COST-BENEFIT ANALYSIS Chapter 3 ©2016 by McGraw-Hill Education Limited

Learning Objectives Distinguish between a Pareto improving allocation of resources and a potential Pareto improvement. Calculate the present value of future cash flows. State the present value criteria for project evaluation. Distinguish between the social discount rate and rates based on private sector returns. Explain how to estimate the shadow prices of commodities.

Learning Objectives (cont.) Explain how to use changes in consumer surplus to estimate project benefits. Infer the value of non-traded goods by observing economic behaviour. Define the certainty equivalent of a risky benefit or cost. State three common pitfalls in conducting cost-benefit analysis.

LO1 Economic Efficiency When resources are allocated inefficiently, then there is a Pareto improvement available: someone can gain and no one need lose Suppose the benefits of a project exceed its costs, thereby increasing the “size of the economic pie” Beneficiaries can fully compensate the losers and still have some benefits left over, generating a Pareto improvement The difference between benefits (B) and costs (C) can be regarded as the contribution of a project to economic efficiency Net Return = B − C

Efficiency of the Competitive Equilibrium Figure 3.1

Distributional Considerations Should who gains and who loses be taken into account? Should benefits and costs be weighted? NO: Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences NO: Let the government costlessly correct any undesirable distributional aspects NO: Relies too much on value judgments and politics

Present Value Project evaluation usually requires comparing costs and benefits from different time periods. The present value of a future amount of money is the maximum amount you would be willing to pay today for the right to receive the money in the future.

Projecting Present Dollars into the Future R=$ T=years r=interest rate How much will $100 earn in 2 years at an interest rate of 5%? R0 = $100 R1 = $100*(1+.05) = $105 R2 = $105*(1+.05) = $110.25 R2 = $100*(1+.05)2 = $110.25 RT = R0*(1+r)T one click per line

Discounting Future Dollars into the Present LO2 Discounting Future Dollars into the Present How much will $100 earned in 2 years at an interest rate of 5% be worth today? Since RT = R0*(1+r)T Present Value R0 = RT/(1+r)T discount rate discount factor Low r – more future-oriented and benefits projects in which returns are concentrated further into the future High r – more present-oriented and benefits projects in which returns are concentrated closer into the future

Present Value of a Stream of Money

Private Sector Project Evaluation Present Value Criteria LO3 Private Sector Project Evaluation Present Value Criteria Annual Net Return Present Value Year R&D Oil Well r = $1,000 -$1,000 $150 $200 1 600 0.01 128 165 2 0.05 46 37 3 550 1,200 0.07 10 -21 Table 3.2 Note choice of r is critical: Low r benefits Oil Well; High r benefits R&D.

Private Sector Project Evaluation Internal Rate of Return IRR: Discount rate that would make a project’s NPV zero r r r Project Year 0 Year 1 ρ Profit PV X -$100 $110 10% $4 3.77 Y -$1,000 $1,080 8% $20 18.87 This criterion is flawed when comparing projects of much differing sizes. Although X has the higher IRR, Y yields the higher profit. Note that the PV criteria, using r=6%, would prefer Y.

Private Sector Project Evaluation Benefit-Cost Ratio Benefit-cost ratio = B/C

Problems with the Benefit-Cost Ratio “Costs or Negative Benefits?” Method B C B/C I $250M $100M 2.5 II $200M 2.0 Suppose that $40 of costs need to be added to method I I: Subtract $40M from B? $210M 2.1 OR I: Add $40M to C? $140M 1.79 Benefit-Cost criterion can lead to incorrect inferences 3-14

Private Sector Project Evaluation The Present-Value Criterion is the most reliable evaluation guide Both IRR and Benefit-Cost Ratio Criteria can lead to incorrect inferences

Public Sector Discount Rate LO4 Public Sector Discount Rate Based on Returns in Private Sector: the market rate Before-tax rate of return Weighted average before- and after-tax rate of return Social Discount Rate (SDR): the rate at which society is willing to trade off present consumption for future consumption Arguments for SDR: Concern for future generations Paternalism Market Inefficiency

Valuing Public Benefits and Costs LO5, LO6 Valuing Public Benefits and Costs Use Market Prices? Use Adjusted Market Prices in imperfect markets? = Shadow price = underlying social MC of a good Monopoly Taxes Unemployment Use Consumer Surplus? Figure 3.2

Valuing Public Benefits and Costs Inferences from Economic Behavior LO7 Valuing Public Benefits and Costs Inferences from Economic Behavior How to place a value on the time saved by a proposed project like a new highway? Earnings Other methods How to place a value on a life saved by a proposed project such as a 4-lane divided highway? Lost earnings Probability of death

Valuing Public Benefits and Costs Intangibles Intangibles can subvert cost-benefit exercises C/B tools can reveal limits on valuing intangibles Cost-effectiveness analysis might be best in the presence of intangible benefits Comparing the costs of various alternatives that attain similar benefits to determine which one is the cheapest

Valuing Public Benefits and Costs Uncertainty LO8 Valuing Public Benefits and Costs Uncertainty Project Benefit Probability CE* X $1,000 1.00 Y 0.50 $2,000 *Certainty Equivalents (Expected Value) 3-20

Games Cost-Benefit Analysts Play Common Errors LO9 Games Cost-Benefit Analysts Play Common Errors The Chain-Reaction Game Including secondary profits (but not costs) The Labor Game Including project workers’ wages as a benefit (rather than what it is, which is a cost) The Double-Counting Game Including benefits from all possible projects, when only one project can be undertaken

An Application: Are the benefits of single-occupancy hospital rooms worth the additional costs? Discount rate Costs Benefits Summing up the components

An Application: Net Social Benefits or a Bed in a Private Hospital Room Relative to a Semi-Private Room Table 3.3

Chapter 8 Summary Cost-Benefit analysis is the practical use of welfare economics to evaluate potential projects. A project generates a potential Pareto improvement if the gainers can compensate the losers and still enjoy a net increase in utility. Present value of future expected costs and benefits must be calculated in order to allow correct comparisons. Although the IRR and B-C Ratio are used to evaluate projects, the NPV criterion has fewer biases and problems. Choosing the discount rate is critical in cost-benefit analysis. In public sector analyses, three possible measures are the before-tax private rate of return, a weighted average of before- and after-tax private rates of return, and the social discount rate.

Chapter 8 Summary (cont.) The costs and benefits of public projects can be measured using market prices in the absence of market failures; otherwise, shadow prices or consumer surplus can be used. Quantifying the value of time and life, is necessary in measuring benefits, but using earnings as a proxy has limitations. Cost-benefit analysis can fall prey to several pitfalls: Chain-reaction game Labour game Double-counting game Uncertainty of future costs and benefits can be included through the use of certainty equivalents.

Appendix: Consumer Surplus Figure 3A.1

Appendix: Producer Surplus Figure 3A.2