a project as they
would be valued in money terms by individuals
affected.
• 2 steps,
- List all parties affected by the project
- Value the effects on their welfare as it would be
valued in money terms by them.
An ‘Efficient’ project
•
We describe a project as ‘efficient’ if,
1. Benefits gained fully compensate the losers.
2. Gainers, in principle, compensate the losers,
even if they do not.
3. Doing a small number of efficient projects
produces more benefits as a whole than doing
a collection of efficient and inefficient projects.
Project costs
• Project cost =
cost of resources + cost imposed on third parties
• Include only incremental costs
• Do not include – interest payments, depreciation
Project benefits
• Use and Non-use values
• Use values = all use benefits to man
• Non-use values =
Direct or Indirect use benefits + option values +
existence values
Environmental values
Environmental
Values
Use Values
Non-use Values
Direct Use
Indirect Use
Values
Values
(Timber, Food,
( Nutrient
Recreation)
Recycling)
Optional Use
Bequest Values
Existence values
Values
(Conservation
(Conservation of
(Gene pool)
Rainforests)
Tiger)
Option values
• Risk is attached to all decisions
• Uncertainty about demand and supply in future
• Pay more to insure demand or supply
• Option value =
value that an individual is willing to pay in
excess to expected use value to preserve an asset
Existence values
• Amount that people would pay to preserve the
natural environment or a species above any use
benefits
• Pure existence
• Altruistic existence
• Vicarious existence
Secondary benefits
• Result from primary benefits of the project
• e.g. project > higher wages to employees >
higher expenditure > improve quality of life
• Not included in CBA
• Viewed as transfer between communities rather
than net addition to community income
Basic Valuation Principles
• Value of a resource = marginal opportunity cost
= highest amount that someone is willing to
pay for it in an alternative use
• Value of a benefit = amount that someone is
willing to pay for it
• Willingness to pay (WTP) values
Willingness to Pay (WTP)
• WTP = P + CS
P’
$
Consumer
Demand (WTP)
Surpluses
P0
Producer Revenues
Quantity
Q0
Q’
Income and welfare
• Although income remains constant, welfare
changes with rise / fall in prices
• Marshallian demand curves
• Need compensation for change in price fall or
rise
• Hickinson demand curve
• M.D. curve is much easier to use
Willingness to Accept (WTA)
• Fairer and more appropriate
• Compensating variation principle
- considers existing situation desirable
• Equivalent variation principle
- considers project situation desirable
WTP vs. WTA
• In practice, CBA studies prefer WTP because,
- WTP more observable
- WTA have wide value ranges
- Difference between WTA and WTP values is
usually very small
- Who has the right to claim compensation ?
Uncertainty
• Quantified and Unquantified impacts
• Need to reduce risk of wild exaggerations
• Expected value approach
•
ENPV =
n
( Eb – Ec )t
t=1
( 1 + r )t
∑
• In risk- neutral case, project with highest ENPV
should be preferred.
Uncertainty continued ….
ENPV
P = 0.5
$ 2.5 M
$5M
$2M
Project A
$-1M
P = 0.5
$ - 0.5 M
//
Project B
P=1
$ 1.5 M
$ 1.5 M
Shadow Prices
• Imperfect competition
- monopoly, subsidy, govt. regulation, taxes
• Domestic vs. International markets
• No market
• SP = MP x CF
• Surrogate or Proxy prices
Distributional Issues
• Fiscal policies fail to distribute income fairly
• WTP values > rich get the edge over poor
• Sustainable development principle
• Need to identify social groups
• Converting WTP values into utility values by use
of weights
Discount Rates
• People require reward for forgoing consumption
now
• Positive real rate of return
• Present value of future money
• Example,
Accept $ 100 today or $ 110 next year
If accepted $ 110 – we forgo $ 100 today
We say that the discount rate is 10%.
