Cost-Benefit Analysis

Invisible-Hand Theorem
• Self-interested behaviour → optimum for society
• Theorem holds if and only if no market failure:
1. Externality; 2. Monopoly; 3. Asymmetric Information
1. All effects relevant to welfare priced in markets
2. Perfect competition in all activities
3. All participants have full knowledge useful for decisions
• Markets do have success, e.g. in smooth functioning of
society, in correcting much monopoly, information
 Departures
• Theorem is a tall order
• Clearly are market failures, esp. externality & asymmetry
• → government may wish to limit individuals’ decisions
• If limit decisions, private profit & loss accounts not useful
• Indispensable: a consistent way to evaluate intervention
 Cost-Benefit Analysis
• CBA an adaptation of profit & loss to determine
1. Whether or not to proceed
2. Which of several alternatives is best
3. Scale of intervention
• Difference: evaluate benefits & costs if wrong or no prices
• Some subjectivity: e.g., cost of suffering from pollution
• → Must set out assumptions clearly for possible criticism
 Efficiency and Efficient Prices
• Invisible hand assumes market prices & everyone follows
• People wonder if “better” to do dishes in a sink or a
dishwasher, or to shave with an electric shaver or razor
• Each person has to know all of many intricate values
• If all costs involved can be adduced, can use the efficient
prices to derive the higher net benefit. No need to calculate
the social values oneself.
• Choose according to the efficient prices
 Imprecision
• Measures not precise
• What we aim to measure may be important
• Keynes: “…better to be roughly right than precisely wrong.”
• Wiener: Economics a two-digit science.
• Seek acceptable accounting prices for valuation
• → impression, hunch, inkling, notion
 Climate
• Climate science relies on computer models: black boxes
• Economic evaluation relies on IAMs
• Pindyck: far less reliable than econometric studies (!)
• → best we can do is impression, hunch, inkling, notion
 Policy
• Ideally a cost-benefit analysis for any environmental policy
• Policies that would benefit from a CBA:
deposit-return systems for bottles (Y or N)
bans on plastics (which among alternatives)
subsidies for green energy, electric vehicles (both)
 Stating the Goal: Recycling Paper
• Does it save trees?
• If profitable, pulp & paper company holding a lease or
owning land reforests and maintains land
• If recycle, may take some land out of production
• If no alternative use, still have trees growing; little difference
• Social gain? Saves room in landfills: less waste
• Important: sites scarce near cities (Montreal’s full
Charge all waste? How?
 Basics
Weimer and Vining

• Four steps:
1. Identify all relevant effects
2. Monetize effects (numeraire, good accounting prices)
3. Discount for time and risk
4. Choose among policies
 1. Identifying Effects
• Most important step: be sure to consider all relevant effects
• Categorize as costs or benefits
• Discipline; recall Benjamin Franklin
 Key: Who has standing?

A. Geographic extent:
UN might use all people
National government mainly interested in its citizens
(Politician: marginal voters + core support)
(US under Pres. Trump estimated SCC at a few dollars)
B. Should all persons have (equal) standing?
Legal vs. illegal residents, law-abiding vs. criminals?
Do families represent children, insane?
Future generations?
 Monetization
• Fundamental principle: Kaldor-Hicks criterion
• Adopt a policy only if gainers could fully compensate losers
• Necessary condition: potential Pareto improvement
• Controversy:
1. Does not guarantee no one loses; some will
2. Compares welfare across individuals
3. Evening over all policies?
Vaccine mandate, vax tax?
• Still, a good test (Willig)
 Measure: Willingness to Pay (W.T.P.)
• Consumer’s surplus: What a consumer would be willing to
pay to be able to buy a good at the current price
• Area under demand curve down to price
• Not exact because of income effects
Usually small reasonable measure of surplus (Willig)
• Validity of WTP if outside consumer’s experience (e.g. SCC)?
• Aggregate over consumers → consumers’ surplus; use
 Value: Opportunity Cost
• “Benefits are the sum of the maximum amounts that people
would be willing to pay to gain outcomes they view as
desirable; costs are the sum of the maximum amounts that
people would be willing to pay to avoid outcomes that they
view as undesirable.” (Weimer and Vining)
• Can be subtle
 Recreational Resource
(Anderson & Bonsor)

