ECONOMIC EVALUATION OF PROJECTS

Universidad de Las Palmas de Gran Canaria

A water supply project has a fixed cost of 90 monetary units (u.m.) and the variable cost
is zero. The water demand function is Q=150-50p, where p is the price of a unit of water
and Q the units of water demanded. Assume that everything happens in the present.

1. Calculate the social net present value (NPV) of the project when a) the price of a
unit of water is equal to 1 u.m.; and b) when the water is supplied free of charge.

2. Suppose now that the total cost of water is composed by the fixed cost (90 u.m.)
and a marginal cost of 1 u.m. per unit of water. Would you change your answers
to 1(a) and 1(b)?

3. Suppose the marginal cost is zero but there is a negative externality of 1 u.m. per
unit of water. Would you change your answers to 1(a) and 1(b)?

4. What is the relation between the NPV and the Kaldor-Hicks compensation
criterion?

5. Suppose perfect price discrimination is possible (each unit can be sold to its
maximum willingness to pay), what is the quantity of water that corresponds to
the maximum NPV? The marginal cost of one unit of water is 1 u.m.

6. Back to point (1) with price and marginal cost equal to zero, calculate the NPV
of the project if net benefits grows 3% per year, the social discount rate is 5%
and the life of the project is 50 years. Compare the result with a infinite project
life.

7. Explain the method of the hedonic prices for the evaluation of environmental
impacts.

8. “Taxes should always be deducted to obtain the opportunity cost of inputs” Do

you agree? Justify your answer.