economic analysis primer

8/6/2019 Economic Analysis Primer

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Economic

Analysis Primer


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Economic Analysis Prim


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TABLE OF CONTENTS

Note From the Director 5

Introduction 7Role of Economic Analysis in Highway Decision Making 7Status of Economic Analysis 8Role of the Federal Highway Administration 8

Economic Fundamentals 9Accounting for Dollars Over the Project Life Cycle 9Inflation 9Time Value of Resources 11

Life-Cycle Cost Analysis 14When to Use Life-Cycle Cost Analysis 14Procedures for Best Results 14Cost Elements to Include 15

User Cost Controversy 16Tools 16

Benefit-Cost Analysis 17The Benefit-Cost Analysis Process 18Benefit and Cost Elements to Include 19Comparing Benefits to Costs 23Misunderstandings 25Avoiding Pitfalls 25

Tools 26

Forecasting Traffic for Benefit Calculations 27Traffic Flows Are Dynamic 27Traffic Forecasting Process 27Network and Corridor Effects 28Impact on Benefit Calculations 28When to Do a Full Demand Forecast 28

Risk Analysis 30Defining Risk 30Sensitivity Analysis 30Probabilistic Analysis 31Mitigating Risk 31

Economic Impact Analysis 32Role of Economic Impact Analysis 32


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How do we know if a highway project is worth undertaking, when it should be

done, or what is the most cost-effective means of accomplishing it? What will

the effects of the project be on the regional economy? These are among the

questions that economic analysis will help to answer when it is coordinated with

transportation planning, engineering, environmental review, budgeting, and policy

making.

Although the idea of comparing the benefits and costs of transportation projects on

a dollar-to-dollar basis has long appealed to decision makers, the application of eco-

nomic analysis to such projects is often neglected in practice. Agencies may believe that

transportation benefits and costs are too hard to quantify and value, or too subject to

uncertainty to provide meaningful guidance. Fortunately, an expanding research base

on economic methods and values, improved modeling of traffic and uncertainty, and

more powerful desktop computers have made the widespread use of economic analysis

for highway projects an attainable goal.

This primer is intended to provide a foundation for understanding the role of eco-

nomic analysis in highway decision making. It is oriented toward State and local offi-

cials who have responsibility for assuring that limited resources get targeted to their

best uses and who must account publicly for their decisions. It presents economic analysis

as an integral component of a comprehensive infrastructure management methodology

h k l f f f d Th

Office of Asset Management,Federal Highway Administration

NOTE FROM THE DIRECTOR


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The issuance of this primer is in keeping with the Federal Highwa

commitment to provide technical assistance, tools, and training to supp

transportation agencies in their critical role of accommodating the Nat

and efficient transportation.

David R. Geiger

Director, Office of Asset Management


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T

his primer begins by explaining what economicanalysis is and why it is important to transporta-

tion decision making. The narrative proceeds tosome of the fundamental concepts required for the

economic analysis of projects (inflation and discounting)and then describes actual applications of economic analysismethodology, especially life-cycle cost analysis and ben-efit-cost analysis. An issue critical to accurate calculationsof project net benefitsforecasting traffic growthisaddressed after the treatment of benefit-cost analysis.

Risk analysis can greatly improve the usefulness of eco-nomic analysis to decision makers. This subject is handledin a separate section, although it applies to all of the eco-nomic methods described in this primer.

Economic impact analysis is discussed at the end ofthe primer. It complements benefit-cost analysis by re-vealing how the direct transportation benefits and costsof highway projects (such as reduced travel time) mani-fest themselves in the form of new jobs, business growth,

tourism, and income. Such information is often impor-tant for making decisions about highway projects.

INTRODUCTION

ROLE OF ECONOMIC ANALYSIS IN HDECISION MAKING

Economic analysis is a critical compohensive project or program evaluationconsiders all key quantitative and quahighway investments. It allows highwatify, quantify, and value the economicof highway projects and programs timeframe. With this information, higbetter able to target scarce resources t

terms of maximizing benefits to the pufor their decisions.

Economic analysis can inform manof the transportation decision makingpage 8). It can assist engineers in the decost-effective designs once a decisiongo forward with a project. In planningto basic cost and performance data to s

ber of potential project alternatives, a velopment of program budgets andemphasis. Similarly, economic analysisrole in screening alternatives to accproject, providing information for tassessment process.

Although economic analysis can pformation for the environmental asses

or program, it is neither a substitute component of the environmental asNothing in this primer about econombe interpreted as supplementing, ovewise modifying Federal regulationsenvironmental assessments conducted Environmental Policy Act of 1969 th


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ROLE OF THE FEDERAL HIGHWAY A

FHWA has a long tradition of promotof economic analysis to highway prosign, construction, preservation, and has strongly encouraged the use of lifcations as part of its pavement designinitiatives, as well as in the Value EngFHWA has also developed more advanthat measure benefits and costs of hig

including the program-level Highway Ements System model described later in

As part of its long-term commitmhighway investment and managementwill continue to develop and advance eguidance. A major new impetus for thmotion of Transportation Asset Manatransportation agencies. Transportati

ment is a strategic approach to maximizresources used to operate, expand, and portation infrastructure over the longeconomic analysis to compare costs alar terms over multiyear periods provtion to this and other comprehensive inagement strategies.

Among the benefits of applying economic analysis tohighway projects are the following:

Cost-Effective Design and Construction. Economic analy-sis can inform highway agencies as to which of several

project designs can be implemented at the lowest life-

cycle cost to the agency and the lowest work zone delaycost to the traveler, and it can identify the best afford-able balance between these costs.

Best Return on Investment. Economic analysis can helpin planning and implementing transportation pro-

grams with the best rate of return for any given bud-

STATUS OF ECONOMIC ANALYSIS

The application of economic analysis to highway invest-ments is not a new concept. The American Associationof State Highway Officials published information on roaduser benefit analysis in 1952, showing that economicmethods and procedures for highway appraisal were wellunderstood and described 50 years ago. Of course, sig-nificant progress has been made since that time in areasas diverse as modeling of future traffic flows; estimating

the consequences of highway projects on jobs and in-comes; and the application of computer technologies tosupport improved economic methods.

Today, many States and metropolitan planning orga-nizations (MPOs) and some local governments use eco-nomic tools in some capacity. There is, however, muchdiversity in application. Most agencies will occasionallyquantify the life-cycle costs or net benefits of projects or

investigate their economic impacts on communities. Onlya minority of agencies, however, regularly measure projectnet benefits in monetary terms. Also, most agencies donot consider the full range of costs and benefits whenconducting their analyses. In general, there is significantpotential for the broader application of economic meth-ods to highway decision making.

Understanding Complex Projects. In a t

public scrutiny of new and costly roadway agencies and other decision makerstand the true benefits of these project

effects that such projects will have on

mies. This information is often very heling the environmental assessment proc

Documentation of Decision Process. Th

quantifying and valuing the benefits an way projects also provides excellent

to explain the decision process to legip blic

BENEFITS OF USING ECONOMIC ANALYSIS


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ECONOMIC FUNDAMENTALS

T

he most basic economic questions that people facein their day-to-day personal and business lives in-

volve the tradeoffs between dollars earned, spent,or invested today and those dollars they hope toearn, spend, or invest in the future. Such tradeoffs mustalso be considered when evaluating highway investments.

ACCOUNTING FOR DOLLARS OVER THE PROJECTLIFE CYCLE

A given project will generate costs and benefits over itsentire service life cycle. During construction, it will gen-erate mostly costs. Once in service, it will generate mostlybenefits, although some costs continue due to mainte-nance, periodic rehabilitation, and operational activities.In many cases, benefits will build over time as traffic lev-els increase. These benefits and costs can be presented indollar terms for each year of the projects life cycle. Fig-ure 1 illustrates a typical time series of costs and benefits.

