national economic development (ned) procedures manual ... · national economic development (ned)...

DACWC72-90-D-0002Task Order 0010

U.S. Army Corps of EngineersHumphreys Engineer Center Support ActivityInstitute for Water ResourcesFort Belvoir, VA

NATIONAL ECONOMIC DEVELOPMENTPROCEDURES MANUAL - NATIONAL ECONOMICDEVELOPMENT COSTS

June 1993

NATIONAL ECONOMIC DEVELOPMENT PROCEDURES MANUALNATIONAL ECONOMIC DEVELOPMENT COSTS

by

Charles Yoe, Ph.D.

of

The Greeley-Polhemus Group105 South High Street

West Chester, PA 19382

for

U.S. Army Corps of EngineersWater Resources Support Center

Institute for Water ResourcesFort Belvoir, VA 22060-5586

June 1993 IWR Report 93-R-12

iii

Preface

This manual was prepared as part of the National Economic Development (NED) ProceduresManual Work Unit within the U.S. Army Corps of Engineers (COE) Planning MethodologiesResearch Program. Mr. William Hansen of the COE Water Resources Support Center (WRSC),Institute for Water Resources (IWR), manages this Work Unit under the general supervision of Mr.Michael Krouse, Chief, Technical Analysis and Research Division; Mr. Kyle Schilling, Director, IWR;and Mr. Kenneth Murdock, Director, WRSC. Mr. Robert Daniel, Chief, Economic and SocialAnalysis Branch (CECW-PD) and Mr. William Hunt, CECW-PD, are the Technical Monitors forHeadquarters, COE.

Dr. Charles Yoe, College of Notre Dame of Maryland, was the principal author of this manualwhile working for The Greeley-Polhemus Group, Inc. (GPG) under contract to IWR. This manualwould not be complete without an acknowledgement of the Corps personnel responsible for itspreparation and the process by which they guided its formation.

From the outset, the content of this manual has been the invention of the IWR and the FieldReview Group (FRG) charged with its oversight. The FRG of eleven Corps personnel wassupplemented by the involvement of personnel from the Office of the Chief of Engineers and theWRSC. These personnel were interviewed along with personnel from a wide variety of Corps officesrepresenting virtually every user of cost data throughout the agency to ascertain the range of NEDand related cost issues of concern to them.

The results of the interviews were compiled to identify those issues that were of interest toa significant number of interviewees. A comprehensive list of cost-related terms used by Corpspersonnel was compiled. The lists of issues and terms were presented to the FRG along with a draftreport outline at a July 7, 1992 meeting of the FRG. From these materials a revised and detailed draftreport outline was prepared by the FRG.

The FRG group reviewed and commented on a draft report during the fall of 1992. The draftwas revised to reflect the views of the FRG and submitted for another review. The revised draft andcomments were the subject of a second FRG meeting held in January, 1993. This manual in itscurrent form was approved at this meeting.

The contractor would like to acknowledge and thank, without implicating, the followingmembers of the FRG.

Mr. William Hansen CEWRC-IWR-RMr. Stuart Davis CEWRC-IWR-RMr. William Bayert CERE-APMr. Kenneth Boire CENPD-PE-ECMr. Glendol Combs CESWD-PL-EMr. Steve Cone CECW-PD

iv

Ms. Betty Mae Eberhardt CEORD-PE-PPMr. William Hunt CECW-PDMr. Russell Iwamura CEPOD-ED-PJMr. Nahor Johnson CENAD-PL-EMr. Larry Kilgo CELMV-PD-EMr. Gerald Melton CESAD-PD-EMr. Andrew Miller CESPD-PD-EMr. Richard Ring CENED-PL-IMr. Ronald Roberts CEMRD-EP-PEMr. Edmond Schiffers CEWRC-WLR-IIMr. Gary Wickboldt CENCD-PE-PD-EC

v

NATIONAL ECONOMIC DEVELOPMENT PROCEDURES MANUAL -NATIONAL ECONOMIC DEVELOPMENT COSTS

Table of ContentsSection Page

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

Chapter 1: INTRODUCTION

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1PURPOSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2AUDIENCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3ORGANIZATION OF THE MANUAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Chapter 2: COSTS AND THE CORPS OF ENGINEERS

CHAPTER OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5ROLE OF COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5WHO USES COSTS? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

PLANNING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7ENGINEERING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7REAL ESTATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7PROGRAMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7PROJECT MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8OPERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8COUNSEL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8CONTRACTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9NON-FEDERAL PARTNER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9OUTSIDE REVIEWERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9INDUSTRY PEOPLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

SUMMARY AND LOOK FORWARD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Chapter 3: THEORY AND LANGUAGE OF COSTS

CHAPTER OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11COST IN ECONOMIC THEORY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

SCARCITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12CHOICE AND OPPORTUNITY COST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12EFFICIENCY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

vi

Table of Contents (Continued)

A TAXONOMY OF COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

THE LANGUAGE OF ECONOMISTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Economic Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

a. Explicit Cost versus Implicit Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19b. Internal and External Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21c. Economic and Money Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23d. Marginal and Incremental Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24e. Typical Cost Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

1. Fixed Cost versus Variable Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272. Average Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273. Cost Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

f. Long Run/Short Run Cost Considerations . . . . . . . . . . . . . . . . . . . . . . . . . 28g. Price Levels: Constant Versus Current Costs . . . . . . . . . . . . . . . . . . . . . . 31

THE LANGUAGE OF THE CORPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

A Plethora of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32Terms Used In This Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

a. NED Project Cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34b. Project Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34c. Baseline Cost Estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Other Terms New and Old . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

a. Cost Estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36b. Construction cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36c. Investment Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36d. Language for the Non-Federal Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

Recurring Cost Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37Micro-Computer Aided Cost Estimating System (M-CACES) . . . . . . . . . . . . . . . 39Cost-Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39Alternative cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

COST AS THE BASIS FOR BENEFITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

vii



Chapter 4: NED COSTS

CHAPTER OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43CONCEPTUAL BASIS (2.12.2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43PLANNING SETTING (2.12.3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46EVALUATION PROCEDURE: GENERAL (2.12.4) . . . . . . . . . . . . . . . . . . . . . . . . . . 46

WHAT IS AND IS NOT AN NED PROJECT COST (2.12.4(A)) . . . . . . . . . . . . . . . 46PRICE LEVELS AND TIME REFERENCE OF NED COSTS (2.12.4(B)) . . . . . . . . 48

Price Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48Planning Horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53Average Annual Equivalent Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

SALVAGE VALUE (2.12.4(C)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

EVALUATION PROCEDURE: IMPLEMENTATION OUTLAYS (2.12.5) . . . . . . . . 56

POSTAUTHORIZATION PLANNING AND DESIGN COSTS (2.12.5(A)) . . . . . . . 56CONSTRUCTION COSTS (2.12.5(B)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57CONSTRUCTION CONTINGENCY COSTS (2.12.5(C)) . . . . . . . . . . . . . . . . . . . . 57ADMINISTRATIVE SERVICES COSTS (2.12.5(D)) . . . . . . . . . . . . . . . . . . . . . . . 57FISH AND WILDLIFE HABITAT MITIGATION COSTS (2.12.5(E)) . . . . . . . . . . 58RELOCATION COSTS (2.12.5(E)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58HISTORICAL AND ARCHAEOLOGICAL SALVAGE OPERATIONS COSTS

(2.12.5(F)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58LAND, WATER, AND MINERAL RIGHTS COSTS (2.12.5(G)) . . . . . . . . . . . . . . . 59OPERATION, MAINTENANCE, AND REPLACEMENT COSTS (2.12.5(H)) . . . . 59

