PPA Chapter 3

Chapter three: Doing policy analysis
3.1. Steps in policy analysis

1) Problem analysis
2) Solution analysis
3) Communicating policy analysis
08/31/2022 Wear your mask!!!

3.1. Steps in policy analysis
 The term Policy analysis comes from a Greek word
meaning to break down into component parts
 These components can be specified as a series of steps.
 There are different steps of the policy analysis process

provided by different scholars. The commonly known
two steps are;
• The five step (US government office of Management

and Budget) analysis process and the eight step
(Eugene Bardach, 2000) policy analysis process.
Steps in policy analysis
The five step The eight step

1) Stating of the policy 6) Defining the problem;
rationales (goals); 7) Assembling evidence;
2) Stating the assumptions in8) Selecting criteria for
the analysis explicitly; making decision;
3) Evaluating the alternatives9) Constructing alternatives;
convincingly; 10) Predicting the outcome of
4) Identify and show measure each alternative;
benefits and costs; and 11) Considering the trade-offs;
5) Verify results through12) Making recommendations;
follow-up studies and
13) Telling the story
Cont…
• Weimer and vining (2007) have summarized
the policy analysis steps in to two major
components:
Problem analysis and
Solution analysis and the result of these two
components will be communicated to the
client.
• And they called it steps in rationalist policy
analysis.

Problem Analysis
 Problem analysis comprises of three major steps:
1. Understanding the problem

2. Choosing and explaining relevant policy goals and
constraints, and
3. Choosing a solution method.

1. Understanding the problem
 This stage involves: Assessing symptoms, Framing
the problem and Modeling the problem.
A. Assessing symptoms
 The whole public or the client perceive problems as
undesirable conditions.
 Thus, they tend to specify problems in terms of
undesirable symptoms or impacts rather than the
underlying causes.
 So, the analysts task here is to assess the symptoms
and provide an explanation of the causes and the
problem.
Cont…
 This is done by locating empirical data that can help you
put the symptoms in quantitative perspective.
e.g. Car Accident Fatalities:
Number of such accidents,
How the number has changed over time/trend
what percentage of total death they comprise
and other measures of magnitude, distribution and
time trend of the symptom.
 To do this, collect empirical data, be familiar with the

current public discussion about the symptom and the
history of existing policy relevant.
Cont…
How to collect data? What source/type of data?
Importance
 Conveys the relative importance and urgency of
the problem and it begins to establish your
credibility as some one who is knowledgeable about
it./importance and severity of the problem

THE PROBLEM:
High and increasing number of road traffic accident

How can the problem be defined?
Road Traffic Accidents (RTA)

“Accidents which occurred or originated on a way or
street open to public traffic and which resulted in one
or more persons being killed or injured and in which
at least one moving vehicle was involved.”
UN

Current Situation
In the world… fatalities / 100,000 people
35.0
Eritrea 48.4
26.0
Tanzania 34.3
32.5
Kenya 34.4
41.6
Peru 21.5
40.5
Colombia 11.7
12.7
United 13.9
States
5.4
Japan 5.0
0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0
… fatalities / 10,000 licensed vehicles
Ethiopia 1191.9
Eritrea 386.2
Malawi 278.0
Tanzania 240.3
Senegal 143.4
Kenya 128.6
Egypt 73.1
Peru 41.6
Libya 13.7
Colombia 10.9
Romania 5.9
United States 1.7
UK 1.0
Japan 0.7
0.0 200.0 400.0 600.0 800.0 1000.0 1200.0

ETHIOPIA
• In Ethiopia car accident is becoming a serious

problem and affecting many individuals and
families as well as the nation.
• every month, around 400 people are killed or

hospitalized due to RTA
• 41% of the injuries registered in Addis Ababa’s

hospitals are due to RTA

The trend is upward…

Localization
• more than 65% of RTA reported

in Ethiopia occur in Addis
Ababa
• Most of the accidents occur in

the central part of the country
(Oromia Regional State and
Addis Ababa)
Who are the victims?
• in cities, 90% of the victims are

pedestrians
• most victims are active people and are
main breadwinners for their families
Who causes the accidents?
• Transportation companies force their employees to
drive in long shifts (more than 8 hrs/day), this
resulting in tired drivers
• In 2006, the number of RTA involving mini buses
increased by 32.6% (the number for private
vehicles only increased by 1.4%)
• Driving under the influence of alcohol and chat is
usual (police does not have devices for alcohol
testing)
• Problems related to roads
• jaywalking is a habit for pedestrians
How Much do accidents cost?
• Estimated cost – 1- 4%
of GNP / year
• 350 - 430 million

Birr/year

B. Framing the problem
 This step is about explaining the problem in terms of
market failure or government failure. But what do we
mean by Market failure and Government failure?
Market failure
 According to Adam smith’s Laissez- faire states,
governments should allow private markets to operate
with a free hand.
• However, he listed three fundamental roles of government:
1) National defense
2) An impartial system of law
3) A set of public works and institutions
Cont…
Government policies beyond these minimum
functions may be justified by the efficiency losses
from imperfect markets or the need of the less
fortunate based on equity concerns.
What is a perfect market/ perfectly competitive

market?
• Economics start its analysis of competition
markets with assumptions.

