INTRODUCTION TO APPLIED WELFARE ECONOMICS AND BENEFIT-COST ANALYSIS

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Market and Public Sector Allocation of Resources  Fundamental Economic Issue  Allocate scarce resources among competing uses  Market performs this function for private goods and private sector resources  Private profitability ranks projects  Public sector resources not allocated by market

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Market and Public Sector Allocation of Resources  Public sector resources not allocated by market  Requires some systematic methodology by which to optimally allocate  Must consider social objectives, not just private

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Public Sector Allocation of Resources  Private profitability does not allocate resources according to social ordering  Specific Reasons:  Promotion of economic growth  Reduction in income inequality  Reduction in poverty  Prices of inputs or outputs may not reflect their true marginal social costs or benefits if there are distorted input or output markets

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Specific Reasons for Public Sector Resources Not Allocated by Market  Account for externalities  Some project inputs or outputs may be non- marketed (e.g. public goods)  Still must be evaluated  Indirect welfare effects  If markets are distorted elsewhere, indirect welfare effects from induced resource allocations on these markets

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Specific Reasons for Public Sector Resources Not Allocated by Market  Private discount rate may differ from social discount rate  Could be capital market distortions or inter- generational externalities in savings  Capital market distortions include taxes on capital income or imperfections in ability of individuals to borrow against future income

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Specific Reasons for Public Sector Resources Not Allocated by Market  Private discount rate may differ from social discount rate Inter-generational externalities in savings could arise from interdependent utility functions between generations Also, if risk is not allocated efficiently in an economy, resources are not efficiently allocated inter-temporally

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Benefit-cost analysis provides systematic manner to evaluate public investments and public policies and efficiently allocated public resources according to social criteria  Assesses costs and benefits of public investment  If B > C, then acceptable  If B < C, then unacceptable

PUBLIC INVESTMENT AND RESOURCE ALLOCATION Basic idea is to measure in monetary units how social welfare is affected by a public policy or project Benefit-cost analysis is a set of procedures for defining and comparing benefits and costs  A way of organizing and analyzing data  A way of thinking about policies and projects  An aid to decision-making

WELFARE ECONOMICS AND COST-BENEFIT ANALYSIS Welfare economics provides theoretical underpinning for CBA Welfare economics is branch of economics concerned with what “ought to be”  Normative rather than positive economics  Focuses on using resources optimally to achieve maximum well-being for individuals in society  Judgements on desirability of particular policies and projects

WELFARE ECONOMICS AND COST-BENEFIT ANALYSIS Basic aim is to provide criteria to rank various policy proposals Welfare economics based on set of assumptions and principles  Primary value judgement is that the individual forms the basis of society and that individual preferences count

FINANCIAL vs. ECONOMIC vs. SOCIAL ANALYSIS Financial EconomicSocial Private Firm Economic CBA Economy-wide perspective Externalities And Public Goods Project Analysis Market prices vs. shadow prices Inter-temporal and intra-temporal income distribution

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Consider now a simple example demonstrating that a project or policy’s outcomes for society may differ from the outcomes to a private firm or individual. Further, the size of the net benefit may itself differ from the social and private viewpoints.

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Firm A considering courier service for express delivery of small parcels  Generates net increase in delivery services and net increase in available inputs Firm A’s service annually:  Revenue = $150,000  Costs = $100,000  Net revenue = $150,000 - $100,000 = $50,000  20% tax on net revenue = 0.20 x $50,000 = $10,000  Profit = $50,000 - $10,000 = $40,000  = Net Benefit to A

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Suppose A’s service allows Firm B to improve efficiency of its operation and increase its sales Firm B annually shows increases:  Revenue = $115,000  Costs = $40,000  Net revenue = $115,000 - $40,000 = $75,000  20% tax on net revenue = 0.20 x $75,000 = $15,000  Profit = $75,000 - $15,000 = $60,000  = Net Benefit to B

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Net private benefit = Benefits – costs = (150, ,000) – (100, , , ,000) = 265,000 – 165,000 = $100,000

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT But society as a whole incurs other annual costs:  Extra police = $50,000  Extra road construction = $95,000 Net benefits to society must include all benefits and costs, whoever incurs them.  Hence, extra costs must be included in society’s net benefit calculations.

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Tax is transfer payment from one sector of society to another, and hence is excluded from calculation of net social benefits. Net social benefit:  All revenues  All costs to firms except transfer payments  All extra costs incurred by society  All extra benefits enjoyed by society  (Not considered here.)

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Net social benefit = Benefits – costs = (150, ,000) - (100, , , ,000) = 265,000 – 285,000 = -$20,000

NET SOCIAL BENEFIT MAY DIFFER FROM NET PRIVATE BENEFIT Thus, size of net social benefit can differ from size of net private benefit An alternative that is desirable to private sector may be undesirable to society (or vice versa)