Introduction to Benefit-Cost Analysis

Goal: Maximize total net benefits (total benefits - total costs)

Benefit-cost analysis calculates the costs and benefits of a project and finds the total net benefits

Some come directly from market data but others need to be inferred from observable data

Environmental services have costs even though they are produced without any human input

Environmental resources have alternate uses, if there is no such human use an environmental
resource can help us in preserving ecosystem and therefore keeping balance in environment

Measuring benefit is mostly adding up the area under demand curve until supply curve, that is total
surpluses

Demand curve is the consumers willingness to pay

Supply curve is he producers requirement for production

Issues in Benefit Estimation

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Primary versus Secondary Effects: Environmental projects usually trigger both primary and
secondary consequences.

Accounting Stance: The accounting stance refers to the geographic scale at which the
benefits are measured

With and Without Principle: The with and without principle states that only those
benefits that would result from the project should be counted, ignoring those that would
have accrued anyway

Tangible versus Intangible Benefits: Tangible benefits are those that can reasonably be
assigned a monetary value. Intangible benefits are those that cannot be assigned a monetary
value

Types of costs
1.

Opportunity costs: The value of the best forgone opportunity of resources used

It is what we give up by using a resource for this use, rather than the next best
alternative use. Example: an opportunity cost of going to school is foregone salary.

2.

Important to distinguish between costs and transfers.

Environmental costs: Because most regulations focus on a single pollutant, regulating one
pollutant may increase the use of another pollutant. Example: using scrubbers to clean SO2
emissions leaves behind a sludge that must be disposed of.

3.

Enforcement costs

4.

Implicit costs: Non-monetary costs of inconvenience, time searching for substitutes, lost
product variety, etc. Few studies include implicit costs

Approaches to Cost Estimation

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The Survey Approach: One way to discover the costs associated with a policy is to ask
those who bear the costs, and presumably know the most about them, to reveal the
magnitude of the costs to policy-makers

The Engineering Approach: The engineering approach bypasses the source being regulated
by using general engineering information to catalog the possible technologies that could be
used to meet the objective and to estimate the costs of purchasing and using those
technologies

The Combined Approach: To circumvent these problems, analysts frequently use a

combination of survey and engineering approaches. The survey approach collects
information on possible technologies, as well as special circumstances facing the firm

Optimality and efficiency

An allocation of resources is said to satisfy efficiency criterion if the economic surplus from the use
of those resources is maximized by that allocation.

Optimality is the best condition that we can achieve, in most cases they are same

First Equimarginal Principle (the Efficiency Equimarginal Principle): Social net benefits are
maximized when the social marginal benefits from an allocation equal the social marginal costs.

Allocations are said to be Pareto optimal if no other feasible allocation could benefit at least one
person without any deleterious effects on some other person.

Government builds a new highway

1.

2.

Benefits

Businesses and people benefit from the highway if people use it.

Relieves congestion from surrounding roads and highways

Creates construction jobs

Costs

Government pays construction companies to build highway

Government has to assess taxes

Opportunity costs

Land could be used for another activity

Construction companies could build something else

Steps to benefit-cost analysis

1.

Specify clearly the project or program.

For environmental economics, this is usually a physical project such as a dam or

wastewater treatment plant, or a regulatory program, such as pollution control
standards.

2.

Determine quantitatively the inputs and outputs of the program.

Can be difficult for example, general equilibrium effects.

Also, it is important to distinguish between transfers of resources due to

substitution and the creation of new resources.

For example, jobs created by a project should normally not be included as a

benefit.

Jobs created are a transfer of resources. If the project was not done, the
workers could have been used elsewhere.

3.

Estimate the social costs and benefits of these inputs and outputs.

4.

Compare these costs and benefits.

Here, one can also include other considerations, such as equity.

Dealing with Uncertainty

The first step in dealing with uncertainty is risk assessment

Risk has two components:

Stochastic depends on chance

Systematic depends on circumstances (e.g. a smoker is more likely to get cancer)

In addition, assessing risk involves two concerns:

o

The probability of an event occurring

How serious the event will be

Risk assessment
o

First, we focus on finding the probability of an event occurring.

Historical data

Risk can be determined by looking at past records.

However, it is important to be aware of changes that occur over time.

For example, increased safety features reduce the risk of death from auto
accidents. This is a change in systemic risk.