Comparison of benefits to costs over the project lifecycle would be a simple issue of summation except forone problem: the value of a dollar changes over time. Inparticular, a dollar that an individual or agency will spend

or earn in the future is almost always wtoday than a dollar they spend or earn

ing value of the dollar must be underfied to enable meaningful comparisonlar streams.

Two separate and distinct factors ac value of a dollar, as seen from the pover time. These factors are inflation of resources.

INFLATION

Causes and Measurement

Inflation is said to occur when the priand services in the economy are risinover timealso referred to as generalmists believe that inflation is usually is more demand expressed for goods

economy than there is supply of thosservices at current prices. To produce vices needed to meet demand, firms mthe inputs (including labor and raw m

produce vices. Fobe necestime preworkers oto attra These passed othe form the goodduced; c

Initial Capital Cost

Benefits

Costs

Do

llars


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Economists usually measure inflation by comparingthe price of groupings or market baskets of goods andservices from year to year. The prices of some goods andservices in the grouping will go up, the prices of othersmay go downit is the overall price level of the group-ing that captures the effect of inflation. A price or infla-tion index is constructed by dividing the price of thegrouping in each year by its price in a fixed base year, andmultiplying the result by 100. The change in the indexvalue from year to year reveals the trend and scale of in-

flation. The Consumer Price Index (CPI) is probably thebest-known price or inflation index to most Americans,but there are many others.

Just as inflation is encountered in the general economy,the costs of highway projects tend to rise over time as aresult of inflation. This is because highway projects mustcompete for many of the same resources (such as labor orsteel) that other sectors of the economy require.

FHWA measures trends in highway construction costsby a Bid Price Index (BPI, also called the Federal-AidHighway Construction Cost Composite Index). The BPIis constructed from the unit prices for materials in actualhighway project bids, compiled from reports of Stateawards for Federal-aid contracts of $500,000 or greater.Inflation in construction costs is measured by the changes

in these unit prices from year to year.

duce their own highway cost indices toditions and practices.Engineering News-Record (ENR

Construction Cost Index andBuildinare widely used in the construction inpublishes various materials prices for two Canadian cities. Other indices inConstruction Co. Composite Index anHeavy Construction Cost Index.

Dollars from one year can be convlent dollars of another year (as measupower) by using price indices to add fects of inflation (see box). Dollars frotion component has been removed arconstant, or base year dollars. A rbuy the same amount of goods and syear as in the base year of the analys

clude the effects of inflation are known rent, or data year dollars. A nomincally buy a different amount of goods ayear of the analysis period.

When to Adjust for Inflation

In the case of economic analysis of invlic agency, it is best practice to forec

and benefits of a project without inflatbase year dollars). Inflation is very haticularly more than a few years intoimportantly, if inflation is added to benjected for future years, it will only hagain before these benefits and costs cthe form of dollars of any given base y

The essential time to consider inf

project budget is being prepared, afterhas shown the project to be economicyear or multiyear project budgets are ature year dollars rather than base yearaccount for inflation in project budgways result in too few future year doll


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When adjusting for inflation, an index appropriate forthe task should be used. For doing cost or budget esti-mates, this index will often be the State version of theBPI. In a few cases, the analyst may believe that aresources cost has grown or will grow much more rap-idly than the rate of inflation. For instance, right-of-waycosts may soar due to real estate speculation in anticipa-tion of a new road. In such cases, the analyst should workwith experts to determine how much the real price of the

resource will change over time and include this adjustedprice in the economic analysis. It is good practice to con-sult with an economist whenever an issue arises over theappropriate treatment of inflation.

TIME VALUE OF RESOURCES

The time value of resources is alsotime value of money or the opportunitresources. It reflects the fact that theated with diverting the resources neement from other productive uses or ption within the economy. This coseconomic return that could be earneresources (or the dollars used to buy tbest alternative use. Equivalently, the

sources can be interpreted as the amotion that must be paid to people to inconsume their resources in the currento make them available for future inve

The Role of the Discount Rate

FORMULAS FOR ADJUSTING FOR INFLATIONThe use of price or inflation indices to adjust for inflation is relatively straightforward.

To remove inflation (i.e., convert data year, nominal dollars into base year, real dollars):

Dollars = Dollars x Price Index /Price Index

To add inflation (i.e., convert base year, real dollars into data year, nominal dollars):

Dollars = Dollars x Price Index /Price Index

For instance, assume that the base year for an analysis is 1999. If a highway structure cost $100in 1992, how much would it have cost in base year 1999 dollars (all else being equal)? The ansthe structure price information contained in the Federal Highway Administrations Bid Pricewould be:

$100,000 x 138.3

/ 108.4

or $127,583 base year 1999 dollars. Similarly, a base year dollar can be converted to an equivalepurchasing power for any other year based on the second formula.

Historical price index data can be used to adjust for inflation in years prior to and includingWhen adjusting future, multiyear project budgets to allow for possible inflation, the analyst shofinancial or economic expert to develop reasonable estimates of anticipated future price growt

base year data year base year data year

data year base year data year base year

data year (1992) BPI structures index (1999) BPI structures index (1992)


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Assume that for the next 20 years no general inflationis expected. That is, $100 would buy the same (or a com-

parable) market basket of goods and services in 20 yearsthat it will buy today. In this environment, would a per-son expect to be able to borrow money at zero interest?Would that person lend money to someone else at zerointerest? The answer to both questions, at least for mostpeople, is no. Money can always be invested now toearn a return (e.g., in real estate or a profitable enter-prise). Alternatively, it can be spent on something a per-

son wants now (e.g., a nicer house), as opposed to havingto wait to buy it in the future.

Thus, people must be compensated for making moneyavailable even if there is no inflation. If, for example,people require at least $105 after one year as compensa-tion for making $100 available today, then they are equat-ing the value of $105 after one year to $100 in the present.Put another way, the present value of $105 one year

from now is $100. The annual rate of return (5 percentin this example) in compensation for the time value ofresources is the discount rate.

If an analyst knows the appropriate discount rate, heor she can calculate the present value of any sum ofresources or money to be spent or received in the future.The application of the discount rate to future sums tocalculate their present value is known as discounting(see box). Through discounting, different investment al-ternatives can be objectively compared based on theirrespective present values, even though each has a differ-ent stream of future benefits and costs.

FORMULA FOR DISCOUNThe standard formula for discoulows:

PV = [1/(1+ r)t ] At

where:

PV = present value at time zero

r = discount rate;t = time (year); andA = amount of benefit or cost

The formula above is the most baof present value. The term

1 / (1+ r)t

which incorporates the discount rathe discount factor. Multiplying athe appropriate discount factor for will yield the present value of thzero (e.g., the year in which the adone).

Of course, most highway procosts and benefits over their entire lentire series of costs and benefitcounted to the present by multipof the PV formula for each applicalife cycle (see formula below). Thvalues are then summed together by) for each year of the life-cycriod (N) to yield an overall presformula for doing this is as follow NPV = [1/(1+ r)

t] At t=1

The present value of a series of nudescribed as the net present valthe fact that the discounted sum othe net value of benefits after costs


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Selecting a Discount Rate

As a rule of best practice, economic analysis should bedone in real terms, i.e., using dollars and discount ratesthat do not include the effects of inflation. A real dis-count rate can be estimated by removing the rate of in-flation (as measured by a general price index such as theCPI) from a market (or nominal) interest rate for gov-ernment borrowing. The selected market rate for gov-ernment borrowing should be based on governmentbonds with maturities comparable in length to the analy-sis period used for the economic analysis. Real discountrates calculated in this manner have historically rangedfrom 3 percent to 5 percentthe rates most often usedby States for discounting highway investments (see box).