Assumptions for perfect competition
1. Many buyers and sellers

2. Perfect information
3. Homogeneous product
4. Freedom of entry and exit/perfect
mobility
5. No collusion

Cont…
 Economist recognize several commonly occurring
circumstances of private choice, referred to as Market
failure, that violates the assumptions of the competitive
economy/market.
 A market failure occurs when the “invisible hand” pushes

in such a way that individual decisions don't lead to
socially desirable outcomes.
 Any time a market failure exists, there is a reason for

possible government intervention into markets to
improve the outcome.
Causes of market failure
a. Public goods
b. Externalities
c. Information asymmetry
d. Monopoly

A. Public goods: a good or service that is
provided without profit to all members of
a society, either by the government or by a
private individual or organization.
The market can not allocate this particular

good efficiently.

Cont…
b. Externalities
Externalities are the effect of a decision on
a third party that is not taken into account by
the decision-maker.
It is cost or benefit to a party not involved in

the production and consumption of a good.
• Positive or Negative externalities
Cont…
• Externalities can be both positive and negative.
- Negative externalities
– second-hand smoke, water and air pollution
- Positive externalities
– innovation, new business formation

c. Information Asymmetry
 Perfectly competitive markets assume perfect
information.
 Real-world markets often involve deception,

cheating, and inaccurate information.
• When there is a lack of information, buyers and
sellers do not have equal information, markets may
not work properly.
 What Policy measures can you think of in order to

deal with informational Problems?
d. Monopoly
• A single seller in a market
• Gives no choice for customers
• Sellers are price setters
• Monopolists charge higher than would exist in

competitive market

 If there is any evidence of market failure then government
intervention can be recommended as a solution to the
problem.
• But will government succeed in designing, implementing,
and enforcing effective policy responses to market
imperfections?
• The translation of the public interest in to public policy
requires several steps:
Identifying the public interest through voting or other
methods (problem Identification)
Creating policies through legislative process (adoption)
and ;
Administrating policy through a public bureaucracy
(Implementation)
Cont…
 Problems related to the three steps above and inherent
behaviors of governments can be named as
Government failure.
Thus,
1. Government failure occurs when government
intervenes unnecessarily: market can be improved
by eliminating government intervention
2. When government intervention couldn’t correct
market failure: Government failure + Market
failure: search for superior government intervention
that can solve the market failure.

Cont…
• The example of traffic accident Fatalities has some aspect
of government failure and market failure.
C. Modeling the problem/ Identifying policy variables
 The Linking policy variables to the conditions of
concern
 Developing a behavioral models that relate the
conditions of concern to variables that can be manipulated
by public policy
• It goes beyond framing to identify important policy

variables
Structure of the problem tree showing causes
and effects or conceptual model

Conceptual Model of the RTA example
Causes
Human Vehicles Environment
•Poor condition of
•Drivers’ Behavior
•Speed management roads
•Pedestrians’ Behavior •Speed limits
•Poor Vehicle •Lack of sidewalks
•Use of Alcohol
•Lack of crash-
•Chewing Chat Inspection (Lighting, protective roadside
Braking, Seat belts, objects
•Tiredness
•Poor rescue facilities
•Not using seat belts etc.) •Poor law
enforcement
•First Aid
08/31/2022
Road Traffic Accidents
Wear your mask!!!
Conceptual Model cont...
Effects
Road Traffic Accidents
Individual Community National
•Death •Lose of active labor

•Families lose main
•Injuries •Burden for the
breadwinners
•Psychological social security
•Poverty
trauma system

Discussion Question
Consider the problem of Drug abuse
• How can this be framed? and
• How can it be modeled?
Ans:
How can drug abuse be defined?
• Drug abuse means when people use illegal drugs or
use legal drugs inappropriately. but we can define it
in what ever way it suits the objective.
• Drug abuse is a patterned use of an illegal drug in
which the user consumes the substance in amounts
or with methods which are harmful to themselves or
others.
Cont…
• The symptoms of the problem can be assessed by
collecting information about:
 The number of people using illegal drugs
 The number and frequency of crimes committed by
addicts
 The estimated amount of health care costs incurred
due to use of drugs
 The estimated amount of revenue forgone due to lost
productivity as a result of drug use
 The number of separated families/affected children
due to use of drugs by parents
Cont…
• For example, the USA losses about 700 million dollar
per year in increased healthcare costs, crime and lost
productivity as a result of drug abuse.
• This shows that drug abuse is nowadays a serious
problem in many countries especially the developed
ones.
How the problem can be framed?
• The problem of drug abuse can be framed as a negative
externality problem (a form of market failure). Why?
Because it affects families, individuals/citizens and the
whole public/state who are not involved in the
consumption or production of illegal drugs through
crimes, neglects and costs.
Conceptual model
Family
Health Crime in
Crime by Spread of separation/ Lost
effects/ the
addicts disease children productivity
costs distribution
abuse
effects
Drug Abuse
Causes
Availability in the
Seems Escape from
Peer pressure distribution
pleasurable reality
system
2. Choosing and explaining relevant policy
goals and constraints
• Before the problem analysis step arrives at its final
stage:
– the analyst makes a list of the goals/criteria that
he/she wants to achieve by means of the policies that
he/she will recommend to his/her client
– explains briefly what each goal means, preferably
in a brief and plain style.
• This is the most difficult step, because goals, especially

in ill-structured public problems, are characterized by
their multiplicity, conflict and vagueness.
Cont…
 Specification of goals is an important input and output
of policy analysis .
 Analysts should present reasoned arguments for
including or excluding a particular goal./Justification
 Since the trade-off between goals is especially difficult

and controversial, clarifying the trade-off between goals
is vital
 It is also important to clarify the distinction between goals
(the values we seek to promote) and policies
(alternatives and strategies for promoting them)
Cont…
 Goals can be classified in to two: substantive and
instrumental goals.
 Substantive goals represent values such as efficiency
and equity that society wishes to secure for their own
sake.
 Instrumental goals are conditions that increase the
prospects for achieving substantive goals.
• Commonly known instrumental goals are political
feasibility, resource constraints (as policy analysis is the
art of the possible), administrative and technical
feasibility.
Cont…
• Instrumental goals often enter the solution analysis
as constraints rather than goals. Thus, we call them
constraints.