• Common property: available to all

• Congestible: one’s use affects others’ benefits
• E.g., ski hill, toboggan slide, national park
• Measure of consumers’ surplus is subtle
• Usual measure: area under observed market demand
• Here, demand curve is quantity demanded given congestion
• Marginal consumer reduces surplus of infra-marginal
 Demand Curve
• Observed “demand function”
• Here, does double duty:
For any , is quantity consumed as well as crowding,
• is willingness to pay for output given
• Most avid skier w.t.p. for one unit of , with no one else
skiing; Crowding
• Adding a second skier reduces most avid skier’s w.t.p.
• Reduction an opportunity cost, not pecuniary
 Constant-Crowding Demand
• As skiers are added, most avid’s continues to fall (intercept)
• The second, then third, then…also fall (→ gentler slope)
• Demand given crowding is more elastic (less steep)
• True consumer’s (and hence consumers’) surplus holds
crowding constant at a given output
p
A

p = A - Bq

p = a - bq
, dwl
ε , gain

A/B q
 Measuring Consumers’ Surplus
• Consider any point on on ,
• rather than : depends on ; cuts
• Control for : Let
• Consumers’ surplus: area under
• Much less than under
 Pricing
• Ski hill has no money cost. At ,
• If charge , there is a small deadweight loss triangle,
• Surplus gain : area between curves
• Continue to raise : ↓, ↑; eventually
• Positive price optimal where
• Maximize sum of consumers’ surplus and (to owner)
 Price of Crowding (Externality)
• Two ways to perceive negative externality and over-usage
1. Reduction in benefits to infra-marginal users
2. Cost imposed on those users; a cost is a negative benefit
• Econometric:
, unobserved
not right to estimate
separate effects of crowding and diminishing
 Non-Market Value
• Methods
1. Hedonic prices. “Location, location, location”: E.g., contribution to
house prices of schools, accessibility, safety, pollution:
statistical techniques to identify
2. Opinion surveys: ask people their w.t.p.; extrapolate
sensitive to wording; randomization difficult; non responses;
questions hypothetical; strategic behaviour
3. Activity surveys: relate use patterns to travel cost; est. demand
data from eco-tourism, e.g., Great Barrier Reef
 Risk
• Outcomes vary; people averse to uncertainty
• Comparison: Expected Value (ideal, Expected Utility)
• Aversion to uncertainty tantamount to decreasing M.U.

• E.g., two outcomes with probability ½;

• : would pay difference to have the certain outcome (→
insurance)
• on curve; on the chord of the curve
• Works for all probability distributions, discrete & continuous
 Risk Preferences
• Risk averse: concave utility (increases at a decreasing rate)
• Risk neutral: utility function linear;
Individual does not need or want insurance
• Risk loving: convex utility (increases at an increasing rate)
• Measure of risk is the variance of utility; in simple example,
 Outcomes
• All things affecting utility
• Market gives an opportunity to diversify risk;
variability of portfolio, not of individual components
• Analogous to stock portfolio
risk of a stock covariance with rest of portfolio
portfolio is whole market available to an investor
 Practical Alternative for Stocks?
• Diversify: across sectors, sometimes across firms, more than 20
companies, quality dividend payers, possibly ETFs if low capital
• Motley Fool: Keep 3 – 6 months’ income in cash;
risk is a possibility of total or nearly total loss;
diversify; set aside cash and a bond ladder for retirement
hold each stock for long periods (at least three to five years)
 More Qualitative Outcomes
• Health, house: cannot diversify through investment
• Insurance companies can diversify risks → gains from trade
• Exception: undiversifiable risks such as “acts of God” →
exclusions or reinsurance
• Even though hard to value, insurance companies are in business
• Problems:
adverse selection: risky individuals more likely to insure
→ unemployment insurance by government
moral hazard: insurance reduces wariness, care
→ waiting periods, limits to coverage
 Expected Value: “Play Percentages”
• Have to deal with uncertainty
• If possible to list contingencies and assign probabilities:
1. Identify mutually exclusive, exhaustive list of contingencies
2. Estimate NPV under each contingency
3. Assign a probability of occurrence to each
4. Multiply and add to get expected value
• Probabilities may be speculative; test sensitivity
 OK for Small Projects

