Annotations on a class of Cost-Benefit Analysis

Carlos Grandet December 2011

1.

Introduction

We live in a world of scarce resources. This force us to always try to get the most out of the things we have or the activities we do. However, accomplishing this is not an easy task. You never take a course in school on decision-making and most people in college will probably go out without taking a class that will be give them a greater orientation in this topic. So, in the end, people are left with their very own intuition to decide what are the actions that will benefit them the most. -It is rather natural - some people will say when asked on how is their internal decision proccess made. However, it does not mean, that is flawless. Most people are unaware of the costs that an action implies or tend to overestimate the benefits. In the end, this lack of analysis will probably turn against them. One or two individuals might not do any damage to the society, but now imagine a government simply doing an inappropiate evaluation of their projects. The current economical crisis has put in evidence the need of governments to wisely choose their policies and the terrible consequences of not doing so. These events pose an interesting challente to all people that wish to properly evaluate a project. In this summary, I will describe the most important things I learned to be able to analyze and evaluate different types of projects.

2.

Project Profile

When it came to the creation of a project profile I think that there are three concepts that really caught my attention. The first is a simple one, but I had not stop to think about it. The first question you have to ask is who are you doing the profile for. It is not the same thing to analyze a house mortgage from the bank perspective than from the household one. The bank will see the money borrowed as a cost and the interests received as a benefit. On that basis, it will take a decision on wheter to give the mortgage or not. However, the household will have greater costs because they will have to put some additional money besides the loan one. On the benefits, it is not as clear what are the benefits because unless they are selling the house, it is hard to estimate how is anyone 1

benefiting from buying a house for themselves. All we can presume, is that if the person buys the house, it is because their benefits are greater than their costs. The problem can become more complex if we include the society’s perspective. The existence of externalities on a house purchase also makes this point relevant. A tax on housing, for instance, could be a benefit in terms of wealth redistribution; a subsidy on the purchase of this house, is a cost to them. In the end, the same project can have completely different approaches depending on which is your viewpoint. Will the household get the house? If so, will the society be affected or benefited? Which of the two benefit is more important? All these questions arise from simply understanding that there different perspectives at which you can look at something. The second concept I learned was more of a practical way of doing a financial analysis. I was thought in my other course to take the net present value of a project to zero. There was not a profound reasoning on the why, I guess is just the way they do it in books and the people do not stop to think in the consequences. However, I learned that a simpler analysis is to take all the flows to the period in which you start receiving benefits (suppose it is time t). By doing this, you turn the Net Present Value a monotonically declining function of R (the rate of discount) that is easier to interpret. This is because, as R increases, the N P Vt will always decrease. On the contrary, when you take all the flows to the time t = 0 then the N P V0 will have a parabola-like behavior, which will make N P V0 to first decrease and the start to increase as R increases. Graph 1. NPV on time t versus NPV on time 0

2

The third concept was on the use of the IRR. The common idea of always taking the project with the highest internal rate of return can have exceptions. This is because, you also have to consider the scale of the project. A profile can yield a high IRR but when it comes to real benefits they might low, because the cost is equally low. This is an example:

Project A B

T=0 -1 -100

T=1 IRR 2 100 % 140 40 %

There were two other concepts I learned when creating a profile of a project. An ex-ante analysis of a project implies uncertainty in the flows estimation. For instance in the case of a cashflow that depends on the price of a volatile commodity. The common statistical figures to deal with this are the mode, median and mean. A common mistake when dealing with this is to ignore the expected value and price outliers. A better approach is to try to incorporate the expected value by assuming a specific distribution function and running Montecarlo experiments. An easier approach is simply to include different scenearios based on fundamented price speculations about that specific market. Another interesting concept is how to deal with a change in the discount rate across the project implementation. Sometimes, the scarcity of funds might cause that the long-run interest rate be lower than the short-run one. In order to include this into your analysis all that is needed is to assume different interest rates across time. F2 F3 F1 + + (1 + R1 ) (1 + R1 )(1 + R2 ) (1 + R1 )(1 + R2 )(1 + R3 )

(1)

N P V0 =

3.

Inflation, scale, timing and replacement

The issues covered in this section were all new to me. They gave me a broader perspective of the cost-benefit analyisis I have learned which had always revolved around the flow discount and NPV value calculation but never went deeper than that or asked more interesting questions such as: How do you include price uncertainity? What is the right scale of a project? when should a project be postponed? In the end, the greatest benefit I get from these concepts is the ability to create an analysis that models with more accuracy the real world.

3.1.

Scale of a project

The problem of the size that a project should have is a common one and the answer the bigger the better clearly does not apply in this case. The most important principle 3

Graph 2. To change the rate of return. 4 . The basic idea is that each increment in the scale of the project has a unique IRR. Therefore it become an analysis of choosing the project that maximizes it. This means. This internal rate of return is called the marginal internal rate of return (MIRR). If this idea holds. PV vs scale An important observation of this graph is that it is comparing the NPV of different scale projects that have the same rate of return and period of time. You could see NPV as a function of the scale and therefore you will choose that point in which the incremental marginal NPV is zero. you could do an analysis with the Internal Rate of Return (IRR). that the decision of changing the scale of a project should be accompanied by an analysis of the present value of the marginal benefits compared to the marginal costs.when choosing the scale of a project is that each incremental change in its size should be treated as a project by itself. then the optimum scale will be the one at which the IRR for the incremental benefits and costs equals the discount rate used to calculate the net present value of the project. The goal when choosing scale is to have that one which has the biggest NPV.

that the benefits of selling a good that increased its price over the years. This is done through an index that divides the price of the relevant goods by a 1 The Laspeyre Index is defined as one Pi ∗Q0 P0 ∗Q0 where Pi ∗ Q0 is the Real GDP and P0 ∗ Q0 is the nominal 5 . On the contrary. Inflation The issue of inflation is usually ignore in a cost-benefit analysis and my previous experience with it was not the exception. When the MIRR is greater than the IRR. However. it is important to note that this is not the scale at which the net present value of the project is likely to be maximized.Graph 3. the Laspeyre Index1 does not consider the relative prices. The reason for this omission is because the common way of controlling for inflation.2. then expansions of the project will cause the IRR to increase. MIRR and IRR These graph shows the relationship between the IRR and the MIRR. A solution to this problem comes with the introduction of relative prices in your analysis. when the MIRR is lower than the IRR. The scale where the IRR=MIRR is always the scale at which the IRR is maximized. the overall IRR will decrease. This is particularly important in some economies that depend on good with a high degree in volatility such as the oil in Mexico. The optimum scale is where MIRR=IRR 3. or the costs of buying the same good. This means for instance.

If we define an economy with n goods.2 By doing this you can control for the inflationary pressures on the nominal prices and at the same time ensure that the changes in real prices caused by the market interaction are reflected. an exante analysis of a project will require an estimation. Pi t as the price for the good i in time t and αi the share of the good i in the economy then: (2) where Σn αi = 1 i By applying (2) in (1). Pt as the price index in time t. then each of the variables is easy to compute because they had already been observed. a decrease the trend in the price of a good is related to the intrinsic change in the productivity of a good or service. If it is a ex-post analysis. The application of this concept in an analysis of a project will have the following structure: Pit ¯ Xit − Pt Wjt ¯ Ljt Pt (5) Ft = where Xit represents the outputs and Ljt the inputs. you can empirically observe that historically the price of a car tends to decrease with time while a computer tends to increase. In general. Therefore. this can be converted to Pit =1 Pt Pt = Σn αi Pit i (3) (4) Σn αi i The estimation of this figure acquires a different difficulty according to the moment in which the analysis wants to be made. ˆ The difference between the two is that the CPI is a price index created from a consumersA´ basket ˆ basket and the GDP is created from a producersA´ 2 6 . To estimate this ration we can use Pt the trends in the price of the relevant products. However.price index such as the CPI or the GDP deflator. the relative prices can adjust to that. the best way to do it is to directly estimate the equation Pit which are the relative prices. For instace.

This approach can also be used for determining wheter an asset or good needs replacement. The winning option must satisfy that P Vw > P Vi for every iw. Keep the old fridge The payoffs would look like: (6) (7) (8) P VA = −PN + P V BN P VB = −PN − RV0 + P V BN +O P VC = −RV0 + P V BO Where RV0 is the residual value of the old fridge in time 0. 7 .3. As we already said. However. Buy a new fridge and keeping the old one 3. 2. lets suppose that option B is the winner.3. For example. The possible choices to which the family faces are: 1. A more complex example will include the externalities of getting the refrigerator into the cost. In cases B and C. Buying a new fridge and selling the old one. the present value of the residual value is subtracted because it is implicitly included in the present value of the net benefits of the old fridge. Choice A) Replace the old fridge. the basic concept required to do any analysis is the margin. then it is appropiate to replace the good. sunk costs are irrelevant. Replacement So far. the residual value is a sunk cost that should not be taken account to make an economic decision. An example could be a family’s acquisition of a new refrigerator. The extra benefit of choosing a project or an increase on its scale should be compared to the extra costs. Choice B) Buy a new fridge. then: (9) (10) P VB − P VA > 0P VO|N > RV0 P VB − P VC > 0P VN |O > PN When the marginal benefit of the new asset is greater than its cost. Choice C) Don’t do nothing.

8 .3. For example. The basic idea to determine this is to is find the time in which the present value of the benefits not perceived by the postponing of the project is equal to the opportunity cost of the capital that could have been invest. A smaller benefit lost than the capital gain in the money not spent means that the the project should be postponed. this is a case in which the method of taking a NPV to the point in which it start receiving benefits should not be used. Timing The decision to postpone a project is also an important idea to consider in a project analysis because of the possible gains obtained from it. Therefore. a highway project could yield different results according to the traffic flow today and the expected one. Graph 4 Benefits of postponing The analysis of timing requires that the period to which the Net Present Value is discounted be the same for all the scenarios.4. This is to guarantee that the NPV are comparable among each other.

the method mantains its properties. Bt is the net benefit of the project in the year t and N P Vt = Σt = 1T Bt − k. Then. when this is not the case.Graph 5. 4. This method assumes the existence of increasing benefits. The best timing is where N P Vtj > N P Vhj with th for every h. If initial costs depends on the time so that k varies in each year then the cost of postponing is expressed by kt − kt+1 − Bt+1 + rkt and appropiate time would be the one that gives the minimum value to that equation t. then you have to check if the NPV is greater than zero.Maximizing of the NPV The modelling of the timing problem is as follows: Suppose k is the initial investment or initial costs of a project. If it is. Distributional Weights There are three fundamental characteristics that apply to welfare economics a) Benefits being measured at each step by demand price (willingness to pay) b) Cost being measured at each step by supply price (willingness to supply) c) Aggregation of these two across individuals regardless of who is enjoying the benefits or costs (adding up) 9 . and N P Vt represents the net present value of constructing in period t. however.

