“MEASURING BENEFITS AND COST-BENEFIT

ANALYSIS” Chapter 15

Use of Cost-Benefit Analysis

Cost-benefit analysis much more widely used in other fields such as in environmental policy than in health field

Ethical objections

Decision Rule Accept all projects for which benefits ≥ cost

Why use difference versus ratio? Pareto optimality: efficiency gain when

winners from adoption of program can compensate losers but this rarely done. Only require that winners be able to compensate losers.

Concept of maximum willingness to pay for a good or service (program)

Some problems encountered in cost-benefit analysis

Not all goods and services (program outputs) marketed or marketable—hence cannot use market outcomes to evaluate maximum WTP

Distributional effects: video games versus vaccines

Two Methods of Establishing Maximum Willingness to Pay

(benefit)

Revealed prevalence approach: infer max. WTP from actions that people take in labor markets, product markets

Stated preference approach: infer max. WTP from responses to survey questions

Economists less critical of stated prevalence approach: “put money where your mouth is”

Revealed Preference Approach: Assumptions

People make choices all the time that reflect the value they place on outcomes from choices.

Choices reveal inherent value of tradeoffs between bearing added risk and equivalent in terms of $ needed to bear risk. Ex. How much extra $/hour needed to compensate for climbing telephone poles versus desk job?

These values reflect ex ante max. WTP not ex post WTP.

Using the Value of Statistical Life (VSL) in Policy Evaluation

In U.S., practice of using VSL in policy evaluation sanctioned by all federal agencies by U.S. Office of Management and Budget) and U.S. Environmental Protection Agency

EPA recommends use of VSL of $6.5 million in 2001 $ based on analysis of 5 stated preference (see Lecture 8) and 21 wage-risk studies

There is no standard VSL for all federal agencies.

Figure 15.1 Choice of Wage and Job-Related Risk

Fig. 15.1

Think of 2 jobs: Job 1 work at Home Depot; Job 2 work in a coal mine in WVA

OC curves: employer willing to pay higher wage if employee assumes more risk, e.g., vehicles that lift employees to high shelves at Home Depot v. an ordinary ladder; more v. less safety equipment at the mine.

EU curves: expected utility expressing tradeoff between wage and risk (positive relationship)

Worker 1-job 1; Worker 2-job 2; W(P) locussee eq. (15.3)

What is observed are combinations of wages and

probabilities of injury/illness/death

Observe several wage-risk combinations which are points of tangency of offer curves and expected utility loci

For the worker and firm, the marginal effect of the probability on the wage reflects both the marginal supply price and the marginal demand for risk.

Estimated wage-risk tradeoff curve w(p) does not imply how a particular worker must be compensated for non-marginal changes in risk

Derivation of Value of Statistical Life (VSL) from Revealed Preference Data

What is a statistical life? Say require $0.10 an hour more to accept

added probability of death of 0.0000008. (0.1/.0000008)=$125,000

Viscusi-Aldy (2003): VSL in U.S. ≈ $5-12 million

Positive elasticity of income on VSL: implications for low-income countries

HETEROGENEITY AMONG WORKERS

“Cigarette Smokers as Job Risk Takers” by W.K. Viscusi and J.

HerschApplication 1

Issues

People plausibly differ in terms of preferences as well as in job market opportunities

How does one account for the stylized fact that some groups of workers are paid less and work at more dangerous jobs

How are revealed preference studies conducted in practice?

Stated Preference Approach

Several difference stated preference approaches listed in text

Most common is the contingent valuation method

Contingent Valuation Methods (CV)

Ask directly about monetary values for a specific non-marketed good (personal health, environmental, etc.) or maximum person would pay to have change occur

Questions often open-ended—individual states number rather than responding to number given by interviewer

Other type is discrete choice question—“Would you be willing to pay $X….?” Only get upper or lower bound of WTP—discrete choice questions

CVM, cont.