New technologies

Component analysis is often used to assess the risks of new technologies.

Problem: components may be related.

Risk by analogy

Often, time lags make perceiving risk difficult. For example, cancer may
be caused after exposure to a toxin, but only after many years.

A complication for policy makers is that, even after risk assessment is complete, people have a hard
time perceiving risk accurately. Risk assessments are hard to understand, as they typically involve
low probability events.

Example: what should the standard for ammonium perchlorate in groundwater be? The example
over the ammonium perchlorate standard shows how different criteria for risk assessment suggest
different answers.
o

EPA:

Proposes a standard of 1 part per billion (ppb)

They look at sensitive populations, including the risk to fetuses.

They also make use of laboratory studies.

Pentagon:

Proposes a standard of 200 ppb

Note that this standard would release the Pentagon from most cleanup
responsibility.

They base their figure on a study of exposure to human adults.

Thus, one study focuses on more sensitive populations, whereas the other focuses on
exposure to a typical person.

Once risk has been assessed, policy makers face several alternatives for using the information:
o

Benefit cost analysis

For BCA, pieces of information needed to deal with risk include:

The risk probability: The government often uses conservative estimates

(e.g. 95% percentile).

The population exposed: For example, Superfund regulations consider

possible future populations on a site.

The value of a life

Cost-Effectiveness analysis

Second Equimarginal Principle (the Cost-Effectiveness Equimarginal Principle):

The least-cost means of achieving an environmental target will have been achieved
when the marginal costs of all possible means of achievement are equal.

Rather than compare costs and benefits, simply show that the agency has adopted
the cheapest way possible to achieve its goal.

We can than ask if the costs justify the benefits received, without needing to place
a dollar value on the benefits.

Risk-risk analysis

Compare risk after regulation to risk before.

Notes that regulation will affect behaviors, and could even increase risk.

Issues:

Substitution risks: If substances that replace banned substances are also

risky, net gain from banning the substance is not as great as it seems.

Risk of other economic behavior: For example, what is the additional risk
of industrial accidents from workers who manufacture scrubbers for
power plants?

Opportunity costs of diverted resources: What do we give up in other

expenditures (e.g. health care) by spending more on regulation?

Discounting

The costs and benefits we have discussed often occur at different times. To compare them fairly, it
is important to discount costs and benefits that occur in the future. The idea is to compare a flow of
benefits and costs into a single value.

The present value of a future amount of money is the maximum amount you would be willing to
pay today for the right to receive that money in the future.
o

Present value accounts for the opportunity cost of not investing the money elsewhere.

General rule:

FV = future value, PV = present value, r = interest rate

FV = PV(1 + r)t

For a stream of payments:

For payments forever:

PV = x + X/(1+r) + X/(1+r)2 + + X/(1+r)t

PV = X/r

Rule of 70

To get the number of years needed to double an investment, divide 70 by 100

times the growth rate. Example: Invested @10%, money doubles every 7 years [=
70/(0.1x100)]

To proceed, we need to know what value to use for r. This is the discount rate.

The discount rate reflects the relative value a person places on future consumption compared to
current consumption.

Since the market interest rate reflects equilibrium of lenders and borrowers, we can use the market
interest rate as a measure of the discount rate.

Why the discount rate matters

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Discounting affects the value placed on future benefits and costs.

Higher discount rates place less importance on future returns.

A very low discount rate suggests we would give up virtually all consumption today to
protect the future.

However, a higher discount rate suggests very distant benefits have little weight in decisionmaking.

Might the social discount rate deviate from the market rate?
o

Some economists argue that the opportunity cost of foregone future consumption might
differ from the opportunity cost revealed in the markets.

In this case, it might make sense to use a social discount rate which is lower than
the rates observed in the marketplace.

The social discount rate represents the willingness of society to trade off
present and future consumption. If there are market failures, this may
differ from discount rates observed from market behavior.

Why might market rates not be appropriate?

Long-term projects involve benefits or costs for future generations.

However, future generations are not represented in the market.

People may be myopic, and thus not save sufficiently.

There may also be other externalities that cause the market rate of return
on investments to deviate from the social discount rate, such as positive
externalities from research and development.

Uncertainty may be a concern, therefore, risk aversion may justify using a

lower discount rate. However, uncertainty is not an excuse to do
nothing.