5 Weighted 750 -500 250 These creates a great efficiency problem that increases as you weighted more the benefits of the poor people. who gets more utility from an incremental dollar?. however.5. and for a poor family it is worth. they will favor the poor instead of the rich. This problem creates the idea that a dollar has a different value according to whom it goes. The results of this approach can cause a proyect to be approved despite having a negative value. usually the poor ones. A better illustration of the efficiency problem can be analyzed with different weights according to income. comes from the fact that people do not know what weight to assign and it is done in a rather hollistic manner. Graph 6. Present Value of Benefits Costs Net Present Value Unweighted 500 -1000 -500 Avg. taking 10 . If you ask anyone. A great limitation. Weight 1.However. Marginal Utility of Income. 2. there are social concerns with the last point because of different values for different people of a certain good. Suppose that the dollar of a rich family is worth . Therefore.5 . This situation has led to the existence of a distributional weight that measures benefits and costs differently according the the family or individual it affects.

It has been demostrated that in terms of utility giving cash transfers is better than in-kind ones. In other words.32 dollars from the rich family and giving 8 to the poor one will be appropiate because they will have the same value (32x. Basic needs versus Distributional Weights There appears to be the confusion that basic needs and distributional weights are just two similar approaches to welfare distributional issues. The idea of Basic Needs externalities is well illustrated when analyzing the in-kind and cash transfers. public education.5)=16 and 8x2=16). a father paying for his children school rather than giving him the money to 11 . Basic need externalities refers to the benefit that people get from the improvement of the circumstances of others. Distributional weights come from an individual framework in which the marginal utility of certain individuals has a greater value than others. This creates a lost of efficiency of 75 % that is acceptable The distributional weights approach also creates a different analysis for tax 5. they are quite different. Nevertheless. etc. they have a willingness to pay for the diseased to be heal. the hungry to be fed. most of the transfers given today are in-kind (food stamps. However.

Basic needs externalities approach This approach. Basic need externalities therefore become a way in which the consumption of other people or the attainment of certain states enters into the utility function of donors. Graph 7. The analysis followed is the same as that of other externalities. a positive externality. poses a great problem which is the fact of how to value the positive effect of an externality in the society. (The slope of the social demand curve in graph 3. Money coming in is a good thing and money going out is a bad. this people are receiving a benefit from the improvement of others. However when you are considering a public project.use it) because the donors are better-off when they know that their money is going to be used for something. Therefore. the evaluation is fairly easy because the profile is clearly defined. Economic opportunity cost Whenever you are evaluating a bussiness project you consider the inflows and the outflows throughout the years and then use an interest rate which is either the cost of borrowing the money or the alternative return to the investment that money could have in another project. however. the 12 . 6. Some technicalities set aside.

these two prices are differen and the social opportunity cost has to become a weighted average of them. the problems of the monopoly and other contributions such as the Ramsey rule for ˆ optimal taxation. In this context the following equations hold: If pd is the demand price. in the presence of distorsions such as a tax.increase in total supply and the displacemente of other demanders. ps is the supply price and D is the distorsion we can say that: (11) pd = ps + D and. there are only two sources from which that demand can be satisfied . Calculating the benefit of a better-educated labor force or a healthier population is often difficult and inexact. if you take them as only postulates instead of absolute truth then you can do interesting analysis One of the analysis that is supported by this ideas is that of the social opportunity costs in a market setting. c) To measure the effect of a project to society. Altough they have met with criticism that they donA´t control for multiple equilibria and the fact that they do not follow a similar result if the order of the policy is changed. A different approach to the three postulates of welfare economic can be: a) Competititive demand price measures the benefit of each marginal unit to the demander b) Competitivie supply price (marginal cost) measures the opportunity cost of each marginal unit from the standpoint of the suppliers. both prices are the same and therefore marginal costs equal social costs. However. These ideas have made possible the analysis of the efficiency costs of a tax. To solve this issue the concept of economic opportunity cost (or shadow prices) is useful. Nevertheless. The welfare postulates indicate us that the increased supply should be evaluated at the supply price and the increased demand at the demand price In a market equilibrum without distorsions. The general concept is this: when a new demand for a good or service is generated. you take the differences between costs and benefits. because the social opportunity cost of one unit is a weighted average (12) (1) can be expressed as (13) (f 1 + f 2)ps → f1 Di 13 f 1 pd + f 2 p s .ˆ profile canA´t be done so easily.

