Notes for Chapter 6 ECON 2390

2 Benefit cost analysis Many definitions and perspectives  Determines optimal policy from the perspective of either government or society (never households, associations, or businesses)  It measures the benefits and costs arising from a policy accruing to all “relevant” parties and determines the “net” benefits.  Kaldor-Hicks criterion  If the gains of those who benefit from a policy exceed those of the losses those who lose, then the change should be made.  Net social benefits = total social benefits – total social costs

3 Steps to Cost-Benefit Analysis Specify the alternative scenarios (there only needs to be one) Whose costs and benefits count (parties of standing) Catalogue (in a table) the nature of the costs and benefits for each party Calculate the costs/benefits experienced over the horizon of the project Calculate the money equivalent of each cost and benefit Apply the appropriate discount rate and compute the net present value of costs and benefits Calculate the benefit-cost ratio

4 Parties of standing Every cost benefit problem needs to define its scope. Parties of standing are those who experience a cost or benefit in the form of Lost/gained income Lost/gained capital value (value of property) Lost/gained time Parties of standing typically do not include those with political or moral preferences for a particular state A major challenge is to define the parties of interest and the scope of the problem.

5 Catalogue the benefits and costs of each party Regulation on chemical use by farms, municipalities and residential property owners Party of standingCostsBenefits Farmers Residential property owners Municipalities Others??

6 Determine the horizon of the project In theory, projects can be seen as having benefits over an extended time. However, beyond 10 – 15 years to things occur: The uncertainty over predicted costs and outcomes increases The monetary value of costs and benefits declines the further into the future that these occur (time value of money) (see separate notes on discounting) Another important factor is that government often has a limited capacity to deal with the long-term (e.g., dealing with climate change).

7 Money equivalent of benefits and costs Some benefits and costs have a direct money equivalent Avoided loss of income of commercial fishers (because fish losses decline or are avoided) Loss of agricultural yield because farmers are required to use less effective measure of weed and insect control Costs of enforcing regulations on chemical use (monitoring and prosecutions) Other costs/benefits are more difficult to “monetize” Enjoyment of recreational users (cleaner water, increase fish catches from sport fishing)

8 Discount rate Make sure you read and understand the notes on time value of money. All cash received (income) or spent (costs) over time has a declining value the farther out the receipt/expenditure The interest we use to calculate the present value has a large impact on the total value of benefits and costs. The higher the interest rate, the smaller the present value of future income/costs The declining time value of money as one goes farther out is a basic concept in finance and economics.

9 Socially Efficient Scale and BCA The socially efficient scale of pollution is where MAC = MD. If no abatement (MAC = 0) at E max Moving to a partial abatement the total damages reduced = a+b at a cost b, for a net of a. (at E 1 ) By reducing emissions to point E*, the total damages reduced = a+b+c+d with a total cost of c+b for a net gain of a+d. Reducing emissions lower that E* ( to E 2 ) will incur a total cost (e+f) that exceed the benefit (reduced damage) = f for a net of e. Remember the area under the marginal curve between two levels of emissions is the total Area under the MAC is the total abatement cost Area under the MD is the total cost of damages

10 Comparison of costs and benefits New benefits = total benefits minus total costs The total benefits are the total damages eliminated by a reduction in a given level of emissions. The total costs are the total abatement costs needed to reduce that given amount of emission. This may be positive or negative. If the benefits and costs persist over a year, we need to calculate the discounted present value of net benefits.

11 Discounted net benefits When benefits and costs accrue over time, we need to discount. Many government agencies set the discount rate for studies to be used – common numbers are 5%, 8% and 10%. Some economists argue that the discount rate for public (government) projects should be the same as used by private firms.