Chapter 4: Cost-Benefit Analysis Chapter 4 Cost-Benefit Analysis Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter 4: Cost-Benefit Analysis Introduction Cost-benefit analysis Building a factory Benefits from improving the safety of a highway Mistakes to avoid Benefits from building a highway Reducing global warming Paying for a costly medical treatment Intervening militarily

Chapter 4: Cost-Benefit Analysis Cost-Benefit Analysis A project should be undertaken if its benefit to society exceeds its costs to society. Cost-benefit analysis is the measuring of the costs and the benefits of a project to help decide: Whether to undertake the project The scale of the project Who uses cost-benefit analysis? Private firms Individuals Government

Chapter 4: Cost-Benefit Analysis Cost-Benefit Analysis The optimal scale of the project is Q*. Q* $ Scale of the project (Q) MSB MSC Figure 4.1

Chapter 4: Cost-Benefit Analysis A Private Firm: Building a Factory Should a firm build another factory? Assumptions: The factory will be built in one year (Year 0) The factory will last one year (Year 1) before wearing out The construction cost in Year 0 = $100,000 The profit from the factory in Year 1 = $110,000

Chapter 4: Cost-Benefit Analysis A Private Firm: Building a Factory Building with borrowing: Will the firm build if the interest rate is 5%? 15%? The firm borrows $100,000 in Year 0 to pay for the construction cost The present discounted value (PV) of a future amount at a future date is the amount you would need to put in the bank today to have that future amount by that future date.

Chapter 4: Cost-Benefit Analysis A Private Firm: Building a Factory Multi-year profits $55,000 in Year 1 $60,500 in Year 2 r = 10% PV of profits = $55,000 (1+ r ) $60,500 (1+ r ) 2 + = $100,000 = $50,000 + $50,000 $55,000 (1.10) $60,500 (1.21) + = Example

Chapter 4: Cost-Benefit Analysis A Private Firm: Building a Factory PV of $110,000 in Year 1 = $110,000 (1+ r ) Table 4.1 r = 5% r = 15% PV of Profit$104,762$95,652 Cost of Project$100,000 Correct DecisionBuildDon’t Build This is true even when a firm uses their own money to finance the construction of the factory.

Chapter 4: Cost-Benefit Analysis Government: Building a Highway Costs Current construction costs Discounted future maintenance costs Benefits What drivers are willing to pay to use the highway in all future years measured as the discounted dollar value of time saved

Chapter 4: Cost-Benefit Analysis Government: Building a Highway Measuring benefit of time saved through Increased Output Estimate how much more output commuters could produce at work if they decreased commute time Example Commuter is paid $20/hr Saves 1 hour of commute time each day because of the new highway Commuter works 250 days a year Time savings = (250 days)(1 hour)($20) = $5000

Chapter 4: Cost-Benefit Analysis Government: Building a Highway Measuring benefit of time saved through Revealed Preference Look at commuter location preferences and estimate how home prices differ depending on commute time. Example Two identical homes in two different suburbs One house is associated with a shorter commute The house associated with the shorter commute costs $20,000 more than the other house. The difference in price “reveals” the value of time saved

Chapter 4: Cost-Benefit Analysis Government: Building a Highway Measuring benefit of time saved through Contingent Valuation Pose a hypothetical question that asks commuters how much they would be willing to pay to reduce their daily commute by one hour. Issues Critics argue surveys produce unreliable results because answers may be sensitive to wording, presentation, etc. Supporters argue that actual market behavior is also subject to similar problems Supporters argue surveys improve with experience

Chapter 4: Cost-Benefit Analysis Benefits of Improving the Safety of a Highway The safer the highway, the greater the cost of building it. Measuring the value of lives saved through Increased Output Estimate how much that person would have produced over the rest of his life. Issues If person A is paid more than person B, then person A is valued higher than person B How do you value the surviving family’s suffering?

Chapter 4: Cost-Benefit Analysis Benefits of Improving the Safety of a Highway Measuring the value of lives saved through Revealed Preference Estimate how much people actually pay to reduce their chance of dying Compensating Differential Measuring the value of lives saved through Contingent Valuation Pose a hypothetical question that asks commuters how much they would be willing to pay to reduce their chance of death on the highway from 2 in 1000 to 1 in 1000

Chapter 4: Cost-Benefit Analysis Benefits of Improving the Safety of a Highway The value of the life of a person we don’t know personally Measuring the value of lives saved through The Value of a Statistical Life Approximately $8 million Is the VSL different for a young person as compared to an old person?

Chapter 4: Cost-Benefit Analysis Mistakes to Avoid Counting job creation as a benefit Double counting the same benefit Counting secondary benefits

Chapter 4: Cost-Benefit Analysis Reducing Global Warming How much should each country cut back on its emissions of greenhouse gasses? Costs: carbon fuel use must be reduced Benefits: reduced global warming Uncertainty and the risk of catastrophe The social discount rate is the rate analysts use to compute the present value of future benefits A cost-effectiveness analysis focuses on achieving the given objective at a minimum cost

Chapter 4: Cost-Benefit Analysis Paying for a Costly Medical Treatment Patients and families want the best care, which tends to be costly. Should the insurer pay for the care? A medical treatment costs $1 million, and it will extend the life of the patient by 1 year. What if the patient is 100? Example What if the patient is 80? What if the patient is 20?

Chapter 4: Cost-Benefit Analysis Intervening Militarily Should a particular military intervention be undertaken? Costs: military budget cost, cost of lives lost, suffering of veterans, disability payments, etc. Benefits: historians, military scientists, international relations experts, and political scientists will determine the benefits.

Chapter 4: Cost-Benefit Analysis Cost-benefit analysis Building a factory Benefits from improving the safety of a highway Mistakes to avoid Benefits from building a highway Reducing global warming Paying for a costly medical treatment Intervening militarily Summary

Chapter 4: Cost-Benefit Analysis Preview of Chapter 5: Social Security Four ways to prepare for retirement The U.S. Social Security system Reforming Social Security