McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 8 COST-BENEFIT ANALYSIS

8-2 Projecting Present Dollars into the Future R 0 = $1000 R 1 = $1000*(1+.01) = $1010 R 2 = $1010*(1+.01) = $ R 2 = $1000*(1+.01) 2 = $ R T = R 0 *(1+r) T

8-3 Projecting Future Dollars into the Present R 0 = $1000 R 1 = $1000*(1+.01) = $1010 R 2 = $1010*(1+.01) = $ R 2 = $1000*(1+.01) 2 = $ R T = R 0 *(1+r) T R 0 = R T/ (1+r) T Present Value discount rate discount factor

8-4 Present Value of a Stream of Money

8-5 Inflation

8-6 Private Sector Project Evaluation Annual Net ReturnPV YearR&DAdvertisingR =R&DAdvertising 0$1,000-$1,0000$150$ , Admissible Preferable Present Value Criteria

8-7 Internal Rate of Return ProjectYear 0Year 1ρProfitPV X-$100$11010%$43.77 Y-$1,000$1,0808%$

8-8 Benefit-Cost Ratio Benefit-cost ratio = B/C

8-9 Problems with the Benefit-cost Ratio MethodBCB/C I$250$ II$200$ I: Subtract $40 mistake from B $210$ I: Add $40 mistake to C $250$

8-10 Discount Rate for Government Projects  Returns in Private Sector  Social Discount Rate Concern for Future Generations Paternalism Market Inefficiency  Government Discounting in Practice

8-11 Valuing Public Benefits and Costs  Market Prices  Adjusted Market Prices shadow price  Monopoly  Taxes  Unemployment  Consumer Surplus Pounds of avocados per year Price per pound of avocados DaDa SaSa d A0A0 Sa’Sa’ $1.35 $2.89 b c g A1A1 e

8-12 Inferences from Economic Behavior  The Value of Time  The Value of Life Lost earnings Probability of Death

8-13 Valuing Intangibles  Subverting cost-benefit exercises  Reveal limits on intangibles  Cost-effectiveness analysis

8-14 Games Cost-Benefit Analysts Play  The Chain-Reaction Game  The Labor Game  The Double-Counting Game

8-15 Distributional Considerations  Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences  Government costlessly corrects any undesirable distributional aspects  Weighted benefits

8-16 Uncertainty ProjectBenefitProbabilityEV X$1, $1,000 Y $1,000 $2, Certainty Equivalent

8-17 Are Reductions in Class Size Worth It?  Discount rate  Costs  Benefits  The Bottom Line and Evaluation

8-18 Use (and Nonuse) by Government  Using Cost-Benefit Analysis  Not Using Cost-Benefit Analysis Clean Air Act Endangered Species Act Food, Drug and Cosmetic Act

8-19 Calculating the Certainty Equivalent Value Income per year Utility C E I* E + y U(E) U* U(E + y) U Expected income Certainty Equivalent