1. B/C – A and distributional issues (Cost Benefit Analysis DEC 51304) Zerbe & Dively Ch.11 R. Jongeneel

2. Lecture Plan  Basics  Full Compensation Criterion  Kaldor-Hicks criterion  Identify gainers and losers  No undesirable transfers  Opportunity cost rule  Use distributional weights

3. Basics   h : marginal social utility of income of individual h   h :  h -  h MUY h times MSU h  Problem: uncertainty w.r.t. MSUY h efficiency distribution

4. Full compensation criterion  Assumes nothing is known about MSUY h  Accepts Pareto Principle as decisive criterion  Requires that losers from a policy change are fully compensated from the gains of the winners  Conclusion: PPI is actually realized!

5. Example: Full compensation criterion (before) GroupMSUY (a h )Net benefit Distributional effect Change in economic welfare Poor1.2-70-14-84 Rich0.8+110-22+88 Total+40-36+4

6. Example: Full compensation criterion (after) GroupMSUY (a h )Net benefit Distributional effect Change in economic welfare Poor1.2000 Rich0.8+40-8+32 Total+40-8+32 Assumption: zero transfer costs

7. The Kaldor-Hicks criterion  Basic rule:  Ignores distributional effects / assures same MSUY for all h’s  Simply calculates the present value of costs and benefits and evaluates whether NPV benefit exceeds NPV costs

8. The Kaldor-Hicks criterion Defense:  Distributional effects easy to identify and remedy  Existing distribution (chosen by government) and already optimal (implying equal MSUY h for all h) Criterion:  Potential Pareto Improvement  Compensation possible, but not actually carried out

9. Identify gainers and losers  Avoid problem of distributional assumptions  Simply identifies who gains (and how much) and who loses (and how much)  Let the policy maker decide

10. No undesirable transfers (Willig & Baily)  Accepts widely used assumptions: i) MSUY decreases as Y increases ii) MSUY is non-negative for all h iii) It is undesirable to transfer money from a poorer to a richer individual  Rank all individuals from poorest to richest A>B if

11. No undesirable transfers  Net benefits must be superior at each stage of the summation process from poorest to richest income group  Weaknesses: - Some policy changes with net social welfare benefits might be rejected (no regressive transfers) - Results are sensitive to group definition

12. Opportunity cost rule (Harberger)  The benefit of a transfer cannot be greater than the cost of making the transfer by the most efficient alternative means (opportunity costs) Example I PoorMiddleRichTransfer B or C NB NB K-H+40+29-700 NB Opp.Cst+40+29-70+8+7 Harberger: Net transfer cost only 1 (cf.-1) instead of 20% of +40 (=8)

13. Opportunity cost rule (Harberger) Example II PoorMiddleRichTransfer B or C NB NB K-H-100+50+580+8 NB Opp.Cst-100+50+58-20-12 Harberger: Taking into account the costs of actually compensating the poor (20% of 100=20) makes the project undesirable

14. Distributional weights  Attach explicit weights to costs and benefits accruing to different groups with weight of class k equal to w k