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Lecture 6

Social choice
and cost-
benefit analysis
Economic Policy Analysis
Choice criteria in private and
public projects

• Cost-benefit analysis (CBA)

• To underscore the difference between the private
and government assessment of a project, when we
discuss government action we speak of costs and
benefits, rather than costs and revenues (like in
project evaluations in private firms).
• Three criteria
• NPV
• Relative NPV
• Internal rate of return (IRR)
First criterion - Net present
value (NPV)
𝑛

𝐵𝑚 = ෍ 𝑏𝑡𝑚 (1 + 𝑖)−𝑡
𝑡=0
• Where i is the interest (discount) rate and (1 + 𝑖)−𝑡 is
the discount factor.
𝑛

𝐶 𝑚 = ෍ 𝑐𝑡𝑚 (1 + 𝑖)−𝑡
𝑡=0

𝑁𝑃𝑉 𝑚 = 𝐵𝑚 − 𝐶 𝑚
Second criterion – ‘relative’
NPV

𝐵 𝑚 − 𝐶𝑚 𝐵 𝑚
𝑁𝑃𝑉𝑚𝑟 = 𝑚
= 𝑚 −1
𝐶 𝐶
Third criterion - IRR

• Internal rate of return

• The discount rate at which the sum of discounted benefits
equals the sum of discounted costs.
• IRR is the discount rate at which the NPV is equal to zero.
𝑛 𝑛

෍ 𝑏𝑡𝑚 (1 + 𝑖)−𝑡 − ෍ 𝑐𝑡𝑚 1 + 𝑖 −𝑡 =0

𝑡=0 𝑡=0

𝐵𝑚 − 𝐶 𝑚 = 0
• A project with the highest IRR will be selected.
Identifying the effects of a
project
• Direct and indirect effects of the project in terms of
inputs and outputs of goods and services
• Direct effects = those generated by changes caused
directly by the project in the demand for input or
supply of output goods
• Indirect effects = those causing changes in the
input or output of other markets
• The effects of the project on incommensurable and
intangible goods
Evaluating the effects
• A general criterion
• Benefits of a project are larger than the benefits the
society could obtain from alternative uses of the
same resources
• The benefits of a project are measured by beneficiaries’
aggregate willingness to pay.
• The benefits of alternative projects are measured by
opportunity costs of resources that would be diverted
to alternative projects.
• To measures willingness to pay and opportunity costs
we could use market prices in competitive economy.
Reasons why prices in actual markets
are not an appropriate measure

• The project is large enough to have an influence on

the prices of outputs and/or inputs, but there are no
distorted markets
• Some markets are distorted by monopoly, taxes,
quotas etc.
• There are intangible (immaterial) benefits and costs
that do not have the market price
Social surplus

• Social surplus is a sum of the private consumer

surplus and the private producer surplus.
• Both consumers and producers are willing to pay
something to avoid a reduction in their surplus.
• Changes in the social surplus brought about by a
change in price should be taken into account when
measuring social benefits and costs.
Case 1 – public project that does not change the price of
a good
Case 2 – public project that changes the price of a good
• In non-competitive markets, the market price no longer reflects
the cost to society, since it is higher than marginal cost.
• The gain in the value of the social objective function from
increasing expenditure on a given project by one unit.
• Shadow prices correspond to the prices that would prevail in an
economy with complete markets where all markets are
competitive.
• Because of difficulties in calculating shadow prices, we should
use market prices when distortions are not significant.
• Shadow prices in non-competitive markets
• In CBA, we should consider the price corrected for the effects of market
power.
• Two categories of workers
• Workers drawn from other jobs = the current or higher market wage
• Involuntary unemployed = unemployment benefits or, at most, the supply
price of labour
• Choosing the social discount rate
• Reasons to use rate different than the market interest rate
• Market power of financial intermediaries and other distortions
• Future generations are unrepresented. Thus, future consumption can be
considered as a form of a merit good, which should be valued regardless
of the current consumers’ preferences.
Valuing non-marketed goods

• Tangible non-marketed goods

• Motorways, bridges or other infrastructure
• Intangible non-marketed goods
• Human life, the environment, time
Valuing life
• Direct (‘constructive’) method
• The value of life is measured by the net discounted
earnings of an individual over his expected life span.
• Indirect (‘hedonic price index’) method
• Uses the preferences revealed by individuals with
regard to alternatives with different probabilities of
death.
• The method measures not only willingness to pay, but
also ability to pay.
• Projects with a lower probability of causing death should
be favoured.
Valuing the environment
• Environment
• Set of conditions, objects and external circumstances
on which the existence, health, satisfaction and
ability of people to carry out certain functions
depend.
• Criteria for value environmental damage
• Individuals’ reduced earning capacity as a
consequence of environmental damage
• Assessing individuals’ willingness to pay to prevent
such damage (a cost assessment technique)
Valuing time

• The impact of a project on individuals’ leisure

time, as leisure time can affect individuals’
utility level.
• Problem of measurement
• Willingness to pay
Other issues in CBA
• Distribution
• If the distribution is non-optimal, the costs and
benefits of a project in terms of market prices can
be corrected by using different weights for the
different groups of income earners.
• Uncertainty
• We need to calculate a ‘certainty equivalent’
using the expected value of costs and benefits for
a risk-averse person.