The U.S. Office of Management and Budget (OMB) cur-rently requires U.S. Federal agencies to use a 7 percent realdiscount rate to evaluate public investments and regulations.1

Federal agencies may use lower rates (based on inflation-

adjusted Federal borrowing costs) for life-cycle cost analy-sis. In January 2003, OMB reported a 10-year real discountrate of 2.5 percent and a 30-year rate of 3.2 percent, basedon current Federal borrowing costs. These latter rates re-flect historically low costs of government borrowing.

In times of budget shortfalls, an agency may increaseits discount rate to reflect the higher opportunity cost of

THE DISCOUNT RATE MA

The selection of an appropriate dimportant. For example, the pre$1,000 of benefits received 30 yearis $412 when discounted at 3 per

$231 when discounted at 5 percen when discounted at 10 percent. values of costs and benefits 30 yearcan be changed by more than a fpending on the discount rate useimportance of the discount rate, ctaken to select one that reflects atime value of resources.

1 This rate is adjusted occasionally. OMB has announced that signifi-cant changes in the 7 percent rate will be reflected in future guidanceto Federal agencies.

such funds. The agency should consithe discount rate applies over the life

adjusting the discount rate to reflect sfluctuations may distort the value of land costs. An agency may also increasto account for project risk. FHWA rever, that risk be treated directly withrather than through adjustments to thesection on Risk Analysis, page 30).


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LIFE-CYCLE COST ANALYSIS

T

he first systematic economic means of comparinghighway investments that will be discussed in this

primer is called life-cycle cost analysis (LCCA). Itapplies the discount rate to the life-cycle costs oftwo or more alternatives to accomplish a given project orobjective, enabling the least cost alternative to be identi-fied.

WHEN TO USE LIFE-CYCLE COST ANALYSIS

LCCA is applied when an agency must undertake a projectand is seeking to determine the lowest life-cycle-cost (i.e.,most cost-effective) means to accomplish the projectsobjectives. LCCA enables the analyst to make sure thatthe selection of a design alternative is not based solely onthe lowest initial costs, but also considers all the futurecosts (appropriately discounted) over the projects usablelife.

LCCA is used appropriately only to select from among

design alternatives that would yield the same level of per-formance or benefits to the projects users during normaloperations. If benefits vary among the design alternatives(e.g., they would accommodate different levels of traf-fic), then the alternatives cannot be compared solely onthe basis of cost. Rather, the analyst would need to employbenefit-cost analysis (BCA), which measures the monetaryvalue of life-cycle benefits as well as costs (BCA is discussed

at length in the next section of this primer, page 17). Ac-cordingly, LCCA should be viewed as a distinct, cost-onlysubset of BCA. Even with these restrictions, however,LCCA has many useful applications (see box).

PROCEDURES FOR BEST RESULTS

USEFUL APPLICATIONS OF

LIFE-CYCLE COST ANALYSI

Life-cycle cost analysis (LCCA) has many areas of interest to State and tation agencies. Common applicatioclude the following:

Designing, selecting, and documentfordable means of accomplishing a

or objective. For instance, if a bridge mLCCA can be used to select the rep

that would cost the least over the expbridge.

Evaluating pavement preservationcosts of each strategy can be evaluat

expected effects it will have on delaexpensive rehabilitations or reconst

Value engineering (VE). Value engiapplied to all Federal-aid highway prtional Highway System with an estim

million or more. Among other requiteam must consider the lowest life-c

of accomplishing a project.

Project planning and implementatio

use and timing of work zones. LCCA

lyst to balance higher agency and/orassociated with off-peak work hourstraveler delay costs associated with f

during peak periods.

Note that these applications involveternatives with identical levels of ser


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In LCCA, the analyst applies the discount rate to thecosts from each year of the projects life cycle. This yieldsthe present value of the projects cost stream. Because thecosts of competing alternatives can only be comparedfairly if the alternatives yield the same benefits, the ana-lyst must compare the project alternatives over the sameoperational time period, known as the study or analysisperiod. As a rule of thumb, the analysis period should belong enough to incorporate all, or a significant portion,of each alternatives life cycle, including at least one ma-

jor rehabilitation activity for each alternative (typically aperiod of 30 to 40 years for pavements, but longer forbridges). In some cases, an analysis period long enoughto capture the life cycle of one alternative may requirethat a shorter-lived alternative be repeated during thatperiod.

It is important to capture all costs that differ amongthe alternatives being compared. Where uncertainty

associated with future costs is identified, the analystshould assess its potential impact on the alternativeusing appropriate risk analysis methods (see section onRisk Analysis, page 30).

COST ELEMENTS TO INCLUDE

Costs associated with construction, rehabilitation, and

maintenance activities of each alternative being comparedshould be identified, monetized, and then discounted totheir present value. Table 1 lists the cost categories andelements generally included in LCCA.

There may be cases where some of

shown in Table 1 need not be quantifing alternatives using LCCA. This is bthat accomplish identical objectives (a using LCCA) often have many coststhey occupy the same right-of-way andesign effort). Costs that are identicaltheir amount and when they occur) tives need not be quantified, as they wcost comparison. In short, the analyston those costs that vary among altern

Of agency cost elements, constructtion typically vary the most among altbe quantified. Routine maintenance covary significantly. Different alternativewith and without preservation treattypes. The BCA section of this primermore information about quantifying a

User costs are those costs pertaalternative that travelers, rather than incur. User costs often vary significanatives, largely due to different work zfor the construction and rehabilitaticiated with each alternative. Using the analyst can estimate user costs assdelay at work zones with some accur

ating costs (VOC) in work zones can but these are typically small relative delay. Work zones can affect safety, bucosts are sometimes omitted from Lconclusive data about crash rates andcific work zone configurations and trstrategies.

User costs under normal facility op

should not vary significantly among ting compared using LCCA. Significantcosts among alternatives would suggesperformance (and therefore the beneftives are not equal and that BCA shouof LCCA.

TABLE 1. Costs Typically Considered in Life-Cycle CostAnalysis

Agency Costs

Design and engineering

Land acquisition

Construction

Reconstruction/Rehabilitation

Preservation/Routine maintenance

User Costs Associated With Work Zones


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USER COST CONTROVERSY

Work zones temporarily reduce capacity and can createsignificant delays to travelers. Best-practice LCCA shouldreflect work zone user costs along with agency costs. Manyagencies, however, have been reluctant to include workzone user costs with agency costs in LCCA calculations.Project design alternatives that reduce work zone usercosts often entail higher agency expensesnot welcomein times of tight highway budgets. This is particularlytrue because agency costs appear in agency budgets anduser costs do not. Agencies may also perceive that thereis too much uncertainty in valuing user travel delay time.

It is inadvisable, however, not to assign a value to workzone travel delay when using economic analysis methodssuch as LCCA or BCA. Highway agencies build roads toaccommodate users. If an agency cites benefits to usersas a justification for spending agency dollars to build orrehabilitate a road, it should also recognize the costs to

users caused by these actions. Most travelers clearly doattach significant value to their travel timeotherwisetraffic congestion would not generate so much publicconcern and irritation. In a national survey conducted in2000, FHWA found that frustration with construction-related delay ranked among the top items of motorist dis-satisfaction.2 Finally, the value of travel time in delay isnot arbitrary or uncertain. Economists are able to mea-

sure its value with a good degree of accuracy (see sectionon BCA for information on the valuation of travel time).

Even if user costs are not counted on a dollar-to-dol-lar basis with agency costs, quantifying them throughLCCA informs decision makers about the level of painto road users from any given project design alternative.It also provides an important perspective about the cost-effectiveness of strategies to reduce work zone disrup-

tions (see box).

