TUTORIAL 4: CHAPTER 8

COST AND BENEFIT ANALYSIS

I. Short answer questions

1. For your senior thesis, you polled your classmates, asking them, “How much would you be
willing to pay to double the amount of parking on campus?” Based on their responses, you
estimated that your fellow students were collectively willing to pay $12 million to double the
amount of on-campus parking. What are some problems with this type of analysis?

Survey willingness-to-pay figures can be suspect for several reasons. First, respondents may not have much
experience with pricing this commodity, so they wouldn't have a good sense of what they would be willing
to pay if they had to pay for it. Second, respondents may have an incentive to either understate or overstate
their true willingness to pay. They will understate it if they are concerned that the regents will raise their
tuition to pay for the parking lot; they will overstate it if they want more parking but don't think they will
actually have to pay for it. Third, you may need to consider your polled audience; if you had an unscientific
sample, your results might be biassed. For example, senior polling his or her friends may have mostly asked
students who will have graduated before the parking is expanded, and they may not place a high value on
future parking. Or a dorm resident may have polled many students who do not drive and thus have little use
for additional parking.

2. A city government is considering building a new system of lighted bike paths. A councillor
supporting their construction lists the following as potential benefits of the paths:
(1) more enjoyable bike rides for current and future bikers,
(2) reduced rush hour automobile traffic from increases in bike commuting, and
(3) the creation of 15 construction-related jobs.
Can all of these actually be considered to be benefits? Explain.

The first two can certainly be considered benefits. The third cannot generally be considered a benefit. If
labour markets are perfectly competitive, then there is no such thing as the"creation" of jobs—the new
government jobs merely crowd out jobs in other sectors of the economy. Even if labour markets are
imperfectly competitive and the government hires workers who would otherwise have been unemployed, it
is still not clear that this job creation can be considered a benefit. For example, consider an unemployed
worker who gets $5 per hour in benefits from leisure. Proper accounting would consider the "true" social
costs of hiring this worker to be the $5 per hour in foregone leisure. Any more money paid to the worker
would be neither a social benefit nor a social cost per se—it would be simply a transfer from the government
to the worker. However, society might value the creation of this job if unemployment has significant
externalities or if society values the redistribution associated with this transfer.

3. How does the opportunity cost of a government purchase vary depending on whether the
market for the purchased good is perfectly competitive or monopolistic?
The opportunity cost should be calculated as the resource cost of producing the input. In a perfectly
competitive market, the price will equal the marginal resource cost. In a monopolistic market, the price will
be greater than the marginal cost. The opportunity cost and thus the figure used in a cost-benefit calculation
should be the marginal cost. The additional price paid to a monopolist is a transfer to that firm, not a net
benefit or cost.

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 4. One approach to calculating the value of life involves the use of compensating differential
studies. What informational problems make these studies difficult to carry out?

Compensating wage differentials compensate workers for taking additional risks or tolerating less pleasant
circumstances on the job. The wage premium that someone is willing to accept in exchange for an increased
risk of loss of life might be used to estimate the value of life. Jobs differ in many ways, however, and wage
differences are attributable to all those differences. For example, risky jobs are less likely to involve sitting
in ergonomically correct desk chairs in climate-controlled offices, and the absence of those amenities might
account for part of a higher wage paid to workers in riskier jobs. This presents an informational problem
because a researcher would not be able to distinguish that part of the compensating wage differential that is
attributable to increased risk and that part of the differential that is attributable to other amenities. The risk
of non-fatal injuries might also be compensated for in the wage differentials, but that difference cannot be
used to infer the value of life.Estimating the value of life based on the willingness of a worker to accept a
wage premium in exchange for increased risk on the job presents informational problems because a
researcher will be unable to observe differences in risk attitudes. If workers who tend to be risk-takers are
more likely to accept jobs with a high degree of risk, the compensating wage differential will reflect only the
value to these workers and will therefore be overstated relative to the average worker.

5. A city is planning to build a new baseball stadium. Make a list of the possible private costs,
private benefits, the external costs and external benefits when building and operating the
stadium.

Benefits Costs

- The cost to hire workers, new equipment

- The revenue generated from selling and other inputs to build the new stadium
tickets and other services for the
investors - The potential cost to maintain the facility
and equipment of the stadium
Private
- The satisfaction of the customers
enjoying baseball matches, and other - The cost to hire employees to operate the
events at the new stadiums stadium

External - More jobs (albeit temporary) were - Noise pollution in the neighbourhood
created to construct the stadium. negatively affects the local dwellers while
constructing the new stadium
- The stadium’s daily operation will
create other more permanent jobs - Environmental costs such as emissions
that will enhance local tax revenues and wastes resulting from constructing the
through increased ticket sales, stadium
concessions sales, and income taxes
from new employee wages.