Which policy goals are relevant to the RTA
example?
Ans:
1. Efficiency: resources are being affected e.g. human,
capital(vehicle) and related consequences which result in
negative economic impact. We need a policy that can
minimize human death, injuries and vehicle crash, thus
improve efficiency.
2. Political feasibility: acceptability, appropriateness, legal,
and responsiveness.
3.Administrative feasibility: authority, commitment,
capacity and support are required to implement/enforce
policies.
4. Technical
08/31/2022 feasibility: vehicle inspection/ very technical
Wear your mask!!!
Group exercise
• Identify the appropriate policy goals in the Drug
abuse example.

3. Choosing a Solution Method
Choosing solution methods is selecting the techniques
we use for endorsing/approving the best policy
alternatives.
Goal selection is a component of problem analysis. In
other words, you must decide which goals are relevant
to your analysis before you can begin to consider
solutions systematically.
This is because the nature and number of goals largely
determine the appropriate solution method.
• Choosing how we will do the solution analysis is also a
component
08/31/2022 of problem analysis.
Wear your mask!!!
Figure below distinguishes three general goal circumstances:
1. Efficiency is the only relevant goal
2. Efficiency and one other goal are relevant
 can efficiency and other goal be quantified?
A. if yes, other question:
 can the other goal be monetized?
I. if yes, use modified cost benefit analysis as a
solution method.
II. if no, use cost effectiveness analysis as a solution
method.
B. If no, use multi-goal analysis as a solution method
3. Efficiency and two or more goals are relevant
in this case the multi-goal analysis should be used as a
solution method.
Cost-Benefit Analysis
• An analytical framework used to assess the benefits
and costs of policy proposals
Formal cost-benefit analysis should be your primary
solution method when you believe that efficiency is
the only relevant goal.
• Focuses on economic efficiency
It reduces all the impacts of a proposed alternative to
a common unit of impact, namely dollars/birrs.
Calculates the net benefits for each policy proposal
Takes a long-term view and incorporates all relevant
costs and benefits
Cont’d……….
Once all the impacts have been reduced to
dollars/birrs, the evaluation rule is to choose
that alternative that generates the largest
aggregate net benefits.
Thus, in cost-benefit analysis, although there
are different goals, they can be reduced to
positive efficiency impacts (benefits) or
negative efficiency impacts (costs), which, in
turn, can all be measured in dollars/birrs, or
monetized.
Cont’d…………..
Sometimes prices revealed in markets provide a basis for
monetization.
However, market prices often do not reflect marginal
social costs or marginal social benefits because of the
distortions caused by market failures and government
interventions.
There are also many classes of impacts, such as willingness
of people, that usually cannot be monetized through
estimations based on direct observation of markets.
Considerable skills and judgment must be exercised to
assess the costs and benefits of these impacts reasonably.
Qualitative Cost-Benefit Analysis
• Even when we decide that efficiency is the only
relevant goal, we must still determine whether all
efficiency impacts can be reasonably monetized.
• If not, the qualitative cost-benefit is the
appropriate solution method.
Like standard cost-benefit analysis, it begins with
a prediction of impacts.
Some of the impacts may be expressed in natural
units (example, hours of delay or tons of
pollutants), while others may be qualitative
(example, a despoiled scenic view).
• If we are unable to monetize one or more of these impacts,
then we cannot directly calculate the dollar/birr value of
net benefits.
Instead, we must make qualitative arguments about the
orders of magnitude of the various non-monetized
impacts.
• Sometimes impacts cannot be monetized because of
technical difficulties in making valuations.
• When standard procedures do exist for inferring such
values, limitations of time, data, and other resources
frequently make monetization impractical.
• Rather than attempt difficult and time-consuming
valuations, even highly skilled professionals resort to
qualitative cost-benefit analyses to assess orders of
magnitude of efficiency impacts.
Modified Cost-Benefit Analysis
If a client is only concerned with equity, or any other
single, non-efficiency goal, then efficiency is irrelevant.
• Yet, some thought should convince you that efficiency is
almost certainly relevant. This can be most clearly illustrated
for the case where equity is the only goal.
Any intervention in the market to finance redistribution
(absent utility interdependence and market failure) must
inevitably result in some deadweight loss.
Even where we are primarily concerned with achieving a
given redistribution, we should seek to minimize the
deadweight loss; in other words, we should attempt to carry
out the distribution as efficiency as possible.
• Policy analysis almost never involves a single goal unless
that goal is efficiency. Wear your mask!!!
08/31/2022
• In a particular analysis you may conclude that efficiency and
one other goal (most frequently, equity) are appropriate.
We can employ modified cost-benefit analysis if we are able
and willing to monetize impacts on both efficiency and the
other goal. You must be willing to assign dollar/birr values to
various levels of achievement of the other goal.
For example, if the other goal is equality of the income
distribution, modified cost-benefit analysis weighing costs
and benefits accruing to different income groups, resulting
distributional weighted cost-benefit analysis.
• The advantage of such approach is that by incorporating
distributional issues into a cost-benefit analysis, we can
come up with a single metric for ranking alternatives.
The disadvantage is that the metric is achieved only by
forcing efficiency and equity to be measurable by the same
standards.
Modified cost-benefit analysis, by assuming a
particular set of distributional weights, also risks
diverting attention from the trade-off between
efficiency and distributional values in the ranking of
alternatives, which merges both the distributional
and efficiency assessments.
When using modified cost-benefit analysis, it is
usually desirable to present both the
distributionally weighted net benefits and the
unweighted net benefits of the policy alternatives.
A comparison of the weighted and the
unweighted net benefits makes clear the
importance of the particular weights selected.
Cost Effectiveness Analysis: Achieving goals
Efficiently
• Cost-Effectiveness analysis is appropriate
when both efficiency and the other goal can
be quantified but the other goal cannot be
monetized.
• In contrast to modified cost-benefit analysis,
where both goals are measured in
dollars/birrs and thus commensurable, the
two goals are treated as non-commensurable.