TOOLS

A wide variety of proprietary and nonproprietary toolsare available with which to analyze the life-cycle costs ofhi h pr j t Th t l r ll pr d h t

THE IMPORTANCE OF KEEUSER COSTS IN PERSPECT

The following excerpt illustrates ouser costs should be evaluated aloncosts for construction projects:

When are they going to be done?tion echoed by frustrated motori

navigate through large constructionthe region. In fact, highway officials

people who complain that road projects are taking longer and long

Traffic is slowing road repairs, the

ways that could be rebuilt quicklycompletely must remain open to p

ups from growing even worse. Mealengthening rush hours have eaten

available to close even one lane. Roaproceed more cautiously when wtraffic. (Road Work Adds to Tra

Versa, Washington Post, May 13, 2

By placing dollar values on user costrategies to maintain traffic flowated and compared. In some cases

analysis may reveal it is less costly fousers to do a temporary road clstretch out construction.

FHWA has undertaken several initthe application of LCCA in the highsign process. Life-Cycle Cost Analysi

sign, an FHWA interim technical bul98-079, 1998), is an important repractitioners. It provides guidance on treatment of both agency and user cossign and maintenance. In 2002, FHWAon LCCA and a spreadsheet software p

d LCCA f d i Th


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L

CCA is a useful economic tool for selecting amongalternatives where benefits of the possible projectalternatives are essentially identical. In many cases,however, alternatives that an agency is consider-

ing may not generate identical benefits. For instance,when reconstructing a road, an agency may wish to con-sider reconstructing it as is or with additional lanes. Theappropriate economic tool for these instances is benefit-cost analysis (BCA), which considers life-cycle benefitsas well as life-cycle costs (see box).

BCA attempts to capture all benefits and costs accru-

ing to society from a project or course of action, regard-less of which particular party realizes the benefits or costs,or the form these benefits and costs take. Used properly,BCA reveals the economically efficient investment alter-native, i.e., the one that maximizes the net benefits to thepublic from an allocation of resources.

BCA is not the same thing as financial analysis. Finan-cial analysis is concerned with how to fund a project over

its lifespan and measures the adequacy of current and fu-ture funds and revenues to cover the cost of building,operating, and maintaining the project. While financialanalysis is an important part of project management, theeconomic merit of the project as measured by BCA isgenerally not affected by how the project is financed.

BENEFIT-COST ANALYSIS

USEFUL APPLICATIONS OBENEFIT-COST ANALYSIS

Benefit-cost analysis (BCA) considein benefits and costs that would bpotential improvement to the statuIn highway decision making, BCAto help determine the following:

Whether or not a project should ball (i.e., whether the projects life-cyexceed its costs).

When a project should be undertreveal that the project does not pass

ter now, but would be worth pursuinnow due to projected regional traff

it would be prudent to take steps nthe future projects right-of-way.

Which among many competing projects should be funded given a

BCA can be used to select from amternatives that yield different bene

struct a roadway with additional additional lanes); unrelated highwayened road versus an interchange on

and unrelated transportation projtransportation modes.


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THE BENEFIT-COST ANALYSIS PROCESS

In BCA, the analyst applies a discount rate to the benefitsand costs incurred in each year of the projects life cycle.This exercise yields one or more alternative measures ofa projects economic merit.

The BCA process (see box) begins with the establish-ment of objectives for an improvement to a highway fa-cility, such as reducing traffic congestion or improvingsafety. A clear statement of the objective(s) is essential toreduce the number of alternatives considered. The next

step is to identify constraints (policy, legal, natural, orother) on potential agency options and specify assump-tions about the future, such as expected regional trafficgrowth and vehicle mixes over the projected lifespan ofthe improvement.

Having identified objectives and assumptions, the ana-lyst (or analytical team) then develops a full set of rea-sonable improvement alternatives to meet the objectives.

This process begins with the development of a do mini-mal option, known as the base case. The base case rep-resents the continued operation of the current facilityunder good management practices but without major in-vestments.3 Under these do minimal conditions, thecondition and performance of the base case would be

expected to decline over time. Reasonalternatives to the base case can inclu

tions, from major rehabilitation of thefull-depth reconstruction to replacemeume facility. Such alternatives will oftention, but alternatives that improve h(such as the use of intelligent transpomanage travel demand (such as incentravel) are suitable for consideration.

To ensure that the alternatives can b

the analyst specifies a multiyear analysisthe life-cycle costs and benefits of all measured. The analysis period is seenough to include at least one major reity for each alternative.

Ideally , the level of effort allocated efits and costs in the BCA is proportiocomplexity, and controversy of the prduce effort, the alternatives are screensure that the greatest share of analyticato the most promising ones. Detailed anatives is usually not necessary.

When an alternative is expected tcant net benefits to users, particularly igestion relief, the analyst evaluates theternative would have on the futurepatterns projected for the base case (se

casting Traffic for Benefit Calculations,in future traffic flows in response to affect the calculation of project benefi

The investment costs, hours of delaother effects of each alternative are meneering methods and then compared tcase, and the differences relative to the tified by year for each alternative. The

lar values to the different effects (e.g., delay associated with an alternative relaare multiplied by a dollar value per hour) to a present value amount. Risk associacosts, traffic levels, and economic valu(see section on Risk Analysis, page 30

MAJOR STEPS IN THE BENEFIT-COSTANALYSIS PROCESS

1. Establish objectives

2. Identify constraints and specify assumptions

3. Define base case and identify alternatives

4. Set analysis period

5. Define level of effort for screening alternatives6. Analyze traffic effects

7. Estimate benefits and costs relative to base case

8. Evaluate risk

9. Compare net benefits and rank alternatives


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ing the best alternative from an economic standpoint. Itis good practice to document the recommendation witha summary of the analysis process conducted. In somecases, particularly for larger projects, this summary will

include a discussion about the economic impact analysisconducted based on the results of the BCA (see sectionon Economic Impact Analysis, page 32).

BENEFIT AND COST ELEMENTS TO INCLUDE

Table 2 lists the benefit and cost categories and elementsthat are generally included in BCA.

The user elements in Table 2 are labeled as cost/ben-efit rather than cost or benefit only. This is becauseimprovement alternatives are being compared to the basecase (the do minimal option), and each may have a dif-ferent impact on users. For instance, one alternative mayreduce crash rates (a benefit) relative to the base case;

TABLE 2. Benefits and Costs Typically ConsBenefit-Cost Analysis

Agency Costs

Design and engineering

Land acquisition

Construction

Reconstruction/Rehabilitation

Preservation/Routine maintenance

Mitigation (e.g., noise barriers)

User Costs/Benefits Associated With Work Zo

Delay

Crashes

Vehicle operating costs

User Costs/Benefits Associated With Facility O

Travel time and delay

Crashes

Vehicle operating costs


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Note that toll receipts and other user fees are not listedas benefits or costs in Table 2. Rather, they represent

transfers of some of a projects benefits from users to theagency operating the project (see box).

Many people are puzzled about how economists as-sign monetary values to highway project benefits andcosts. For instance, how does one value an hour of traveltime, or a crash? The valuation of each of the major ele-ments listed in Table 2 is described below.

Agency costs. The assignment of monetary values to thedesign and construction of a project is perhaps the easi-est valuation concept to understand. Engineers estimatethese costs based on past experience, bid prices, designspecifications, materials costs, and other information.Care must be taken to make a complete capital cost esti-mation, including contingencies and administrative ex-penses such as internal staff planning and overhead costs.

A common error in economic analysithe underestimation of project constr

opment costs. Particular care should bing large or complicated projects.