- Indirectly spawn ancillary

development such as new restaurants
and retail outlets. These new
businesses will also provide hefty

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 contributions to the public treasury

II. Multiple-choice questions

1. What is total of the present discounted value of $400 a year from now and $500 two years
from now if the interest rate is 10%?
a. $676.18
b. $743.80
c. $818.18
d. $776.86
e. $900

2. If the present discounted value of $400 next year is $380 this year, what is the implied rate of
interest?
a. 5.26%
b. 5%
c. 2.56%
d. 2.60%
e. None of the above

3. Suppose you have 3 years to live and you value each year of life at $7 million but have a
discount rate of 5%. How much do you value the rest of your life in today's dollars?
a. $20 million
b. $19.06 million
c. $21 million
d. $18.14 million
e. None of the above

4. The county supervisor sends out a survey via mail asking residents how much they are
willing to pay for a new swimming pool. This is an example of which of the following?
a. Contingent valuation
b. Revealed preference valuation
c. Cost-benefit analysis
d. Social discounting
e. Cost-effectiveness analysis

5. The county supervisor who is considering building a pool sums up all of the valuations
received in the survey and compares that number to the estimate received by the contractors.
This is an example of which of the following?
a. Contingent valuation
b. Revealed preference valuation
c. Cost-benefit analysis
d. Social discounting
e. Cost-effectiveness analysis
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 6. Now the county supervisor figures out how much some residents pay to drive to the public
swimming pool in the next county. This is an example of which of the following?
a. Contingent valuation
b. Revealed preference valuation
c. Cost-benefit analysis
d. Social discounting
e. Cost-effectiveness analysis

7. The county supervisor decides that the swimming pool should be constructed based on
everything that has been learned to this point. This is a result of which of the following?
a. Contingent valuation
b. Revealed preference valuation
c. Cost-benefit analysis
d. Social discounting
e. Cost-effectiveness analysis

8. Now the county supervisor decides to figure out who should construct the public swimming
pool by collecting bids from various contractors. This is an example of which of the following?
a. Contingent valuation
b. Revealed preference valuation
c. Cost-benefit analysis
d. Social discounting
e. Cost-effectiveness analysis

9. Suppose that building a new highway will cause the land nearby to become more valuable
because the increased would increase the profits of the businesses there that own the land.
Which of the following should be counted as a benefit of the road?
a. The jobs of the construction workers hired for the work
b. The jobs of the construction workers who were previously unemployed
c. Net increases in commerce to the area
d. All of the above
e. Both b and c

10. Suppose you estimate the value of a life for the average person by comparing the risk of
death faced by retail clerks and miners to their relative wages. Which of the following would
NOT bias your estimate?
a. The risk of injury might also differ between those occupations.
b. Miners get paid more than do retail clerks.
c. Miners might get particular joy out of mining and see this as a benefit.
d. Retail clerks might see the relative cleanliness of their job as a benefit.
e. None of the above is correct.

III. Case study: A Cost-Benefit Analysis of the Job Corps Program

Cost-benefit analysis is valuable to evaluate the success or failure of programs that have been in
operation for a while. Data for existing programs are usually easier to obtain and more accurate than
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data for programs under proposal. One such study was done for a controversial federal program
designed to increase the future earnings of disadvantaged teenagers: the Job Corps. The Job Corps
provides education and training in a residential setting to disadvantaged teenagers and young adults
between the ages of 16 and 24. The goal of the program is to provide participants with skills that
increase their potential to earn income while improving their education and literacy to make them
more productive and law-abiding citizens. While enrolled in the program participants receive food,
clothing, and modest pay from the government. Each year about 60,000 new participants enter the
program and receive such services as basic education, vocational skills training, health care, and
counseling. There are 120 centers throughout the United States and the annual budget for the
program was in the range of $1.5 billion in 2006. Current annual cost per participant is therefore
$25,000, making the Job Corps a very expensive program on a per participant basis. Is the program
worth its costs? To find out, the U.S. Department of Labor commissioned a cost-benefit analysis of
the program by Mathematica Policy Research, Inc. Let’s look at the benefits and costs of the
program. Because the costs for the sample of participants were incurred in 1995, all benefits are also
valued in 1995 dollars. Earnings after 1995 are discounted and the effect of inflation is removed. The
initial study tracked the earnings of the two groups for a four-year period after 1995 and assumed
that any positive differential in the earnings of participants over non-participants would continue
over their entire working lives. The most recent study tracked earnings for a seven-year period after
1995.
The benefits of the Job Corp program include:
1. Increased output from increased productivity of Job Corps participants after they enter the labor
market, measured by the impact of the program on their compensation in the labor market (including
fringe benefits from work) less the costs of child care associated with working.
2. Reduced outlays for other programs that would otherwise provide the participants with assistance,
such as other education and training programs, welfare programs, and health care programs.
3. Reduced costs of crime committed by participants and against the participants.
The costs of the Job Corp program include:
1. Outlays for operating costs of the Job Corp Program. However, the student pay, as well as food
and clothing received by participants, is treated as a transfer and not included in these costs (this is a
cost to taxpayers but it is offset by a direct benefit in the year of the outlay to Job Corp enrollees).
2. Donated goods and services for the program.
3. Economic costs of capital (real estate, furniture, and equipment) used by the program.
The Mathematica National Job Corps Study is based on a national random sample of eligible
applicants for the Job Corp in 1994 and 1995. With both a program group in the sample that actually
enrolled in the Job Corps, and a control group that did not, the study was able to use statistical
methods to compare the earning gains and other gains of program participants over and above the
earnings of non-participants. The study was conducted over a number of years and initial results
published in 2001 indicated the benefits of the Job Corp program exceeded its costs per participant
by nearly $17,000. However, a revised study released in 2003, based on improved methodology and
a longer term perspective, reached the opposite conclusion: On average the benefits of the Job Corps
program per participant fall short of the costs.
The increments in earnings of participants in the program, on average, do not persist after a four-year
period. Because increased labor compensation is a major benefit of the program, the new research
concludes that the decay of the earnings differential attributable to the program after four years
results in benefits falling short of costs. The net benefit per participant is estimated at $10,150.
The table at right shows the estimated benefits and costs per participant in the Job Corp program.