with an opportunity cost of p and from stimulated saving. Assuming we have two taxes tc a capital income tax and tp a personal income tax. because f1 is just the measure of displaced demand. A graphical analysis of the project shows the following: Graph 9 Economic Opportunity Cost 14 .However. it can be expressed as (14) ps + Di ∆Xi Another way of looking at this is through an example with specific taxes. the market rate of interest and r = i − tp the after-tax return on investment received by savers. we will have three rates of return. with an opportunity cost of r. (17) This is equal to (18) i + f1 tc − f2 tp f1 + f2 = 1 f1 (i + tc ) + f2 (i − tp ) f1 p + f2 r That is. i = p − tc . the gros return to investment. This means that the social opportunity cost of capital will come from the expression: (15) which can also be expressed (16) given that. the money raised fo a project will come from displaced investment. a market rate of interest adjusted for distorsions. p. In this market for capital.

the demand price will be Em + Tj where Tj is the tax on exports j. In the case of the market for foreign exchange.The analysis advantage is that it can be applied to the changes in more than one good in the demand and supply side. The supply price will be Em + Sk where Sk is the subsidy on imports k. Opportunity Cost of Investment 15 . we will have Em as the market exchange rate for the dollar. The end result is an expression for the social opportunity cost on foreign exchange: (19) Σj fj (Em + Tj ) + Σk fk (Em + Sk ) which can be converted with (8) to (20) Em + Σj fj Tj ) + Σk fk Sk which is equal to the market rate adjusted by the distorsion. Then. An example Assume we have the following tax composition: Rate Adjusted Corporate Investment 14 % Non-corporate Investment 8% Housing Investment 6% Property Tax Corporate Tax 2% 6% 2% 2% 2 % (home subsidy) Market Rate 6% 6% 6% A graphical representation: Graph 10.

Then.1 % On the savings side.30.1(.05(.1 The analysis of the open economy creates a different result.03) + .35(.1(. fn = .14) + . Now.08) + .10 and fh = .35. the interest rate for the rich is .06(1 − .1(.06) = 1 % This means that the opportunity cost comes from both the savings and the investment and is 7. the economic social cost also includes the marginal cost of foreign funds (M Cf ) making the equation.1 % + 1 % = 8.In this case. because it allow us to include the capital funds from abroad. the interest rate is given by r = i(1 − tp ) In here we can assume that the rich households have an interest of 50 %. assuming a weight of 10 % for the rich.3(.04) + . then (22) .06) = 7.06(1 − . 10 % for the middle and 5 % for the poor. Opportunity Cost of Saving In the case of the same 6 % market interest rate.04. the opportunity cost of capital is given by the following fc pc +fn pn +fh ph where the weights are given by fc = . (21) .5) = .03 and for the middle is . A graphical representation: Graph 11.: f1 p + f2 r + f3 M Cf 16 .33) = . the middle ones of 33 % and no tax for the poor ones.

This means that the country can draw funds from abroad but not at the same price. The supply curve is not infinitely elastic but with an upward slope Graph 12. Capital International Market b) The upward slope of any supply curve means that the marginal cost (of getting an extra unit as one moves along that supply curve) is higher than the supply price. Another way of analyzing it is by assuming that the country has monopsony power for the funds destined to that country therefore: 17 .The marginal cost becomes the economic opportunity cost of social capital because of two reasons: a) The capital market for international funds is not perfect.

The estimation should therefore consider both equity and debt financing and should be expressed in real terms. marginal cost = average cost (1 + 1 ) ε Since the supply is upward sloping then the marginal cost is greater than the average cost. A monopsony case for the borrowing of funds This can be further demostrated with the following equations (23) (24) (25) δ(pq) = pδq + qδp δ(pq)/dq = p + q(δp/δq) δ(pq)/dq = p(1 + 1/ε Then. An appropiate estimation of the economic cost of foreign funds needs to recognize that they have a behavior that is not as straightforward as the domestic. This is because the supply of foreign savings is more volatile than the domestic one.Graph 13. s 18 .

In order to do a proper analysis of the economic cost of labor we must consider certain principles a) People have a different supply price according to where they work b) The opportunity cost is the supply price after taxes and deductions have been made. However. these do not consider the lost of 120 pesos from import tariffs caused by the 60 dollars of displaced income (60 ∗ 10 ∗ . We have a project that buys $100 dollars from which $60 come from displaced imports and $40 from stimulated exports. It is therefore important to analyze labor just as the previous markets. Therefore. The false idea of job creation is brought down by the fact that the project should not be measured against nothing but rather the second best alternative.20 pesos.20 pesos. foreign exchange. 19 . Applications of economic opportunity cost in foreign exchange and labor markets The same analysis can apply to other markets rather than the capital market. an added demand for labor will displace the demand and stimulate the supply. any selling of foreign exchange will bring a benefit of 11. In the end. labor is a cost to a project. Suppose Mexico has an import tariff of 20 % and an exchange rate of 10 pesos per dollars. the project will pay 1000 pesos for the 100 dollars bought. This extra cost becomes an externality of the project. However. In such case. the economic cost of the project is 1120 pesos and of a dollar is 11.20). New demand for dollars will come from displaced imports and newly estimulated exports caused by the increase in the price of the foreign money. For instance. one should analyze an with and without project scenario to determine wheter the supply comes from other jobs or from newly stimulated entrants. Similarly. Then. a “foreign exchange premium” is created of 12 % Labor in cost-benefit analysis has always been subject of errors derived from considering job creation as a benefit. they fail to see that such as capital or material.7. c) When answering the question of where jobs come.

1.6) This means that the economic opportunity cost of labor is different in each city and is given by the available income of a worker in a city.1x0) = 177 50 − 5 + (.1) Hawaii 30 0% (.1..8x5 + ..x50 + .4x5 + .Graph 14...5 20 200 − 50 + (.6x0 = 36.1x50) + .3x5 + ..3. Opportunity Cost in Labor Market One way of approaching the economic opportunity cost of labor is through the comparison of the same job in different places Market Wage Incom Tax Sourcing Fractions Chicago 50 5 (.1x0 = 54 .5.8..1) Alaska 200 50 (. Chicago (26) Alaska (27) Hawaii (28) 30 − 0 + (.1. plus the loss in taxes that the displacement of other workers caused.4.5x50 + .

. however you will use a way for compensating for the distorsions.75) + . Using the economic cost of capital as discount rate In the public projects evaluation there is a debate of which is the appropiate discount rate that should be used.04(.8. When you are doing. 10 .12. which causes the shadow price to be 2..04 rate. There is a division between the ones that one to use the social opportunity cost of capital mentioned before (w = f1 p + f2 r) and those who say that the marginal rate of time preference (r) should be the proper discount rate. has the values p = ..12(. then we will have the following flows Period Stimulated Savings Replaced Investments Total 0 750 250 1000 1 90 10 100 2 90 10 100 3 90 10 100 4 .. the present value is 2500. i = .. When you are using the second type of discount rate you will take the perpetuity of the annual payment for both the investment and the savings: 90 = 2250 . the reality is that a correct estimation using any of these methods will yield the same result: Assuming we have a project that requires 1000 dollars. 90 .. In this case the discount rate is .04 10 = 250 .06 and r = . the first method is preferred for three reasons: 21 .5 because it represents how many times should the 1000 borrowed needs to multiply itself overtime to have costs equal to benefits.25.04 (29) (30) Therefore. the second approach you will only consider the r = .1 = 10 % which is also the minimum return rate for this project to have a cost equal to its benefit...25) = . Despite both procedures being able to control for distorsions.75 and f2 = . The intuitively reasoning is that the second discount rate does not consider the distorsions existing in the market which also affect the marginal productivity of capital in the private sector (p). 100 .04 and the weights of f1 = . However. This method is called shadow price and it consists on a lower bound for economic success of a project.

but if you take the future value. The group with the lower discount rate will have a bigger NPV than the the group with the higher one. varying across different groups of consumers will mean that that the benefits of a group should be measured at their own rate. 9. On the contrary. different results can be obtained depending on the discounting period even though both projects have the same benefits. the contrary will occur. This causes problems of evaluation because if you outweight the costs of a two different projects in two different neighborhoods against their benefits. Dual Labor Market In this graph we see the effect of a dual labor market. Labor Market Issues Graph 15. which is a common situation when there is a big enterprise that will be paying a higher salary than the one existing in the 22 . because the justification for r comes from intertemporal consumption decision.a) The second method is harder to communicate because the shadow price appears to be randomly generated. On the other hand. This is because it can also be interpreted as Σj fj (Em + Tj ) + Σk fk (Em + Sk ). w is easier to sell to the audience b) c) It is easy to consider different rates for r when using the first method.

Graph 15a Distribution of protected workers The justification of this new supply curve of people left comes from the fact that the big enterprise does not distinguish between the different reserve price of the supply. As you can observe. Graph 15b The existence of quasi-voluntarily unemployed. this causes two different supply curves. Therefore. the one of the people being hired by the enterprise and the workers left.market. 23 . so they choose anyone in the supply curve which has different wage ranges. it causes people in every of the wage ranges to be left and the ones that had a higher supply price will not be willing to work in the regular market.

An increase in the job demand will increase the wage and bring more people to the city to work. Therefore. In the end. However. 24 . the ones that got a job at the market wage Lf and the ones that are not wanting to work because they want the higher wage. this will cause two economic opportunity costs: The cost for the regular workforce (31) EOCLf = wf The cost for the big enterprise workforce (32) Vqu wf + wp Lf wf + Lf + Vqu Lf + Vqu 2 A common problem experienced in employment policies is to try to reduce it by telling enterprises to produce more jobs or having a decree saying they should increase their workers by a certain percentage. In the end. This is determined. this will cause an increase in the supply of labor that will move the total amount of people working but preserve the unemployment rate and the expected earnings.5 4 The application of the theory in actual projects helped me to connect the concepts and have a better understanding of them.The labor market will distinguish between two people. if this growth is high enough that the transaction costs of the users is higher than the cost of the project then it should be implemented. through the growth of traffic. for example. then all highway projects should be approved because they will decrease to some degree the costs of someone. However. the appropiate question is why and for whom are we doing the project? An important concept is that a highway project is not usually the construction from scratch of a project but the improvement of a road. this often ends up creating more unemployment because the increase in jobs displaces people that werent in the workforce. 10. THe objective is to reduce the transaction costs of the people that were using a certain path or road. The correct approach is to analyze if the improvement is justified. The second type of people will be called quasi-voluntarily unemployed Vqu . if the cost reduction is the only criterion use to evaluate the project. Initial Equilibrum With 100 jobs more Short Run Response Long Run Response Employed 800 900 900 Unemployed 200 100 225 Full Employment 1000 1000 1125 Expected Earnings 4 4. Transportation: Highway Projects The first step is to analyze the profile of the project.

