Lecture 3 Economic Efficiency and Cost Benefit Analysis Tianxu Chen Economics 387 Lecture 3 Economic Efficiency and Cost Benefit Analysis Tianxu Chen

Outline Economic Efficiency Cost-Benefit Analysis: Background Cost-Benefit Analysis: Basic Principles Valuing Human Life Cost-Effectiveness Analysis Cost-Utility Analysis, QALYs, and DALYs QALYs Revisited: Praise and Criticism Conclusions Appendix—Discounting

ECONOMIC EFFICIENCY Economic Efficiency Defined Economic efficiency exists when the economy has squeezed out every opportunity for net benefits possible through voluntary means. Demand Curve: willingness to pay Supply Curve: willingness to offer or say, marginal cost

Demand Curve Figure 4-1 Consumer’s Surplus The demand curve for apples represents consumers’ willingness to pay for various amounts of apples.

Supply Curve Figure 4-2 Producer’s Surplus In a competitive market, the supply curve measures the marginal costs for producers to bring apples to market

Maximum Social Welfare Figure 4-3 Efficient Quantity The economic criterion for maximizing well-being is to maximize the sum of the consumer and the producer surplus.

Efficiency of Competitive Markets In competitive markets, supply and demand provide the efficient quantities of goods to the market—prices ration supply and demand according to consumer preferences and producer costs.

Market Failure There is a wide range of goods for which such market signals are not readily available, these include bridges, parks, water purification systems, or mandated clean air. Decisions on whether to screen for certain types of cancers or whether to provide vaccines to the public, for example, must also be evaluated on criteria that do not easily lend themselves to market tests.

COST-BENEFIT ANALYSIS: BACKGROUND Public Policy By it’s nature public policy makes some people better off and others worse off and therefore from a societal perspective creates both benefits and costs. Cost-benefit analysis (CBA) measures benefits and costs of projects in money terms.

COST-BENEFIT ANALYSIS (CBA) CBA requires that we place dollar values on years of life or improvements in health and well-being. New ideas: economic evaluations to represent the entire collection of tools CEA and CUA have emerged as the principal alternatives to CBA.

Cost-Effectiveness Analysis (CEA) CEA applies to problems where the goal is accepted at the start and the problem is only to find the best, most efficient, means to achieve it.

Cost-Utility Analysis (CUA) CUA is a special form of CEA that introduces measures of benefits that reflect individuals’ preferences over the health consequences of alternative programs that affect them.

COST-BENEFIT ANALYSIS: BASIC PRINCIPLES Overview CBA rests on the premise that a project or policy will improve social welfare if the benefits associated with it exceed the costs. The benefits and costs that are counted must include not only those directly attributed to the project but also any indirect benefits or costs through externalities or other third-party effects.

Measurement Issues Costs are measured as opportunity costs. In public projects, both costs and benefits may not have a market to serve as a guide for monetary evaluation. Difficult-to-evaluate costs and benefits For example, a dam can destroy animal habitat or attract waterfowl.

Measurement Issues Public investments may have side effects that create additional measurement difficulties. Public project also raises similar questions of how to treat externalities.

Marginal Analysis in CBA Figure 4-4 Efficient Use of Resources Where Marginal Benefits Equal Marginal Costs The graph to the right shows the marginal social benefits and the marginal social costs from a pollution abatement program. Social welfare is maximized at Q1, where MSB = MSC.

Discounting Many public projects incur the costs immediately but have benefits that occur well into the future. Because benefits or costs that occur in the future are not equivalent to benefits or costs that occur today, the future benefits and costs must be discounted.

Reasons for Discounting First, a dollar today has opportunities other than the project of study. Second, people have a tendency to prefer the present when allocating spending.

Discounting Note the denominator becomes larger as t grows larger. This assumes that we discount the more distant future more heavily. Some discussion about the discount rate

Risk Adjustment and CBA In the market, there are many rates of interest reflecting differences in associated risk. Chief among the reasons that these differ is that projects that are relatively more risky tend to have relatively higher rates of interest. Often evaluators will adjust the social rate of discount to reflect the riskiness of the public project. However, pubic project’s risk might be difficulty to discern.

Risk Adjustment and CBA Public projects inherently differ in terms of their riskiness, so it is important that benefits and costs be discounted at a rate that accounts for the riskiness of the project being evaluated. Usual method: a probability distribution over project income New method: Certainty Equivalent-the value at which the decision-makers are indifferent between the risky set of outcomes and a value received with certainty.

Distributional Adjustments CBA primarily deals with the efficient use of society’s scare resources; however, when benefits are disproportionately distributed across the population, adjustments may need to be made in the analysis.

Inflation Inflation can be accounted for by introducing an inflation factor into the discount rate used in the analysis.

VALUING HUMAN LIFE Overview One of the most difficult but often unavoidable tasks in health care CBA is to place a value on human life.