If cost – benefit analysis is not applicable,
1) Cost effectiveness analysis

2) Cost minimization analysis:
3) Cost utility analysis

a. Cost effectiveness analysis:
• the comparison of policy alternaitves where the
consequences (output) are measured using the
same natural or physical units
• CEA is commonly used in healthcare, for

example, where it is difficult to put a value on
outcomes, but where outcomes themselves can
be counted and compared, e.g. ‘the number of
lives saved’.
b. Cost minimization analysis:
• asimple cost comparison of policy alternatives
as it is assumed that the consequences
(outputs) are identical or the differences
between the outputs are insignificant:
• This method of cost evaluation is the one used
most often in evaluating the cost of a specific
drug. Cost minimization can only be used to
compare two products that have been shown
to be equivalent in dose and therapeutic effect
c. Cost utility analysis:
• A comparison of policy alternaitves’ inputs
which are measured in monetary units with
the consequences (outputs) measured using
utility or a preference
• scale
• cost-utility analysis is used to compare two
different drugs or procedures whose benefits
may be different.

• We can approach cost-effectiveness analysis in one of two
ways.
1) The fixed budget approach
choose a given level of expenditures (say, 10 million birr) and
find the policy alternative that will provide the largest benefits
(i.e. the greatest achievement of the non-efficiency goal).
2). The fixed effectiveness approach
Specify a given level of benefit and then choose the policy
alternative that achieves the benefit at the lowest cost.
• Both of these methods are cost-effectiveness procedures.
• For each approach, it is important to consider incremental
changes in costs and the non-efficiency goal when comparing
alternatives.
• In some cases the increments are assessed relevant to the
status quo but in others they are assessed relative to another
alternative that is logically between it and the status quo.
• The crucial distinction between cost-benefit
analysis and cost-effectiveness analysis is that:
• Cost benefit analysis can assess both whether any
of the alternatives are worth doing (i.e. whether
social benefits exceed social costs) and how
alternatives should be ranked if more than one
generates positive net social benefits.
• Cost-effectiveness cannot tell the analyst whether
a given alternative is worth doing (this requires a
cost-benefit analysis), but if a decision is made to
redistribute or achieve some other goal, it can
help in deciding which policy alternative will do
so most efficiently (with minimum losses of
social surplus).
Multi goal analysis
• Multi goal analysis is appropriate when three or
more goals are relevant and;
• when one of two goals can not be quantified.
• Policy analysis involves rarely one goal. Thus,
Multi goal analysis serves as the appropriate
solution method almost always.
• All the other solution methods can be viewed as
special cases of multi goal analysis.
• The whole section of solution analysis will focus
on how to conduct multi goal analysis.
Cost Benefit Analysis
• Cost Benefit Analysis (CBA)
• Basic Steps in a CBA
• Net Present Value
• Benefit Cost Ratio
• Internal Rate of Return
• Pay Back

Cost-Benefit Analysis
• Cost Benefit Analysis (CBA) is helpful in answering
the following questions:
• Is the policy worthwhile financially?
• Is it the best option?
• Should it be undertaken at all?

Basic Steps in a CBA
1. Identify all Costs & Benefits
2. Discounting
3. Assess policy(ies) by calculating
a) Net Present Value (NPV)
b) Benefit Cost Ratio (BCR)
c) Internal Rate of Return (IRR)
d) Payback

1) Identification of Costs and Benefits
 what are they?
 what are they worth?
• Measurement issues:
– Direct & indirect (i.e. externalities) effects
– Tangible & intangible effects

Example: Typical Costs and Benefits

2) Discounting
• Policies & projects last a long time
• Frequently costs & benefits occur at different times
• Money has a time value, i.e. ceteris paribus

– current Dollars are more valuable than future
Dollars
• Thus, we need to place current & future costs &

benefits on an equal basis for comparison

Cont…
• This is done by “discounting,” that is by reducing

future Birr value to present value by applying a
discount rate
• The discount rate is an interest rate a national bank

charges depository institutions

Discount Rate vs. Interest Rate
• Discount Rate means the minimum rate of return to

be paid by recipient of financing facilities from
central bank (Central bank for commercial banks)
• Whereas Interest Rate means a rate which is

charged or paid for the use of money. (Commercial
banks for its customers)

