PF-lec 3 - Chap 8 and 9 2020 SV

Cost-Benefit Analysis 8
8.1 Measuring the Costs of Public Projects

8.2 Measuring the Benefits of Public Projects
8.3 Putting It All Together
8.4 Conclusion
PREPARED BY
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 1 of 26
C HAPTER 8 ■ C O ST– B EN E FI T ANALYS I S
8
Cost Benefit analysis
This chapter covers cost-benefit analysis.

• Cost-benefit analysis: The comparison of
costs and benefits of public goods
projects to decide if they should be
undertaken.
• Cost-benefit analysis is widely used to
evaluate potential public programs and
projects.
8.1
Costs and Benefits of Highway Construction
Quantity Price/Value Total

Costs Asphalt 1 mill bags
Labor 1 mill hours
Repairs $10 million
(yearly)
Benefits Time saved 500k hours
(yearly)
Lives saved 5 lives (year)
• What are the costs and benefits of the project? In the

first year? Over time?
8.1
Measuring Current Costs
How to measure costs?

• Cash-flow accounting: Accounting method that
calculates costs solely by adding up what the government
pays for inputs to a project and calculates benefits solely
by adding up income or government revenues generated
by the project.
• Opportunity cost: The social marginal cost of any
resource is the value of that resource in its next best use.
• Measuring opportunities costs faces several challenges.
8.1
Imperfect Markets
Economic costs are only those costs are associated

with diverting the resource from its next best use.
• Rents: Payments to resource deliverers that exceed
those necessary to employ the resource.
• If labor is efficiently employed, then wages are a
social cost.
• If some workers are unemployed, then we value
their time at the value of leisure, not the wage.
( imperfect market)
8.1
Imperfect Markets: Measuring the Cost of Labor
• Suppose that the wage of construction workers is

$20/hour.
• But half the construction workers for the project are
unemployed and value their leisure at $10/hour.
• Then the true labor cost of the project is
$20/hour × (500,000 hours) + $10/hour × (500,000
hours)
• $15 million, not the $20 million accounting price.
8.1
Measuring Future Costs
How to measure future costs against current costs?

• Use presented discounted value, discounting at the
social discount rate.
• Present discounted value (PDV): A dollar next year is
worth 1 + r times less than a dollar now because the
dollar could earn r % interest if invested.
• Social discount rate: The appropriate value of r to
use in computing PDV for social investments.
8.1
Costs and Benefits of Highway Construction: Filling
in Costs

Costs Asphalt 1 mill bags $100/bag 100
Labor 1 mill hours ½ at 20, 15
½ at 10
Repairs $10 million 7% discount 43
(yearly) rate
Benefits Time saved 500k hours
(yearly)
Lives saved 5 lives (year)
PRESENT DISCOUNTED VALUE

FUTURE VALUE RECEIVED YEARS IN THE FUTURE
PDV=
( 1 + INTEREST RATE) NUMBER OF YEAR
Ex: The company is selling 200 shares of stock and profits are
expected to be $15 million right away, in the present, $20
million one year from now, and $25 million two years from now.
All profits will be paid out as dividends to shareholders as they
occur.
The financial investor decides that appropriate interest rate to
value these future payments is 15%. For each time period,
when a benefit is going to be received, apply the formula:
PRESENT DISCOUNTED VALUE
Calculating Present Discounted Value of a Stock
Payments from Firm Present Value
$15 million in present $15 million
$20 million in one year $20 million/(1 + 0.15)1 = $17.4 million
$25 million in two years $25 million/(1 + 0.15)2 = $18.9 million
Total $51.3 million
8.2
Using Market-Based Measures to Value Time:
Wages
• Suppose we can show that the time that individuals

save from driving faster is spent at work.
• Then we could value their time saved at their wage.
• This theoretical proposition runs into some problems
in practice:
o Individuals can’t freely trade off leisure and hours
of work; jobs may come with hours restrictions.
o There may be nonmonetary aspects of the job.
8.2
Using Survey-Based Measures to Value Time:
Contingent Valuation
An alternative approach to measure benefits is

contingent valuation.
• Contingent valuation: Asking individuals to value
an option they are not now choosing or do not
have the opportunity to choose.
• This approach relies on answers to hypothetical
questions.
• Straightforward, inexpensive to apply.
8.2
APPLICATION: The Problems of Contingent
Valuation
Critics of contingent point out that contingent

valuations are very sensitive to the survey.
• Isolation of issues: Different value for sum of
single issues or issues asked in combination.
• Order of issues matters: Asking about an issue
first or second changes its reported value.
• The “embedding effect” matters: Asking about
one, two, or three sites does not affect
answers.
8.2
Using Revealed Preference to Value Time
An alternative to contingent valuation is to

use revealed preference.
• Revealed preference: Letting the actions
of individuals reveal their valuation.
• Market prices potentially reveal
preference: If people are willing to pay P
for something, then it is worth at least P
to them.
8.2
EVIDENCE: House Prices and Commuting Time
How much do commuters value reductions in

commuting time?
• Price differences between houses close and far from
downtown might reflect the value of commuting time.
• But treatments and controls may differ, leading to bias.
o Everett is only 4 miles from downtown Boston,
while Lexington is 11 miles away.
o Average home price in Everett: $345,000.
o Average home price in Lexington: $798,000.
8.2
EVIDENCE: House Prices and Commuting Time:
Solving the Problem of Bias
• One solution is to control for house characteristics.