EVALUATION PROCEDURE: ASSOCIATED COSTS (2.12.6) . . . . . . . . . . . . . . . . . 59EVALUATION PROCEDURE: OTHER DIRECT COSTS (2.12.7) . . . . . . . . . . . . . . . 60EVALUATION PROCEDURE: PROBLEMS IN APPLICATION (2.12.8) . . . . . . . . . 61EVALUATION PROCEDURE: DATA SOURCES (2.12.9) . . . . . . . . . . . . . . . . . . . . . 62REPORT AND DISPLAY PROCEDURES (2.12.10) . . . . . . . . . . . . . . . . . . . . . . . . . . 62SUMMARY AND LOOK FORWARD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

viii


Chapter 5: SELECTED APPLICATIONS

CHAPTER OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63ECONOMIC VERSUS FINANCIAL COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

TRANSACTIONS WITH ECONOMIC AND FINANCIAL COSTS . . . . . . . . . . . . . 64

Economic Cost Equals Financial Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64Economic Cost Less Than Financial Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66Economic Cost Exceeds Financial Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

TRANSACTIONS WITH FINANCIAL COST BUT NO ECONOMIC COST . . . . . 68TRANSACTIONS WITH ECONOMIC COST BUT NO FINANCIAL COST . . . . . 68TRANSACTIONS WITH NEITHER ECONOMIC NOR FINANCIAL COSTS . . . . 69

INTEREST DURING CONSTRUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

EQUIVALENCE OF MONEY VALUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70TIME PREFERENCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Interest During Construction Can Be A Financial Cost . . . . . . . . . . . . . . . . . . . . . 72IDC As A Pre-Base Year Cost Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

THE IDC CALCULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

REAL PROPERTY VALUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

REAL PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74VALUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74THREE MEASURES OF REAL PROPERTY VALUE . . . . . . . . . . . . . . . . . . . . . . . 74

Sales Comparison Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74Cost Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Income Capitalization Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

USE OF REAL PROPERTY VALUES IN WATER RESOURCES PLANNING . . . 77VALUE OF UNIQUE OR HISTORIC STRUCTURES . . . . . . . . . . . . . . . . . . . . . . . 78

AVERAGE ANNUAL COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

COMPUTING AVERAGE ANNUAL EQUIVALENT COSTS . . . . . . . . . . . . . . . . 79

ix


EXTERNALITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

IMPLICATIONS OF EXTERNALITIES FOR PLAN FORMULATION . . . . . . . . . 80INDUCED FLOODING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81OTHER EXTERNALITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82


Chapter 6: FROM PROJECT COSTS TO NED COSTS: AN ILLUSTRATEDSUMMARY

CHAPTER OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87PROJECT COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

THE PROJECT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88PROJECT COST ESTIMATE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89EQUIVALENCE OF COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

NED COST ANALYST'S RESPONSIBILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

COMMUNICATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90APPLICATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

PLAINVILLE EXAMPLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

IDENTIFY POTENTIAL DIVERGENCES IN ECONOMIC, FINANCIAL & NEDCOSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

Lands and Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

a. Damage Surveys . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92b. Donated Lands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92c. Streambed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93d. Relocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93e. Short Run Perturbations in the Land Market . . . . . . . . . . . . . . . . . . . . . . . 93

Relocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

a. Advanced Replacement of Bridges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93b. Betterments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

Fish and Wildlife Facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

x


a. Fish and Wildlife Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

Levees and Floodwalls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

a. Unemployed and Underemployed Resources . . . . . . . . . . . . . . . . . . . . . . . 94b. Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

Potential Cost Issues Not in Project Cost Accounts . . . . . . . . . . . . . . . . . . . . . . . 94

a. Interest During Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94b. Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

QUANTIFYING, DOCUMENTING AND DISPLAYING COSTADJUSTMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

Damage Survey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95Donated Lands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95Streambed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Relocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Short Run Perturbations in Land Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Advanced Replacement of Bridges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Betterments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Fish and Wildlife Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Unemployed and Underemployed Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Interest During Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Total Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

Endnotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

Appendix 1: A BRIEF HISTORY OF THE NED PERSPECTIVE . . . . . . . . . . . . . . . . . 114

Appendix 2: SUGGESTIONS FOR FURTHER READING . . . . . . . . . . . . . . . . . . . . . . 118

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

xi


FIGURES:

Figure 1: Dichotomous Nature of Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Figure 2: Manual Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3Figure 3: Major Uses of Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Figure 4: Opportunity Cost Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Figure 5: Rules of Marginal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25Figure 6: Typical Cost Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26Figure 7: Cost Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28Figure 8: Evolution of Project Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33Figure 9: Terminology of Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34Figure 10: Life-Cycle of a Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41Figure 11: NED Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44Figure 12: Price Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Figure 13: Market Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Figure 14: Planning Horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50Figure 15: Implementation Outlays . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56Figure 16: Other Direct Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61Figure 17: Potential Relationships Between Economic & Financial Costs . . . . . . . . . . . . . . . 64Figure 18: Base Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70Figure 19: Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71Figure 20: Sales Comparison Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Figure 21: Cost Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Figure 22: Income Capitalization Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Figure 23: Cost Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79Figure 24: Accumulated Present Worth of Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80Figure 25: Negative Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81Figure 26: From Project Costs to NED Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

TABLES:

Table 1: Incremental Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25Table 2: Typical Cost Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29Table 3: Selected Non-Federal Cost-Sharing Percentages . . . . . . . . . . . . . . . . . . . . . . . 40Table 4: Example of Cost Allocation & Cost-Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . 40Table 5: Induced Flood Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82Table 6: Induced Damage Effect on Project Economics . . . . . . . . . . . . . . . . . . . . . . . . 83Table 7: Project Cost Estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88Table 8: NED Cost Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

1

Chapter 1: INTRODUCTION

"Project measures, whether structural or apportionment is based on total project costsnonstructural, require the use of various which are $45 million. Congress authorizesresources. NED costs are the opportunity the project at the cost of construction. Thecosts of resource use. In evaluating NED project cost agreement (PCA) is based on thecosts, resource use must be broadly defined so fully funded project cost, which is $60 million.as to fully recognize scarcity as a component The Section 902 maximum cost limitation isof value. This requires consideration of the based on the baseline cost estimate which isprivate and public uses that producers and established at the end of the feasibility phaseconsumers are currently making of available and never changes, though costs may deviateresources or are expected to make of them in from it. Is it any wonder that people becomethe future." Economic and Environmental confused by the answers to a very simplePrinciples and Guidelines for Water and question, "How much does the project cost?"Related Land Resources ImplementationStudies (P&G), p. 96, March 1983. This manual provides a detailed look at

INTRODUCTION

Plan formulation is complete and the implementation costs. Non-Federal partnersnational economic development (NED) costs and many elements of the Corps of Engineersof the recommended plan are $50 million. The may have little or no interest in NED costs.non-Federal partner wants to know what his Yet, NED costs are the costs that matter mostshare of the costs are. Cost-sharing or when a decision is made about recommending

1

NED costs. These costs are used in the planformulation process and the economicevaluation of alternative plans. After that,NED costs are of secondary importance to

2

a project. This dichotomous nature of NED most of the controversy evaporates once wecosts, illustrated in Figure 1, being of realize there are different kinds of problemsparamount importance in the decision process that require different kinds of cost information.but of little interest to most parties to thatprocess, has understandably led to a great deal The purpose of this manual is to provideof bewilderment and misunderstanding. The a framework for thinking about NED costspurpose of this manual is to replace this and their various uses by the Corps ofbewilderment with comprehension and this Engineers. The intent of this manual is tomisunderstanding with understanding. furnish the reader with the tools necessary to