Cont..
• Example:
– ETB 100,000 invested at a 3% interest rate today

will be worth roughly ETB 115,927 in five years
• FV = PV * (1+r)t
– ETB 100,000 in anticipated benefits five years

from now is worth roughly ETB 86,261 today,
when discounted by 3%
• PV = FV / (1+d)t

What To Use As a Discount Rate?
• There are various approaches to selecting one
– “Givens” (i.e. some authority imposes one)
– Bank interest rates
– Rates of return on certain investments (e.g.

government bonds)
– “Social” discount rates

3) Assessing policies
Policies or projects can be assessed by calculating
a) Net Present Value (NPV)
b) Benefit Cost Ratio (BCR)
c) Internal Rate of Return (IRR)
d) Payback

Net Present Value
• The difference between total discounted benefits and total
discounted costs
– NPV = (PVB ‑ PVc)
• NPV is the sum of all terms
Where: Σ – sum of all years i to N

i – the beginning year
N- the final year
NV- net value (benefit - cost)
t – number of years
d- discount rate
Cont..
NPV: decision criteria
– For a single policy/project:

• a positive NPV indicates acceptability
– For multiple (competing) policies/projects:

• the project(s) with the highest NPVs should
receive highest priority

Example (assume d as 10%)
Policy/ Year 1 Year 2 Year 3 Year 4 Year 5 Total Total
Project A Discounted
Benefits - 2,000.00 3,000.00 4,000.00 5,000.00 14,000.00 9,743.00
Costs 5,000.00 1,000.00 1,000.00 1,000.00 1,000.00 9,000.00 7,427.00
Cash Flow (5,000.00) 1,000.00 2,000.00 3,000.00 4,000.00 5,000.00 2,316.00

Policy / Year 1 Year 2 Year 3 Year 4 Year 5 Total Total
project B Discounted
Benefits 1,000.00 2,000.00 4,000.00 4,000.00 4,000.00 15,000.00 10,783.00
Costs 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 10,000.00 7,582.00
Cash Flow (1,000.00) - 2,000.00 2,000.00 2,000.00 5,000.00 3,201.00

Cont…
• Project A
– Year 1 = -5000 * (1 + .1)-1 = -4545

– Year 2 = 1000 * (1 + .1)–2 = 826
– Year 3 = 2000 * (1 + .1)–3 = 1503
– Year 4 = 3000 * (1 + .1)–4 = 2049
– Year 5 = 4000 * (1 + .1)–5 = 2484
NPV = 2316
Or
= 9743 - 7427 = 2316
Cont…
• Project B
– Year 1 = -1000 * (1 + .1)-1 = -909

– Year 2 = 0 * (1 + .1)–2 = 0
– Year 3 = 2000 * (1 + .1)–3 = 1503
– Year 4 = 2000 * (1 + .1)–4 = 1366
– Year 5 = 2000 * (1 + .1)–5 = 1242
NPV = 3201
Or
= 10783 - 7582 = 3201
Decision based on NPV
• NPVA = 2316
• NPVB = 3201
Since NPVB is greater than NPVA and is greater than 0

: Accept Project B

Benefit Cost Ratio (BCR)
• BCR = (PVB / PVC)
• If Future Value (FV) is a payment that will be made

t years in the future, then the "Present Value" of this
Payment is
PV = FV / (1+d)t

Cont…
• Benefit Cost ratio: decision criteria
– For a single policy/ project:

• a BC R which is greater than 1 indicates
acceptability
– For multiple (competing) policies/ projects:

• the project(s) with the highest BC ratios
(greater than 1) should receive highest priority

Example
Based on the previous information:
• Project A
– BCR = 9743 / 7427 = 1.31
• Project B
– 10783/ 7582 = 1.42

Decision based on BCR
• BCRA = 1.31
• BCRB = 1.42
• Since BCR of policy B is greater than BCR of policy

A and is greater than 1 :
Accept Policy B

Class Exercise
• Assume a particular plot of land could be developed
as residential housing, an industrial park, or a
factory. Also assume there is a possible road
adjoining the property and that the property is half a
kilometer away from the highway. Note that only one
alternative at most can be ultimately approved.
a) Rank these choices in terms of their NPV and
choose the one that places first.
b) Calculate the BCR and rank these choices.
c) Compare the two rankings

Cont…
Residential Industrial Factory (in

housing (in park (in million
million birr) million birr) birr)
PV Benefits 10.00 12.50 16.00

PV Costs 11.00 9.00 12.00
NPV
BCR

Answer
Residential Industrial Factory (in
housing (in park (in million
million birr) million birr) birr)
PV Benefits 10.00 12.50 16.00
PV Costs 11.00 9.00 12.00
NPV -1.00 3.50 4.00
BCR 0.909 1.389 1.333

Cont…
• Ranking in terms of their NPV

1. Factory
2. Industrial park
3. -----
• Ranking in terms of their BCR

1. Industrial park
2. Factory
3. -----
NPV & BCR Comparison
• From the above exercise we can understand that

there are inconsistencies
• The main questions are:
– Why do such inconsistencies arise?
– Which method is superior?

