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Civil Systems PlanningBenefit/Cost Analysis

Scott Matthews12-706/19-606 and 73-359Lecture 2 - 9/1/2004

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Benefit/Cost Analysis

Framework to systematically identify major benefits and costs associated with a particular investment or policy.

Often controversial, with different analysts coming to different conclusions or not agreeing on objectives.

BCA is a framework, not a recipe.

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Why do we use it?

Required: Exec Order 12291 (Reagan) ex-ante Perform RIA for agency programs over $100 M

Market failure (when used by government).Comparison of projects/alternative policies

(contribution to improved quality of information).

Explain divergence between expected and actual outcomes.

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Steps in a CBA - Read ‘Reality’1. Determine standing.2. Select portfolio of alternatives. 3. Catalogue potential (physical) impacts

and select measurement indicators.4. Predict quantitative impacts of the life

of the project.5. Monetize.6. Timeframe and money.7. Sum.8. Sensitivity Analysis9. Recommendation.

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Graphic interpretation of CBA

Benefits B(Q)Costs

C(Q)

Maximum netbenefits

Q0 Q1 Q2 Q*

Qm

Output Q

Taken from Figure 1.1 from Boardman et al

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Efficiency Definitions/Metrics

Allocative - resources are used at highest value possible

But welfare economics uses another:An allocation of goods is Pareto efficient if

no alternative allocation can make at least one person better off without making anyone else worse off. Inefficient if can re-allocate to make better

without making anyone else worse Assumed that decisions made with this in mind?

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A Pareto Example

Try splitting $ between 2 people Get total ($100) if agree on how to split No agreement, each gets only $25

Pareto efficiency assumptions: More is better than less Resources are scarce Initial allocation matters

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$100

$1000

Given this graph, how canWe describe the ‘set of all Possible splits between 2 peopleThat allocates the entire $100??

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$100

$1000

Line is the ‘set of all possible splits that allocates the entire $100, Also called the potential pareto frontier. Is the line pareto efficient?

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$100

$1000

No. Could at least get the ‘status quo’ result of (25,25) if they do not agree on splitting. So neither person would accept a split giving them less than $25. Is status quo pareto efficient?

$25

$25

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$100

$1000

No. They could agree on splits of (25, 30) or (30, 25) if they wanted to - all the way to (25,75) or (75,25). All would be pareto improvements. Which are pareto efficient?

$25

$25

$75

$75

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$100

$1000

The ‘pareto frontier’ is the set of allocations that are pareto efficent. Try improving on (25,75) or (50,50) or (75,25)…We said initial alloc. mattered - e.g. (100,0)?

$25

$25

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Pareto Efficiency and CBA

If a policy has NB > 0, then it is possible to transfer value to make some party better off without making another worse off.

To fully appreciate this, we need to understand willingness to pay and opportunity cost in light of CBA.

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Willingness to Pay

Example: how much would everyone pay to build a mall ‘in middle of class’ Near middle may not want traffic costs Further away might enjoy benefits

Ask questions to find indifference pts.Relative to status quo (no mall)E.g. middle WTP -$2 M, edges +$3 MEdges could ‘pay off’ middle to buildOnly works if Net Benefits positive!

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Opportunity Cost

Def: The opportunity cost of using an input to implement a policy is its value in its best alternative use. Measures value society must give up

What if mall costs $2 M? Total net WTP = $1M, costs $2M

Not enough benefits to pay opp. cost Can’t make side payments to do it

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Wrap Up

As long as benefits found by WTP and costs by OC then sign of net benefits indicated whether side payments can make pareto improvements

Kaldor-Hicks criterion A policy should be adopted if and only if

gainers could fully compensate losers and still be better offPotential Pareto Efficiency (line on Fig 2.1)

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Three Legs to Stand On

Pareto Efficiency Make some better / make none worse

Kaldor-Hicks Program adopted (NB > 0) if winners

COULD compensate losers, still be better

Fundamental Principle of CBA Amongst choices, select option with

highest ‘net’ benefit

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What about Other Goals, non-Efficiency?

Multigoal Analysis Economic performanceSocial performanceEnvironmental performanceTechnological performanceFlexibility

We’ll come back to this later in course

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Distributionally weighted CBA

SW = sum of net benefits across entire population. SW = (NB)i for all

Are there conditions under which we want to weight individuals differently when maximizing net benefit?

SW = (NB) for all and =1 where is the weight assigned to person .

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Welfare EconomicsConceptsPerfect Competition

Homogeneous goods. No agent affects prices. Perfect information. No transaction costs /entry issues No transportation costs. No externalities:

Private benefits = social benefits.Private costs = social costs.

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Discussion - WTP

Survey of students of WTP for beer How much for 1 beer? 2 beers? Etc.

Does similar form hold for all goods? What types of goods different?

Economists also refer to this as demand