Chapter 3 - BU Blogs

Economics 387
Lecture 3
Economic Efficiency and Cost
Benefit Analysis
Tianxu Chen
Economic Efficiency
Cost-Benefit Analysis: Background
Cost-Benefit Analysis: Basic Principles
Valuing Human Life
Cost-Effectiveness Analysis
Cost-Utility Analysis, QALYs, and DALYs
QALYs Revisited: Praise and Criticism
Economic Efficiency Defined
• Economic efficiency exists when the
economy has squeezed out every
opportunity for net benefits possible
through voluntary means.
• Demand Curve: willingness to pay
• Supply Curve: willingness to offer or say,
marginal cost
Demand Curve
• The demand curve for
apples represents
willingness to pay for
various amounts of
Figure 4-1 Consumer’s
Supply Curve
• In a competitive
market, the supply
curve measures the
marginal costs for
producers to bring
apples to market
Figure 4-2 Producer’s
Maximum Social Welfare
• The economic
criterion for
maximizing wellbeing is to maximize
the sum of the
consumer and the
producer surplus.
Figure 4-3 Efficient
Efficiency of Competitive Markets
• In competitive markets, supply and demand
provide the efficient quantities of goods to
the market—prices ration supply and
demand according to consumer preferences
and producer costs.
Market Failure
• There is a wide range of goods for which such
market signals are not readily available, these
include bridges, parks, water purification systems,
or mandated clean air.
• Decisions on whether to screen for certain types of
cancers or whether to provide vaccines to the
public, for example, must also be evaluated on
criteria that do not easily lend themselves to
market tests.
Public Policy
• By it’s nature public policy makes some people better
off and others worse off and therefore from a societal
perspective creates both benefits and costs.
• Cost-benefit analysis (CBA) measures benefits and
costs of projects in money terms.
• CBA requires that we place dollar values on
years of life or improvements in health and
• New ideas: economic evaluations to
represent the entire collection of tools
• CEA and CUA have emerged as the
principal alternatives to CBA.
Cost-Effectiveness Analysis
• CEA applies to problems where the goal is
accepted at the start and the problem is only
to find the best, most efficient, means to
achieve it.
Cost-Utility Analysis (CUA)
• CUA is a special form of CEA that
introduces measures of benefits that reflect
individuals’ preferences over the health
consequences of alternative programs that
affect them.
• CBA rests on the premise that a project or policy will
improve social welfare if the benefits associated with it
exceed the costs.
• The benefits and costs that are counted must include
not only those directly attributed to the project but also
any indirect benefits or costs through externalities or
other third-party effects.
Measurement Issues
• Costs are measured as opportunity costs.
• In public projects, both costs and benefits may
not have a market to serve as a guide for
monetary evaluation.
• Difficult-to-evaluate costs and benefits
• For example, a dam can destroy animal habitat
or attract waterfowl.
Measurement Issues
• Public investments may have side effects
that create additional measurement
• Public project also raises similar questions
of how to treat externalities.
Marginal Analysis in CBA
• The graph to the right
shows the marginal
social benefits and the
marginal social costs
from a pollution
abatement program.
• Social welfare is
maximized at Q1,
where MSB = MSC.
Figure 4-4 Efficient Use of
Resources Where Marginal
Benefits Equal Marginal
• Many public projects incur the costs
immediately but have benefits that occur
well into the future.
• Because benefits or costs that occur in the
future are not equivalent to benefits or costs
that occur today, the future benefits and
costs must be discounted.
Reasons for Discounting
• First, a dollar today
has opportunities other
than the project of
• Second, people have a
tendency to prefer the
present when
allocating spending.
• Note the denominator becomes larger as t
grows larger.
• This assumes that we discount the more distant
future more heavily.
• Some discussion about the discount rate
Risk Adjustment and CBA
• In the market, there are many rates of interest
reflecting differences in associated risk.
• Chief among the reasons that these differ is that
projects that are relatively more risky tend to have
relatively higher rates of interest.
• Often evaluators will adjust the social rate of
discount to reflect the riskiness of the public
• However, pubic project’s risk might be difficulty
to discern.
Risk Adjustment and CBA
• Public projects inherently differ in terms of their
riskiness, so it is important that benefits and costs
be discounted at a rate that accounts for the
riskiness of the project being evaluated.
• Usual method: a probability distribution over
project income
• New method: Certainty Equivalent-the value at
which the decision-makers are indifferent between
the risky set of outcomes and a value received
with certainty.
Distributional Adjustments
• CBA primarily deals with the efficient use
of society’s scare resources; however, when
benefits are disproportionately distributed
across the population, adjustments may
need to be made in the analysis.
• Inflation can be accounted for by
introducing an inflation factor into the
discount rate used in the analysis.
• One of the most difficult but often
unavoidable tasks in health care CBA is to
place a value on human life.
• The human capital approach, estimates the present
value of an individual’s future earnings.