National economic development used and how they differ from other definitionsconsistent with environmental laws and of costs. To understand NED costs it isregulations is the stated policy objective of the essential that the nature of these other costs beFederal government's role in water and related considered as well. land resources planning studies . The NED2

principle articulates a very specific perspective Costs are used by the Corps in two- a national rather than state or local primary ways. First, NED costs are used toperspective - to be used in valuing project make decisions about the relative economicoutputs or benefits and project inputs or costs. efficiency of alternative actions. Once such aThe NED principle is primarily an economic decision has been made, dollar costs becomepolicy. Instances when that policy deviates the focus of Corps elements as they refinefrom economic theory are discussed as they construction cost estimates, prepare budgetsarise throughout this manual. It is a national and let contracts. Non-Federal partners focuswater resource development policy, i.e., one on their dollar costs as they plan for financingthat addresses what decision makers feel ought their share of project costs. Thus, what weto be the economic priority of Federal water will call implementation decisions require thatresource development agencies. Although it is attention be paid to a different set of costs.a policy firmly rooted in economic theory, the Though the focus of this manual is distinctlyNED principle is a matter of law, policy and on NED costs, other costs commonly used byinterpretation. the Corps will be discussed as appropriate.

PURPOSE

Cost, one of the most widely used words will be discussion and elucidation of suchin the English language, is an extraordinarily terms at times, but resolution ofcomplex concept, with all kinds of economic, communication or other problems that arisefinancial, accounting, budget, engineering, and from concepts and terminology outside that oflegal implications. As we might expect from a NED costs will not be offered. There is aconcept so rich in nuance, there is frequent great deal of confusion, much of it withincontroversy over the nature of costs. Howshould costs be defined? What costs arerelevant for decision making? Fortunately,

understand what NED costs are, how they are

As important as what this manual does, iswhat it does not do. This manual does notdefine terms outside the NED context. There

3

the agency, about some of the cost as a useful refresher to experienced Corpsterminology that is used by the Corps. planners, it is directed more specifically to newBecause the correct definition of cost varies Corps employees and other experienced Corpsfrom context-to-context, situation-to-situation personnel who work with planning studies.and district-to-district it would bepresumptuous for this manual to deign todefine terms that are perfectly serviceable tothose who use them. Each element of theCorps has its own program, responsibilities, The manual consists of this and five othercontext and jargon. Though it may be chapters, as well as an index, two shortunfortunate that a duplicitous jargon has appendices and a bibliography as shown inarisen, standardization of that jargon is a Figure 2. Chapter 2 discusses costs in thepolicy matter that won't be addressed by this context of the Corps of Engineers' program.manual. This chapter will be of most interest to readers

Closely related to this last point is the fact uses costs and how they use them. Chapter 3that this is not a policy manual. There are provides an overview of some economicconflicts between economic theory and theory relevant to NED costs and follows withprinciples (i.e., positive economics) and the some development of the language of costs.economic policies (i.e., normative economics) Most of the cost terminology used byof the Corps of Engineers that have developed economists and Corps personnel is introducedover a period of time as a result of legislation here. Chapter 4 is devoted exclusively to aand other policy decisions. Where appropriate discussion of NED costs. Concepts arethese conflicts will be identified. This manual discussed in a format that follows the P&Gintends no advocacy position on any of theseconflicts. Economic theory is the domain ofthe economist. Economic policy is the domainof the decision-maker.

AUDIENCE

The manual has been written for thosewho are partners to or have an interest in thewater resources planning process of Federalwater resource agencies that use the"Economic and Environmental Principles andGuidelines for Water and Related LandResources Implementation Studies," morecommonly referred to as the Principles andGuidelines or P&G. It provides anintroduction to NED costs for non-Federalpartners. Though we hope the manual serves

ORGANIZATION OF THE MANUAL

seeking a broad overview of who in the Corps

4

presentation of NED costs. Selectedapplications of economic theory to commoncost problems encountered in the planningprocess and clarification of the NED costissues are presented in Chapter 5. Many of theideas presented earlier in the manual areintegrated in Chapter 6 by translating theproject costs into NED project costs in ahypothetical example. An index is provided toassist readers interested in a specific topic.The first appendix presents a brief history ofthe evolution of planning principles for Federalwater resource development agencies. Thesecond one provides suggestions for furtherreading to assist those who want more detailson a topic than are given here.

5

Chapter 2: COSTS AND THE CORPS OFENGINEERS

CHAPTER OVERVIEW

This chapter provides a brief overview of (NED). For a plan to be implemented it musthow costs are used by the Corps of Engineers be efficient from the perspective of the nation .in the conduct of their missions. The emphasis Actions that make a positive net contributionis, of course, on the conduct of planning (efficient) to the economic development of thestudies and the implementation of nation may be considered for possiblerecommendations that come from them. After implementation. Actions that fail to make aan overview of the role that costs play in the net positive contribution (inefficient) to theplanning and construction functions of the economic development of the nation will notCorps, attention is turned to groups that be taken. An economic evaluation is carriedperform specific functions in the Corps out to determine whether a particular waterprogram. This chapter will be most useful to resource project is economically efficient orthose with little familiarity with the Corps' not. Only actions that are efficient from theprogram. national perspective are usually implemented.

ROLE OF COSTS

The Civil Works planning process begins planners and engineers estimate the time andwith the perception of a problem, e.g. flooding materials required to implement them. Theor shoreline recession. Through a variety of costs of this time and these materials ismeans the local community may request and estimated and becomes part of the project3

obtain action by the Corps of Engineers. costs. The Federal government, in the P&G,Generally, this action begins with a study of has defined what is appropriate to consider asthe problem and a report recommending a cost of the alternative plans considered. Thisspecific responses to it. Studies, of course, is a condition of Federal involvement in thetake money, so study costs must be estimated, planning process. It's also a constant source ofbudgeted, appropriated, received, obligated confusion for non-Federal interests.and spent to accomplish the work.

In deciding whether or not to take a they are expressed on an average annual basisspecific action, the Corps will consider a so they can be directly compared to projectnumber of goals and objectives. The single benefits which are also estimated in average

overarching objective of the Federalgovernment is national economic development

4

With the problem identified, a number ofalternative plans to address it are considered.As these alternatives begin to take shape,

Once the NED costs have been identified

annual dollars. If the average annual benefitsexceed the average annual costs, the project iseconomically feasible. The plan with the

6

greatest positivenet benefits that reasonably Eventually, as the project is built and themeets the planning objectives is designated the money is spent, someone will have to keepNED plan. The NED plan usually becomes track of all the expenditures.the plan recommended for implementation.