Let H be the value of the vehicle-hours. M C is above marginal private cost AC. However. then traffic congestion in a highway also means time loss by user. and that gained by the new induced traffic. Then H/S is the value of a vehicle mile. (36) (M C − AC) (a − S) = AC S The externalities derived from an incremental vehicle are shown in the following graph: Graph 16. 1/2(V1 − V0 )(C0 − C1 ). should therefore be also measured in the benefits. a vehicle mile gets cheaper. Then.Let Ci be the private cost that an individual pays in order to use the road (gasoline. etc). The save on time that the highway improvement will bring. asides from the costs an individual pays. we asume that speed is a function of volume with the following values: (33) S = a − bV we can also write the Total Cost function as (34) TC = V ∗ H S if we take the derivative with respect to V we have the marginal cost: (35) a ∂T C =H 2 ∂dV S The percentage speed deficit can be defined as the percentage that the marginal social cost. tires. suppose that the improvement change the cost from C0 to C1 . As a bigger car volume in a highway is related to a lower speed. This value means that as speed increases. This is. The benefit can be divided into the one of the the existing users. there are also social costs. Let S be the speed. Let V be the volume. Externalities from incremental vehicles 25 . This is the time that people spend on a highway. V0 (C0 − C1 ). Then. Let T C represent the total time cost per mile.

In the City of Chicago. The ideas was therefore to analyze the difference in costs and time spents from using each alternative. took advantage of different alternatives faced by transportation consumers to estimate their opportunity cost. A method proposed by Thomas Lisco. So it is hard to find an optimal tow. 26 .To eliminate the externality. The problem is that DPC curve is changing because the demand for traffic in the road will be different at different hours of the day. Once you have the difference. with new technologies maybe in the future this will be a reality. then we could introduce a toll fate that acts as a tax and equals the marginal private cost to the marginal social one. Using the expressway and paying to do it or taking public transportation. is estimated using a regression of P C = α + β(timesaved) + γ(extracost) + (income) + u Once you have the coefficients. Graph 17. Once you do this you solve for the ratio Time Saved/Extra Cost to get the value of time through different income levels. the probability of going by car be P C. However. By doing this you can have a complete profile of the flows of a project. there were two ways of getting to the downtown from a suburb area. If the increase i traffic does not justifies the costs. A last issue to be solved is the assigning to a value of time. Internalizing the externality. An important lesson that I learned is that the biggest incentive to improve a route is strictly related to the flow of traffic. There was a time save related to the first option. the next step is to set the probability equal to 1/2 in order to get the indifferent agents between both options.

In terms of the project. therefore.05)($800) = $120 per year. From there. and that the relevant depreciation rate (δ) for this equipment is 5 % per year. the cost-benefit profile analysis requires a forecast to be made on how the whole electricity system will operate in the absence of a project. because it considers ˆ the alternative scenario as the benchmark to evaluate a project. Similarly. we will want to spend in extra capacity if the cost is satisfied. We measure the capacity of a plant in kilowatts (KW). Thia means an increase in the variable costs for energy. This is a brief resemblence of some of them: 11. the necessary benefit is (0.1 + 0. there should be a different price charged in the peak hours.then there should not be a road constructed.1. we will try to estimate the cost of the different alternatives to determine the best one. the relevant discount rate is 10 %. for example. To keep the analysis simple. + 11. This principle is a use given to the opportunity costs. we will conclude that it is extremely important to make the project altough there was en ever rising price of energy. which is the potential power of the plant. This comes come from the sale of energy during the peak hours at a different 27 . Example Suppose that costs are $800 per KW. For instance. if we assume that the demand for electricity rises faster than the overall generating capacity. This means that the objective is to use the most efficient plant first and move on from there. As with other projects. Homogeneous Thermal This type of plants use the same thermo-energy. fuel. If we donA´t use this principle then you will have an incorrect project appraisal. an assumption for a system managed efficiently will be made. it is necessary to have additional thermal plants In this analysis of the project. In the presence of this price volatility. the comparison between the creation of a new plant and the retirement of another should be give a method to measure the profile of a project. we can conclude that the project is terrible if the price of energy does not rise. Electricity The evaluation of any electricity projects requires the use of ”the least alternative cost”principle. When the demand for energy pushes beyond the actual capacity. The homogeneous thermal plan is the benchmark of the project. This principle states that one project should not be assigned benefits greater than the least alternative cost one would have to incur by providing an equivalent benefit stream in a different way. the peak hour requires an special analysis because it represents an extra demand that we are not capable of supplying. Then in order to justify the addition of a new KW of capacity.

11. Run on the Stream This energy is caused by the water from a river that is sent to turbines to produce mechanical energy. the total installed capacity will generate a revenue of $470.4 per KW. Because of the variable flow of the stream.2. Now we can calculate. If the peak hours per year were 2000. To evaluate the benefits of this project. we start assuming that the turbine capacity will be fully used. Note that 4 cents would be the charge in off-peak hours and 10 cents during on-peak hours. for each KW of turbine capacity the revenue: 2000hrs@10cents = $200 6760hrs@4cents = $270. turbines will not be used at full capacity always. then the relevant peak-time surcharge would be 6 cents ($120/2000) per kwh. Let assume 28 .4 Then. This is typical a graph used to evaluate a run of stream project Graph 18 Run of the stream Example (Taking the same assumptions as the thermal energy). If the peak hours are 2000 a year then we are left with 6760 hours of off-peak use.price.

Graph 19. T he next graph shows the excess of water-capacity (green area). the size of the dam will be chosen according to the peak time electricity demand.3. Daily Reserve A way to improve the water availability is the creation of a dam that will help accumulate water and control the river flow.it is an 80 % of capacity. this are: a) The cost of the dam 29 . The project is accepted. Daily reserve As with prior analysis. The estimated benefits would then be $376.32(= 0. then the project will be accepted. If the peak time surcharge multiplied by the peak time hours is bigger than the costs.4) per year per KW.8∗$470. 11. This becomes efficient becomes often you will have the river flow running when there is not enough electricty demand and therefore it will be wasted. The principal cost of this project are related to their constraints. In the other hand. The blue area represents the water that is valued at 4 cents because is used in peak hours. the cost of the new capacity would be $300(= 2000∗15 %) per year per KW. This will allow for the water release when electricity is needed. It that can be stored and used later at the value of 10 cents or 4 cents.

it is necessary to understand the concept of a load curve.b) If the amount of the turbine capacity is not increased. 11. This curve represents the electrical energy demanded in the whole year from the most demanded hours to the least demanded hours. For the case of the nuclear energy. So a load curve could show us how much energy from the nuclear can be used to pump the water. The idea is to pump it back in low demand period so the same energy is used. for instance. the benefit of extra peak time energy would be limited to the amount by which the turbine capacity of the ROS project exceeds the stream flow. This means that often the built capacity will be unused because there is not enough demand. Pump Storage The main idea of the pump storage is the re-utilization of the water that already has been used to generate energy. because it will mean taking water from others downstream.4. Graph 20. therefore you will a greater water stream in a high peak period. A concern that this project might cause relates on the water rights of the river. Both technologies work together to provide an efficient source of electricity. This project requires the construction of a second dam (lower reservoir) to capture water and then pump it back to upstream. To understand how this mix works. they are usually never shut down. The existence of this technology usually is combined with the nuclear energy. A necessary condition for this project is the existence of cheap off peak energy so the cost of pumping the water is not high. Pump storage 30 .

this works in the other way. In this case.6. therefore it should be used last. Also. then there must be a function R = f (G) that relates the optimal storage to fulfill peak hours demand. Economics of Electricity: A more realistic approach A energy decision-making in the real world usually has all of the previous technology installed at the same time which leads to the need of analyzing which ones are to be activated first based on the energy demand and the costs. but the demand of energy is highly concentrated in some seasons 11. Load curve 31 .In the previous graph. ROS is the cheapest technology and therefore it should be used first. When it comes to seasonal storage plants and thermal plants. If we assume that N* is the optimal nuclear capacity. we can see that R is the energy available for pump and G is the energy generated once the water has been pumped up. This means that it could be used in rivers that have pretty steady stream flow. The order of use will depend on how expensive is the energy. The pumping technology is the most expensive one.5. 11. Seasonal Storage Seasonal hydro dams aim at allowing extra water to be shifted from one part of the year to another to supply a steady energy demand. the problem can be expressed like this: Graph 21.

Therefore. Irrigation Projects When thinking on irrigation projects it is fundamental to consider that they are linked to the amount of water delivered. you estimate the value of a crop with or without 32 . As a result we should think that strategy B is usually the winner in the stacking process. Then. We say ˆusuallyˆ because it could happen than that there is no extra room for more a a turbines (if it is a old dam) in the dam. two methods can be used: a) Residual Value Method: The basic idea is to suppose the construction of an irrigation project that increases water availability in a farm and leave another farm without a project. The saving of strategy A is 200MW in hydro but an extra 200MW in thermal.To solve you could have the following procedure Example Strategy A: 300MW turbine HA 600MW TA StrategyB400M W TB 500MW turbine HB Difference (B-A)Uses 200MW less in TUses 200MW more in H Assume that we already have the plants but we are wondering which plant must be bigger in order to attend the peak hours. 12. In order to value water. as we move from strategy A to B. the amount of water is given by water rights over it which are determined by the hectares of land. there is no way of paying a price for a marginal unit of water or for that matter knowing the marginal productivity of water based on what farmers pay for it. one can never know how much water you will get because it depends on the forces of nature for that year. we are reducing 200MW of homogeneous thermal capacity and adding 200MW of turbine capacity in our seasonal hydro dam. In other words. Lets focus on the costs of these strategies. The main problem that arises with water in an irrigation project is that there is not a market system that leads to an equilibrum in which the marginal product is equal to the price that has to be paid. so the history is different. And second. the start-up and shutdown costs vary significantly since in a hydro dam are practically zero. Once this is considered the next important step is to analyze the value of water delivered by the project. In the case of water in agriculture. Intuitively it is cheaper to add 1MW of turbine capacity to an existing dam with a place already prepared for additional turbines than to add 1MW of homogeneous thermal capacity which entails building the whole plant plus its associated turbines. Aditionally.

the reason why the value of land can increase is because it entitles access to water. Since the amount of water is determined by nature. This is possible when water is such a scarce resource and the land is so abundant that the marginal productivity of it is close to 0. Therefore. However. Distribution of water in a year The next step is to calculte the prices of water which is given by Ql Pl = PI I 33 . By substracting one residue value from the other you get the difference that can be attributed to water in the project. b) A second approach uses the land prices as estimates of the current value of water rights. then a buyer wouldnt buy a specific amount of water but an expected one. because this method is innacurate you can end up with a big standard deviation that keeps the value of water relatively unknown. Graph 22. which is the difference between the inflow and the outflow. Therefore. it is necessary to create a distribution of the water quantity across a period of time and get an expected value of the water according to the the probability given to each quartile of water available that year. In order to do a correct evaluation for this project one should consider the real product that the land buyers are getting. or the value of water.the project and also the cost of input other than land and water. You then obtain a residual value for each of the two profiles. people will be willing to buy land just because of the water. Therefore.

Since these two effects have opposing signs and they account for a small fraction of the costs and benefits and there the available data ˆ couldnA´t allow them to incorporate this variables into the analysis. 13. However. The benefits were given by the future earnings and the costs by the forgone earnings that studying implies. therefore Σd Wt. they were omitted. The Net Present Value of education is a function given by the discounted difference between the wage of a worker with an educational level n and the wage of a worker with an educational level preceding n. I 1 which is the no project one and I 2 which is the project one.n−1 (1 + r)t This analysis allows an estimation of the opportunity cost. The objective was to determine a rate of return of finishing the four levels of education in Mexico : primary. Education The relationship between education and future earning power has always been noted. These profile creates somes bias problems caused by the existence of students that work and study at the same time or the existence of private school which require additional costs.n−1 is the t=1 (1+r)t 34 . n-1. These causes the benefit of the dam to partially be B = PI (I 2 − I 1 ). Because water in the damn is more readily available it is worth more. high school and college.where l is land and I is an index created with the probability of water according to the distribution over the years. A methodology to estimate the NPV and IRR was given by Harberger and Peon in their paper Estimating Private Returns to Education in Mexico. To evaluate the effect of constructing a dam. we use the fact that water availability will increase with the dam to create two different indexes. We know that Wt. the benefit is not only caused by the increase in the amount of water but also by the increase in the value of water from the damn when compared to the water from the river. The application of financial tools such as NPV or IRR to the education effects is important for public policy to determine wheter or not should there be a greater effort on reducing drop-out rates in a country.n = 0 for the d number of years spent in schooling. the total benefit is T B = PI (I 2 − I 1 ) + d(PI I) where d is the increase in the value of the water of the dam against the river water. middle school. forgone earnings. N P Vn = ΣT t=1 Wt. In it. This could allow the creation of a financial profile that could weigh the benefits received by education to the costs it has. However.n − Wt. they took the viewpoint from an individual demanding education to establish the profile of the project. More years of education will in average yield a greater wage. the interesting question is to determine what is the actual effect of an extra year to your increase in salary. Therefore.

Genre Masculine Femenine Primary 2. By doing this present value. the conclusion should not be so eager to determine that because there is an increase in the earnings as people continue studying which end paying-off for that initial lost. this creates a strong case for suggesting an integrated labor market in the country.39 The low rate of return that finishing primary school gives to students is interesting because it means that with the used discount rate it is better to be working than studying at that age. there are other variables that influence the earnings profile such as the genre. 35 .49 % Middle School 5. this is incorrect because it does not consider the costs associated with education.27 % 10. However. The occupation is included because if the educational level is related to the occupation.opportunity cost of education at level n. g is a dummy that is equal to 1 when the worker belongs to the n level of education and O is a dummy for a specific type of occupation.26 % 14. Finally. A traditional approach was to estimate wages a function of education and experience and consider the coefficient of education as the rate of return.13 % 5. the equation used was: In(w) =1 ∗a ge +3 age2 +G +Σ5 αn gn + Σ5 λn (agegn ) + Σi=1 δi Oci + e n=2 n=2 where W is the wage income. however. The salary for each educational level could be estimated with the traditional earnings equation which is a function of experience and education. makes this values trustworthy and important to model in the educational project profile. the conservative estimates of a 1 % and 2& for Mexico during the next years. Using a survey that inquired on the wages of workers from different industries they estimated the model using a state regression and a pooled regression They assumed an interest rate of 5 % because it is the average return that people get from banks and is close to the mortgag rate. the study analyzes the decision of passing to the next education level for each individual based on the benefits that going to that level will create minus the cost of doing it which is salary they will perceive with that education level if they were not studying. unlike the proposed methodology.86 % 7. Another interesting result is that the rates did not vary significantly between all of Mexico states. This analysis was applied to estimate the returns on education in the 32 states of Mexico. In order to estimate the value of Wt . incorporating economic growth into the analysis does change the results and creates higher IRR and NPV. The rate of return does not favor an specific gender as it varies in each educational level. then the estimators will be biased if they ommitted this variable. G is a dummy for gender.28 % High School College 11. However. Results show that there is an increasing rate of return as an individual pursues an additional level of education.36 % 14.

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