Chapter 5

Cost-Benefit Analysis and

Government Investments

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Economic Analysis for the Budget Process:
Achieving the Least-Cost Means of
Accomplishing an Authorized Objective
 A Program is a combination of government activities
producing a distinguishable output.

 Program Budgeting is the system of managing government

expenditures that attempts to compare the program
proposals of all government agencies authorized to achieve
similar objectives.

 The mission of a government agency is comparable to a

business firm’s product.

 Cost-Effectiveness Analysis is a technique for determining

the minimum-cost combination of government programs to
achieve a given objective
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Cost-Effectiveness Analysis:
In the Example of Saving Lives
 Cost-Effectiveness Analysis requires
 stating an objective (saving lives)
 recognizing the alternative means of
meeting the objective (inoculations and
smoke detectors)
 choosing the mix of alternatives that
meet the objective in the least cost
fashion

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Inoculations per Year Figure 6.1 Cost-Effectiveness Analysis

20,000 B

A
10,000
Lives Saved = 5,000

0 10,000 20,000
Smoke Detectors per Year 4
 The Cost-Effective Mix
 At the point of tangency, the slope of the isoquant is
equal to the slope of the isocost lines, and

MRTS  PSD PI
 The MRTS, the marginal rate of technical substitution
between smoke detectors and inoculations, depends on
the marginal productiveness of each program.

 The cost-effective mix of the two programs depends both

on their productivity in terms of lives saved and the prices
of units of services provided by the programs themselves.
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Cost-Benefit Analysis
 Enumerate all costs and benefits of a
proposed project
 Evaluate all costs and benefits in dollar
terms
 Discount future net benefits

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Enumerating Benefits and Costs
 Direct Costs and Direct Benefits are
those attributable to the purpose of the
project.
 Indirect Costs and Indirect Benefits are
those attributable to the project, but
which were not part of the intended
purpose of the project.

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Evaluating Costs and Benefits in Dollar
Terms
 Though some costs and benefits
are easily quantifiable, others like s
the value of a human life saved or
lost because of a project, are not
as easy to objectively count.

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Discounting Future Net Benefits
 Present Value
 An interest-adjusted value of costs or
benefits that will occur in the future
 PV of X dollars received in n years at an
interest rate r is:

PV = (X/(1+r)n)

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Discounting Payment Streams

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 Illustrating the Effect of Interest
Rate Changes on Present Value
 Project 1 yields $90 in net benefits
immediately.
 Project 2 yields $100 two years from now.
 Results
 At 0% interest $100 two years from now is worth
$100 so project 2 is better than project 1.
 At 5% interest $100 two years from now is worth
$90.7 so project 2 is better than project 1.
 At 10% interest $100 two years from now is
worth $82.6 so project 1 is better than project 2.
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Choosing the Social Rate of Discount
 If the private sector interest rate is r,
then the social rate of discount must be
set equal to this social opportunity
cost of funds because of the
distortions in the market caused by
government taxation.

 The rate must also account for the

taxation on investment returns.
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 Figure 6.2 A Tax on Investment Income and the
Social Opportunity Cost of Capital
S
20 = rG
Return (Percent)

E
16

D = Gross Return

I = 10 = rN E’
D’ = Net Return After Taxes

Funds Invested and Saved per Year

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Weighting Net Benefits

It also matters who gets the

benefits and who pays the costs.
Benefits accruing to certain
people may be viewed as more or
less important than costs that
accrue to others.

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Disaggregating Net Benefits

Disaggregating benefits according to

demographic, income, and other social
characteristics of those who will receive
benefits and bear the costs allows cost-
benefit analysis to take into account
distributional considerations.

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Treatment of Inflation

If all dollar figures are nominal,

then interest rates must be
nominal and account for inflation.
Alternatively, all accounting can be
done using real dollars and real
interest rates.

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 Ranking Projects
 Net Benefit Criterion: Rank according
to the highest net benefits

 Benefit-Cost Ratio Criterion: Rank

according to the highest ratio

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Figure 6.3 Cost-Benefit Analysis and Efficiency

Marginal Social Cost and Benefit

Net Social Gain
from Q1
MSC
A
B G
F
Net Social Loss
E from Q2

C D H J
MSB
Q1 Q2

0 Q1Q2 Q* Q3Q4
Miles of Highway per Year
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Cost-Benefit Analysis in Practice
Physical Infrastructure Analysis
Transportation

Environmental Capital

Schools

Power and Communication Networks

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Government Infrastructure Investment in
LDC’s
 LDC’s have invested considerable sums in
agricultural infrastructure because the estimated
project rate of return approaches 17%.

 Projects like the creation of large water reservoirs

typically displace locals and these costs
(externalities) must also be counted.

 Projects have been shown to help the poor by

adding substantially to their ability to produce crops
for sale.

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Cost-Benefit Analysis of a Hypothetical
Irrigation Project
  Year
Costs 1 2 3 4 5 6 … N
Engineering and Planning E              
Building and Construction F1 F2 F3 F4 F5      

Maintenance           M6 … MN
Loss in Agriculture A1 A2 A3 A4 A5 A6 … AN
Loss in Recreation R1 R2 R3 R4 R5 R6 … RN
Total Costs C1 C2 C3 C4 C5 C6 … CN
                 

Benefits                

Increased Agriculture           A6 … AN
Increased Recreation           R6 … RN
Total Benefits           B6 … BN
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Figure 6.4 The Benefits of Widening a Highway

Average Cost per Trip

C B
D
C' A

DT

0 T T'
Number of Trips per Year
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Value of a Human Life
A number of techniques have been used to
estimate the value of human life saved:
 A common method is to value lives according to the
discounted present value of future earnings.

 The benefits of saving a life could be measured in

terms of the willingness of individuals to pay for a
reduction in hazards or risks to which they are
exposed.

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Cost-Benefits Analysis of Job Corps
Program
Costs per Participant
 Operating the Program ($8,380)
 Forgone Output of Participants ($1760)
Benefits Per Participant
 PV of Increased output ($8,080)
 PV of reduced crime ($5,840)
 Reductions in costs of other programs ($880)

Net PV of Benefits: $4,660

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The Role of Cost-Benefit Analysis in
Budgeting
 Useful tool to policy makers attempting
to quantify decision making

 Some social benefits difficult to quantify

 Distribution of benefits affects the

political decisions of which programs
are funded.
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 Sports Stadiums
 Cost-benefit analysis often used by state and
local governments to justify subsidies to such
projects as sports stadiums and civic centers

 Supporters of sports stadiums argue that

combined benefits of the community will
more than offset costs.

 Prominent economists argue that the logic

used by supporters of sports stadiums
substantially overestimates benefits while
underestimating costs.

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