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Cost-Benefit AnalysisPublic Economics

Minda DC. Eduarte

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“Things don’t have costs, choices do.”

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What Is Cost-Benefit Analysis?

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Cost –Benefit Analysis

• is a set of practical procedures for guiding public expenditure decisions.

• is the implicit or explicit assessment of the benefits and costs (i.e., pros and cons, advantages and disadvantages) associated with a particular choice.

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Continuation. . .

• is a technique for assessing the monetary social costs and benefits of a capital investment project over a given time period.

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Principles of Cost-Benefit Analysis

•Appraisal of a project: It is an economic technique for project appraisal, widely used in business as well as government spending projects (for example should a business invest in a new information system)

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•Incorporates externalities into the equation: It can, if required, include wider social/environmental impacts as well as ‘private’ economic costs and benefits so that externalities are incorporated into the decision process. In this way, CBA can be used to estimate the social welfare effects of an investment

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•Time matters! CBA can take account of the economics of time – known as discounting. This is important when looking at environmental impacts of a project in the years ahead

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Stages in the application process

•Identify all costs and benefits

•Measure them

•Discount them back to common time period

•Assess whether benefits>costs

•Assess who bears the benefits and costs

•Perform sensitivity analysis

•Assess whether proposal is worth it

THE APRON

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CBA of tree clearingImpacts Benefits CostsProperty level - direct, medium term Income from improved pasture

productionCost of clearing trees, improvingpasture, controlling regrowth

- indirect, longer term Possible reduction in grazingpressure on rest of property

Reduced benefit of tree cover (egshade, shelter, nutrient recycling)

Improved access for mustering Pastoralists own value for risk ofsalinity, erosionPastoralists own value forbiodiversity loss

External impacts - Social value of land quality Possible reduction in land

degradation on some propertiesPossible increased risk ofsalinity/erosion above landholderexpectations and on otherproperties

- Cost of greenhouse gases Impact of land clearing ongreenhouse gas emissions

- Social value of biodiversity Effect of tree clearing onbiodiversity

- Indirect effects of production Social value of positive effects onrural communities

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Present Value

• Project evaluation usually requires comparing costs and benefits from different time periods

• Dollars across time periods are not immediately comparable, because of inflation and returns in the market.

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Discounting the Future

“The value of a cost or benefit now > the of a Cost or benefit in future years.”

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Private Sector Project Evaluation

• Admissible: Are the benefits greater than the costs?

• Preferable: Are the net benefits the highest?

• Most projects involve a stream of benefits and costs over time.

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Private Sector Project Evaluation

• Admissibility using the benefit-cost ratio requires: B

C1

• This ratio is virtually useless for comparing across admissible projects however.

• Ratio can be manipulated by counting benefits as “negative costs” and vice-versa.

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Discount rate for government projects

• Government decision making involves present value calculations

• Costs, benefits and discount rates are somewhat different from private sector

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Valuing Public Benefits and Costs

• Recall that the discount rate, benefits, and costs are needed to compute the present value of a project

• For private company:

– Benefits = revenues received

– Costs = firm’s payments for inputs

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Valuing Public Benefits and Costs

• For public sector, market prices may not reflect social benefits and costs.– Externalities, for example

• Several ways of measuring benefits and costs– Market prices

– Adjusted market prices

– Consumer surplus

– Inferences from economic behavior

– Valuing intangibles

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Valuing Public Benefits and Costs

• Market prices

– In a properly functioning competitive economy, the price of a good simultaneously reflects its marginal social cost of production and its marginal value to consumers.

– Ignores market imperfections

– Easy to gather

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Valuing Public Benefits and Costs

• Consumer surplus

– Public sector projects can be large, and change market prices

Keep in mind

• The choice is the alternative selected.

• The opportunity cost is the alternative not selected, the opportunity given up.

• Every choice has a cost; there is no such choice as a free choice.

• Disadvantages are not costs.

• With every decision, there is only one choice and one cost.

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THANK YOU!