Use of payment cards with various payment values. Respondents asked to pick a number from card or state their own value if not on card—alternative to open-ended approach

In discrete choice format, individuals first asked whether they would be willing to pay $X. If individual says “yes,” the question is repeated with a higher price. Procedure repeated until individual says “no.”

Problem of starting point bias—answers may depend on at what $ value start bidding process

Can randomize starting point to deal with this

CVM, cont.

With series of discrete choice questions can get double-bounded measure (upper and lower bound) of WTP. With a large number of bids, bounds can become small

Advantages of discrete choice over open-ended CVM: (1) Individuals used to making choices on take-it-or-leave it basis; (2) easier to answer “yes”-“no” than give a $ value; (3) is incentive-compatible—respondents best strategy is to give truthful answer

Stated Choice or Attribute-Based Methods

Respondents given set of hypothetical alternatives and asked to choose most preferred alternative or to rate them on some scale

Based on responses, can infer marginal rate of substitution between any pair of attributes that differentiate the alternatives

If one of the alternatives is money, can compute the respondent’s WTP for the attribute based on the responses

More complex designs used in environmental economics (alternatives have many characteristics)

Contingent Behavior or Contingent Activity Questions

Individuals asked how they would change level of some activity in response to change in level of non-market good (e.g., environmental amenity)

If activity can be interpreted in context of some behavioral model, such as averting behavior or a recreation travel cost model, the method can be used to obtain measure of WTP

Need to have data on prices from another source, e.g., travel cost data to a recreational site to estimate demand curve for visits

Assessing the Validity of Stated Preference Measures

Criterion Validity. Are values from hypothetical SP questions close to “true” values? Need “gold standard” comparison such as results of choices people actually made when given alternatives in actual experiment. Some evidence that CVM studies yield too high WTP estimates and calibration proposed (methods for adjusting SP methods down)

Convergent Validity. How well do values from SP compare with results from revealed preference (RP) method? Some evidence that SP and RP quite close

Assessing SP Measures, cont.

Construct validity. Are CV responses related to variables that economic theory suggests should be predictors of WTP? E.g., income

Content validity. Does the design and implementation of the survey confirm to generally recognized best practice? Examine survey instrument, including scenario specification, elicitation question, especially its incentive properties, and payment vehicle, sample size and design, analysis of data

KNUPNICK, A. ET AL., “AGE, HEALTH AND THE WILLINGNESS TO PAY FOR

MORTALITY RISK REDUCTIONS: A CONTINGENT VALUSATION SURVEY OF

ONTARIO RESIDENTS”

Application 2

Avoiding Past Pitfalls of CV Studies

Respondents may not understand the risk changes they are asked to value.

Respondents may not believe the risk changes (or baseline risks) apply to them.

Respondents may lack experience in trading money for quantitative risk changes or fail to realize that they engage in this activity.

Remedies for Pitfalls

To enhance understanding of risk changes, use graph containing shaded squares to convey changes in probability of dying (see Fig. 1)

To deal with issue that people do not apply objective health risks to themselves, extend time period over which risk reduction applies and ask respondents to assume that risks are their own.

To help people make trade-offs, acquaint respondents with quantitative risk reductions for common diagnostic tests (e.g., mammograms, medicine to reduce blood pressure)

Fig. 15.3. Use of Grids to Represent Probabilities in Mortality Risk Questionnaire

Source: Krupnick, Bernini, Cropper et al. (2002)

CBA or CEA? Which is better?

Economists prefer CBA arguing that it is possible to adjust WTP estimates for income to deal with the distributional objection; CEA does not really eliminate placing a value on a life year, a QALY, a life. Rather valuation reflected on where draw cost-effectiveness ratio line (see Goldie et al. HIV article for drawing the line)

Cost and benefit analysis/Cutler (2004)

Medical costs 1950：＄ 500 2000：＄ 4500

Medical benefits? Live longer Live better