Expenses associated with a projectsdepreciation and interest payments, athe BCA. The equivalent value of suready captured in the BCA through the discount rate to the agency cost oing depreciation or interest expense

BCA would in most cases lead to doubl

Travel time and delay. An hour of travebusiness trip or commerce is usually vage travelers wage plus overheadrepto the travelers employer. Personal for commuting or leisure) is usually vage of average personal wage and/or

Tolls, taxes, and other user charges for transporta-tion projects constitute important potential revenuesources to State agencies for financing transporta-

tion projects. However, these revenue sources are notbenefits of a project as measured by economicanalysis such as benefit-cost analysis (BCA). Rather,these charges represent a means by which some ofthe benefits to users of the transportation project (asmeasured by their implicit willingness to pay for re-duced travel time or improved safety) can be trans-ferred in whole or in part (in the form of cash pay-

ments by the users) to the State or private agencythat operates the facility. Adding toll or tax revenuesto the value of travel time, safety, and vehicle operat-ing cost benefits already included in the BCA wouldbe double counting benefits.

Nonetheless, when significant tolls, taxes, andh h d f j h BCA

efits realized by the traveler. Conseqeler would typically use the facility lesstolled than if it were not tolled, affecti

gestion and user benefits on the facilitying roads. This response can be meaan economic factor known as pricdemand (see section on Forecasting Tr

Revenues from tolls and taxes are afor an evaluation of a projects financiaopposed to economic efficiency)whprovement generates enough cash to pdevelopment and operation. This finanmay be important to determine if thecan be implemented, particularly if conlic transportation funding sources arSimilarly, it will help reveal if the projeand operated by a private sector vendop bli pri t p rtn r hip

TREATMENT OF REVENUES, TOLLS, TAXES, AND OTHER TRANSFERS INBENEFIT COST ANALYSIS


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EXTERNALITIES VERSUS INDIRECT EFFECTS

Externalities considered in benefit-cost analysis (BCA) are the uncompensateddirectimpacts of the project on nonusers of the project. These effects are addi-

tive to other direct costs and benefits (such as the value of time saving or re-duced crashes and saved lives) measured in the BCA. Direct effects, however,usually lead to indirect effects on the regional economy through the actions ofthe marketplace. Indirect impacts of a transportation project could include lo-cal changes in employment or land use. The value of indirect effects is usuallynot additional to that of direct effects measured in BCA; rather indirect effects

of what travelers would be willing to pay to reduce traveltime. The U.S. Department of Transportation (USDOT)

recommends that analysts value local personal travel timeat 50 percent of average wage (see Departmental Guid-ance for the Valuation of Travel Time in Economic Analy-sis, available on the internet, for additional guidance).The value of reduced travel time often accounts for thegreatest share of a transportation projects benefits.

Crashes. The assignment of monetary values to changes

in crash rates or severities can provoke controversy be-cause crashes often involve injury or loss of life. The useof reasonable crash values is critical, however, to avoidunderinvesting in highway safety. Economists often usethe dollar amounts that travelers are willing to pay to re-duce their risk of injury or death to estimate monetaryvalues for fatalities and injuries associated with crashes.Medical, property, legal, and other crash-related costs arealso calculated and added to these amounts. USDOT of-fers extensive guidance on this subject (see Revision ofDepartmental Guidance on Treatment of the Value ofLife and Injuries, and The Economic Impact of MotorVehicle Crashes, 2000 (DOT HS 809 446), available onthe internet).

Vehicle operating costs. The costs of owning and operatingvehicles can be affected by a project due to the changes

that it causes in highway speeds, traffic congestion, pave-

ment surface, and other conditions thaconsumption and wear and tear. Accur

a projects effect on vehicle operatinquire good information on the relationformance to highway conditions, andabout future vehicle fleet fuel efficiencyUSDOT does not provide official guiing VOC, but useful information on the(and other BCA elements) is provided iManual on User Benefit Analysis of H

Transit Improvements and its succesin the Highway Economic Requiremume IV: Technical Report (FHWA-Pter 7. Benefits attributable to lower VOa major component of a projects bene

Externalities. One of the more challenis the treatment and valuation of thetransportation projects. In economicthe uncompensated impact of one perswell-being of a bystander (see box). Inportation investments, bystanders athe project. When the impact benefitis called a positive externality. Whenverse, this is called a negative external

Often, when there is talk about extways, the focus is on negative externa

ternalities include undesirable effects


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and water quality, noise and construction disruptions, andvarious community and aesthetic impacts. Positive exter-

nalities, however, also exist. A project may serve to re-duce air or noise pollution from levels that would haveotherwise prevailed without it.

Several methods exist for including externalities inBCA. In some cases, scientific and economic studies haverevealed per-unit costs for air pollutants, for example, thatcan be incorporated directly into the BCA. Much uncer-tainty surrounds these valuations, however. Values can

vary from project to project due to location, climate, andpre-existing environmental conditions. Risk analysis tech-niques (see section on Risk Analysis, page 30) can yieldhelpful information about the sensitivity of results to theseuncertain values.

Externalities are specifically dealt with in environmen-tal assessments required by the National EnvironmentalPolicy Act (NEPA). Where adverse impacts are identi-fied, mitigation is required to avoid, minimize, or com-pensate for them. Required mitigation is part of the en-vironmental decision, and the costs of mitigation willbecome internalized in the projects cost in the BCA.The BCA effort should be coordinated closely with theNEPA assessment (see box).

When an externality cannot be put into dollar terms,it can often be dealt with on a qualitative basis relative toother, monetized components of the BCA. If the mea-

surable net benefits of a project are highly positive, thepresence of minor unquantified externalities can be tol-erated from an economic standpoint even if they are per-ceived to be negative. On the other hand, if the net ben-efits are very low, then the existence of significantunquantified negative externalities may tip the economicbalance against the project.

ECONOMIC ANALYSIS ANNATIONAL ENVIRONMENPOLICY ACT PROCESS

Any State or local project or actFederal funds or other Federal aundergo analysis of a comprehensicial, economic, and environmental

the provisions of the National EPolicy Act of 1969 (NEPA). The NEPA analysis have a major infselection of a particular project ornative.

When an environmental imp(EIS) is prepared under NEPA asocial, natural, or physical environare interrelated, then the EIS m

of these effects on the human envbenefit-cost analysis (BCA) is prein project selection, it should be inreference or appended to the EIevaluating the environmental consinformation will complement othassembled in the EIS. However, fcomplying with NEPA, the merits

of the various alternatives need noin a monetary BCA, and typically

Accordingly, information revealeinform the NEPA process. Similaron the direct costs or benefits of impacts of a project measured review can be incorporated into analysis.


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COMPARING BENEFITS TO COSTS

Once the analyst has calculated all benefits and costs ofthe project alternatives and discounted them, there areseveral measures to compare benefits to costs in BCA.The two most widely used measures are described below.

Net present value (NPV). NPV is perhaps the most straight-forward BCA measure. All benefits and costs over an

alternatives life cycle are discounted to the present, and thecosts are subtracted from the benefits to yield a NPV. If

benefits exceed costs, the NPV is positive and the project is

worth pursuing. Where two or more alternatives for a projectexist, the one with the highest NPV over an equivalent analy-sis period should usually be pursued. Policy issues, perceivedrisk, and funding availability, however, may lead to the se-

lection of an alternative with a lower, positive NPV.

Benefit-cost ratio (BCR): The BCR is frequently used to se-lect among projects when funding restrictions apply. In thismeasure, the present value of benefits (including negative

benefits) is placed in the numerator

present value of the initial agency inves

in the denominator. The ratio is usuallytient (e.g., $2.2 million/$1.1 million =

budget, the projects with the highest Bto form a package of projects that yiel

tiple of benefits to costs (see box, page

FHWA recommends the use of eithermeasures for most economic evaluameasures are available and may be used

ing on agency preference. For exampuniform annual value approach convesure into an annuity amount. The intemeasure represents the discount rate an NPV of zero from a projects mucost stream.


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APPROPRIATE USE OF THE BENEFIT-COST RATIOThe benefit-cost ratio (BCR) is often used to se-lect among competing projects when an agency isoperating under budget constraints. In particular,use of the BCR can identify a collection of projectsthat yields the greatest multiple of benefits to costs,where the ability to incur costs is limited by avail-able funds. However, care must be taken when re-

lying on the BCR as the primary benefit-cost analy-sis (BCA) measure.

The Federal Highway Administration (FHWA)recommends that only the initial agency investmentcost be included in the denominator of the ratio. Allother BCA values, including periodic rehabilitationcosts or user costs, such as delay associated with con-struction, should be included in the ratios numera-

tor as positive or negative benefits. Adherence to thisguidance facilitates consistent project comparisons.For instance, assume there are two potential projects,each with a present value of $1 million in initial investment costs, $4 million in user benefits, and $1million in negative benefits associated with user de-lay at construction work zones. If the analyst includesthe negative benefits with the benefits in the numera-

tor of the BCR, the BCR would be ($4 million - $1million)/$1 million, or 3, for both projects. On theother hand, if the analyst includes the negative ben-efits with the initial investment costs in the denomi-nator of the BCR, the BCR would be $4 million/($1million + $1 million), or 2, for both projects. If theanalyst were inconsistent and assigned the respec-tive negative benefits to the numerator of one projectand the denominator of the other, then the firstproject would appear superior based on the BCR (3versus 2), when in fact, each project would yield thesame net present value of $2 million ($4 million $1 million $1 million).

It is also good practice not to base a among two or more alternatives solely ovalues, without reference to the budgevestment opportunities. Consider the ternatives to improve an intersectionative (improved traffic signals with lehas modest benefits to the public ($

present value) but a low initial inv($500,000)yielding a BCR of 20. Thnative (constructing a grade-separatedhas high benefits ($100 million in presan initial investment cost of $10 milliolower BCR (10) than the first alternatof the first alternative, based solely on itwould preclude (at least for some perio

opportunity for the traveling public to higher net benefits associated with thenative. In fact, selection of the first alteonly be appropriate if enough other pwith BCRs above 10 such that the collof the first alternative plus these other pwith the $10 million needed for the setive would equal or exceed the $100 m

efits of the second alternative.Use of specialized procedures suchtal BCA, in which the increments in benof one alternative relative to another in ratio format and prioritized subject tstraints, can minimize the risk of selealternatives using BCRs. A good descincremental BCA approach is provideof HERS-ST 2.0 Highway EconomicSystemState Version Overview, FHber 2002, http://isddc.dot.gov/OLPF010617.pdf.


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MISUNDERSTANDINGS

BCA is a powerful, informative tool available to assistplanners, engineers, and decision makers. Agencies oftenavoid or underutilize BCA due to misconceptions about it.

In some cases, agency personnel are skeptical aboutthe accuracy of BCA due to perceived uncertainties inmeasuring or valuing costs and benefits. In reality, thereis much more substance to economic analysis techniquesand values than is generally understood. Where uncer-tainty does exist, it can usually be measured and man-

aged. It is helpful to remember that sound economicanalysis reduces uncertainty. Not doing the analysis onlyserves to hide uncertainty from decision makers.

Another concern is that the workload involved in BCAmay be excessive relative to agency resources. Once theengineering and economic capabilities are in place, how-ever, BCA workloads diminish markedly. BCA level ofeffort should also reflect project cost, complexity, and

controversyroutine projects may be analyzed with mini-mal effort.

Finally, some agencies are concerned that the resultsof BCA could conflict with preferred or mandated out-comes. In any situation, an objective and independentassessment of a projects economic consequences can con-tribute valuable information to the decision process.There are, however, valid reasons why decision makers

may choose to override or constrain economic informa-tion. For example, if there are concerns that BCA resultswould disproportionately favor projects in urban areas,policy makers can initially apportion funds betweenurban and rural areas based on equity considerations.Urban projects would then compete based on their eco-nomic merits for the urban funds; rural projects wouldsimilarly compete for the rural funds.

AVOIDING PITFALLS

As with any analytic method, BCA cresults if it is misused. Perhaps the forror in BCA is the selection of an unThe base case must be premised on management of the asset during thFor instance, allowances should be mversion and changing peak periods asin the base case (the broader importanfic forecasts is discussed in the next sect

ure to do this can lead to overly pessidelay levels in the base case, to which balternative would look attractive. BCAbiased by the comparison of only oneto the base case, even though less exist. Proper BCA considers a full raalternatives.

Another common BCA problem in

tion of a project that is actually a coor more independent or separable projthe net benefits of one project may hithe other, or vice versa. Both of the probe built or rejected if incorrectly joinin fact one should be built and the oth

BCA results can be erroneous if ththe correct cost or benefit elements o

ated with a project. This problem hawith the omission of user costs or mapresent). In some cases, an agency maycal costs and benefits, failing to includoutside its jurisdiction. Care must alsinclude benefits that are simply resbenefits (or costs) measured elsewherelatter error, a form of double countinemployment, business, or land use efing economic impact analysis are addesaving, safety, and vehicle operating project. A more thorough discussion oprovided later in this primer, in the secImpact Analysis (page 32).


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TOOLS

Many tools that can accommodate BCA are available. Themajority of tools capture benefits and costs at the projectlevel only, but some tools can estimate the net benefits ofprojects at the program level.

In the United States, perhaps the best-known BCAtool for highways is that presented in the 1977 AASHTOManual on User Benefit Analysis of Highway and Bus-Transit Improvements, referred to as the 1977 Redbook.This guide is being updated under a National Coopera-

tive Highway Research Program contract and will be re-issued. The Texas Transportation Institute developed theMicroBENCOST model to implement the guidance inthe 1977 Redbook. A few States have developed their ownBCA models.

Some software applications are specific to subsets ofhighway investments. For instance, the Federal Railroad

Administrations Gradedec softwareBCA evaluation of upgrades, separatio

highway-rail grade crossings.In 2000, FHWA released a State-l

Highway Economic Requirements SyHERS-ST is a computer model thasection-level highway data to predict sment requirements. HERS-ST considements directed at correcting pavemecapacity deficiencies. HERS-ST can d

gram funding levels required to achievperformance goals in a cost-beneficial the model can estimate the highway sythat would result from various progrAn abundance of material concerning Hable on the Office of Asset Managhttp://www.fhwa.dot.gov/infrastructurehtm.


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Traffic volumes determine both the number

of travelers who will benefit from a highwayimprovement project and, in the case of capacityenhancement projects, the future congestion re-

lief provided by the project. Accordingly, accurate fore-casts of traffic volumes are critical to obtaining valid re-sults from BCA.

Traffic forecasting is often more complicated than itfirst appears. An assumption that the historic growth rateof traffic on a road will continue unchanged after it isimproved can lead to significant miscalculations of itsactual future traffic. In fact, traffic levels on an improvedroad may increase faster than anticipated as drivers seekto take advantage of its better driving conditions.

FORECASTING TRAFFIC FOR BENEFIT CALCULAT

TRAFFIC FLOWS ARE DYNAMIC

Why would a road attract more traffiimproved than it would if it were not

Drivers who formerly avoided thewas too congested may start to use it ohas been reduced by an improvement. Mers will divert to the improved facilit

gested regional roads. Similarly, sommerly traveled in off-peak hours on thsevere congestion will shift back to peapeak hour volumes when congestion to commuters.

Other drivers will unchain existitiple trips or make new trips that thehave avoided due to excessive delay as

gestion. Some individuals may shift fromobile. Drivers may also make longermote locations) than they did before Other traffic responses can and do occ

The new and diverted users of thewill enjoy benefits, just as will the exiadditional users, however, will use up ity of the improved facility, reducing lief that would have resulted for exisadditional users not arrived.