NPV & BCR Comparison

Cont…
 NPV method is absolute in the sense that it ignores

the capital requirement of projects
• indicates the amount by which benefits exceed (or
do not exceed) costs (total benefit or loss)
 BCR is relative in the sense that it finds the worth of

a project in relation to its investment cost
• measures the ratio (or rate) by which benefits do or
do not exceed costs (efficiency)

Cont..
– Since the capital base requirement for W is smaller
than X, BCR ranks W better than X.
– In this context, BCR method must be preferred to

NPV when projects involve different investment
cost
– If the capital market is perfect, meaning any

amount of funds could be raised at a given cost of
capital, then the NPV method is preferred to BCR.

Internal Rate of Return
• The discount rate at which the present value of
benefits is equal to the present value of costs
– The discount rate when NPV = 0
• It is used to measure and compare profitability of an

investment

Cont…
Internal Rate of Return: decision criteria
– For a single project:

• when IRR is greater than market discount rate,
accept the project
– For multiple (competing) projects:

• the one with the largest IRR is the most
desirable

IRR Formula
• At IRR, Net Present Value (NPV) is zero, thus:
• NPV = 0; or
• PV of future cash flows − Initial Investment = 0; or
CF1 + CF2 + CF3 + … − Initial Investment
( 1 + r ) 1 ( 1 + r )2 ( 1 + r ) 3
Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...

Cont..
• But the problem is, we cannot isolate the
variable r (= IRR) on one side of the above
equation. However, there are alternative
procedures which can be followed to find IRR.
The simplest of them is described below:
1. Guess the value of r and calculate the NPV
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and
go to step 5.
4. If NPV is smaller than 0 then decrease r and
go to step 5.
5. Recalculate NPV using the new value of r
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Example
• Find the IRR of an investment having initial cash outflow of
$213,000. The cash inflows during the first, second, third and fourth
years are expected to be $65,200, $96,000, $73,100 and $55,400
respectively.
Solution
1. Assume that r is 10%. NPV at 10% discount rate = $18,372
2. Since NPV is greater than zero we have to increase discount rate,
thus NPV at 13% discount rate = $4,521
3. But it is still greater than zero we have to further increase the
discount rate,
thus NPV at 14% discount rate = $204
4. NPV at 15% discount rate = ($3,975)
Since NPV is fairly close to zero at 14% value of r, therefore
IRR ≈ 14%
Group exercise
Policy A requires $10 million investments and

generates $10 million each in year 1 and year 2.
Project B requires $1 million investment and
generates $2 million in Year 1 and $1 million in
Year 2. Rank policy A and policy B using IRR

Cont…
IRR has a certain attraction, but also has some
problems
– The argument that an IRR which is greater than the
market/selected discount rate is desirable can be
questioned - discount rates can be arbitrary
– Calculation (by hand) is tedious & prone to error
– Under certain conditions there may be more than

one correct solution to an IRR problem

Flaws in CBA
• Cost-benefit analysis is a deeply flawed method that

repeatedly leads to biased and misleading results.
• Cost benefit analysis offers no clear advantages in

making regulatory policy decisions and often
produces inferior results, in terms of both
environmental protection and overall social
welfare, compared to other approaches (exclude
indirect benefits and costs).

Payback
• This is literally the amount of time required for the
cash inflows from a capital investment project to
equal the cash outflows.
• The formula to calculate payback period of a
policy/project depends whether the cash flow per
period from the policy/project is even or uneven.
• In case they are even, the formula to calculate payback
period is:
Payback period = Initial payment
Annual cash inflow
• Decision: The shorter the payback period, the better
the investment, under the payback method.
Example (even)
• If 4 million is invested with the aim of earning 500

000 per year (net cash earnings), the payback period is
calculated thus:
• P = 4,000,000 / 500,000
= 8 years

• When cash inflows are uneven, we need to calculate
the cumulative net cash flow for each period and then use the
following formula:
• Payback Period = A + B
C
• Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of
cumulative net cash flow at the end of the period A; and
C is the total cash inflow during the period following period A
• Cumulative net cash flow is sum of inflows to date, minus the

initial outflow.
Example (uneven type of cashflow)
Project A
Year 1 Year 2 Year 3 Year 4 Year 5
Cash Flows (4545 ) 826 1503 2049 2484
Left To Repay ($4,545) ($3,719) ($2,216) ($167) $2,317

Example
Project B
Year 1 Year 2 Year 3
Cash Flows (909) 0 1503
Left To Repay ($909) ($909) 594

Cont…
• PA = 4.07 years
• PB = 2.6 years
• Since the payback period for project B is lesser than

that of project A: Accept Project B

Exercise
• An institution is planning to spend birr 50 million
initial investment and the expected cash inflow is birr
10 million in Year 1, birr 13 million in Year 2, birr 16
million in year 3, birr 19 million in Year 4 and birr 22
million in Year 5. Calculate the payback value of the
project.

Solution Analysis
1. Choosing impact categories for goals (evaluation

criteria)
2. Concretely specifying policy alternatives
3. Predicting impacts of alternatives and Valuing them in

terms of criteria
4. Assessing and Recommending actions

1. Choosing impact categories for goals
(evaluation criteria)
• The first step in solution analysis is specifying

relevant impact categories for assessing how well
each policy alternative contributes to each of goals.
• Impact categories are used to measure the
contributions of different proposed policy
alternatives to the goal’s objectives.
• Thus, the process of choosing evaluation criteria
means in fact moving from generality of goals to
specificity of concrete calibrations of these goals.

