Cost-Benefit Analysis (CBA)

What is a Benefit and a Cost?The benefits of a change are those goods or services that result from the change for which someone would be willing to make sacrifices to obtainWe measure benefits in terms of Willingness to Pay (WTP)Cost is the value of opportunities forgone! (it could be a Euro value, but could include much more e.g. the value of your time).Opportunity Cost: An activity's opportunity cost is equal to the most net benefits that you could have obtained from doing something else.

Important Concepts1) Benefit - marginal benefit - total benefit2) Cost - marginal cost - total cost3) Net benefits - marginal net benefit - total net benefitAn efficient allocation maximizes Total Net Benefit minus=!!!!!!

The distance de can be interpreted in efficiency terms. It is a measure, in money terms, of the efficiency gain that would come about form producing X* compared with a situation in which non is produced.de is equal to the triangle gfh: the area beneath a marginal function over some range gives the value of the change in the total function for a move over that range.So, X=0 to X=X* beneath MBx is the total benefits of X* and equal to the distance ad, and X=0 to X=X* beneath MCx is the total costs of X* and equal to the distance ae.Px is equal at the margin* consumers' subjective valuations of additional units of the good (expressed in money terms), and* the costs of producing an additional unit of the good. Px = MBx = MCxPartial equilibrium interpretation of economic efficiencyX*X*X*X*B(X*)C(X*)NB(X)NB(X*)NB(X)B(X)C(X)XXXXghfMCxMBxg'h'f'Dx = MBxSx = MCxPx(a)(b)(c)(d)NB(X*)deaconsumer surplusproducer surplusnet-benefits

Recent DevelopmentsTotal economic value = Use value + Intrinsic valueUse value = Actual use value + Option value + Quasi-option valueOption value = Value in potential use by self + Value in potential use by others + Value in potential use by future individualsQuasi-option value = Value of avoiding irreversibilities in the light of expected future knowledgeIntrinsic value = Existence value

Existence ValueExistence value is unrelated to any actual or potential useExistence value may be related to sympathy, or stewardship; as such, existence values do not fit into neo-classical economicsExistence value may also be related to "spiritual consumption", and then it does fitExistence value is not right-based, as rights are absolute, and values relative

Cost-Benefit Analysis (CBA)by 'Cost-Benefit Analysis' we mean the social appraisal of investment projects (to appraise investments that correct for market failure).CBA and Environment: 1) benefits in the form of the provision of goods and services that have environmental impacts (e.g., damming a river in a wilderness area; i.e. negative environmental effects)2) projects with beneficial environmental impacts (sewage treatment plant; i.e. positive environmental effects)

CBACBA should be used for policies and projects, which unfold over time and be assessed by calculating a Net Present Value (NPV), or a Benefit-Cost Ratio (BCR).4 informational inputs:1. time horizon2. benefit schedule3. cost schedule4. discount rate

Present Value ConceptTime Value of Money Concept: = a Euro today is worth more than a Euro tomorrowwhy: * uncertainty: the future is unknown, will you be around to spend the dollar. * inflation: erodes the buying power of a Euro * utility gain from consumption today versus future consumption, * investment opportunities: invest today, earn interest, and have more than a Euro to spend in the future.Basic idea is to get the present value of some future payment to be received at time t.

Present Value ConceptDiscounting: = process to obtain the present value of future Euro amounts:

PV = present value, FV = future value, r = discount rate, and t is the number of periods into the future.0ttimepresent valuefuture valueidea of discountingEuro

Present Value ConceptNominal versus Real: = nominal refers to the Euro value in current terms (not discounted), whereas real refers to the dollar value discounted to some base Euro value (discounted values).Discount Rate: indicates how you value present consumption (utility) versus future consumption (utility)- the higher the discount rate the more you value present consumption relative to future consumption- the lower the discount rate the more you value future consumption relative to present consumption.

