Cost-Benefit Analysis (CBA

)

What is a Benefit and a Cost? 

The benefits of a change are those goods or services that result from the change for which someone would be willing to make sacrifices to obtain We measure benefits in terms of Willingness to Pay (WTP) Cost is the value of opportunities forgone! (it could be a Euro value, but could include much more e.g. the value of your time). Opportunity Cost: An activity's opportunity cost is equal to the most net benefits that you could have obtained from doing something else.   

marginal net benefit .total benefit minus 2) Cost .marginal benefit .total cost = 3) Net benefits .marginal cost .Important Concepts 1) Benefit .total net benefit !!! An efficient allocation maximizes Total Net Benefit !!! .

de is equal to the triangle gfh: the area beneath a marginal function over some range gives the value of the change in the total function for a move over that range. It is a measure. and * the costs of producing an additional unit of the good. X=0 to X=X* beneath MBx is the total benefits of X* and equal to the distance ad. in money terms. of the efficiency gain that would come about form producing X* compared with a situation in which non is produced. Px = MBx = MCx NB(X) NB(X*) NB(X) X* g f MCx X (b) net-benefits h (c) MBx X* g' consumer surplus f' Sx = MCx X Px producer h' surplus X* (d) Dx = MBx X . Px is equal at the margin * consumers' subjective valuations of additional units of the good (expressed in money terms). and X=0 to X=X* beneath MCx is the total costs of X* and equal to the distance ae.Partial equilibrium interpretation of economic efficiency B(X) B(X*) NB(X*) C(X*) e a X* d C(X) (a) X The distance de can be interpreted in efficiency terms. So.

Recent Developments Total economic value = Use value + Intrinsic value Use value = Actual use value + Option value + Quasioption value Option value = Value in potential use by self + Value in potential use by others + Value in potential use by future individuals Quasi-option value = Value of avoiding irreversibilities in the light of expected future knowledge Intrinsic value = Existence value .

as such. and values relative .Existence Value Existence value is unrelated to any actual or potential use Existence value may be related to sympathy. or stewardship. existence values do not fit into neo-classical economics Existence value may also be related to "spiritual consumption". as rights are absolute. and then it does fit Existence value is not right-based.

negative environmental effects) 2) projects with beneficial environmental impacts (sewage treatment plant. i. damming a river in a wilderness area.g.e. i. CBA and Environment: 1) benefits in the form of the provision of goods and services that have environmental impacts (e.Cost-Benefit Analysis (CBA) by 'Cost-Benefit Analysis' we mean the social appraisal of investment projects (to appraise investments that correct for market failure)..e. positive environmental effects) .

CBA CBA should be used for policies and projects. which unfold over time and be assessed by calculating a Net Present Value (NPV). or a Benefit-Cost Ratio (BCR). cost schedule 4. time horizon 2. 4 informational inputs: 1. benefit schedule 3. discount rate .

Present Value Concept Time Value of Money Concept: = a Euro today is worth more than a Euro tomorrow why: * uncertainty: the future is unknown. will you be around to spend the dollar. and have more than a Euro to spend in the future. Basic idea is to get the present value of some future payment to be received at time t. * inflation: erodes the buying power of a Euro * utility gain from consumption today versus future consumption. * investment opportunities: invest today. earn interest. .

Present Value Concept Discounting: = process to obtain the present value of future Euro amounts: ¨ 1 PV ! FV * © © .

and t is the number of periods into the future.1  r t ª ¸ ¹ where ¹ º PV = present value. 0 time t present value future value Euro idea of discounting . FV = future value. r = discount rate.

the higher the discount rate the more you value present consumption relative to future consumption .Present Value Concept Nominal versus Real: = nominal refers to the Euro value in current terms (not discounted).the lower the discount rate the more you value future consumption relative to present consumption. Discount Rate: indicates how you value present consumption (utility) versus future consumption (utility) . . whereas real refers to the dollar value discounted to some base Euro value (discounted values).

Cost-Benefit Analysis (CBA) In any CBA. several stages must be conducted (Hanley and Spash. 1993): 1) Definition of the Project 2) Identification of the Project Impacts 3) Which Impacts are Economically Relevant? 4) Physical Quantification of Relevant Impacts 5) Monetary Valuation of Relevant Effects 6) Discounting of Cost and Benefit Flows 7) Applying the Net Present Value Test 8) Sensitivity Analysis .

interpersonal utility comparison are admissible .Cost-Benefit Analysis (CBA) Private appraisal 1) The net present value test 2) The internal rate of return test Social appraisal 1) Utility based appraisal Problems: .no general agreed social welfare function .utilities are not observable NPV ! § 0 T T NRt .

