PPA 723: Managerial Economics Lecture 21: Benefit/Cost Analysis 2, Valuing Benefits and Costs The Maxwell School, Syracuse University Professor John Yinger

Managerial Economics, Lecture 21: Valuing Benefits & Costs Outline  Where to Look for Benefits and Costs  Valuing Benefits and Costs

Managerial Economics, Lecture 21: Valuing Benefits & Costs Collapsing Across Outcomes  Today we investigate the B/C tools that help combine program impacts in different markets or on different outcomes.  This “collapsing across outcomes” has 2 steps:  Identify the relevant outcomes.  Express the outcomes into dollar terms, that is, in terms of willingness to pay.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Where to Look for Program Impacts  In most cases, government projects are supposed to correct some market failure or inequity.  So the best way to start a B/C analysis is to identify this “correction” and determine what impacts it involves.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Resources Gained and Lost  A project takes resources out of the private sector (costs) and returns them in the form of government services (benefits).  A good project obviously generates more benefits than costs.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Project Costs: Resources Used Benefits: Resources Gained Difference = Net benefits Resources Gained and Lost, 2

Managerial Economics, Lecture 21: Valuing Benefits & Costs Selecting an Accounting System  A word of caution: do not get hung up on the labels assigned to various program impacts.  Project-induced pollution, for example, could be a negative benefit or a cost.  As long as the signs are correct, these labels have no impact on the final net benefits.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Ripple Effects  A project’s effects generally are not confined to the obvious. For example,  Taxpayers change their spending habits and spend less for certain goods.  Participating firms may have more profits.  The farther from the circle you get the more nervous you should be about claiming B or C.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Ripple Effects, 2 Project Costs Benefits Ripple Effects

Managerial Economics, Lecture 21: Valuing Benefits & Costs Managing Complexity  How do we handle all this complexity, short of modeling the whole world?  The key is to recognize that  In almost all cases, these ripple effects represent a shuffling of the benefits or costs;  That is, they transfer resources from one group to another  And are important only to the extent that they influence equity.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Introduction to Transfers  Consider this B/C table: GroupCostsBenefitsNet TaxpayersProgram Cost =CY-C ParticipantsYParticipant benefits = B 1 B1B1 Other CitizensSpillover benefits = B 2 B2B2 Group 4X-X Group 5XX TotalC+ X+ YB 1 + B 2 + X+ YB 1 + B 2 - C

Managerial Economics, Lecture 21: Valuing Benefits & Costs Looking Ahead  So X and Y don’t affect the (unweighted) total but do affect outcomes for particular groups.  We will return to these “transfers” and how to handle them in the next lecture.  Today we focus on the benefits and costs in the main circle.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Consumer Surplus and Cost/Benefit  A demand curve indicates the quantity demanded at a given price or the willingness to pay for another unit at each quantity.  The latter interpretation leads to the notion of consumer surplus, which is the aggregate willingness to pay for some quantity above the price paid.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Total Willingness to Pay  Similarly, total willingness to pay is the area under the demand (=MB) curve: $ Q D = MB

Managerial Economics, Lecture 21: Valuing Benefits & Costs Valuing a New Good  Some government programs provide a new good, such as visits to a (new) park.  The benefits equal the total willingness to pay up to Q*, the quantity provided.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Valuing a New Good, 2 $ Q Q* D = MB

Managerial Economics, Lecture 21: Valuing Benefits & Costs Valuing a Price Change  Sometimes a project lowers the price of a good from P 1 to P 2.  A dam might lower the price of water for irrigation, for example.  The benefits equal the change in consumer surplus.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Valuing a Price Change, 2 P1P1 P2P2 D = MB

Managerial Economics, Lecture 21: Valuing Benefits & Costs Other Ways to Obtain WTP  Other methods for obtaining a measure of WTP include  Valuing goods at their market price  Using adjusted market prices  Estimating Cost Savings  Using property value effects

Managerial Economics, Lecture 21: Valuing Benefits & Costs Using Market Prices  If a government program adds products that already are sold in a market,  And if the number of units added is small relative to the existing market,  Then the products can be valued at the market price, which is a measure of marginal willingness to pay.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Use Adjusted Market Prices  Sometimes these conditions for using market price are met, but the market price is not an accurate measure of marginal benefits because the market has an externality of a monopoly.  In this case, raise the observed price to account for a negative externality or monopoly and lower it to account for a positive externality.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Use Cost Savings  Many government programs or projects result in cost savings.  A program to remove rats or mice lowers the costs of treating asthma.  Cleaning up lead paint saves the cost of treating lead- paint disorders.  A new highway saves commuters time.  Cost savings are benefits because people are willing to pay $1 for $1 of cost savings.

Managerial Economics, Lecture 21: Valuing Benefits & Costs Use Changes in Property Values  If you cannot measure benefits directly, you may be able to pick them up in property value changes.  People pay more for houses (or apartments) to capture the benefits of shorter commutes or better access to a park.  But be careful; one cannot use a direct measure of benefits (time savings, park benefits) and property values. (More on this in the next class.)

Managerial Economics, Lecture 21: Valuing Benefits & Costs Economic Rent  Another type of benefit refers to factors of production, not consumption.  Economic Rent (another name for Producer Surplus) is the amount a supplier of labor, capital, and entrepreneurship receives over and above the minimum needed to get him or her to work.

Managerial Economics, Lecture 21: Valuing Benefits & Costs W Market Wage = W* Economic Rent SLSL L Economic Rent in the Labor Market

Managerial Economics, Lecture 21: Valuing Benefits & Costs Changes in Economic Rent as a Benefit Changes in economic rent are legitimate benefits from a program. WARNING: If a market is in equilibrium, changes at the margin do not generate economic rent. In equilibrium, the marginal worker is indifference between work & leisure; hiring that worker brings benefits (wages) just equal to her costs (lost leisure).

Managerial Economics, Lecture 21: Valuing Benefits & Costs Economic Rent and Unemployment  With unemployment, there is potential economic rent, even at the margin. Economic Rent at the Margin L = Employment Market Wage = W* W SLSL

Managerial Economics, Lecture 21: Valuing Benefits & Costs Jobs Benefits in B/C Hence, a program might be able to generate jobs benefits (= economic rent) at the margin. This is the only sense in which creating jobs yields benefits in B/C However, unemployment does not guarantee such benefits because of possible displacement, which is discussed next class.