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B/C – A and distributional issues (Cost Benefit Analysis DEC 51304) Zerbe & Dively Ch.11 R. Jongeneel

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Lecture Plan Basics Full Compensation Criterion Kaldor-Hicks criterion Identify gainers and losers No undesirable transfers Opportunity cost rule Use distributional weights

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Basics h : marginal social utility of income of individual h h : h - h MUY h times MSU h Problem: uncertainty w.r.t. MSUY h efficiency distribution

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Full compensation criterion Assumes nothing is known about MSUY h Accepts Pareto Principle as decisive criterion Requires that losers from a policy change are fully compensated from the gains of the winners Conclusion: PPI is actually realized!

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Example: Full compensation criterion (before) GroupMSUY (a h )Net benefit Distributional effect Change in economic welfare Poor Rich Total

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Example: Full compensation criterion (after) GroupMSUY (a h )Net benefit Distributional effect Change in economic welfare Poor Rich Total Assumption: zero transfer costs

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The Kaldor-Hicks criterion Basic rule: Ignores distributional effects / assures same MSUY for all h’s Simply calculates the present value of costs and benefits and evaluates whether NPV benefit exceeds NPV costs

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The Kaldor-Hicks criterion Defense: Distributional effects easy to identify and remedy Existing distribution (chosen by government) and already optimal (implying equal MSUY h for all h) Criterion: Potential Pareto Improvement Compensation possible, but not actually carried out

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Identify gainers and losers Avoid problem of distributional assumptions Simply identifies who gains (and how much) and who loses (and how much) Let the policy maker decide

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No undesirable transfers (Willig & Baily) Accepts widely used assumptions: i) MSUY decreases as Y increases ii) MSUY is non-negative for all h iii) It is undesirable to transfer money from a poorer to a richer individual Rank all individuals from poorest to richest A>B if

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No undesirable transfers Net benefits must be superior at each stage of the summation process from poorest to richest income group Weaknesses: - Some policy changes with net social welfare benefits might be rejected (no regressive transfers) - Results are sensitive to group definition

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Opportunity cost rule (Harberger) The benefit of a transfer cannot be greater than the cost of making the transfer by the most efficient alternative means (opportunity costs) Example I PoorMiddleRichTransfer B or C NB NB K-H NB Opp.Cst Harberger: Net transfer cost only 1 (cf.-1) instead of 20% of +40 (=8)

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Opportunity cost rule (Harberger) Example II PoorMiddleRichTransfer B or C NB NB K-H NB Opp.Cst Harberger: Taking into account the costs of actually compensating the poor (20% of 100=20) makes the project undesirable

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Distributional weights Attach explicit weights to costs and benefits accruing to different groups with weight of class k equal to w k

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