Cost-Benefit Analysis (CBA)In any CBA, several stages must be conducted (Hanley and Spash, 1993):1) Definition of the Project 2) Identification of the Project Impacts 3) Which Impacts are Economically Relevant? 4) Physical Quantification of Relevant Impacts 5) Monetary Valuation of Relevant Effects 6) Discounting of Cost and Benefit Flows 7) Applying the Net Present Value Test 8) Sensitivity Analysis

Cost-Benefit Analysis (CBA)Private appraisal 1) The net present value test2) The internal rate of return testSocial appraisal 1) Utility based appraisal Problems: - no general agreed social welfare function - interpersonal utility comparison are admissible - utilities are not observable2) Consumption based appraisalNPV>0IRR=0

Cost-Benefit Analysis (CBA)NPV test is a potential compensation test => is concerned with allocative efficiency (select projects that move the economy toward an efficient allocation of its resources).The proper time horizon for the appraisal of a project is the date at which its impacts cease, not the date at which it ceases to serve the purpose for which it was intended. e.g., for a nuclear fission plant the time horizon is not the 40 years to the time when it ceases to generate electricity but the time over which it is necessary to devote resources to storing the plant's waste products - 100s of years.

Choice of discount rateThe Present Values of 100 Euros arising from 25 to 200 years ahead at discount rates from 2 8 %=> need for judgementshowever, there is universal agreement among economists such that the real rates should be taken not nominal rates in CBA.

time horizon in yearsdiscount rate2550100200260.9537.1513.801.91437.5114.071.980.04623.305.430.290.0009814.602.130.050.00002

Environmental Cost-Benefit Analysiswhere Bd/Cd is the discounted of benefit/cost stream over the project lifetime. NPV ignores environmental impacts => NPV'. EC = environmental costECBA decision rule!!!

Environmental Cost-Benefit AnalysisEC = UV + EV + OV +QOVUV = Use Value and arises from the actual and/or planned use of the service by an individual, for recreation for example;EV = Existence Value and arises from knowledge that the service exists and will continue to exist, independently of any actual or prospective use by the individual;OV = Option Value and relates to willingness to pay to guarantee the availability of the service for future use by the individual;QOV = Quasi-Option Value and relates to willingness to pay to avoid an irreversible commitment to development now, given the expectation of future growth in knowledge relevant to the implications of development.

Direct Benefit EstimationIn private CBA it it usually relatively easy to perform because prices are readily observed.Often this is not the case (no price exist) or prices are socially biased due to externality, public good, or market power considerations.This problem is particularly apparent for non-use values which tend to be more intangible.intangible = cannot be valuedif intangibles remain in our analysis, then NPV and BCR are incomplete.So, what can we do when prices and demand information is absent or is clearly biased?

Alternative Approaches1. Contingent Valuation - use surveys that ask - widely applicable2. Travel-Cost Method - obtain a demand curve by examining how participation varies with the cost of getting there. - primarily useful for recreation benefits.3. Property value and Wage differentials (hedonic prices) - statistically investigate how these prices vary with property of job conditions - more limited application possibilities than for CV.

Indirect (Secondary) Benefits= Ripple effects due to economic linkagesWe have all heard public projects and policies being touted for their employment and income generating effects.In a full employment economy, however, these inputs were necessarily reallocated away from other productive uses.!! Do not count secondary effects in a full employment economy!! also no transfer payments should be included, e.g, unemployment payments

Overall Appraisal of CBACons: - intangibles - BC analysts and information sources are often biased - distributional Issues occasionally objectionable * weighs same period impacts equally * weighs future impacts lessPros: - help prevent bad decisions which would otherwise be undiscovered - counters rent-seeking (which might normally be successful in the political process).

Analytical Styles other than CBACost Effectiveness Analysis Try to achieve a non-economic target at least cost - often practical when there is an intangible physical quantity in need of enhancement; if it was tangible, we could just use CBA.Impact Analysis usually employed in lieu of or as a complement to CBA because either * There are many intangible impacts of the policy/project and they need to be described, or * the impacts are tangible but not allowed into CBA (such as secondary economic impacts)Multi Criteria Analysis will be used in public project

CBA ExampleSomeone has proposed a 4-period pollution control project that will cost $ 100.000 to construct in the initial period. After that, the project will cost $ 10.000 to operate in each following period. After the construction is completed, the benefits of this project will be $ 40.000 in the first period, $ 45.000 in the second, and $ 50.000 in the last period. The facility is expected to be non-functional for any future periods. There are no intangibles to be considered for this project.Calculate Net Present Value (NPV), and Benefit-Cost Ration (BCR) using a discount rate of 5%.

CBA- Exampler = 5%NPV = ???BCR = ???

tBtCtNBt00100-100140103024510353501040totals

************NR = net returns*********