• The willingness to pay or willingness to accept
approach measures what individuals are willing to
pay (accept) to avoid (accept) additional risk to
life and limb.
• The contingent valuation approach elicits
individuals valuation of alternative contingent
Why do we Spend so Much on Health
Care in the Last Years of Life?
• For many of the very old and sick, their resources
have very low opportunity costs.
• They may rationally have “hope” for living,
including the hope that more advanced health care
will be developed within their extended lifetime.
• Their “social” value of life may be very high.
• The value of an extended life year may be as high
for frail patients as it is for those of higher quality
Table 4-1 How Much Is One Life Worth?
• Many choose to describe the value of a
human life as a bit over $6 million dollars
while $100,000 describes the value of one
life year.
TABLE 4-2 Costs and Benefits of
Medical Technology for a Lifetime
• CEA compares the costs of achieving a
particular nonmonetary objective, such as lives
• In cost-effectiveness analysis, one assumes that
the objective is desirable even if the benefits
have not been evaluated in monetary terms.
CEA Measurement
• Let the change in social costs incurred due
to a particular project be C1 - C0, and let
the gain in health output be E1 - E0. Then
the various projects are compared by the
Advantages of CEA
• Conceptually, this approach amounts to
identifying the lowest cost approach of
producing a given benefit.
• CEA can be a useful first step toward
undertaking a cost-benefit study. If analysts
run into significant problems in undertaking
a CEA, it is unlikely that a CBA will be
• Cost-utility analysis is a more practical variation of
cost-effectiveness analysis.
• Quality-adjusted life-year (QALY) is one type of CUA.
• Disability-adjusted life-year (DALY) is another type
of CUA.
• Projects are evaluated
on the basis of their
incremental costs per
extra QALY delivered
to the patients or other
subjects (Garber and
Phelps, 1997; Ried,
where Fi is the probability
that the person is still alive
at age i; d is the time
discount factor; and the
value qi is the quality weight
Quality-adjusted life years (QALYs)
• Adjust quantity of life years saved to reflect
a valuation of the quality of life
– If healthy QALY = 1
– If unhealthy QALY < 1
QALY procedure
• Identify possible health states - cover all
important/relevant dimensions
• Derive utility ‘weights’ for each state
• Multiply life years (spent in each state) by
‘weight’ for that state.
Calculating QALYs example
• Weights:
– Good health = 1
– moderate health = 0.8
– poor health = 0.5
• LYs:
– Year 1 + year 2 + year 3 = 3LYs (1+1+1)
• QALYs:
– Year 1(x0.5), year 2(x0.8), year 3(x1) = 2.3 QALYs (0.5+0.8+1)
• Intervention may increase recovery such that
– year 1(x0.8), year 2(x1), year 3(x1) = 2.8 QALYs (0.8+1+1)
• No difference in LYs but gain in QALYs
Praise for QALYs
• Provides another technique for judging public projects.
• Accounts for the notion that each person is entitled to a
life in which he or she can use a basic set of
capabilities to achieve personal goals in life.
Importantly, these capabilities would include basic
health and functioning.
Critique of QALYs
• A developing criticism of CUA with QALYs focuses
on the method’s linear valuation of medical
interventions as the simple sum of quality gains times
life-years saved times the number of people treated.
• It has long been pointed out that QALYs tend to place
a reduced value on older people when evaluating a
medical intervention.
• QALYs are not consistent with standard Pareto based
welfare economics.
Disability-adjusted life-year
• DALY points out that we humans tend to
dependent on the middle age groups when
we are very young or every old. To the
adherents of this view, the greater social
related weights should be placed on people
in the middle age groups.
Note on CUA
• CUA still does not address:
– Allocative efficiency: is health gain ‘worth’
more than benefits those resources could yield
elsewhere (health or non-health)?
– Valuation of non-health benefits eg process,
information, convenience
– Valuation of non-use benefits ie externalities,
option value
• Cost-Benefit analysis
• Cost-Effectiveness analysis
• Cost-Utility analysis (QALYs)
The Problem
• An analyst might be asked to compare
Investment A, which provides $20 at the end
of Year 1 and $20 at the end of Year 2, with
Investment B, which provides $12 at the end of
Year 1 and $29 at the end of Year 2.
• Although Investment B returns $41 over the 2
years compared to $40 for Investment A, most
of the return on Investment B comes later, at
the end of Year 2.
What is Discounting?
• Discounting is a method that accounts for
differences in the timing of benefits or costs
associated with different projects.
How does it work?
• Suppose George is
• Since George always
offered the
has the option to keep
opportunity to buy a
his money and earn
bond that will return
interest rate r, the
$1, one year from now.
present value of $1 to
How much is he
be received 1 year
willing to pay now?
from today (x1) is:
In General,
• In summation notation, the present value of
a stream of returns R and costs C, over time,
is given by: