COST-BENEFIT ANALYSIS What is it? Why do it? How’s it done? Associate Professor Richard Brown r.brown@economics.uq.edu.au

Cost-Benefit Analysis What is CBA? A method for evaluating projects, policies, programs More precisely: A process of identifying, measuring and comparing the social benefits and costs of an investment project, program or policy intervention, from a public interest perspective CBA is used for both prospective (appraisal) and retrospective (evaluation) Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis What is CBA? Used primarily but not exclusively in public sector decision-making Some examples: investment in public infrastructure – roads, schools, hospitals, dams, universities, R&D public policies and regulations: health and safety, air and water quality, smoking, speed limits Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis Why CBA? Why for public sector? Why not leave all investment decisions to private sector, based on calculations of financial profitability? Market failure! The free market is not always capable of providing the correct price signals to guide private investment decisions in the ‘right direction’ Markets can be distorted for various reasons Price distortions inefficient outcomes Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis Why CBA? Why for public sector? Purely market-based decisions by private sector do not always deliver an outcome that is socially desirable – in the best interests of the public at large Private sector unlikely to invest in roads, dams, schools, hospitals, defence, etc. if left completely to the free market Why? Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis Three main reasons for market failure: uncompetititve market structures eg. monopolies, oligopolies, etc. government interventions eg. taxes, subsidies, import duties, price controls, quotas externalities i.e. costs and benefits arising from a decision (investment) not born/received by the private investor making the decision eg. air pollution (external cost), education (external benefit) Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis Correcting for market failure and price distortions Aim is to come up with interventions that would bring investment decision-making more in line with the socially desirable outcomes Various means to steer private and public sector decisions towards more efficient, socially desirable outcomes: regulations and penalties; eg. fines for speeding, smoking in public, noise, anti-competitive behaviour taxes and subsidies to correct for externalities eg. ‘sin taxes’ on alcohol, tobacco, gambling Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis Correcting for market failure and price distortions: Tradeable permits - where markets do not exist ‘create’ a market eg. tradeable permits for carbon trading Application of CBA - using a different set of prices ‘Shadow Prices’ used in calculation of profitability ‘Shadow Prices’ = ‘Opportunity Cost’ We have two types of shadow prices: ‘adjusted’ market prices - to offset distortions ‘non-market values’ – where prices non-existent Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis What main economics principle underlies CBA methodology? Standard CBA methodology requires the application of the core economics concept of opportunity cost We have limited resources and unlimited wants or needs The key economics question is how to make best use of our limited resources By using them for the production of a given output will yield certain benefits. Using them for the production of some other good (or service) generates other benefits Which produces the greater benefit to society? Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Standard CBA Methodology: Opportunity Cost Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Comparing ‘with’ vs ‘without’ Scenarios $ net benefit Measure this – the difference The ‘with’ project scenario NOT THIS! The ‘without’ project scenario The ‘before’ project scenario Project introduced Time/years Richard Brown: UQ Economics Schools' Day, July 2015

What do we mean by the public interest? A private or public sector project has implications for: Government revenue – taxes, charges Government expenditure – provision of services Employment The Economy The Environment These need to be assessed as part of a CBA before project or policy approval Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Practical Examples: Comparing ‘with’ vs. ‘without’ scenarios Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Practical Examples: Using Opp. Cost in Place of Market Price Remember: OC = value in alternative use Ask: (i) How would resource otherwise be used? and (ii) What is value in alternative use? Example 1: A project generates 100 new jobs for otherwise unemployed youth, paid say $20 In Private Profitability calculation labour would be costed at 100 x $20 = $2000 In CBA we would first ask “What is value of labour’s output in alternative use?” Assume they have casual/informal work equivalent to $5 each In CBA labour would be costed at 100 x $5 = $500 Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Practical Examples: Using Opp. Cost in Place of Market Price So what? How would use of opportunity cost of labour in a CBA change anything? By costing labour at lower opportunity cost, projects that generate relatively more jobs would be ranked higher - prefered Example 2: A project requires 100Mwh of electricity per day. The power company charges $5 per Mwh In private profitability calculation electricity costed at $500/day In CBA we need to ask first, where would that additional power supply come from, and, at what opportunity cost? Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Practical Examples: Using Opp. Cost in Place of Market Price Example 2 (cont.): Case A: If the power supply system is already operating at full capacity, we would have to divert it from other users The opportunity cost would be the loss of output to them Assume lost output = $8, then opportunity cost = $800 Case B: If there is spare capacity, we would price it at the marginal cost of producing more output Assume marginal cost = $3, then opportunity cost = $300 CBA shows higher net benefit when there is spare capacity Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Practical Examples: Using Opp. Cost Where No Market Price Example 3: A proposed coal-fired power project generating additional electricity is expected to make a profit of $1250 But, the production of power also produces 50 tonnes of carbon pollution for which the producer is not charged In CBA we include the cost to society of the carbon pollution If the economists value this at, say, $30 per tonne the CBA would recalculate the ‘economic profitability’ at $1250-1500 ($30x50) = -$250 (ie. from an economic point of view there would be a loss) The implication is that a less financially profitable project which produces less or no carbon would appear more profitable in the CBA and thus preferred from a public interest perspective Richard Brown: UQ Economics Schools' Day, July 2015

Richard Brown: UQ Economics Schools' Day, July 2015 Practical Examples: Using Opp. Cost Where No Market Price Example 4: A proposed health sector project is expected to reduce human fatalities by 10 persons per annum As there is no ‘market price’ for an avoided fatality (a saved human life) a financial profitability calculation would show no $ benefits for this In CBA we include the value to society of each human life saved Moral and ethical issues/objections? A thought experiment using universal speed limit of 10km/hour which eliminates all road fatalities. For or against? Richard Brown: UQ Economics Schools' Day, July 2015

Comparing Costs & Benefits Among Stakeholders The underlying principle of CBA is that net benefits should be positive for a project to be considered worthwhile Total Benefits – Total Costs > $0 BUT… this does not necessarily mean that all stakeholders gain – some will but others will no doubt lose We need to look at the distribution of net benefits among stakeholders - who gains and who loses, and how much? In some instances the project will not succeed if the costs and benefits are unevenly distributed – complementary policies might be recommended to compensate the losers Richard Brown: UQ Economics Schools' Day, July 2015

Comparing Costs and Benefits Over Time We cannot compare dollar values that accrue at different points in time To compare costs and benefits over time we apply the concept of “discounting” The reason is that $1 today is worth more than $1 tomorrow WHY? Richard Brown: UQ Economics Schools' Day, July 2015

Comparing Costs and Benefits Over Time Inflation – purchasing power of $ declines in real terms as prices rise ‘Opportunity cost’ – you could have earned some income (eg. interest) Risk – some unforeseen event in the future ‘Pure time preference’ – more distant objects appear smaller Richard Brown: UQ Economics Schools' Day, July 2015

Comparing Costs and Benefits Over Time Year 0 1 2 3 Project A -100 +50 +40 +30 Project B -100 +30 +45 +50 WHICH PROJECT OPTION: A or B ? Cannot say until we convert all future values into present day equivalent values – discounting using ‘discount factors’ Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis: Further Thoughts Decision-support vs. decision-making? CBA cannot remove from the decision-maker ultimate responsibility for a decision In this sense I prefer to think of CBA as a decision-support rather than a decision-making process: its ultimate purpose is to better inform the decision-making process rather than replacing it In many respects it is also the process of applying the principles of CBA, using a coherent framework and ‘thinking like an economist’ that is more important than the numbers generated by a CBA Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis: Further Thoughts I’ve been teaching and practicing CBA for almost 40 years! “What’s different today, I am often asked?” Two major innovations in recent decades affecting the practice of CBA - one technological and one methodological invention of the PC and electronic spreadsheet (Excel), and, development of non-market valuation methods and techniques for valuation of environmental and other non-market, ‘intangible’ costs and benefits Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis: Further Thoughts Do a CBA of a CBA! Richard Brown: UQ Economics Schools' Day, July 2015

Cost-Benefit Analysis: Further Thoughts CBA can be applied to any decision/situation, but beware ... it could get you into trouble if taken too far! Richard Brown: UQ Economics Schools' Day, July 2015

PRIMARY REFERENCE Benefit-Cost Analysis: financial and economic appraisal using spreadsheets H.F. Campbell and R.P.C. Brown Cambridge University Press, 2003 (2ND Edition Routledge, 2015, in press) Companion website has a number of worked case studies: www.uq.edu.au/economics/bca Login to “Other Users” username=user; password=abc2004 My contact: r.brown@economics.uq.edu.au Richard Brown: UQ Economics Schools' Day, July 2015

Questions and Comments Thank you