Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 12: Cost-Benefit Analysis and Government Investments

Public Finance

Economic Analysis for the Budget Process:

• A Program is a combination of government activities producing a distinguishable output.

• Program Budgeting is the system of managing government expenditures attempting to compare the program proposals of all government agencies authorized to achieve similar objectives.

• Cost-Effectiveness Analysis is a technique for determining the minimum-cost combination of government programs to achieve a given objective

Achieving the Least-Cost Means of Accomplishing an Authorized Objective

Cost-Effectiveness Analysis

• Allows policy makers to see trade off between programs of various agencies with similar objectives– Not visible under line budgeting

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Cost-Effectiveness Analysis

• Reduce the cost of achieving a specific goal• Encourage competition among various Govt

agencies– Improve effectiveness– Encourage innovation– Improve productivity– Reduced cost– Reduced burden to tax payer

Incremental Budgeting

• Budgeting as an incremental process• Previous year’s budget

– Previous collective choices– Previous equilibrium

• Government seeks to – minimize the resources that go into the budgetary

process each year– Minimizes political conflict– Avoids disruptive changes in government spedning

Cost-Benefit Analysis • A practical technique for relative merits of alternative

government projects

• Projects where MSB is less than MSC are not

considered

• A statement of pros & cons of an activity

• Benefits must include indirect effects and costs must

include opportunity cost.

Cost-Benefit Analysis • Three main steps:

– Enumerate all costs and benefits of a proposed project

– Evaluate all costs and benefits in dollar terms

– Discount future net benefits

Enumerating Benefits and Costs • Direct Costs and Direct Benefits are those

attributable to the purpose of the project.• Indirect Costs and Indirect Benefits are

those attributable to the project that were not part of the intended purpose of the project.

Enumerating Benefits and Costs • Direct & Indirect Benefits

– Irrigation project• To increase the fertility of particular tract of land

– Direct Benefit – Increase in the output– Indirect Benefit – increase in adjoining land’s

output– Double Counting Problem

• Increase in Value of land

– Increase in retail sales – Indirect effect or not?

Enumerating Benefits and Costs • Direct & Indirect Costs

– Irrigation project• To increase the fertility of particular tract of land

– Direct Costs – Resources employed in the project

– Indirect Costs – Decrease in water level in surrounding areas

Evaluating Costs and Benefits in Dollar Terms

• Though some costs and benefits are easily quantifiable others, such as the value of a human life saved or lost because of a project, are not as easy.

• Difficult to put dollar value benefits from health and education

Evaluating Costs and Benefits in Dollar Terms

• Output of a project not sold in the market

– Surrogate measures

• Increased earnings of those who have benefited from

health program

• Increased earning of former students

Evaluating Costs and Benefits in Dollar Terms• Marketable output but price and cost doesn’t reflect

True Social Value– Products sold in monopolistic market, or under

government taxes/subsidies – Agri output prices subsidized– Inputs from Monopolistic markets are over priced– Need to reflect true social value– Might require arbitrary estimating decision by the

analyst

Discounting Future Net Benefits• Present Value

– It is an interest-adjusted value of costs or benefits that will occur in the future

– The PV of X dollars received in n years at an interest rate r is

PV = (X/(1+r))