Chapter 10 CBA and valuation1 CHAPTER 10 Cost-Benefit Analysis and Valuation

Chapter 10 CBA and valuation2 Cost-benefit analysis Typical questions –Investment in a nature preserve area? Costs can be determined (but how)? Benefits: difficult => valuation methods –New road network? Benefits might be estimated But what about the costs (in particular for nature and landscape)? => valuation methods

Chapter 10 CBA and valuation3 Cost-benefit analysis (general expression) NPV = net present value (see also chapter 4) B = benefit C = costs N = net result (can be negative!) i = discount rate (assumed to be constant during the total period) T = total period of the project t = time (in years).

Chapter 10 CBA and valuation4 Cost-benefit analysis; alternative route to quantify General expression (national perspective) Reminders: –Aggregation over time! –Framework not always suitable W= Welfare CS= Consumer surplus PS= Producer surplus GR= Government revenue EE= External effects

Chapter 10 CBA and valuation5 Cost-benefit analysis (principles) Opportunity costs Discount rate Theoretical basis –Pareto criterium –Hicks Kaldor criterium Level of analysis (regional, national, etc.)

Chapter 10 CBA and valuation6 Cost-benefit analysis (classifications) Primary /Secondary benefits and costs (goal); Example: –Road (primary goal) –Attracts an industry (secondary goal) (Both secondary benefits and costs!) Direct and indirect benefits and costs (main actor / other actors); Example: –Government is main actor (direct) –Other actors (e.g. Producers & consumers): indirect

Chapter 10 CBA and valuation7 Cost-benefit analysis Harberger rule: Only include effects on ‘other’ markets if they are: –Related and –Distorted This Harberger rules contributes substantially to ease Cost-benefit analysis in market economies!

An example of CBA for a project with considerable external effects Look at the complete set-up and also the wording Only main categories have been provided (based on an actual example) Difference between a national and a regional approach (e.g. rural area) Chapter 10 CBA and valuation8

9 National CBA Scheme; nature CostsBenefits Net product of factors in previous use ANet product generated by nature E Cost of additional factors BNet product of released factors F MaintenanceCNon-marketable benefits from nature G Non-marketable benefits; previous use DAllocation lossesH TotalS S

Chapter 10 CBA and valuation10 Rural CBA Scheme; nature CostsBenefits Net product of factors in previous use ANet product generated by nature E Cost of additional factors BNet product of released factors FrFr MaintenanceCNon-marketable benefits from nature GrGr Non-marketable benefits; previous use DrDr Allocation lossesHrHr TotalSrSr SrSr

Chapter 10 CBA and valuation11 Valuation in relation to ‘nature’ Elements of total economic value (TEV) –Measurable by price mechanism: secondary benefits (Direct / Indirect) –Not measurable by market price mechanism Use values –Current: primary benefits –Future use value: option value Non-use value –Existence value (several items) –Bequest value (future generations) –Vicarious use (non-users => users)

Chapter 10 CBA and valuation12 Valuation in relation to ‘nature’ (fig) Total value Value measurable by the price mechanism: Secondary benefits Value not measurable by the price mechanism Direct secondary benefits Indirect secondary benefits Use valueNon-use value Current use value: Primary benefits Future use value: Option value - existence value - bequest value - vicarious-use value

Chapter 10 CBA and valuation13 Traditional valuation methods Market approach (see chapter 5) –Exchange value at the market Income approach –Expected value of future net benefits Cost approach –Compensation for the costs of producing the goods

Chapter 10 CBA and valuation14 Non-market valuation; principles Central issue is: what are individuals willing to pay (for more public goods) or willing to accept (less public goods) Compensating and Equivalent welfare measures now Compensating Surplus (CS) and Equivalent Surplus (ES): changes in quantities!

Chapter 10 CBA and valuation15 Valuing changes in public goods? Inverse Hicksian demand curves for public goods x pxpx p x (x|p q0,q 0,u 0 ) p x (x|p q0,q 0,u 1 ) A B x0x0 x1x1 CS WTP CS WTA ES WTP ES WTA From x 0 to x 1 Without change: u 0 With change: u 1

Chapter 10 CBA and valuation16 Stated Preference techniques Contingent valuation (WTP/WTA) –Hypothetical market –Obtaining bids –Estimating WTP/WTA Choice modelling –Evaluating attributes (different combinations)

Chapter 10 CBA and valuation17 Observations on WTP / WTA Reference point is important One observes systematic differences: WTA>> WTP Cannot be explained by standard neoclassical economic theory =>prospect theory; takes the reference point into account

Chapter 10 CBA and valuation18 Revealed preference techniques Starts from actual observations on behaviour in the market Travel cost method –Calculated from number of visits and travel costs –Travelling is a disutility –Does not consider substitution possibilities –Only the use value is estimated –How to valuate time?

Chapter 10 CBA and valuation19 Revealed preference techniques Hedonic pricing –Based on price differences due to specific characteristics (e.g. the environment) –Often based on differences in house prices (transactions of a property which has both individual characteristics and an implicit valuation of the ‘environment’) –Data and level of detail can be a problem Example P = ‘transaction’ price ; z’s are attributes

Chapter 10 CBA and valuation20 In practice Method depends a lot on: –Type of question –Available data There will always be discussion about non-market valuation methods

Non-market valuation; principles Central issue is: what are individuals willing to pay (for more public goods) or willing to accept (less public goods) Compensating and Equivalent welfare measures (importance of reference point) 21Chapter 10 CBA and valuation

Non-market valuation; principles 22Chapter 10 CBA and valuation

Observations on WTP / WTA Reference point is important One observes systematic differences: WTA>> WTP Cannot be explained by standard neoclassical economic theory =>prospect theory; takes the reference point into account 23Chapter 10 CBA and valuation

Conclusions Cost-Benefit Analysis is powerful method to determine consequences of different alternatives (if one believes the basic assumptions of welfare economics) The provision of public goods and the valuation of external effects might is not an easy task Several methods are mentioned Chapter 10 CBA and valuation24