CostBenefit Analysis CBA

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Cost-Benefit Analysis (CBA)
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What is a Benefit and a Cost?

• The benefits of a change are those goods or
  services that result from the change for which
  someone would be willing to make sacrifices to
  obtain
• We measure benefits in terms of Willingness to
  Pay (WTP)
• Cost is the value of opportunities forgone! (it
  could be a Euro value, but could include much
  more e.g. the value of your time).
• Opportunity Cost An activity's opportunitycost
  is equal to the most net benefits thatyou could
  have obtained from doing something else.

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Important Concepts

• 1) Benefit - marginal benefit - total benefit

2) Cost - marginal cost - total cost
minus

3) Net benefits - marginal net benefit -
total net benefit
!!!
!!!
An efficient allocation maximizes Total Net
Benefit
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Partial equilibrium interpretation of economic
efficiency
B(X)
B(X)
C(X)
d
NB(X)
(a)
C(X)
e
a
X
X
NB(X)
The distance de can be interpreted in efficiency
terms. It is a measure, in money terms, of the
efficiency gain that would come about form
producing X compared with a situation in which
non is produced. de is equal to the triangle gfh
the area beneath a marginal function over some
range gives the value of the change in the total
function for a move over that range. So, X0 to
XX beneath MBx is the total benefits of X and
equal to the distance ad, and X0 to XX
beneath MCx is the total costs of X and equal to
the distance ae. Px is equal at the margin
consumers' subjective valuations of additional
units of the good (expressed in money terms),
and the costs of producing an additional unit
of the good. Px MBx MCx
NB(X)
NB(X)
(b)
X
X
g
MCx
f
net-benefits
(c)
MBx
h
X
X
g'
consumer surplus
Sx MCx
f'
Px
(d)
producer surplus
Dx MBx
h'
X
X
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Recent Developments

• Total economic value Use value Intrinsic
  value
• Use value Actual use value Option value
  Quasi-option value
• Option value Value in potential use by self
  Value in potential use by others Value in
  potential use by future individuals
• Quasi-option value Value of avoiding
  irreversibilities in the light of expected future
  knowledge
• Intrinsic value Existence value

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Existence Value

• Existence value is unrelated to any actual or
  potential use
• Existence value may be related to sympathy, or
  stewardship as such, existence values do not fit
  into neo-classical economics
• Existence value may also be related to "spiritual
  consumption", and then it does fit
• Existence value is not right-based, as rights are
  absolute, and values relative

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Cost-Benefit Analysis (CBA)

• by 'Cost-Benefit Analysis' we mean the social
  appraisal of investment projects (to appraise
  investments that correct for market failure).
• CBA and Environment
• 1) benefits in the form of the provision of
  goods and services that have environmental
  impacts (e.g., damming a river in a wilderness
  area i.e. negative environmental effects)
• 2) projects with beneficial environmental
  impacts (sewage treatment plant i.e. positive
  environmental effects)

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CBA

• CBA should be used for policies and projects,
  which unfold over time and be assessed by
  calculating a Net Present Value (NPV), or a
  Benefit-Cost Ratio (BCR).
• 4 informational inputs
• 1. time horizon
• 2. benefit schedule
• 3. cost schedule
• 4. discount rate

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Present Value Concept

• Time Value of Money Concept a Euro today is
  worth more than a Euro tomorrow
• why uncertainty the future is unknown, will
  you be around to spend the dollar. inflation
  erodes the buying power of a Euro utility gain
  from consumption today versus future
  consumption, investment opportunities invest
  today, earn interest, and have more than a Euro
  to spend in the future.
• Basic idea is to get the present value of some
  future payment to be received at time t.

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Present Value Concept

• Discounting process to obtain the present
  value of future Euro amounts
• PV present value, FV future value, r
  discount rate, and t is the number of periods
  into the future.

0
t
time
present value
future value
Euro
idea of discounting
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Present Value Concept

• Nominal versus Real nominal refers to the Euro
  value in current terms (not discounted), whereas
  real refers to the dollar value discounted to
  some base Euro value (discounted values).
• Discount Rate indicates how you value present
  consumption (utility) versus future consumption
  (utility)
• - the higher the discount rate the more you
  value present consumption relative to future
  consumption
• - the lower the discount rate the more you value
  future consumption relative to present
  consumption.