Methods The human capital approach, estimates the present value of an individual’s future earnings. The willingness to pay or willingness to accept approach measures what individuals are willing to pay (accept) to avoid (accept) additional risk to life and limb. The contingent valuation approach elicits individuals valuation of alternative contingent risks.

Why do we Spend so Much on Health Care in the Last Years of Life? For many of the very old and sick, their resources have very low opportunity costs. They may rationally have “hope” for living, including the hope that more advanced health care will be developed within their extended lifetime. Their “social” value of life may be very high. The value of an extended life year may be as high for frail patients as it is for those of higher quality health.

Table 4-1 How Much Is One Life Worth?

VALUING HUMAN LIFE Many choose to describe the value of a human life as a bit over $6 million dollars while $100,000 describes the value of one life year.

TABLE 4-2 Costs and Benefits of Medical Technology for a Lifetime

COST-EFFECTIVENESS ANALYSIS Overview CEA compares the costs of achieving a particular nonmonetary objective, such as lives saved. In cost-effectiveness analysis, one assumes that the objective is desirable even if the benefits have not been evaluated in monetary terms.

CEA Measurement Let the change in social costs incurred due to a particular project be C1 - C0, and let the gain in health output be E1 - E0. Then the various projects are compared by the ratio:

Advantages of CEA Conceptually, this approach amounts to identifying the lowest cost approach of producing a given benefit. CEA can be a useful first step toward undertaking a cost-benefit study. If analysts run into significant problems in undertaking a CEA, it is unlikely that a CBA will be feasible.

COST-UTILITY ANALYSIS, QALYS, AND DALYS Overview Cost-utility analysis is a more practical variation of cost-effectiveness analysis. Quality-adjusted life-year (QALY) is one type of CUA. Disability-adjusted life-year (DALY) is another type of CUA.

Measurement Projects are evaluated on the basis of their incremental costs per extra QALY delivered to the patients or other subjects (Garber and Phelps, 1997; Ried, 1998). where Fi is the probability that the person is still alive at age i; d is the time discount factor; and the value qi is the quality weight

Quality-adjusted life years (QALYs) Adjust quantity of life years saved to reflect a valuation of the quality of life If healthy QALY = 1 If unhealthy QALY < 1 No matter what measure you use the important thing is what you do with them, use them to adjust the quantity of life in a health state to give an outcome measure which represents both quality and quantity.

QALY procedure Identify possible health states - cover all important/relevant dimensions Derive utility ‘weights’ for each state Multiply life years (spent in each state) by ‘weight’ for that state.

Calculating QALYs example Weights: Good health = 1 moderate health = 0.8 poor health = 0.5 LYs: Year 1 + year 2 + year 3 = 3LYs (1+1+1) QALYs: Year 1(x0.5), year 2(x0.8), year 3(x1) = 2.3 QALYs (0.5+0.8+1) Intervention may increase recovery such that year 1(x0.8), year 2(x1), year 3(x1) = 2.8 QALYs (0.8+1+1) No difference in LYs but gain in QALYs

QALYS REVISITED: PRAISE AND CRITICISM Praise for QALYs Provides another technique for judging public projects. Accounts for the notion that each person is entitled to a life in which he or she can use a basic set of capabilities to achieve personal goals in life. Importantly, these capabilities would include basic health and functioning.

Critique of QALYs A developing criticism of CUA with QALYs focuses on the method’s linear valuation of medical interventions as the simple sum of quality gains times life-years saved times the number of people treated. It has long been pointed out that QALYs tend to place a reduced value on older people when evaluating a medical intervention. QALYs are not consistent with standard Pareto based welfare economics.

Disability-adjusted life-year (DALY) DALY points out that we humans tend to dependent on the middle age groups when we are very young or every old. To the adherents of this view, the greater social related weights should be placed on people in the middle age groups.

Note on CUA CUA still does not address: Allocative efficiency: is health gain ‘worth’ more than benefits those resources could yield elsewhere (health or non-health)? Valuation of non-health benefits eg process, information, convenience Valuation of non-use benefits ie externalities, option value

CONCLUSIONS Cost-Benefit analysis Cost-Effectiveness analysis Cost-Utility analysis (QALYs)

APPENDIX - DISCOUNTING The Problem An analyst might be asked to compare Investment A, which provides $20 at the end of Year 1 and $20 at the end of Year 2, with Investment B, which provides $12 at the end of Year 1 and $29 at the end of Year 2. Although Investment B returns $41 over the 2 years compared to $40 for Investment A, most of the return on Investment B comes later, at the end of Year 2.

What is Discounting? Discounting is a method that accounts for differences in the timing of benefits or costs associated with different projects.

How does it work? Suppose George is offered the opportunity to buy a bond that will return $1, one year from now. How much is he willing to pay now? Since George always has the option to keep his money and earn interest rate r, the present value of $1 to be received 1 year from today (x1) is:

In General, In summation notation, the present value of a stream of returns R and costs C, over time, is given by: