1. Engineering Economics in Canada Chapter 10 Public Sector Decision Making

2. Copyright © 2006 Pearson Education Canada Inc. 10-2 10.1 Introduction Organizations and engineers need to take into account the effects of what they do on society as a whole. This is because the market prices that guide most decisions may not reflect all the social benefits and costs adequately. Airport, highway, nuclear power, etc. When we consider the broader social context, the concept of profitability is extremely difficult to define because the frame of reference is society at large.

3. Copyright © 2006 Pearson Education Canada Inc. 10-3 10.1 Introduction…con’t In this chapter we look at the social aspects of engineering decision making. First, we consider the reasons markets may fail in such areas as the environment and health. –We also consider methods that society uses to correct these failures. Second, we consider decision making in the public sector. –Here we are concerned mainly with government or government-supported projects.

4. Copyright © 2006 Pearson Education Canada Inc. 10-4 10.2 Market Failure A market is a group of buyers and sellers linked by trade in a particular product or service. The prices that guide decisions usually reflect all the social benefits and costs of engineering decisions. When prices do not reflect all social benefits and costs of a decision, we say that there has been market failure. Market failure occurs when a market, left on its own, fails to make decisions in which resources are allocated efficiently.

5. Copyright © 2006 Pearson Education Canada Inc. 10-5 Market Failure…con’t Why does market failure occur? 1.there may be no market through which those affected by the decision can induce the decision maker to take their situations into account. (Airport) 2.a single buyer or seller (a monopolist) can influence prices or output. 3.someone decides not to do something that would create benefits to others.

6. Copyright © 2006 Pearson Education Canada Inc. 10-6 Remedies for Market Failure Formal methods to remedy market failure: 1.Government-set policy instruments (e.g. standards, bans, permits, or quotas). The regulations are backed by penalties. 2.Litigation 3.Government provision of goods and services such as police, health care, transportation, education. Informal methods can also be effective –Boycotts, dissemination of information

7. Copyright © 2006 Pearson Education Canada Inc. 10-7 Public Goods and Services Public production in Canada has occurred mainly in two classes of goods and services: 1.Services for which it is not practical to require people to pay. (eg. Police and fire protection, defense, maintenance of streets) 2.Services for which scale economies make it inefficient to have more than one provider (e.g. natural gas and electric power) The single provider (a monopolist) may charge excessive prices and/or be inefficient. An alternative is for the government to monitor and regulate performance of a private monopolist.

8. Copyright © 2006 Pearson Education Canada Inc. 10-8 Benefit-Cost Analysis (BCA) Benefit-cost analysis (BCA) is a method of project evaluation widely used in the public sector. BCA provides a general framework for assessing the gains and losses associated with alternative projects when a broad societal view is necessary to produce the greatest overall social benefit. BCA can also be used for project evaluation in the private sector where the broader impact on society must be taken into account.

9. Copyright © 2006 Pearson Education Canada Inc. 10-9 BCA Overview Once projects are identified, there are two issues to resolve: –The first is to identify and measure the benefits associated with each project, and to clearly understand to whom these benefits accrue. –The second is to identify and measure the costs associated with each project, and to establish who pays the costs. For comparison purposes, benefit-cost ratios are commonly used, though the methods of Chapters 4 and 5 are also applicable.

10. Copyright © 2006 Pearson Education Canada Inc. 10-10 10.3.1 Point of View for BCA Analysis Before conducting a BCA, it is important to identify the point of view that will be taken. The basic questions to address are: –Who will benefit from the project? –Who will pay for the project? By identifying these two points of view clearly, confusion about what to include and what not to include can be reduced. Generally, it is members of society who are the users and beneficiaries of project services, and the government, the sponsor, who pays for the project.

11. Copyright © 2006 Pearson Education Canada Inc. 10-11 Point of View for BCA Analysis…(con’t) One of the challenges associated with the analysis of public projects is that there may be several reasonable points of view, each with a different set of users or sponsors to be included in the analysis. This can lead to ambiguity and controversy over the results. Nonetheless, BCA is a common framework for analysis.

12. Copyright © 2006 Pearson Education Canada Inc. 10-12 Frame of Reference for BCA Analysis Another important factor to consider in project evaluation is the frame of reference for measuring the impacts of the project We concern ourselves with the marginal benefits and costs associated with the project so that its impact is fairly measured. –we ask about the benefits and costs with and without the project.

13. Copyright © 2006 Pearson Education Canada Inc. 10-13 10.3.2 Identifying and Measuring the Costs of Public Projects The fundamental questions are: –What costs will be incurred by the sponsor? –How much will these costs be? The sponsor costs: resources, goods, and services required to develop, implement, and maintain a project. These can be generally classified into the initial capital costs and ongoing operating and administration costs.

14. Copyright © 2006 Pearson Education Canada Inc. 10-14 10.3.3 Identifying and Measuring the Benefits of Public Projects The benefits of a project to society include the value of all goods and services that result from the project. Generally, the benefits of a public project will be positive. However, some of the effects from a project may be negative. These negative effects are referred to as social costs, and are subtracted from the benefits to obtain a net measure of social benefits.

15. Copyright © 2006 Pearson Education Canada Inc. 10-15 Identifying the Benefits of Public Projects The task of identifying benefits can be challenging, they may not be reflected in the monetary flows of the project. –E.g. Real cash flows for road construction –Vs. the intangible cost of traffic disruption during road construction. Intangible costs are not reflected in the cash flows of a project, but are nonetheless an important cost of putting the road in place.

16. Copyright © 2006 Pearson Education Canada Inc. 10-16 Measuring the Benefits of Public Projects Beyond the challenge of identifying certain costs and benefits is that of assigning a value or measure to each. For goods and services that are distributed through markets, their prices provide a measure of value intangible, non-market goods and services can be challenging to value. –E.g. improved health and safety, value of noise abatement, value of the environment.

17. Copyright © 2006 Pearson Education Canada Inc. 10-17 Example 10.1 Consider the construction of a bridge across a narrow part of a lake that gives access to a provincial park. The major benefit of the bridge will be reduced travel time to get to the park from a nearby urban centre. This will lower the cost of camping trips. More people are expected to use the park because of the lower cost per visit. How can these benefits be measured?

18. Copyright © 2006 Pearson Education Canada Inc. 10-18 Example 10.1… Data concerning the number of week-long visits and their costs are shown in Table 10.1.

19. Copyright © 2006 Pearson Education Canada Inc. 10-19 Example 10.1 (Answer) First, the reduction in cost for the 8000 visits that would have been made even without the bridge creates a straightforward benefit of $420,000: Travel cost savings = ($140-$87.50) x 8000 = $420,000 Next, the number of visits to the park is expected to rise from 8000 per year to 11 000 per year. –before the bridge, the cost of a week-long park visit, averaged $290; –we assume that it was worth at least $290 to anyone who incurred that cost. If the bridge were built, the average cost to visit a park would fall from $290 per visit to $237.50. –none of the extra 3000 visits would be made if the cost were $290 per trip. –each of them is worth at least $237.50

20. Copyright © 2006 Pearson Education Canada Inc. 10-20 Example 10.1 (Answer)

21. Copyright © 2006 Pearson Education Canada Inc. 10-21 Example 10.1 (Answer)… The standard approximation in cases like this is halfway between the highest and lowest values. Therefore, the value of the incremental 3000 visits per year is estimated as about $791 000 per year: (½)($290+$237.50) x 3000 = $791 250 However, there is also a cost of $237.50 per visit. The net benefit of the incremental 3000 visits is $791 250 - $237.50(3000) = $78 750 The total benefits are therefore $498 750: $420 000 + $78 750 = $498 750.

22. Copyright © 2006 Pearson Education Canada Inc. 10-22 Summary Introduction to Public Sector Decision Making Market Failure –Market Failure Defined –Remedies for Market Failure Decision Making in the Public Sector –The Point of View used for Project Evaluation –Identifying and Measuring the Costs of Public Projects –Identifying and Measuring the Benefits of Public Projects –Benefit-Cost Ratios –The MARR in the Public Sector Project: Compare bridge and ferry to Vancouver and Seattle