o Lot size, number of bedrooms, square footage.
o But some features are hard to observe, such as
granite countertops.
• In order to provide a more convincing estimate of the
value of time savings, a quasi-experimental approach
can be used.
• Deacon and Sonstelie (1985) look at how much
people save by standing in line to buy price-controlled
gasoline—about $20/hour.
8.2
Valuing Saved Lives
Saving lives is a central benefit of many interventions.

• Valuing human lives is the single most difficult issue in
cost-benefit analysis.
• Many would say that human life is priceless.
• By this argument, valuing life is a reprehensible
activity; there is no way to put a value on such a
precious commodity.
• Every possible intervention has a chance of saving
lives. To decide which to finance requires valuing lives.
8.2
Valuing Saved Lives
How to value saved lives?

• Using Wages to Value a Life
o Life’s value is the present discounted
value of the lifetime stream of
earnings.
• Contingent Valuation
o Ask individuals what their lives are
worth.
8.2
Revealed Preference
• We can value life by estimating how much individuals

are willing to pay for something that reduces their
odds of dying.
• Ex: A passenger air bag could be added to a new
car for $350, and there is a 1 in 10,000 chance that
it would save the life of the car passenger. This
implies that the value of lives to individuals who
buy airbags is at least $3.5 million.
8.2
Revealed Preference
• Compensating differentials: Additional (or reduced) wage

payments to workers to compensate them for the negative
(or positive) amenities of a job, such as increased risk of
mortality (or a nicer office).
• Suppose that we compare two jobs, one of which has a
1% higher risk of death each year ; The riskier job pays
$30,000 more each year. This $30,000 is called a
compensating differential.  individuals must be
compensated by $30,000 to take this 1% increased risk of
dying, so that their lives are valued at $3 million
($30,000/0.01).
8.2
Discounting Future Benefits
• In addition to finding the value of lives saved in

each year, a cost-benefit analysis must discount
these future benefits.
• Choosing the proper discount rate is difficult.
• Since many projects have benefits that last long
into the future, the discount rate matters
enormously.
o Reducing global warming will bring benefits
hundreds of years into the future.
8.2
Cost-Effectiveness Analysis
Cost effectiveness is an alternative to cost-benefit

analysis.
• Cost-effectiveness analysis: For projects that have
immeasurable benefits, or are viewed as desirable
regardless of the level of benefits, we can compute
only their costs and choose the most cost-effective
project.
• Finding the cost of a life saved—and choosing
projects with the lowest costs—avoids making
judgments about the value of life saved.
8.1
Putting It All Together

Costs Asphalt 1 mill bags $100/bag $100
Labor 1 mill hours ½ at $20, 15
½ at $10
Repairs $10 million 7% discount 43
(yearly) rate
Benefits Time saved 500k hours $19/hour 9.5
(yearly)
Lives saved 5 lives (year) $7 35
million/life
8.3
Other Issues in Cost-Benefit Analysis
• Common Counting Mistakes

o Counting secondary benefits.
o Counting labor as a benefit.
o Double-counting benefits.
• Distributional Concerns
o Costs and benefits may not go to the same people.
• Uncertainty
o Costs and benefits are often highly uncertain.
8.4
Conclusion
• Turning the abstract notions of social costs and

benefits into practical implications for public project
choice is challenging.
• What at first seems to be a simple accounting
exercise becomes quite complicated when
resources cannot be valued in competitive markets.
• Economists have developed a set of tools that can
take analysts a long way toward a complete
accounting of the costs and benefits of public
projects.
Political Economy: Public choice theory and government failure
9.1 . Public choice theory

9.2. Voter behaviour in Direct democracy
9.3 Voter behaviour in Representative Democracy
9.4 Politician behaviour
9.5 Government failures
PREPARED BY
9.1
Political Economy: Public choice theory
Why do governments do what they do?

 Public choice theory: a branch of economics that
developed from the study of taxation and public
spending.
• Public choice theory: School of thought
emphasizing that the government may not act to
maximize the well-being of its citizens.
• Government failure: The inability or
unwillingness of the government to act primarily
in the interest of its citizens
9.1
Political Economy: public choice theory
• Ideal case: Government measures preferences

and acts accordingly- Lindahl pricing
• Real cases
• Direct democracy: a form of government in
which the people themselves vote on every
law or policy considered at every level of
government.
• Representative democracy: a form of
government in which the people elect officials
to create laws and policy on their behalf.
9.1 Public choice theory- Example
9.1. Public choice theory- Example
9.2
Voter behavior in Direct Democracy
• Referendum: A measure placed on the ballot by the

government allowing citizens to vote on state laws or
constitutional amendments that have already been
passed by the state legislature.
• Most governments only use majority voting.
• Majority voting: The typical mechanism used to
aggregate individual votes into a social decision,
whereby individual policy options are put to a
vote and the option that receives the majority
of votes is chosen
9.2. Voter behaviour in Democracy- Example
Information and voting cost = $20
9.2. Voter behaviour in Democracy- Conclusion:

Voting results in worse outcome for society.
Information and voting cost = $20
9.3 Voter behavior in Representative Democracy
9.3 Voter behaviour in Representative Democracy:

Assigning representatives to population?
9.3 Voter behaviour in Representative Democracy:

Assigning representatives to population?
9.3Voter behaviour in Representative Democracy:

Conclusion
Gerrymandering can give

silence to minority and give
majority power to minority.
• Vote-Maximizing Politicians Represent

the Median Voter
• The median voter theory in the
representative democracy context
rests on the single key assumption
that all politicians care about is
maximizing the number of votes they
get.
Median Voter theorem animation
9.4. politician behaviour: median voter theorem
9.5 Government failure: Bureaucrat behaviour
• Bureaucracies: Organizations of civil servants, in

charge of carrying out the services of government.
• The budget-maximizing bureaucrat runs an agency
that has a monopoly on the government provision of
some good or service.
• Maximizes his own revenue or influence.
9.5 Government failure: Bureucrat Behaviour
9.5
Government failure: Private versus Public Provision
If government can fail, is it more efficient to

provide by the public or private sector?
• For purely private goods and services, such as
steel, telecommunications, or banking, it
seems abundantly clear that private production
is more efficient.
• A large literature finds that when state-owned
companies are privatized, efficiency improves
dramatically, and a smaller company is
required to produce the same level of output.
9.5
Government failure: Corruption
Corruption is an important form of government failure.

• Corruption: The abuse of power by government
officials in order to maximize their own personal
wealth or that of their associates.
• May be constrained by electoral accountability, the
ability of voters to throw out corrupt regimes.
• Corruption also appears more rampant in political
systems that feature more red tape, bureaucratic
barriers that make it costly to do business in a country.
9.6 Government failures: Conclusion
Conclusion
• The government is a collection of individuals who

have the difficult task of aggregating the preferences
of a large set of citizens.
• The core model of representative democracy
suggests that governments pursue policies preferred
by the median voter. Evidence for this model is
mixed.
• The extent to which government serves or fails to
serve the interests of its citizens is a crucial one for
future research in political economy.
Reference
1. Search video about Government failures video:
Why government often fails by Prof. Antony
Davies
2. Search video: The Median Voter Theorem by

Mandi Broderson

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Cost-Benefit Analysis 8

8.1 Measuring the Costs of Public Projects

This chapter covers cost-benefit analysis.

Quantity Price/Value Total

• What are the costs and benefits of the project? In the

How to measure costs?

Economic costs are only those costs are associated

• Suppose that the wage of construction workers is

How to measure future costs against current costs?

Quantity Price/Value Total

PRESENT DISCOUNTED VALUE

PRESENT DISCOUNTED VALUE

Calculating Present Discounted Value of a Stock

Payments from Firm Present Value

$15 million in present $15 million

$20 million in one year $20 million/(1 + 0.15)1 = $17.4 million

$25 million in two years $25 million/(1 + 0.15)2 = $18.9 million

Total $51.3 million

• Suppose we can show that the time that individuals

An alternative approach to measure benefits is

Critics of contingent point out that contingent

An alternative to contingent valuation is to

How much do commuters value reductions in

• One solution is to control for house characteristics.

Saving lives is a central benefit of many interventions.

How to value saved lives?

• We can value life by estimating how much individuals

• Compensating differentials: Additional (or reduced) wage

• In addition to finding the value of lives saved in

Cost effectiveness is an alternative to cost-benefit

Quantity Price/Value Total

• Common Counting Mistakes

• Turning the abstract notions of social costs and

Political Economy: Public choice theory and government failure

9.1 . Public choice theory

Why do governments do what they do?

• Ideal case: Government measures preferences

9.1 Public choice theory- Example

9.1. Public choice theory- Example

• Referendum: A measure placed on the ballot by the

9.2. Voter behaviour in Democracy- Example

9.2. Voter behaviour in Democracy- Example

9.2. Voter behaviour in Democracy- Example

Information and voting cost = $20

9.2. Voter behaviour in Democracy- Conclusion:

Information and voting cost = $20

9.3 Voter behavior in Representative Democracy

9.3 Voter behaviour in Representative Democracy:

9.3 Voter behaviour in Representative Democracy:

9.3Voter behaviour in Representative Democracy:

Gerrymandering can give

9.4 Politician behaviour

• Vote-Maximizing Politicians Represent

Median Voter theorem animation

9.4. politician behaviour: median voter theorem

9.4 Politician behaviour

9.4 Politician behaviour

9.5 Government failure: Bureaucrat behaviour

• Bureaucracies: Organizations of civil servants, in

9.5 Government failure: Bureucrat Behaviour

If government can fail, is it more efficient to

Corruption is an important form of government failure.

9.6 Government failures: Conclusion