• “Small” project’s utility near linear in relevant range

• Expected value less valid for large or multiple, statistically
dependent projects
• Alternative:
Option price: sum max w.t.p. over citizens (Kahneman Nobel 2002
& Tversky (d. 1996))

• Especially for local projects:

small jurisdictions have less scope to spread risk
→ mayor’s objective concave, PM’s nearly linear
 Validity?
• Typically for a large, important, new sort of project:
• What does WTP mean if the question is outside respondents’
experience? How can they evaluate a WTP?
 Large Project
• Social utility “is” concave (increases at a decreasing rate)
• Prefer average value to the expected value
• If a project is very important to a society, use option price:
• Maximum certain payment to have the project, summed
over citizens
• How? Very hard for climate: disparate countries
• → use expected value
 Misconceptions
• Sometimes physicists challenge economics as wrong-headed
• Use mathematical models unmodified for human volition
• Ole Peters Challenges expected utility as flawed math
• Illustration:
1. start with 100 in wallet;
2. fair coin flipped times: H → 1.5 x; T → 0.6 x holding
3. Expected:
 Choice
• If , EV
• If , EV
Get 2.25 w.p. ¼; 0.9 w.p. ½; 0.36 w.p. ¼
• Distribution ever more skewed as increases
A. Choice of a typical person with concave utility between an
even chance of 1.5 and 0.6?
B. Choice between chance of ¼ to win big at 2.25, chance of ½
to lose a little at 0.9; and of ¼ to lose a lot at 0.36?
C. …
 Decision
• May accept the bet if is small and the cost is small
• People do play lotteries, usually with small sums
• Considered addicted if play with large sums
• For choice between 15,000 and 6,000, unlikely to bet 10,000
• As increases, less likely to the pay option price to play
 CBA
• Step 1, list all relevant outcomes, pro & con
Discipline: Never done by activists!
• Measurement concept: opportunity cost
• Commensurate: use willingness to pay
• Narrow criterion: whether winners could compensate losers
• Ideally → discussion and revision
 Policy Evaluation
• Some form of balancing essential for any policy
• Will always be controversial
• Need rigorous framework for evaluating efficiency
 Results
• Forces DM to consider unpriced values consistently
• → reasoned estimates from imperfect data
• Not precise; often controversial
• , use advisedly: tentative, food for thought
• Same for computer projections and econometrics
• Do not rely on any of the above
 CBA: Summary
• A framework for evaluation
• Could winners compensate losers? (Not will…)
• All relevant effects: discipline
• Make effects commensurable: w.t.p., opportunity cost
• An estimate from incomplete data: uncertain
• Most important: address all effects of a policy, think
consistently, list assumptions
 Climate?
• Much at stake; unknown, “probabilities” from asking experts
• How do we evaluate?
• A vast exercise in non-market valuation over a long time
→ any policy must be adjusted
can one commit to maintain if can adjust?
• What if a many small, independent “fixes” vs. a few big bets?
• Main choice: price on carbon vs. government mandates
 Cost-Benefit Analysis: Small Project
• Use present value of benefits net of costs:
• Future benefits and costs not known; projected
• If can list future contingencies, use expected discounted net
benefits
1. Identify all contingencies
2. Estimate present value of net benefits under each
3. Take probability of occurrence of each
4. Multiply NPV of each by the probability and sum
 Methods for Non-Marketed Goods

• Estimate the value attached to living where risk of climate

damage is low through house prices
Data problems, confounding of influences on choice
• Opinion Surveys: just ask, then extrapolate
Problems: sensitivity to wording, biases, difficulty in
evaluating hypothetical questions, strategic responses
• Travel cost (N/A for climate, except for migration)