Cont…
• For example in the drug abuse problem, efficiency is an
appropriate policy goal.
• There are negative impacts of the problem on
productivity, crime, health which are relevant to the
efficiency goal.
• Thus we can write improving productivity, reducing
crime, improving health/minimizing health costs and
minimizing policy/program costs and maximizing benefits
as the impact categories of efficiency.
• Similarly, equity could be a goal regarding the distribution
of some service. The impact category can be the variance
in service consumption across income groups.

The impact categories of the RTA example
Criteria Impact categories
Efficiency - number of fatalities
- number of injuries
- number of crashes
- net benefit, benefit cost ratio by using NPV or BCR
Effectiveness - What are the strategies to be used and are they

capable of achieving the objective of the policy options
Political feasibility - Acceptability

- Appropriateness , legality and responsiveness
Administrative feasibility - Administrative ease

- Resource , capacity, commitment and support
Technical feasibility - Availability and accessibility of technology as well as

skilled human power
2. Concretely specifying policy alternatives
• This step involves the detailed specification of

policy alternatives that can achieve policy goals.
• Policy alternatives are concrete plans and programs

consisting of sets of actions designed to provide
solutions for the problem at hand.
• The process of developing policy alternative requires

a clear understanding of the real causes of the
problem.

Cont…
• Possible alternatives include:
– preserving the status quo (do nothing), and
– any other alternative that can mitigate the
undesirable impacts of the problem.
• It is usually appropriate to include the current policy

(status quo) as a policy alternative to avoid the risk
of recommending a best alternative that is worse
than the current policy.

Sources for specifying policy alternatives
There are variety of sources :
1. The existing policy proposals: this includes the
status quo as well as earlier proposals which are
results of earlier analysts.
2. Other jurisdictions: we can borrow policy
proposals from other jurisdictions by studying how
other cities, states or countries handled policy
problems similar to the one that your jurisdiction
faces.
3. Generic policies: after generating a portfolio of
generic policies, modification can be done to make it
fit the particular situation of the policy problem.
COMMON GENERIC POLICY INSTRUMENTS
Policy types Examples

Organization -Based •Direct provision
Instruments •Public enterprises
•Community and voluntary organizations
•Market organization (consumers and producers
market )
•Government reorganization
Authority- Based •Command and control
Instruments •Delegated or self regulation
Treasure -Based •Subsides :Grants, tax incentive, Loans

Instruments •Financial Disincentive: Taxes and user charges
Information- Based • Public information campaigns

Instruments • Advertizing
• Research Inquiries & investigative commissions
Cont…
4. New or unique or custom-made policy alternative:
can be issue lurking in the literature or may be product
of your imagination/creative solution.
Points to remember while crafting alternatives

 Do not expect to find perfect policy alternative
 Don’t contrast a preferred policy with a “ dummy” or
“straw person” alternatives.
 Do not have a favorite alternative until you have
evaluated all the alternatives in terms of all the goals.
 Ensure your alternatives are mutually exclusive.
 Limit the number of alternatives between 3 and 7.
Cont…
 The alternatives should provide real choices
 Alternatives should be consistent with available
resources
 policy alternatives should be concrete set of actions

Policy alternatives for the RTA example
A0 - Status Quo
A1 - Standardized Drivers Licensing and Vehicle
Inspection
A2 - Traffic Law Enforcement
A3 - Road Safety Education and Awareness Raising
Campaigns

3. Predicting impacts of alternatives and Valuing
them in terms of criteria
• Evaluating alternative policies according to chosen
criteria is the final stage of policy analysis.
• Relevant impact categories and policy alternatives will
come together to facilitate choice.
• It involves constructing a goal/policy matrix with
scores of different alternatives in different criteria.
• The task here is to forecast how each policy option will
perform in terms of each goal and each impact category
and value the effect/ the contribution to the goal.
• If there is uncertainty regarding the effect, do not
suppress it.
Cont..
The decision to select the best alternative is easy when

there is either
– a single criterion, such as efficiency, or
– an alternative that dominates all other alternatives
in all evaluation criteria.

Cont…
• This is rarely the case in real-life situations, because
different alternatives score high and low scores in
different criteria.
• The analyst job here is to clarify the tradeoffs among

different criteria.

Simple Structure of a Goal/Alternative Matrix
goals Impact Policy alternative

category
Policy 1 Policy 2 Policy 3
Status quo
Impact A 1 Medium Low High
Goal A
Impact A 2 1.2 million 4.5 million 3.3 million
Impact A 3 35 units 65 units 80 units
Goal B Impact B 1 Poor excellent Very Good
Impact B 2 Meets Under Exceeds
Minimum Minimum Minimum
Standard Standard Standard
Goal C Impact C 1 Very Likely Likely Somewhat
Likely

Valuation of the RTA example
Goals Impact categories A0 A1 A2 A3
efficiency - minimize number of fatalities 1 2 3 2

- minimize number of injuries 1 2 3 1
- minimize number of crashes 1 2 3 1
effectiveness capacity of achieving the 1 2 3 1

objective
-
Acceptability ,Appropriateness 2 1 2 3
Political , legality and responsiveness
feasibility
Administrativ - Administrative ease 1 1 3 3
e - Resource , capacity,
feasibility
commitment and support
Technical - Availability and accessibility 2 2 2 0

feasibility of technology as well as
skilled human power
TOTAL
9 12
20 11
Scale: 0 = not relevant; 1 = weak; 2 = medium; 3 = strong

4. Assessing and Recommending actions
• Finally, the analyst must assess the alternatives in

terms of the goals, identifying the almost inevitable
tradeoffs faced in choosing one alternative over the
others.
• The recommendation to adopt a policy alternative

should follow directly from this assessment.