Valuation of benefits and cost
•
Based on WTP values
•
3 ways
1. Observe prices in various markets
2. Observe individual expenditures of money and
time
3. Ask people what they are willing to pay for
goods
Valuation methods (Market based)
1. Market Price Method (MPM)
2. Hedonic Pricing Method (HPM)
3. Travel Cost Method (TCM)
4. Contingent Valuation Method (CVM)
5. Contingent Choice Methods (CCM)
6. Contingent Ranking Method (CRM)
Market Price Method (MVM)
• Environmental change causes change in outputs
or inputs
• Market based approach
• Uses economic values of ecosystem products and
services for evaluation
• e.g. soil erosion > output falls > input increases
• Only used for market goods and services
Hedonic Pricing Method (HVM)
• Evaluation based on housing prices
• e.g. reduction in noise> increase in residential
property prices
• Reflects value of local environmental attributes
• Only measures environmental benefits related to
housing prices
Travel Cost Method (TCM)
• Cost of access
• How much people are willing to pay to travel or
visit the site
• To value recreation sites
• Example,
Evaluation of annual preservation value of a
park
TCM continued….
Zone
Trips per
Average
1000
consumer
persons per costs ($)
annum
Average
consumer
surplus
($)
Populati Trips
on
per
(thousa annum
nd)
Total
consumer
surplus ($)
X
150
5.0
7.5
10
1500
11250
Y
100
10.
5.0
20
2000
10000
Z
50
15.0
2.5
50
2500
6250
all
100
10
5.0
80
6000
30,000
Maximum Travel Cost = $ 20
Contingent Valuation Method (CVM)
• Relies on survey techniques
• Hypothetical change in environmental resources
• Elicitation methods include,
I.
Open ended / Direct Questions
II. Bidding Game
III. Dichotomous Choice Method
IV. Double Bonded Dichotomous Choice Method
• Useful for marketed and non-marketed goods
CVM continued ….
• Asks people the WTP values for an
environmental asset
• Most widely used for non-market goods
• Exxon Valdez case
CVM continued ….
• Prone to bias
• Types of Biases
I.
Strategic Bias
II. Information Bias
III. Starting Point Bias
IV. Hypothetical Bias
V. Sampling Bias
VI. Non-response Bias
Contingent Choice Method (CCM)
• Trade-offs between environmental systems
• Used for use and non-use values
• Example,
Wilderness or Hospital ?
Scenic beauty or Mobile network ?
• Difficult for some respondents to respond
Contingent Ranking Method (CRM)
•
•
•
•
Referendum method
Ranking of environmental attributes
Easy for the respondent
Example,
Choice
#
Savings in travel time Cost of saving
(in minutes)
(in dollars)
1
10
0.50
2
20
1.50
3
30
2.20
4
40
3.00
• Confusion if too many choices
Valuation based on public decisions
• Government judgments
• Example,
I.
Compensation for accidental death
II. Zoning regulations
• Inconsistent with individual preferences
• Basis of decision not clearly stated
• Need more research
Valuation based on defensive
expenditure
• Precautionary expenditure
• Corrective expenditure
• e.g. Smoke detectors, seatbelts
• Routinely included in project expenditures
• Marginal cost of pollution
Value of life
• Present value of future output or consumption
forgone = human capital method of evaluation
• U.S. = 350 000 $ (1990s)
• Depends on age and earnings
• Value of life of a newborn = 0 $
• Risk of death – accept or reject ?
• Hedonic wedge equation
W = W (S, X, R)
Value of life continued ….
• Risk of death – how to calculate ?
• 0.44 million – 14.9 million US dollars
• Wedge / Risk studies should be combined with
other valuation methods like CVM
• Value depends on
I.
Individual preferences
II. Risk aversion
III. Level of risk assumed
Alternatives to CBA
• Cost – effectiveness analysis
- Useful finding option with the least cost
• Environmental Impact Assessment
- Describes physical & social impacts of the project
• Multi-criteria Decision Analysis
- Identifies and apply weights to likely impacts to
determine a preferred option
Criticisms to CBA
• Morally unacceptable to put value on nature
• Not practical – how to measure visual beauty ?
• CBA does not deal with social values
• Based on income, thus biased
• Individuals have different preferences
• Narrow outlook to environment
Conclusion
• CBA provides systematic and consistent
evaluation method
• CBA gives clear results
• CBA highlights trade-offs and opportunity cost
• ‘One person one vote’ is more preferred ‘over
one dollar one vote’
References
1. Project Appraisal and Valuation of the
Environment - Peter Abelson, Chp. 2, 3, 4
2. Cost-Benefit Analysis and the Environment –
Cass R. Sunstein
3. Cost Benefit Analysis of Environmental
Systems by Applying Contingent Valuation
Method – S.U Ahmed, K. Gotoh
Thank You !