1  r t t t NPV>0 0!§ 0 .

1  x IRR=0 2) Consumption based appraisal !§ 0 T Bt .

1  r t .

Cost-Benefit Analysis (CBA)  NPV test is a potential compensation test => is concerned with allocative efficiency (select projects that move the economy toward an efficient allocation of its resources).. The proper time horizon for the appraisal of a project is the date at which its impacts cease.100s of years. for a nuclear fission plant the time horizon is not the 40 years to the time when it ceases to generate electricity but the time over which it is necessary to devote resources to storing the plant's waste products . e. not the date at which it ceases to serve the purpose for which it was intended.g.  .

Choice of discount rate The Present Values of 100 Euros arising from 25 to 200 years ahead at discount rates from 2 -8 % time horizon in years discount rate 2 4 6 8 25 60. there is universal agreement among economists such that the real rates should be taken not nominal rates in CBA.05 200 1.91 0. .00002 => need for judgements however.43 2.51 23.80 1.07 5.15 14.13 100 13.30 14.98 0.0009 0.29 0.60 50 37.04 0.95 37.

Environmental Cost-Benefit Analysis NPV ! § 0 T T N t t .

1  r t NPV ! § 0  Ct t .

1  r !§ 0 T t .

1  r t § 0 T Ct .

NPV ! Bd  NPV ' ! d  E ! NPV '  E EC = environmental cost d  Cd " C ECBA decision rule!!! .1  r t ! d  Cd where Bd/Cd is the discounted of benefit/cost stream over the project lifetime. NPV ignores environmental impacts => NPV'.

given the expectation of future growth in knowledge relevant to the implications of development. independently of any actual or prospective use by the individual. .Environmental Cost-Benefit Analysis EC = UV + EV + OV +QOV UV = Use Value and arises from the actual and/or planned use of the service by an individual. QOV = Quasi-Option Value and relates to willingness to pay to avoid an irreversible commitment to development now. EV = Existence Value and arises from knowledge that the service exists and will continue to exist. OV = Option Value and relates to willingness to pay to guarantee the availability of the service for future use by the individual. for recreation for example.

Direct Benefit Estimation In private CBA it it usually relatively easy to perform because prices are readily observed. This problem is particularly apparent for non-use values which tend to be more intangible. So. what can we do when prices and demand information is absent or is clearly biased? . public good. Often this is not the case (no price exist) or prices are socially biased due to externality. intangible = cannot be valued if intangibles remain in our analysis. then NPV and BCR are incomplete. or market power considerations.

Contingent Valuation . Travel-Cost Method .Alternative Approaches 1. .statistically investigate how these prices vary with property of job conditions .primarily useful for recreation benefits. Property value and Wage differentials (hedonic prices) . .obtain a demand curve by examining how participation varies with the cost of getting there.widely applicable 2.more limited application possibilities than for CV.use surveys that ask . 3.

!! Do not count secondary effects in a full employment economy!! also no transfer payments should be included. In a full employment economy. unemployment payments .g.Indirect (Secondary) Benefits = Ripple effects due to economic linkages We have all heard public projects and policies being touted for their employment and income generating effects. e. these inputs were necessarily reallocated away from other productive uses. however.

help prevent bad decisions which would otherwise be undiscovered .counters rent-seeking (which might normally be successful in the political process).intangibles .Overall Appraisal of CBA Cons: .BC analysts and information sources are often biased . .distributional Issues occasionally objectionable * weighs same period impacts equally * weighs future impacts less Pros: .

Analytical Styles other than CBA Cost Effectiveness Analysis .= try to achieve a non-economic target at least cost . we could just use CBA.often practical when there is an intangible physical quantity in need of enhancement. if it was tangible. or * the impacts are tangible but not allowed into CBA (such as secondary economic impacts) Multi Criteria Analysis .usually employed in lieu of or as a complement to CBA because either * there are many intangible impacts of the policy/project and they need to be described. Impact Analysis .

the project will cost EUR 10.000 to construct in the initial period.000 to operate in each following period. and Benefit-Cost Ration (BCR) using a discount rate of 5%.000 in the first period.000 in the last period. After the construction is completed.000 in the second. Calculate Net Present Value (NPV).CBA Example Someone has proposed a 4-period pollution control project that will cost EUR 100. EUR 45. The facility is expected to be non-functional for any future periods. After that. the benefits of this project will be EUR 40. . There are no intangibles to be considered for this project. and EUR 50.

Example t 0 1 2 3 r = 5% t Bt 0 40 45 50 Ct 100 10 10 10 NBt -100 30 35 40 totals Ct t N t t t .CBA.

1  r .

1  r .

1  r NPV = ??? BCR = ??? .

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