If the project is efficient and acceptable, is talking about costs. There are manya new major issue comes to the fore - paying different groups that use cost information.for the project. If the project serves more than These costs are put to many different uses. Asone purpose, e.g. it reduces flooding and a result of the multitude of users and uses,increases recreation, the costs of the project problems are inevitable. Sometimes people aremust be allocated to the different purposes using different words that mean the sameserved by the project. Then the costs allocated thing. Other times people use the same wordsto each purpose are apportioned between the that mean two entirely different things. Costnon-Federal partner and the Federal concepts used for efficiency decisions aregovernment based on legislated cost-sharing frequently confused with cost concepts forpolicies and implementing formulas. implementation. The many steps to

Financial analyses are conducted to assure with communication problems. In this chapterthat the local partner has the capability to pay we briefly consider selected users of costs and5

its share(s) of project costs. The sharing and the uses they make of them.payment of costs is formalized in a projectcost-sharing agreement. Up to this point, theproject remains on the "drawing board" andcosts are typically estimated based on theprices that prevail at that point in time. As Focussing on the district level of theconstruction becomes more imminent it is Corps, it is possible to identify some more-or-necessary to obtain better estimates of the less typical groups of users of costactual amounts of money that will have to be information. Though districts can be uniquelylaid out by the Federal and non-Federal organized to suit their specific needs the usersentities. Because construction usually takes identified below can be found in some shape orplace over several years it's necessary to form in every district. The descriptions of theestimate what the cost of various things will be cost-related activities of these elements areone, two, three or more years down the road. offered as examples. They are by no meansLikewise, the costs of operating, maintaining, comprehensive descriptions of an element'srepairing, rehabilitating and replacing the activities.project over the next 50 or 100 years mustalso be estimated. In one district the planning function might

Meanwhile, other personnel are busy with another, it may be conducted by a planningthe budget work necessary to get the money branch that is part of anengineering division.from Congress and the local partner at the It is of no real consequence for this manualtime and in the amounts needed. Others are where any function is actually conducted.busy soliciting and awarding contract bids. Hence, we refer to the group that performs the

Throughout this entire process, everyone

implementing a civil works project are replete

WHO USES COSTS?

be conducted by a planning division. In

7

planning function simply as Planning. The services. These estimators can often be foundgroup that handles the engineering function is in a cost engineering group. called Engineering, and so on.

PLANNING

Planners use cost information to make the contracts have been awarded and moniesbasic efficiency decision about alternative spent.plans. NED costs are used to make thisdecision. NED costs play a crucial role in theidentification of the NED plan. Plannersallocate costs to their various purposes anddetermine cost-sharing for each purpose. Real estate personnel are responsible forPreliminary estimates of project costs are estimating the value of real property, costs ofprepared by planners but they typically receive acquisition and severance damages. Once aninformation about those costs from one or alternative plan has been identified, propertymore other Corps offices. Within the district, acquisition is often a major cost for waterquantity estimates and unit costs are provided resource projects. Appraisers estimate theby engineering or, more recently, a cost costs of acquiring land and its improvements,engineering group. Real property values are relocating businesses or residences, andprovided by a real estate group. obtaining easements and rights of way. These

Planners have the most contact with the estimate.general public and the local partnersthroughout the problem study and reportpreparation. In this role they are the first toinitiate discussions about project costs.Planners frequently provide cost information Programs personnel prepare annualto other elements of the Corps. For example, budget submissions to Congress and coststudy costs may be managed by planners. information for longer range planning. CostProject cost estimates for the budget process data for budget submissions include all Federalare also prepared by planners. and non-Federal costs for real estate

ENGINEERING

Engineering divisions in each districttypically have an organization whose functionis to estimate the quantities of goods andservices required to implement the alternativeactions under consideration. They also provideestimated costs for the required goods and

As a study progresses, the estimates ofquantities and costs become more and moredetailed. All cost information to this point isestimated. Actual costs are not available until

REAL ESTATE

costs become part of the overall project cost

PROGRAMS

acquisition; construction features; planning,engineering and design; construction

8

management; and, a contingency allowance for outputs are realized. Operating andunforeseen changes in the cost estimate based maintaining a project incurs costs. Over aon its level of reliability. longer period of time, components of a project

Project cost estimates used by programs obsolete necessitating repairs or replacement.are based on a 1 October price level for the The physical deterioration that occurs overcurrent year with an allowance for future time may require a more comprehensiveinflation through the construction period. rehabilitation of the project. Costs ofExpected inflation rates reflect average annual operation, maintenance, repair, replacementrates over a 10-year period. Refinements of and rehabilitation (OMRR&R) are generallythe cost estimates are coordinated with the responsibility of the operations group.planning, engineering, construction, real estateand other personnel within the district throughthe project manager. Project cost estimatesare updated at least annually for activeprojects. Counsel's role in project costs is one of

PROJECT MANAGEMENT

Once the feasibility study is completed, typically be involved in real estate issues thatthe resulting cost estimate is used by the can substantially affect costs. PCA negotiationproject management group to develop the often requires Counsel to deal directly withProject Management Plan (PMP). The PMP State and local representatives as well asprovides details for the cost estimate and its agency personnel at all levels of government.schedule for design and construction of the Frequently, costs are the primary focus ofentire project. Once the PMP is approved, a these negotiations. Issues may range fromproject cost summary is maintained by the complex and controversial discrepancies overproject manager to monitor deviations from the value of resources to the mundane butthe baseline estimate. Changes to the current confusing establishment of construction costproject cost estimates must be documented accounts, such as archeological andand accounted for in a formal manner through construction accounts.appropriate channels. Status reports submittedto headquarters are used to document and Counsel may also be required to becomemonitor district management efficiency and involved in the resolution of contract disputesproject performance. that include awards and claims that can affect

OPERATIONS

Once a project has been constructed itmust be operated in a manner consistent withits design to ensure that the intended project

may wear out, be damaged, or become

COUNSEL

the least visible and most all encompassing. Itis not unusual for Counsel to be involved in aproject from the feasibility study stage throughconstruction and even beyond. Counsel will

costs. Litigation that can result in long andcostly delays or modifications of projects willnaturally require involvement of counsel.

9

CONTRACTS

Contracts personnel are responsible for NED costs are also used to determine costsoliciting, awarding and administering the allocations. Thus, NED costs are important tocontracts required to complete studies, non-Federal interests because they are used toimplement projects or to operate, maintain, determine what if anything can be done to helprepair, replace or rehabilitate projects once local interests and they provide the basis forbuilt. Specifications for the contract are determining the local share of implementationtypically provided to the contracts group by costs . Implementation costs are of obviousone of the other Corps offices. These concern to the non-Federal partner becausespecifications might describe the work to be these are the costs they must share.done, for example in a planning study, or theymight consist of design features and quantitiesrequired to construct a project or projectcomponent. Contract bids are solicitedconsistent with current contracting procedures On occasion where Corps reports areand a contract award is made to the successful reviewed by personnel from outside thebidder. agency, costs are frequently a major focus.

The contract cost is generally an upper Office of Management and Budget (OMB),limit on costs. Contracts personnel then and the Army Audit Agency (AAA) are a fewadminister the contract to assure that outside reviewers extremely interested inpayment is received for work completed. It is costs. Congress is interested because theyonly after work is completed and payment is must make funding decisions; OMB because itreceived that actual costs are known. includes or excludes projects from the

NON-FEDERAL PARTNER

The non-Federal partner is required to project cost estimates.pay a portion of the costs to implement aproject and often a portion or all of the normalcosts of operating and maintaining it. Once areconnaissance study has been completed localinterests may be required to pay a portion Corps cost estimates are often of(normally 50 percent) of the feasibility study considerable interest to industry peoplecosts and a portion of subsequent costs because of the quality of work done by thethrough implementation and operation of the Corps. Previous estimates of project costsproject. may provide the basis for subsequent contract

The non-Federal partner must understand source of hard to get cost data or hard tothe basic nature of both the NED costs and the estimate costs. Conversely, costestimators forimplementation costs. NED costs are used in the Corps sometimes rely on industry people

the determination of which, if any, alternativeplans are economically efficient, i.e., feasible.

6

OUTSIDE REVIEWERS

Within the Federal government, Congress, the

President's budget; and, AAA because itconducts formal audits of selected projects.Outside the Federal government, State andlocal agency personnel review and scrutinize

INDUSTRY PEOPLE

bids. Often Corps cost estimates are the best

10

for unit cost estimates. Estimated costs ofdredging, for example, are most oftenprovided by industry experts.

SUMMARY AND LOOK FORWARD

There are many users of cost informationwithin the Corps and they make a great varietyof uses of their cost information. Each of the"user groups" described here must interactwith virtually every other group at some pointduring the study and implementation of awater resource project. For certain pairs ofgroups, for example planning and engineering,the coordination is constant.

Each of these groups has developed itsown cost jargon. Within a group this jargonmay serve the group's interests well. Outsidethe group communication problems can result.In the next chapter, some of the economictheory necessary for understanding the specificrole of NED costs is presented. Then, much ofthe specific cost jargon used by the economicsprofession and by the Corps of Engineers areexplained.

11

Chapter 3: THEORYAND LANGUAGEOF COSTS

CHAPTER OVERVIEW

NED costs are used for the economic costs us something. It costs us theanalysis of alternative projects; hence, we must opportunity to have done something else.take an economic perspective of costs tounderstand the nature of NED costs. The first Economic decision making, such as thepart of this chapter provides a brief efficiency decision made during the planningintroduction to the economic nature of costs. process, is based on this notion of opportunityMost of the early material appears in sidebars costs. The cost of any action taken is thebecause it is more technical in nature than the value of the most valuable action not taken. rest of the chapter. The sidebars can beskipped with no loss of continuity. The Non-economists think of costs as theNational Economic Development Procedures dollars that must be expended to acquire orManual - Overview Manual for Conducting use something. Fortunately, in most situationsNational Economic Development Analysis opportunity costs and dollar costs are equal,IWR Report 91-R-11 is a useful companion avoiding the confusion that results when theyreader for this chapter and should be referred are not. Unfortunately, in the case of waterto by those looking for additional information. resources planning, there are many instances

The second half of the chapter offers a diverge. Economists who are trying totaxonomy of costs. The reader will find terms allocate scarce resources efficiently are onlydefined and distinctions made among terms interested in the opportunity costs. Thoseused by economists and the Corps of who must come up with the money to financeEngineers in this section of the manual. the project are primarily concerned with the

COST IN ECONOMIC THEORY

We, as individuals or collectively as a both have legitimate but varying interests.society, can't have everything we want. Theresimply aren't enough resources available to In this chapter basic economic concepts,meet every need or want. Because we can't fundamental to the understanding of economichave everything, we must make choices. costs, NED costs and the other costsWhen we choose what we will do we are frequently confronted in planning and

simultaneously making a choice about what wewill not do. Thus, when we make a choice it

where opportunity costs and dollar costs

dollar costs. The result is two groups payingattention to two different definitions of costs;two different sets of numbers. Is it confusing?Yes. Is one of the groups wrong? No, they

12

implementing water resource projects, are for a resource. Nowhere can this point bepresented. The key to understanding the made as vividly as it can with water. concepts presented here is to concentrate onthe role of resources. If the use of a resource Consider the mythical desert oasis -palmchanges or an unused resource is used, there is trees and a small pond of water surrounded byan opportunity cost. There may or may not be thousands of square miles of barren desert.a dollar cost. If the right to use a resource Though many would be tempted to call thischanges hands but there is no change in the water scarce, if no one or nothing desires theuse of the resource, there will probably be a water beyond the modest needs of the fewdollar cost but there is no opportunity cost. trees and desert insects there is no scarcity

SCARCITY

To the person on the street scarcity isolated wild through which it sometimesimplies that something is rare or difficult to winds, it is difficult to imagine ever runningfind. Hen's teeth, a toaster that can out of water in this river. Yet, we know allaccommodate a bagel, or a flattering bathing too well that desires for the waters of thesuit are a few things most of us would agree Colorado exceed that river's ability to satisfyare hard to find. To an economist, scarcity society's thirsts for its flows.means something entirely different. Scarcityis the term used by economists to indicate thatpeople's desire for a "thing " exceeds the CHOICE AND OPPORTUNITY COST7

amount of it that is freely available fromNature.

For example, air to breathe (notnecessarily clean air), is freely available at alltimes and everywhere in quantities greater thandesired by all the people on the earth. Thus,breathable air is currently not scarce. Try tothink of another example of a good that is notscarce. It's not easy, virtually all goods arescarce. If less of a good is freely available thanconsumers would like; it is scarce. 8

Scarcity does not result from the fact thata good exists in small quantities. Nor do largequantities of a good guarantee an absence ofscarcity. What does matter is the relationshipbetween people's desires for goods and theirproduction possibilities. The only requirementfor scarcity is that there be more than one use

though the water resources are limited.Contrast this with the waters of the ColoradoRiver that drain the Rocky Mountains.Watching the raging torrents of this river in the

Scarcity of any resource dictates thatchoices be made. Choosing more of one thingsimultaneously means choosing less ofsomething else. Choose to preserve thespotted owl and you are simultaneouslychoosing not to harvest the trees in which theylive. When we have the opportunity to domore than one thing with a resource, forexample, to use land as wildlife habitat or tostore water on it for municipal usage, everychoice costs us an opportunity to have donesomething else.

Frequently, that which a choice costs uscannot be quantified in dollar terms. Supposeyou are at a carnival where a new ride is beingpromoted by letting everyone ride free. Asyou take your place in line you notice the signthat says, "one hour wait from this point." Isthe ride free? With the hectic lives most of uslead leisure time is very precious to us and theopportunity cost

13

Opportunity Cost Illustrated

Consider a simple society that has a finiteamount of water resources and a fixed and given levelof technology. Assume that water can be put toinstream uses such as hydropower, recreation andenvironmental quality, or it can be withdrawn and putto agricultural, municipal and industrial uses. Theproduction possibilities frontier in the figure shows allthe possible combinations of instream and withdrawaluses that can be made if all the water is used fully andefficiently, given the existing technology.

The frontier itself divides society's choicesinto two groups of combinations of instream andwithdrawal uses: the attainable which includes thearea inside the curve and curve itself; and theunattainable, the area outside the curve which can't berealized with current resources and technology. In aworld beset with scarcity there are always limitationson society's ability to get all they want. Thecombination of instream and withdrawal usesindicated by point A is not possible given currentresources and technology.

People are forced to make choices fromamong the attainable options. If all resources aredevoted to instream uses, then a maximum output ofinstream uses, shown as the distance OB, will result,with no withdrawal uses. If, on the other hand, allresources are devoted to withdrawal uses, a maximumof OC withdrawal goods could be produced.Society's production possibilities frontier restrictspeoples ability to have all they want. It is worthnoting that points inside the frontier are attainable butinefficient. For example, the combination of point Gcan be produced but society has no reason to do that.They can produce more of both withdrawal andinstream goods by moving to point D. It would bewasteful to produce at G.

Using the production possibilities curve, it'seasy to see how choice comes with costs. If societychooses OB of instream uses they must forego OC ofwithdrawal uses. The benefits are OB, the costs OC.The choice is, however, not an all-or-nothing choice.Society may prefer a combination of both goods suchas shown at point D. OE of instream uses meanssociety must forego the opportunity to produce anadditional FC of withdrawal goods. Likewise, theproduction of OF withdrawal uses means society will

lose the opportunity to produce an additional EB ofinstream goods.

