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A Primer on Benefit-Cost Analysis Presented to: The Reclaimed Water Technical Committee June 2, 2006 By Bruce Flory, Ph. D. Seattle Public Utilities.

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Presentation on theme: "A Primer on Benefit-Cost Analysis Presented to: The Reclaimed Water Technical Committee June 2, 2006 By Bruce Flory, Ph. D. Seattle Public Utilities."— Presentation transcript:

1 A Primer on Benefit-Cost Analysis Presented to: The Reclaimed Water Technical Committee June 2, 2006 By Bruce Flory, Ph. D. Seattle Public Utilities

2 A Little History of BCA Idea of economic accounting – France, 1848 Foundational concepts - Alfred Marshall Practical development - Federal Navigation Act of 1936 –Required the U.S. Corps of Engineers carry out projects for the improvement of the waterway system when the total benefits of a project, to whomsoever they accrue, exceed the costs of that project. –The Corps developed methods without economists

3 History - continued Economists get in the act – 1950s –provide a rigorous, consistent set of methods BCA expands into new areas -1980s –all major new regulations Some technical issues of BCA still unresolved However, the fundamentals are well established.

4 General Definitions Benefit-cost analysis is a way of identifying, portraying and assessing the factors which need to be considered in making rational economic choices. BCA is a method of evaluating the relative merits of alternative public investment projects in order to achieve efficient allocation of resources. In principle, BCA entails adjusting conventional business profit-and-loss calculations to reflect social instead of private objectives, criteria, and constraints in evaluating investment projects.

5 Pearls from Tom Fox A benefit-cost analysis is a systematic evaluation of the advantages (benefits) and disadvantages (costs) of a set of investment alternatives. Typically, a base case is compared to one or more alternatives.

6 Another Pearl A full social cost accounting identifies and accounts for all the benefits and costs of a potential action, including economic, environmental and social costs and benefits, even those that do not have readily observable market values.

7 Some Useful Concepts Externalities Public Goods – Non-rival – Non-excludable – Non-rejectable

8 BenefitsCosts Costs and Benefits of Project X

9 BenefitsCosts Private Interests Private Costs and Benefits

10 BenefitsCosts Private Interests Public Interest Public Costs and Benefits

11 BenefitsCosts Private Interests Public Interest The Reverse Case

12 Example Getting to work

13 More Useful Concepts Scarcity Choice Opportunity Cost Opportunity cost: What we forego when we make a choice

14 Inefficient Use of Resources Scarce community resources Valuable community services Community well-being

15 Scarce community resources Valuable community services Community well-being Improved Efficiency (Most Bang for the Buck)

16 And More Still Sunk Costs Common Unit of Measure Present Value (Discounting the Future)

17 Ignore Sunk Costs Sunk costs are sunk, – they cannot be recovered Do not include them in BCA Do not use them to justify project

18 Common Metric Apples and Oranges –Capital costs ($) –Revenue ($) –Reduced traffic congestion (driver hours) –Reduced cancer risk (deaths per million) –Improved habitat for endangered species (spotted owls per acre) Ideal: Quantify all in $ terms

19 Present $ vs. Future $ Not all dollars are equal $1 a year from now < $1 now –Time preference –Risk –Opportunity cost of capital Discount future values to obtain…

20 Present Value

21 Present Value Formula (for those so inclined) PV = FV (1+r) t

22 Putting It All Together Identify the problem to be solved Define Baseline Identify Alternatives Identify All Benefits and Costs for Each Alternative

23 Putting It All Together – cont. Quantify All Benefits and Costs in $ Calculate Present Values Calculate Net Present Value Rank by NPV

24 Net Present Value for One Option

25 Net Present Value (NPV) Table

26 Problems with BCA #1 Problem: Difficulty of quantifying all benefits and costs in $ Non-Market Valuation Methods –Stated Preference Contingent Valuation Conjoint Choice Analysis –Revealed Preference Hedonic Pricing Travel Cost Method –Benefits Transfer Method

27 So, What Do You Do? Rule Sensitivity Analysis Cost Effectiveness Analysis

28 Cost Effectiveness (another pearl) The phrases cost effectiveness analysis and benefit-cost analysis are often confused. Cost effectiveness analysis involves specifying a set of benefits or level of service, then comparing the costs of various alternatives that can deliver those benefits. The alternative with the lowest life-cycle costs is the most cost effective.

29 Perspectives Analysis Who gains, who pays? BCA doesnt answer this question –Compensation Principle Ideally, design financing scheme to: –charge those who benefit –compensate those who lose

30

31 Summary (+s) BCA useful tool to help public agencies –Ask the right questions –Make good investment decisions –Avoid costly mistakes –Get the most Bang for the Buck

32 Summary (–s) BCA is not the only tool –Necessary but not sufficient –Measurement issues –Susceptible to abuse –Doesnt do distribution


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