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Cost-Benefit Analysis I

PAI 723 Economics for Public Decisions11/19/2013

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Outline

• Introduction to Cost-Benefit Analysis

• The First Three Steps in Cost-Benefit Analysis- Define the scope- Estimate the costs- Estimate the benefits

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Introduction: Why do we need cost-benefit analysis?

• Cost-benefit analysis (CBA) can be used to guide several decisions for public officials:

- Whether a project should be undertaken?- Which of several alternatives should be

selected?- What is the appropriate scale of the projects

to be undertaken?

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Introduction: Basic Logic

Basic Logic of CBA• Calculate the economic benefits and economic costs of each

alternative.• These costs and benefits are discounted over time to reflect

opportunity costs.• Choose projects with the highest net benefit.

The ultimate goal of CBA• To ensure that society’s resources are put to their most

highly valued uses.- Scarcity is also a concern for government officials.

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Introduction: Roles of CBA in Policy Analysis

• CBA required by federal law for evaluating major rules since 1981 (Executive Order 12291)

• A tool of rational planning:- To provide answers to which choice to select- To provide a process to help decision making

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Steps to Performing CBA

1. Define the situation2. Estimate the costs3. Estimate the benefits4. Discounting5. Interpret the results6. Equity issues7. Sensitivity analysis

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Step1 Define the Situation/Scope

• CBA looks at how a project will change the community’s resources

1. What resources are at stake?

2. What jurisdiction should CBA be done for?- One community? Its neighbors? A state? whole country?

This is a political decision!

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Step 1 Define the Situation/ScopeExample: A PUBLIC SWIMMING POOL

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Step 2 Estimate the Costs

• Costs: resources that the community will use to carry out the project.

• The PUBLIC POOL EXAMPLE What are the possible costs for the city to

have the new public pool?

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Step 2 Estimate the Costs

• Types of Costs 1. Resources purchased for the project by the

government- Costs of construction (materials, equipment, labor,

etc.)- Costs of operating and maintenance- Overhead costs (time and resources spent by park

and recreation dept., police etc.)2. Resources owned or purchased by local residents

and firms

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Step 2 Estimate the Costs• Types of Costs

1. Resources purchased for the project by the government

2. Resources owned or purchased by local residents

3. Opportunity costs

- For assets owned by the government (e.g. land): the value of these assets in their next most valuable use

- For assets which are underutilized by the society (e.g. labor): opportunity costs is not the full market price.

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Step 2 Estimate the Costs

• Types of Costs

1. Resources purchased for the project by the government

2. Resources owned or purchased by local residents

3. Opportunity costs

4. External costs (externalities): How to monetize them?

- Environmental damage

- Increased congestion or traffic in the neighborhood

- Other social costs (e.g. increased crime)

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Step 2 Estimate the Costs – Shadow Price

• In the public arena, the “price” mechanism often fails to

reflect the true social values or costs of a resource.

• Thus, we estimate the “shadow price” in order to

monetize the social costs and benefits of those resources.

• The shadow price of an input or output is its value to the

economy as a whole.

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Step 2 Estimate the Costs – Shadow Price

• For inputs, the shadow price is the marginal opportunity cost – the value of the best alternative use of the input.

• Shadow prices are related to the market price, but not exactly the same because of market imperfections.

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Step 2 Estimate the Costs – Shadow Price

• Monopoly (P>MC)

P

Pm

Ps=MC

Qm Q

MR

D

MC

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Step 2 Estimate the Costs – Shadow Price

• Tax (P>MC)

P

Pm

Ps=MC

Qm Q

D

S

S’

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Step 2 Estimate the Costs – Shadow Price

• Negative Externalities(P<MSC)

P

Ps Pm

Q* Qm Q

D

S=MPC

MSC = MPC+MEC

18Source: Boardman, Greenberg, Vining and Weimer, 1997. “Plug-in Shadow Price Estimates for Policy Analysis”. Annals of Regional Science, 31.

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Step 2 Estimate the Costs

• Distinguish between costs and transfers- When resources are not used up nor created, but just

shifted from one set of individuals to another, we say the resources are transferred.

e.g. Destiny USA Increased property tax from houses near the pool

- A transfer does not change the total amount of resources in a community. It just changes the distribution of the resources.

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Step 3 Estimate the Benefits• Benefits: new resources made available to the

community.

• Types of Benefits1) Resources measurable in monetary terms: goods and

services sold in the market places Price2) Resources measurable in physical units, but not in

monetary terms.3) Resources valued by the community, but not

measurable by any means.- The shadow prices of crimes in Vining and Weimer (2010)

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Step 3 Estimate the Benefits• How to estimate the benefits?

- Measured by a community’s willingness to pay (WTP)

- WTP: the amount that individuals are willing to pay to

receive the benefits (or the costs they are willing to pay

to avoid negative effects).

- The demand curve tells us the marginal willingness to

pay for consumers. Total benefits are the area under

the demand curve.

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Step 3 Estimate the Benefits

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Step 3 Estimate the Benefits

• Estimate the benefits using WTP

The PUBLIC POOL EXAMPLE:

- Capacity=2000 visits/day

- The pool will open 6 days a week for 14 weeks during the summer

- At a fee of $0.50, 2000 users

- At a fee of $2.50, 0 user

What is the total benefits of building the pool for the

community?

-- Total benefits are the area under the demand curve.

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Step 3 Estimate the BenefitsWTP

Visits/day

$2.5

$0.5

2000

A

B

Demand

Total benefits/day = A+B= (2.5 – 0.5)(2000)/2 + 0.5(2000)= $3,000/day

Total benefits in a year:$3,000 * 6* 14 = $252,000

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Step 3 Estimate the Benefits• How to get the demand/community’s WTP?Approach 1: Surveys- Ask people how much they are willing to pay for services

Approach 2: Use information on demand and prices from neighboring communities

Approach 3: Use information on related markets- Recreational services: differences of property values between

neighborhoods with and without the service

- Value of life? Average salary*average life expectancy People’s WTP on safety devices for automobiles (V=C/P) C=$180, P=4 in 10,000, V= 180/0.0004 = $450,000

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Step 3 Estimate the Benefits

• Distinguish between benefits and transfers The benefits should not reflect transfers from

one section of the population to another.

e.g. - Tax abatement for elderly people - Creating jobs for pool construction and

operation

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Step 3 Estimate the Benefits

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Step 3 Estimate the Benefits

• Distinguish between benefits and transfers: Are jobs a benefit?

- If the economy is at full-employment (which is often the assumption of CBA), the opportunity cost of using workers is that they are not used somewhere else.

- Thus, the new jobs are simply a transfer of workers from one sector to another.

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Step 3 Estimate the Benefits

• Distinguish between benefits and transfers: Are jobs a benefit?

• At the local level, could there be net gains in employment locally?

- Need to prove there’s significant unemployment in the region and the project hires the unemployed

• A better way to deal with this issue is to adjust the costs of labor.

- The unemployed faces lower opportunity costs