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 However, by disaggregating the data, the researchers were able to reach some other interesting
conclusions. Although the impact of the program on earnings for the entire sample after the fourth
year were close to zero, the impact on participants between the ages of 20 and 24 remained positive.
This age group accounts for about one-quarter of all Job Corps participants.
Benefits and Costs of the Job Corps (1995 Dollars per Participant over Working Lifetime)a
BENEFIT VALUE
Increased output 269
Reduced use of other 2186
Programs Reduced crime 1240
Total benefit 3,695
Costs
Operating costs net of transfers Misc 12,285.
other costs 543
Capital costs 1,016
Total costs 13,844
Net Benefit 10,150

Based on Sochet, Peter Z, McConnell, Sheena, and Burghardt, John. “National Job Corps Study:
Findings Using Administrative Earnings Records Data,” Final Report, October 2003. Submitted to
the U.S. Department of Labor by Mathematica Policy Research, Inc. Numbers might not add due to
rounding.
This suggests that the program could result in benefits that exceed costs if it concentrates its efforts
on an older group of participants. The program still remains a good deal for participants because the
transfers they enjoy while participating typically offset the earnings they forego by enrolling in the
program.

TASK: Based on the above case study, Propose your own public good project to the local
government with comprehensive cost-benefit analysis.

A Cost-Benefit Analysis of the Climate Change Adaptation project

Vietnam is one of the countries heavily affected by climate change, the impact of climate change is even
faster than expected. Up to now, all sectors and fields have assessed the impacts of climate change. Climate
change also threatens food security, water resources, and human health, especially for poor and vulnerable
groups. The overall effect of continued high emissions could result in a 23% reduction in global average
income, of which average income in Vietnam by 2100 would also be lower than in the absence of climate
change.

The benefits the Climate Change Adaptation project include:

1. If measures are taken to respond and forecast, GDP by 2030 may increase compared to the normal
development scenario.

2. Climate change adaptation measures in agriculture have the greatest impact on GDP; followed by
energy, and waste. The output of agriculture, forestry, and high energy consuming industries will all
increase.

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 3. Other indicators of investment capital, employment opportunities, consumer price index, and the
inflation rate will also increase to different degrees compared to the normal development scenario.

4. The rate of rural poor households can be reduced by investing in livelihood transformation and
developing models that are more resilient to natural disasters and climate change.

5. Human health has improved. Reducing carbon emissions would provide health benefits that are
twice as large as the global costs of carbon mitigation measures.

The costs the Climate Change Adaptation project include:

1. Expenses for operating expenses for technological innovation and change, infrastructure for
natural disaster prevention and control

2. Currently, most models focus on short-term damage, assuming that climate change has no long-
term effects on economic growth, but in fact, the investment costs are cut when carbon emissions
inexpensive long term

3. As the temperature increases, the response costs also increase

4. The total economic cost of climate change could reach $523 billion by 2050.

Projects can deliver benefits that exceed costs if they focus their efforts on tackling climate change as soon
as possible because late climate action will cause damage. economic losses will be equivalent to or cause
great unforeseen damage, and the cost to improve will be many times higher.