It makes sense to move from all instreamuses to a point like D if the value of OF, thewithdrawal uses gained, exceeds the value of EBinstream uses foregone. Benefit-cost analysis isconceptually nothing more than the systematicvaluation of such trade-offs, albeit in more complexsituations.

14

of waiting in line may be very high indeed, consumer goods that would have been enjoyedthough it is not a cost that can be easily had the project not been built.quantified in dollars.

A more pertinent example occurs whenwe choose to rehabilitate a lock that willproduce impacts like noise. The noise from The purpose of economic analysis ofconstruction may disrupt the migration of water resource projects is to aid the efficientwaterfowl to a nearby wildlife preserve. The allocation of the Nation's scarce naturalshorter lockage times that result from resources. We don't want to waste resources.rehabilitation costs us, among other things, the We don't want to pay more than we have toopportunity to have undisturbed migration of for a project and we don't want to pay morewaterfowl. Project costs of concrete and steel than it is worth. This is easier said than done.are much easier to quantify in dollar terms thanis the disruption of waterfowl migration.

Economists view costs differently thanmost people do. To an economist cost is notnecessarily the amount of money you have tospend to produce or buy something. The realmeasure of cost is opportunity cost, i.e., thevalue of that which is foregone when a choiceis made. The more you valued the alternativeopportunities, the higher is your opportunitycost.

Society, like individuals, faces scarcityand must make choices. Society incursopportunity costs as well. Consider theproduction of a new lock and dam that usesland, labor, materials, and equipment worthroughly $600 million. That same quantity ofresources could have been used to build 100miles of electrified railroad, one nuclear attacksubmarine or thousands of other things. Tomake this more personal let's consider whatthe money costs could mean to us. Assumethe $600 million was raised through taxes. Iftaxpayers had kept their money they wouldhave spent it on clothing, entertainment,automobiles, etc. Hence, we could see theopportunity cost of the lock and dam as the

EFFICIENCY

15

The goal of economics is the efficient useof resources. Economic efficiency, forsociety as a whole, is achieved when weproduce the combination of outputs with thehighest attainable value given our resources.Economic efficiency at the national level is theintent of the National EconomicDevelopment (NED) objective. A waterresources project should be economicallyefficient. Anything else would be wasteful. Ifwe use our natural resources to produce acombination of project outputs that is lessvaluable than another feasible combination ofproject outputs, we could have done better.

A TAXONOMY OF COSTS

The simple notions of scarcity, choice andopportunity cost underlie the economist'sconcept of costs but the economist's ideasabout costs are very different from other'sviews of costs. As most people are not trainedin economics they often find opportunity costless compelling than a price tag. Nonetheless,it is the economist's view that is most relevantwhen considering

16

MARGINAL PRODUCT & MARGINAL COST

Sections ofLevee

IncrementalStructures Protected

Total StructuresProtected

Sections of Levee PerStructure Protected

0 0 0 --

1 20 20 0.050

2 24 44 0.042

3 15 59 0.067

4 11 70 0.091

5 7 77 0.143

6 3 80 0.333

7 0 80 infinity

Production, Resources and Costs

Because costs are the focus of this manual itis useful to consider from where costs come. Costsresult from ordinary production activities. Aproduction process takes inputs and combines themvia some technology to produce outputs. Planningand implementing water resource projects is, in thissense, very much a production process.

Inputs for a water resources project areresources that include many types of labor, materials(e.g., concrete, steel, rip-rap), equipment (e.g., drills,earth-moving machinery, cranes, handtools), and land.The outputs of a project are flood control,hydroelectricity, transportation services, recreation,water supply, etc. The technology used to combinethese inputs and turn them into the desired outputsresides in the knowledge and techniques imbedded in

the many different disciplines required to developand implement a plan.

Outputs require inputs and technology. Thecost of producing that output is based on the prices ofeach input and the quantities of each input. The quantity required is determined by the technology.

Consider a sample production examplewhere the only input is levees, measured in leveesection (LS) and the output is flood control, measuredin the number of structures protected (SP), as shownin the table. Column one shows the number of LS oflevee; column two shows the incremental (marginal)product of each LS; column three is the cumulativenumber of structures protected; column four showsthe incremental (marginal ) cost of each structureprotected measured in LS rather than dollars.

(Continued next page)

17

Production, Resources and Costs (Continued)

The first LS protects 20 structures at acost of 0.05 LS per structure protected. Thesecond LS protects 24 additional structures for atotal of 44 structures protected by the twosections of levee. The additional 24 structurescost 0.042 LS each. The seventh LS protects noadditional structures so the incremental cost goesoff to infinity. Additional sections of levee wouldrequire the removal of structures so theincremental protection actually becomesnegative. These are not shown.

Column four shows the amount ofresources required to produce each additional LS.Production has costs. Those costs are measuredhere in terms of the resources required to producean output. If a LS costs $1 this is equivalent tomultiplying the values in columns one and four by$1 so they can be reinterpreted as the dollar costsof protecting structures. It is usually a simplestep from resource costs as shown in column fourto dollar costs as long as the cost of the resourcehas a known price.

The purpose of this example is to clearlyestablish the link between resources and dollarcosts. From an economic perspective, the truecosts are the value of resources used. If theresources used have a price, as most resourcesused in a water resources project do, project costscan be expressed in money terms.

Looking ahead to the problems thatarise when resource and money costs divergefrom one another two points need to be madehere. First, true economic costs are expressed interms of resources used. If there is no change inthe resources used there is no cost. Second, if theresources used have no readily discernible priceit will not be easy to express costs in dollar terms.

national efficiency and it is the economist'sview that is the basis for NED costs.

In the following paragraphs we offer ataxonomy of some of the cost terminologymost commonly used by economists and theCorps of Engineers. The language of costs isextraordinarily complex. The jargon haseconomic, accounting, engineering, financialand legal implications. There are frequentcontroversies and misunderstandings about thenature of costs. What words should be used?How are they defined? Which terms arerelevant? The particular information requiredvaries from one problem to another.

Within the Corps' program, costs can beclassified into two major categories ofparticular interest in this manual and a thirdcategory of less interest here. Figure 3 showsthese categories. First, cost information isrequired to formulate water resource projects.It is specifically needed to answer questions ofeconomic efficiency posed during the planningprocess and to select a recommended plan.Second, cost information is required toimplement water resource plans. Someonemust pay for the project. Third, the Corps'budget requires extensive cost information to run the Corps'program.

Economics, as a discipline, and the Corps,as an agency, both operate within thefunctional areas of Figure 3. Though bothspeak the common "language" of costs eachhas its "dialect". With economists and agencypeople working together on formulation andimplementation issues the potential forcommunication problems is widespread.

The economist's "dialect" is predominantamong the formulation

18

Opportunity Cost

! Explicit & Implicit Costs! Internal & External Costs! Economic & Money Costs! Marginal & Incremental Costs! Fixed & Variable Costs! Average Costs

FIGURE 4: OPPORTUNITYCOST COMPONENTS

functions. The economist's jargon is built The remainder of this section turns to theupon the basic concepts presented earlier in cost terminology that is most familiar to non-this chapter and is addressed first in the economists. Marginal costs are the relevantremainder of this chapter. The Corps' "dialect" opportunity costs for most water resourceis preeminent in use for the implementation decision problems. Incremental costs are afunctions and is addressed next. This special type of marginal cost. The typical costterminology is principally the innovation of theCorps of Engineers. The third category ofcosts is not explicitly addressed in this manual.

THE LANGUAGE OF ECONOMISTS

Figure 4 maps the topics of this section.Beginning with the concept of opportunitycost we work backwards, decomposing themfirst into explicit and implicit costs. Each ofthese can, in turn, be comprised of internal andexternal costs. Figure 4 shows the relationshipof these costs. Once these basic concepts aredefined the differences between economic andmoney costs are discussed.

19

relationships that follow are the costs that opportunity or economic cost. Policycomprise a major portion of the cost theory decisions over the years have caused thepresented in microeconomic theory courses. concepts of opportunity cost and NED cost toThe section concludes by considering two diverge in some few cases. For example, thetopics that greatly influence economic notions opportunity costs of providingof cost: time and price level. better housing for people relocated as a result

Economic cost, opportunity cost,resource cost and NED cost are some of thephrases frequently used by economists thatremain a mystery to most people. They are allvery close in meaning but they vary by contextand nuance. The key to understandingopportunity cost is, as mentioned above, tounderstand that every time we make a choiceit costs us something. Fortunately, the price ofa good or service is usually a proper measureof opportunity cost. It is, however, significantthat the definition of opportunity costs doesnot refer to or depend on dollars. Any choiceincurs a cost. Donated land or land alreadyowned by the project sponsor has no dollarcost. When we choose to use it for a project,a cost is incurred because we forego theopportunity to use the land in some otherfashion at some future point. Whether thatcost is ever covered by an actual expenditureof money or not is immaterial to the existenceof a cost.

Economic cost means exactly the samething as opportunity cost. Economic costmore directly conveys the notion that these arethe costs of concern to economists. Resourcecost is, as previously noted, the basis foropportunity cost. Resource cost is generallyused to shift the focus of cost considerationsback to the real resources that are being usedand away from the exchange of money.

NED cost are defined as "the opportunitycost of resource use." For the most part, NEDcost means exactly the same thing as

of a project are, by policy, excludedfrom NED costs. Thus, we cannot say thatNED cost and opportunity cost are identical,though that appears to have been the originalintent.

Economic Cost

a. Explicit Cost versus Implicit Cost.Opportunity costs are the sum of explicit plusimplicit costs. The costs of using resources inproducing outputs involve out-of-pocket costs and noncash costs.Explicit costs, sometimes called money costs,are out-of-pocket expenditures for goods andservices received. When you have to write acheck or turn over cash to complete atransaction you have incurred an explicit ormoney cost. These costs are relatively easy toidentify. However, it should be noted that notall explicit costs are opportunity costs. Thistopic is taken up in the following section oneconomic and money costs and again inChapter 5.

Another kind of opportunity cost isimplicit cost sometimes called imputed cost.Implicit cost is a noncash cost that does not9

show up in accounting records. Implicit costsare nonetheless opportunity costs and areimportant for decision-making.

Suppose you own an office buildingdowntown that could be rented for $10,000per month. If you use this building to houseyour own business you incur costs. You

20

Resource Costs

Resource costs are mentioned in the P&Gbut the term "resource cost" is not often encounteredin the economics literature. Opportunity costsrepresent the use of resources and they are oftenexpressed in dollar terms. Resource costs, on theother hand, are always expressed in quantities ofresources used. The concept of resource costs can bean extremely useful one in clarifying some of thediscrepancies between what is an NED cost and whatis an implementation cost.

For example, consider a cubic yard ofconcrete used in a project. What does the rest of theeconomy/society ultimately lose when this concrete isused for the project? Picking up on the concept ofopportunity cost developed above, society loses thealternative uses for this concrete. It may have beenused for a few blocks of sidewalk, a driveway, or inthe construction of an office building. It's use in aproject precludes its use in any of these otherendeavors. The resource cost is one yard of concretebut its money cost represents the value of that concretein its next best alternative usage. The dollar cost percubic yard of concrete is a reasonable estimate of theopportunity cost of the concrete. The resource costincludes the labor, raw materials and equipmentrequired to produce and transport the concrete.

Now let's consider an acre of government-owned wetlands used in a project. Because thewetland is already owned by the government there willbe no dollar cost to acquire it. Clearly there is aresource cost. To determine the true economic cost ofthe wetland we again ask the question, "What does therest of the economy/society ultimately lose when thiswetland is used for the project?" Wetlands providehabitat, they can be important links in the food weband energy chain, they may provide recreationalopportunities or scenic values. All of these uses arelost. Can we place a dollar value on the highest ofthese foregone opportunities? Perhaps, but not veryeasily or reliably. Nonetheless, the use of the wetlandcosts society something. The resource cost is easy toidentify, one acre of wetlands. If the project costestimate is to reflect the true economic costs we must

estimate a dollar value for the resource cost, though noone will ever have to actually pay this cost. The dollarvalue of the resource cost is an NED cost.

Suppose an unemployed person is used tobuild a project. What does the rest of theeconomy/society ultimately lose when this person isused for the project? If he had no job and wasproducing no output, society will lose little. Thus,society will sacrifice very little to use him for thisproject. The opportunity cost of this person's time isvery low, though it is not zero. The economic cost ofhis labor is considerably less than the money wage heis paid.

Economic theory would suggest that theopportunity cost of his time be based on the value ofthe lost opportunity, presumably foregone leisure,rather than the wage paid the worker. This wouldresult in economic costs below the money costs of theproject. Corps' policy has determined that rather thanuse this approach some of the money wages paid canbe considered redevelopment benefits if the projectarea meets certain qualifying criteria. The effect onnet benefits will be the same whether NED costs arereduced by a certain amount or NED benefits areincreased by the same amount.

Let's consider one final example. Supposewe have a streambed that will continue to be used asa streambed in a project. What does the rest of theeconomy/society ultimately lose when this streambedis used for the project? In this case, society losesnothing at all. The land that constitutes the streambedwas originally a submerged streambed and its usedoes not change at all. There is no opportunity cost ofthis resource because there is absolutely no change inthe way the resource is being used. Society will losenothing. Will there be a dollar cost for this resource?Perhaps. Someone owns the streambed in question.If they are asked to relinquish their

(Continued Next Page)

21

Resource Costs (Continued)

ownership, they are transferring the right to use aresource, which is quite different from the actualuse of the resource, to someone else. The sale ofthat right may be judged to have a monetaryvalue, despite the fact that there is no trueeconomic cost.

The question posed in each of theseexamples, "What does the rest of theeconomy/society ultimately lose when thisresource is used for the project?," is critical fortranslating the idea of resource costs toopportunity costs. The next question is "Can theopportunity cost be readily quantified in monetaryterms?" When the resource used has anopportunity cost that is easily quantified inmonetary terms there are few problems. Whenthis is not true, however, cost estimating canbecome complex and confusing.

have the explicit costs of labor and materials,etc. to pay each month. In addition you havethe implicit cost of using your building, ascarce resource. If you did not use yourbuilding you could earn $10,000 in rent eachmonth. Though you may not owe a penny onthis building it costs you $10,000 a month touse it. You have the opportunity to make$10,000; foregoing that opportunity costs youthat $10,000.

Whether you make an explicit paymenteach month or bear an implicit cost, the cost toyou in either case is identically the same. Youmay have a different psychological reaction toan explicit cost than you do to an implicit cost,but the cost is the same. For example, losingrecreation activity valued at $1 million per year(an implicit cost) is as much an opportunitycost as buying $1 million worth of concrete.

b. Internal and External Costs. Implicitcosts may be internal or external. Likewise,

explicit costs can be internal or external.Internal costs, sometimes called privatecosts, are the costs borne directly by theperson, firm or entity that is taking someeconomic action, i.e., consuming or producingsomething. The internal costs of consuming acup of french fries at the beach is the timespent waiting in line for them, the price of thefries, and the health effects of consuming friedfood. These are all internal costs. Some ofthese costs are explicit, the price of the fries;and some of them are implicit, time in line andhealth effects.