Cont…
• The analyst should convey the important

uncertainties encountered in reaching the
recommendation.
• A competent analysis that carefully considers

tradeoffs and uncertainties will often be useful to
the client even if the client rejects the
recommendation.

Public policy analysis trade-offs
Trade-Offs: Definition
• Trade-off: a situation that involves losing one
quality or aspect of something in return for
gaining another quality or aspect.
• Opportunity cost concept - Where you have to give

up something to get something else.
• Can’t have both

Example
• Assume that you want to buy a car and there are only
two cars (blue and green) in the market.
• Further assume that:
– The blue car has airbag but the green car does not
– Your favorite color is green, and you prefer a car
with airbag
– Obviously, green car with airbag is not one of your
options
• How to decide?

Cont’d………….
• You could make your decision based on color, or on
air bag, or you could combine the two attributes into
some composite notion of satisfaction such as:
Safety,
Durability,
Maintenance costs,
size, etc and decide based up on it.

Cont’d………..
• But remember that there is no way to
objectively conclude that one policy
alternative is better than another, especially
where non-monetary trade-offs are involved.
• Therefore, the purpose of multi-criteria trade-

off methods is to improve the quality of
decisions by making the decision making
process more explicit, rational, and efficient.
Why policy tradeoffs are important?
• Policy-trade-offs are necessary because most
policy analysts tend to be engaged in the
rational assessment of public problems through
economic analysis using quantitative methods
with the assumption of coming to logical
conclusions.
• The underlying question to be raised is the other

dimension of the use, the democratic process.
Cont’d………….
• In identifying policy direction there are always
competing values to be considered and this becomes
the basis for policy trade-offs.
• policy analyses have become consensual/mainstream
approaches rather than being skewed to either
contentious or value critical or paradigm
challenging approaches (Kraft and Furlong 2004).
• Should analysts consistently adhere to consensual
norms/mainstream public values, or should they
challenge the status quo is a frequently asked question.
Cont’d…………
• According to Martin Rein (1976), analysts
need to pursue a value critical approach that
urges analysts to be skeptical and have to
distrust orthodoxy.
• The scholar, therefore, recommends that policy

analysts have to become a “moral critic” who
can question the value and belief assumptions
behind a given proposition.
Critical exercises
1. Explain why public policy analysis has to consider trade-
offs?
2. Consider that you are chosen as member of a group of policy
analyst in Ethiopia. In your group, there are economists and
rationalists who strictly adhere to their discipline principles
of efficiency and insisting on the cost-benefit analysis
approach. What are some of trade-offs that you are going to
present to members of your group that there are also equally
non-economic factors to be considered in the analysis?
3. What are the merits and demerits of consensual or
mainstream policy analysis?

Communicating Analysis
• The format of your PA plays an important part in

determining how effectively you communicate your
advice to your client.
• Clients Vary greatly in their levels of technical and
economic sophistication; you should write your
analysis accordingly.
• Guidelines on how you can present your work:
– Structuring interaction
– Keeping your clients attention
– Establishing credibility
Communicating Policy Analysis: Dos
• Remember the Client! Keep in mind that your task is

to provide useful advice.
• Set priorities! Organize your information carefully.
(essential material in the text, supporting material in
appendices).
• Decompose your analysis into component parts
• Use heading that tell a story. Avoid abstract headings
• Be balanced
• Acknowledge uncertainty but provide your resolution
of it.
Cont…
• Be credible by documenting as extensible as possible

• Be succinct / to the point
• Avoid jargon and clearly explain any technical terms
• Make explicit arguments for importance of goals
• Favor short and direct sentences, use active voice.
• Provide clear tables and figures that stand alone.

Thank You

• Thank you

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Chapter three: Doing policy analysis

3.1. Steps in policy analysis

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 There are different steps of the policy analysis process

• The five step (US government office of Management

The five step The eight step

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1. Understanding the problem

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 To do this, collect empirical data, be familiar with the

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Road Traffic Accidents (RTA)

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United States 1.7

0.0 200.0 400.0 600.0 800.0 1000.0 1200.0

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• In Ethiopia car accident is becoming a serious

• every month, around 400 people are killed or

• 41% of the injuries registered in Addis Ababa’s

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• more than 65% of RTA reported

• Most of the accidents occur in

• in cities, 90% of the victims are

• 350 - 430 million

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What is a perfect market/ perfectly competitive

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1. Many buyers and sellers

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 A market failure occurs when the “invisible hand” pushes

 Any time a market failure exists, there is a reason for

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The market can not allocate this particular

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It is cost or benefit to a party not involved in

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 Real-world markets often involve deception,

 What Policy measures can you think of in order to

• Gives no choice for customers

• Sellers are price setters

• Monopolists charge higher than would exist in

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• It goes beyond framing to identify important policy

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Individual Community National

•Death •Lose of active labor

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• This is the most difficult step, because goals, especially

 Since the trade-off between goals is especially difficult

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1) Cost effectiveness analysis

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• CEA is commonly used in healthcare, for

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