TRAFFIC FORECASTING PROCESS

The traffic forecasting process begins f d ffi h f ili


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Data on expected regional traffic growth can thenbe entered into the regions travel demand model to

simulate regional traffic flows with and without the newhighway capacity. MPOs and States typically maintainthe travel demand models for planning purposes. Mosttravel demand models now in use are effective at mea-suring the extent to which existing network traffic willdivert to new capacitya major source of new traf-fic on improved roads. Other traffic responses can beapproximated even when they are not measured explic-

itly by the models. For instance, the models can bemanipulated, through various feedback adjustments, tosimulate the effects of mode shifts and alternative des-tinations chosen by regional travelers in response to areduction in congestion. Although not explicitly cap-tured in most travel demand models, the shifting oftraffic to and from peak periods as congestion levelschange can be estimated using supplemental methods.

NETWORK AND CORRIDOR EFFECTS

A travel demand model may indicate that a significantamount of future traffic on the facility to be improvedwill be diverted from other roads in the region. This ef-fect, while mitigating some of the congestion relief onthe improved facility itself, will reduce congestion on theother roads. In this case, the BCA for the new capacity

project should attempt to incorporate the beneficial ef-fects (as measured by the travel demand model) of theimproved facility on other roads in the corridor as well ason the facility itself. Of course, reduced delay on the af-fected roads may lead to some compensating, new tripgeneration on those roads as well.

IMPACT ON BENEFIT CALCULATIONS

Unless the analyst considers traffic responses to an im-proved facility, he or she may overestimate the benefitsof the improved facility to existing users and understatethe benefits to the new users and those drivers on otherroads in the regional highway network. This can lead to

still be positive. This saving can be from the reduction in delay based o

volume/capacity ratios caused by the iallowing for traffic adjustments. Usersthe network who do not divert to thewill similarly receive time saving benreduction in traffic volume due to the to the improved facility.

Users on the improved facility who droutes will receive benefits equal, on av

point between those of pre-existing usefacility and those of users of other facdivert from those facilities. This midpthe fact that some diverted users willsaving of the improved facility but oslightly better than had they not divecomputation, users making new (as optrips on the improved facility or other r

to experience benefits equal, on averaexperienced by pre-existing users on cilities.

Numbers of affected users for eacwith data on the amount of time savifrom the travel demand modeling proin this section.

WHEN TO DO A FULL DEMAND FORStandard travel demand modeling, ping trip diversion, is often sufficient fcapacity projects. State or MPO planundertake such modeling as a matterpreparation of transportation improvemeral, it is a good idea to conduct BCAtion with planning offices.

A comprehensive traffic forecast, incrange of traffic responses to capacishould be done for regionally significaprojects. It is easy for the credibility challenged if it is learned that new triof new capacity were ignored. Traffic


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PRICE ELASTICITY OF DEMAND AND TRAFFIC FORECASTINGAn important benefit of a capacity expansion projectis the reduction in travel times for highway users.Travel time is a major component in overall price orcost to the user, which includes time as well as out-of-pocket costs. As with most goods and services, alower price can be expected to lead to more quantitydemandedin this case, some additional travel.

Price elasticity of demand is an economic conceptused to summarize how much more or less of some-thing people will consume if its price changes. Fromthe standpoint of estimating future traffic levels, elas-ticity represents how a change in the cost of driving,due to a reduction in travel time or implementationof a toll, may affect the volume of travel that willtake place. These changes in volume result from some

drivers decisions to make more or fewer trips thanthey otherwise would have made.

Elasticity is stated in percentage change terms, e.g.,an Xpercent reduction in travel price leads to a Ypercent increase in travel miles or trips. An elasticityof zero implies that travel is unresponsive to a price

change, no matter how large, while aticity implies that even a one-second detime will cause all capacity to be compl

While price elasticity is a generallyin economics, there are differing opinito apply it in a transportation context.tation economics literature reveals a

measured elasticity values, reflecting methods, data, time periods, and locaties, however, suggest that travel demaeither zero or infinite. When measurfacility, observed elasticity includes thediverted trips, which represent existingsimply shifted from other routes or timnew travel taken as a consequence of

cost. Additional research is needed range of elasticity values that are applicset of circumstanceswhether facilitregionand to develop methods for brating demand elasticity into traffic fo


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RISK ANALYSIS

Uncertainty is a factor in the analysis of transpor-tation projects just as it is in any other enter-prise. Fortunately, much of the uncertaintyassociated with transportation investments can

be evaluated and managed.

DEFINING RISK

Typically, the analyst is faced with a number of uncer-tainties when evaluating a highway investment. Many ofthese uncertainties can be measured by quantifying theprobability of an event and its impact if it occurs. Mea-sured uncertainty is known as risk. Risk can be identi-fied and understood by answering three questions:

What can happen? The following are examples of things that

can happen that would change BCA results: there are initialconstruction or future rehabilitation cost overruns, facilityservice life is less or more than expected, or traffic volumes

vary significantly from projections.

How likely is it to happen? Some things are more likely tooccur than are others. For instance, it may be that the projectin question is well understood and unlikely to have con-

struction cost overruns.

What are the consequences of an event occurring? In some cases,

an input variable may be subject to significant variability,but any given occurrence (within a realistic range) would

not substantially affect the economic justification for theproject. For instance, the price of a paving material may be

subject to large swings, but the benefits of a particular alter-native using that material may be sufficiently large to main-

Risk analysis will help the analyst answand determine if efforts to mitigate somwould be cost-effective.

SENSITIVITY ANALYSIS

The traditional means by which analyrisk is through sensitivity analysis. In aanalysis, the value of an input variablenificant potential source of uncertainther within some percentage of the inirange of reasonable values) while all are held constant, and the amount of results is noted. This sensitivity procother input variables for which risk hThe input variables may then be ranke

effect of their variability on BCA resuSensitivity analysis allows the analy

the impact of the variability of individall economic results. In general, if the reveals that reasonable changes in an unable will not change the relative ecoproject alternatives or undermine the justification, then the analyst can hav

fort that the results are robust. Alternable change in an uncertain input vaundermine the projects economic jusanalyst would investigate methods to rchange in that input value and analyzeconsequences if the adverse event occu


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PROBABILISTIC ANALYSIS

There is usually some uncertainty associated with severalvariables in an economic analysis, and these variables may vary simultaneously. Sensitivity analysis as traditionallypracticed can measure the effect of a change in more thanone variable at a time, but the results of analysis involv-ing many different scenarios can become confusing tointerpret. Fortunately, continuing advances in comput-ing power available through microcomputers permit thepractice of probabilistic-based risk analysis, most often

through a method known as Monte Carlo simulation.In Monte Carlo simulation, the analyst assigns an ap-

propriate probability distribution (based on expert opin-ion, historical data, and other information) to each of theinput variables subject to uncertainty in the economicanalysis. The Monte Carlo simulation samples randomlyfrom the probability distributions for each input, runsthe selected input values through the BCA formula to

calculate a discrete economic result, and then repeatsthis process over and over again. The results, whichare based on the randomly selected input values, arearrayed in the form of an average BCA result and aprobability distribution covering all potential outcomesof the BCA.

Figure 2 illustrates the NPV outcomes of two com-peting project alternatives analyzed using the Monte

Carlo simulation method. This particular analysis is rela-tively easy to interpret. Assume that these are two alter-natives to accomplish a particular project, or two projectscompeting for the same funding. Alternative B has a

higher mean NPV (represented by thpeak) than does alternative A. The N

A, however, has a tighter range of podoes alternative B, and, unlike alternatnificant risk of having a negative NPmaker were risk neutral (or a risk tawould be preferred. If the decision makalternative A, with its somewhat lowerange of downside outcomes, might b

MITIGATING RISK

Once risks have been identified and qstep is to evaluate potential actions Many actions may be taken to reducecreased engineering, additional qualittion of value engineering, and variousods such as design/build. In some casemitigation may be to shift risk to theable to control it, such as through the uwarranties.