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Cost-Benefit Analysis (CBA)

• In any CBA, several stages must be conducted
  (Hanley and Spash, 1993)
• 1) Definition of the Project2) Identification
  of the Project Impacts3) Which Impacts are
  Economically Relevant?4) Physical Quantification
  of Relevant Impacts5) Monetary Valuation of
  Relevant Effects6) Discounting of Cost and
  Benefit Flows7) Applying the Net Present Value
  Test8) Sensitivity Analysis

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Cost-Benefit Analysis (CBA)

• Private appraisal1) The net present value test
• 2) The internal rate of return test
• Social appraisal1) Utility based
  appraisal Problems - no general agreed social
  welfare function - interpersonal utility
  comparison are admissible - utilities are
  not observable
• 2) Consumption based appraisal

NPVgt0
IRR0
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Cost-Benefit Analysis (CBA)

• NPV test is a potential compensation test gt is
  concerned with allocative efficiency (select
  projects that move the economy toward an
  efficient allocation of its resources).
• The proper time horizon for the appraisal of a
  project is the date at which its impacts cease,
  not the date at which it ceases to serve the
  purpose for which it was intended.e.g., for a
  nuclear fission plant the time horizon is not the
  40 years to the time when it ceases to generate
  electricity but the time over which it is
  necessary to devote resources to storing the
  plant's waste products - 100s of years.

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Choice of discount rate
The Present Values of 100 Euros arising from 25
to 200 years ahead at discount rates from 2 -8
gt need for judgements
however, there is universal agreement among
economists such that the real rates should be
taken not nominal rates in CBA.
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Environmental Cost-Benefit Analysis
where Bd/Cd is the discounted of benefit/cost
stream over the project lifetime. NPV ignores
environmental impacts gt NPV'.
EC environmental cost
ECBA decision rule!!!
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Environmental Cost-Benefit Analysis
EC UV EV OV QOV UV Use Value and arises
from the actual and/or planned use of the service
by an individual, for recreation for example EV
Existence Value and arises from knowledge that
the service exists and will continue to exist,
independently of any actual or prospective use by
the individual OV Option Value and relates to
willingness to pay to guarantee the availability
of the service for future use by the
individual QOV Quasi-Option Value and relates
to willingness to pay to avoid an irreversible
commitment to development now, given the
expectation of future growth in knowledge
relevant to the implications of development.
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Direct Benefit Estimation

• In private CBA it it usually relatively easy to
  perform because prices are readily observed.
• Often this is not the case (no price exist) or
  prices are socially biased due to externality,
  public good, or market power considerations.
• This problem is particularly apparent for non-use
  values which tend to be more intangible.
• intangible cannot be valued
• if intangibles remain in our analysis, then NPV
  and BCR are incomplete.
• So, what can we do when prices and demand
  information is absent or is clearly biased?

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Alternative Approaches

• 1. Contingent Valuation- use surveys that ask-
  widely applicable
• 2. Travel-Cost Method- obtain a demand curve by
  examining how participation varies with the cost
  of getting there.- primarily useful for
  recreation benefits.
• 3. Property value and Wage differentials (hedonic
  prices)- statistically investigate how these
  prices vary with property of job conditions-
  more limited application possibilities than for
  CV.

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Indirect (Secondary) Benefits

• Ripple effects due to economic linkages
• We have all heard public projects and policies
  being touted for their employment and income
  generating effects.
• In a full employment economy, however, these
  inputs were necessarily reallocated away from
  other productive uses.
• !! Do not count secondary effects in a full
  employment economy!!
• also no transfer payments should be included,
  e.g, unemployment payments

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Overall Appraisal of CBA

• Cons- intangibles- BC analysts and
  information sources are often biased-
  distributional Issues occasionally
  objectionable weighs same period impacts
  equally weighs future impacts less
• Pros- help prevent bad decisions which would
  otherwise be undiscovered- counters
  rent-seeking (which might normally be successful
  in the political process).

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Analytical Styles other than CBA

• Cost Effectiveness Analysis- try to achieve a
  non-economic target at least cost- often
  practical when there is an intangible physical
  quantity in need of enhancement if it was
  tangible, we could just use CBA.
• Impact Analysis- usually employed in lieu of or
  as a complement to CBA because either there
  are many intangible impacts of the policy/project
  and they need to be described, or the impacts
  are tangible but not allowed into CBA (such as
  secondary economic impacts)
• Multi Criteria Analysis

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CBA Example

• Someone has proposed a 4-period pollution control
  project that will cost EUR 100.000 to construct
  in the initial period. After that, the project
  will cost EUR 10.000 to operate in each following
  period. After the construction is completed, the
  benefits of this project will be EUR 40.000 in
  the first period, EUR 45.000 in the second, and
  EUR 50.000 in the last period. The facility is
  expected to be non-functional for any future
  periods. There are no intangibles to be
  considered for this project.
• Calculate Net Present Value (NPV), and
  Benefit-Cost Ration (BCR) using a discount rate
  of 5.

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CBA- Example
r 5
NPV ??? BCR ???