The reduction of risk to the agencypublic associated with a potential riskmust be weighed against the cost of thingly, the range of potential economicproject should be calculated with anmitigation action in place. If a highwa

neutral, it would pursue risk mitigationthe cost of the action(s) is at least cohigher expected value of the mean Bdue to a reduction in the number of p

NPV outcomes). If averse, it may decideexpected NPV in excdownside risk.

More informatioparticularly as appliedable in Life-CyclePavement Design, technical bulletin (F1998). This documen

0.18

0.16

0.14

0.12

0.1

0.08

0.06Relative

Probability

Alternative A


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Economic impact analysis (EIA) is the study of the way in which the direct benefits and costs of ahighway project (such as travel time saving) affectthe local, regional, or national economy. It at-

tempts to measure the consequences that a highwayproject or action will have on considerations such as lo-cal or regional employment patterns, wage levels, busi-ness activity, tourism, housing, and even migration pat-terns. As used in this primer, EIA should not be confusedwith Environmental Impact Analysis as related to require-ments of the National Environmental Policy Act of 1969and other environmental laws, regulations, and guidance.

ECONOMIC IMPACT ANALYSIS

ROLE OF ECONOMIC IMPACT ANALY

BCA measures the direct benefits and causes for highway agencies, travelers case of externalities, to nonusers affecDirect benefits and costs are the first oimpacts of the transportation project oers, and consist of elements described ea

including changes in travel time, crashecosts, agency construction costs, and potypically does not measure how these costs are converted into indirect effect

such as changes in embusiness sales, or land of EIA.

Economists gener

direct benefits and ction improvementsBCA are converted ineconomic impacts thtion of the marketp verted, indirect effehave the same net moBCA-measured direcantly, the value of mnomic effects is not aof the BCA-measurerather, the former valor capitalization of th

For instance, fai i d


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form of a higher purchase price than he or she wouldhave paid had the highway improvement not been built.

WHEN TO DO ECONOMIC IMPACT ANALYSIS

In many instances, the findings of BCA are compellingin their own right. A project intended to improve safetyor reduce traffic congestion can often be justified in lightof the number and value of crashes avoided or hours oftraveler time saved. Even so, indirect economic impacts

measured by EIA based on BCA results are of major in-terest to decision makers, planners, and the public, espe-cially for large projects that are expected to generate majordirect transportation benefits and costs.

Similarly, individuals are generally at least as concernedabout the specific effects of a project on themselves asthey are about its overall effect on the public. People whowould particularly benefit may advocate for the project;those who perceive that they would be worse off may raisestrong objections to the project. EIA can identify whothese people are likely to be and how they would be af-fected. If EIA shows that those who are better off fromthe project greatly outnumber those who are worse off, itis easier to build public support for the project.

Any State or local project or activity receiving Federalfunds or other Federal approvals must undergo analysisof a comprehensive set of its social, economic, and envi-

ronmental impacts under the provisions of NEPA. EIAcan play an important role in supporting this analysis.

METHODS AND TOOLS

There are many different levels of sophistication in EIA.As with BCA, the best method and level of effort for anygiven project depends on the scale, complexity, and con-

troversy of the project.4

Basic methods of EIA include survey studies, marketstudies, and comparable case studies. Surveys may takethe form of expert interviews (e.g., with businesses alonga route), vehicle origin-destination logs, collection ofshopper origin-destination data, and corridor inventory

tation projects, preferably informed beconomic data pertaining to the transphighway projects.

Market studies consider demand anness activity and then attempt to quanthe market of a change in transportatia project. Comparable case studies ar

to evaluate the localized economic imon neighborhoods, downtowns, or smproach is applied to projects such astowns, where comparable projects anwhere in the same State or region canfied and studied.


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Input-output analysis is a key component of most regionaleconomic modeling of the employment, output, and income

impacts of transportation infrastructure investments. Input-output analysis quantifies the multiple economic effects re-sulting from a change in the final demand for a specific prod-uct or service. For example, a person being paid to work ona highway project will spend some of those wages to buygoods and services. The money he or she spends shows upas sales and wages to other parties, who spend the moneyelsewhere, and so on. This chain of effects, known as the

multiplier, captures the distributive effects of transporta-tion capital spending and operating benefits across a broadrange of industries. Typically, the input-output multipliersare driven by the initial, direct benefits and costs of the projectmeasured by BCA.

The simplest regional economic models are direct ap-plications of input-output models, such as RIMS II (Re-gional Input-Output Modeling System, 2nd edition, U.S.Department of Commerce). These applications arestatic in the sense that they provide an all-at-once viewof economic effects, without a time component that isnecessary for understanding when the effects will berealized. More sophisticated applications of regional eco-nomic models supplement input-output relationships with

simulation techniques to forecast the yof projects on economic and demogra

most complex EIA models are those thdemand models, land use models, dyeconomic models, and input-output m

PRESENTATION OF RESULTS

As a matter of best practice, EIA resusented as a complementary analysis

results show whether a project is worthwill be invested in it from a total sopoint. EIA results are helpful in informers and the public about how and in wefits and costs of the project will ultimawithin the economy. Information frombe summarized in a recommendationssidered jointly in reaching a decision to go forward with a project. The EIA ther state nor imply, however, that theindirect economic effects is additionalsured in the BCA. To do so would overjustification of the project by effectivethe projects net benefits.


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CONCLUSION

T

he goal of this primer has been to describe the

major principles, concepts, and methods fordoing economic analysis of highway projects. Thecoverage of these subjects has been necessarily

brief. For the interested reader, a wealth of additionalinformation is available from publicly accessible sources.5

The material in this primer, however, will hopefully besufficient to provide a learning framework, and to makethe reader aware of several key points.

First and foremost, economic analysis provides valu-able information to the planning, design, construction,preservation, and operation of the transportation infra-structure. The limited supply of transportation dollarsmust be invested in a manner that gives the greatest re-turn to the public. The most objective way to accomplishthis is to compare the benefits and costs of transporta-tion projects through the standard unit of the discounteddollar over the life cycles of projects. As such, economic

analysis is an integral component of any comprehensiveinfrastructure management methodology, such as Trans-portation Asset Management.

Benefit-cost analysis is the most comprehensivemethod to evaluate the reasonableness of highway projectsin economic terms. In some cases, when it is clear that aproject must be undertaken regardless of its cost (e.g., acritical bridge on an interstate highway must be repaired

or replaced in kind), LCCA will reveal the most cost-effective way of accomplishing the project. Used prop-erly and in coordination with other disciplines, thesemethods can accommodate everything from user delayassociated with work zones to measuring the net benefitsof new roadway capacity.

State agencies and other practition

invest some effort to establish the skineeded to conduct economic analysis.however, economic analysis integratesning, environmental, and engineering pmal additional work. In fact, by directlsuch as the effect of new highway capaterns or the justification for a project,can considerably lessen agency worklodesigning projects to appropriate scaling the need for such projects to the p

Uncertainty is a complicating factor sis as it is in virtually every area of humcertainty can be measured and quantifrisk analysis methods. Using economiate the net benefits of various risk recan help agencies manage risk.

Finally, through the mechanism o

the direct benefits and costs of highwayvarious indirect effects on local and reincluding impacts on employment leveactivity, and housing prices. EIA toolsindirect effects of highway projects basof BCA. Indirect effects are often ofdecision makers and the public, and, paprojects, can be presented in a comp

to the BCA.


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For further information and additional copies of

this document, contact:

Office of Asset Management (HIAM)Federal Highway Administration

U.S. Department of Transportation

400 7th Street, SW, Room 3211

Washington, DC 20590

Telephone: 202-366-9242

Fax: 202-366-9981


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FHWA IF-03-032

economic analysis primer

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