External costs are the costs of an activitythat are borne by parties not directly involvedin the activity. When you get in line for friesyou increase the time that anyone arriving afteryou must wait in line. If it takes 2 minutes toserve you and there are 20 people in linebehind you, your presence costs the group 40minutes of time. Thus, your presence on lineimposes costs on others. If you carelessly tossyour cup on the ground after consuming thefries you impose a cost on others as well.Someone will expend some resources to pick-up your cup.

If you are a typical consumer you willconsider only the private costs of your actionsin deciding whether to undertake an economicactivity or not. A ten minute wait and a $3cost are important to you. That you may causeothers to wait a cumulative 40 minutes andcause an expenditure of &1 to have your litterpicked up are of no concern tp you.

22

Another Meaning for Incremental Cost

Among Corps' planners "increment"does not mean the same thing it means toeconomists. To the Corps planner, an incrementis a part of plan and the costs of that part of theplan are often referred to as incremental costs.Incremental cost in this context does not mean thesame as it does in the preceding discussion.

An increment is a term that takes itsmeaning from its context. Planners may speak ofan increment of protection as a part of a plan. Inthis case, increment means an increase in outputas described above. In other cases, increment isused to describe a part of a plan that is moreaccurately a separable element of the plan. Forexample, a water resources plan might consist ofone or more separable elements or componentsthat are hydrologically independent of oneanother. The working definition of"hydrologically independent" is that such acomponent of a plan could be built and wouldfunction by itself. It does not require anothercomponent to assure its proper functioning. Suchplan components are often called increments.

Levees protecting development on theright and left banks of a river can be consideredseparable elements. Their proper functioning isindependent of one another. Unfortunately, forthe purity of the language, these levees are oftencalled plan increments. Within one of theseseparable elements we can have vertical (level ofprotection) and horizontal (area protected)increments of protection. Once planners useincrement indiscriminately to refer to any or all ofthese components of the plan "incremental cost"becomes a very difficult term to understand.Used in this way, it no longer bears aresemblance to incremental cost used in marginalanalysis. The only solution to this confusion is tobeware of the context in which the term is used.

Social costs are sometimes defined to bethe sum of all internal and external costs. Inthis interpretation they are essentiallyopportunity costs. Less frequently social costsmay be used synonymously with externalcosts. In this sense they are costs imposed onthe rest of society by the actions of anindividual or some other agent of economicactivity.

Pollution is the classic example of anexternal cost. A papermill incurs costs toproduce the paper and dumps its untreatedwastes into an adjoining stream. The costsdirectly borne by the papermill include rawmaterials, labor, rent, interest, etc. Cleanwater is another resource used up in theproduction process as wastes are dumped inthe river. Because the costs of pollution areborne by the fishermen on this river and thedownstream town that must remove thewastes before drinking the water, not all costsare borne by the mill. The external costs areimposed on third parties.

External costs are commonly encounteredin many of the Corps' missions. For example,a permit was requested to open a boat salvageyard along a major river. Adjacent to theproposed salvage site was a popular urbanpark. An estimate of the costs of the salvageoperation was very thorough in estimating thecosts of building, owning and operating asalvage yard. They did not include theexternal costs. In this case, considerable costwas imposed on the park as the quality of therecreational experience was significantlydiminished by the noise, odors, and sightsintroduced by the yard. The nature of the parkwas changed by the

23

introduction of the salvage yard. In explicit cost without there being anyretrospect, it is not apparent that had the opportunity cost. analysis thoroughly investigated all therelevant costs of the yard, including external The streambed example from abovecosts imposed on the park, that the permit comes to mind. A streambed is a resource. Ifwould have been given because the operation a streambed has always served as a streambedmay in fact be economically inefficient. and always will, there are effectively no

c. Economic and Money Costs. ManyCorps planners are familiar with the termseconomic cost and financial cost. Theworking definitions go something like this:economic costs are those costs economists useto calculate the benefit-cost ratio; financialcosts are the costs that someone is going to10

have to pay. In recent years a financialanalysis has become a standard part of everyCorps project. To avoid confusing people by rights. Property rights are a legal constructusing the term "financial cost" when it does and we distinguish the right to use a resourcenot refer to this financial analysis we will use from the use of the resource. It is the use ofthe term money costs in this manual.

In the context of this manual economiccost has two meanings. First and foremosteconomic costs means opportunity costs.Second, in the context of the Corps mission,economic costs has come to mean the coststhat are needed for the economic analysis orNED costs. Though there may be differentnuances to the two definitions they can11

effectively be considered synonyms.

Opportunity costs can be considered toconsist of two parts, explicit and implicit costs.If economic costs are identical to opportunitycosts then one would conclude that economiccosts are equal to implicit plus explicit costs.There is a little recognized problem withmaking this connection, however. There canbe an

alternative uses for the resource. If there isonly one use for a resource and it is alreadybeing put to that use then it does not costsociety anything to continue to use it in thisfashion. There is no next best alternative useto which the resource can be put, so there isno opportunity cost.

In the U.S., ownership of a resourceconveys certain rights of usage or property

the resource that incurs the opportunity costfor society. The right to use the resource doesnot impose an opportunity cost. The exchangeof property rights is an exchange of somethingof value that has no effect on a resource's use,it merely transfers the right of usage from oneperson to another.

If a project requires that the right to usea resource be acquired there will be an out-of-pocket cost. Someone will make an explicitpayment for the right. These cases whereexplicit costs do not entail opportunity costsare rare. Though there is a temptation toignore them for the sake of simplicity wecannot. Unfortunately, the exceptions to therule are the most confusing cases. The bestwe can do here is to point out that economicor opportunity costs can almost always bedefined as explicit costs plus implicit costs.There are, however, circumstances where thatis not true. In the greater scheme of

24

water resources planning this distinction in cost is the term used most often by the Corpsterminology is minor, but it is a distinction of of Engineers .which planners and economists must be aware.

Money costs are explicit costs. They arethe costs that must ultimately be paid indollars. Money costs are relevant for thefinancing decisions that Congress and the non-Federal partner must consider when decidingto support a project or not. As noted in thepreceding paragraphs, not all money costs areeconomic costs.

It is tempting to say that the differencebetween economic and money costs is implicitcosts. That is almost but not quite true. Thedifference between economic and money costs is that economiccosts include all implicit costs and omit explicitcosts that do not impose an opportunity coston society.

d. Marginal and Incremental Cost.Few notions of cost are more important toeconomists and less understood by non-economists than marginal cost andincremental cost. Water resource projectsproduce outputs. Marginal and incrementalcosts are dependent upon the amount ofoutput produced by a project. Marginal cost isdefined as the change in total cost divided bythe change in output. In other words, it is theamount by which costs change when output isincreased or decreased. Incremental costs aredefined the same way. The difference betweenthe two terms is that the change in output isarbitrarily small for marginal cost and a largermore discrete change for incremental cost.Thus, marginal cost would be appropriatewhen hydropower output increases by akilowatt. Incremental cost would beappropriate when output increases by 200,000kilowatts. Incremental

12

In water resources planning incrementalcosts are encountered more often than trulymarginal costs. Hydropower capacity changesare given in thousands of kilowatts rather thankilowatts. Levees raising are consideredseveral feet at a time not inches. For thepurposes of this manual, however, there are nosubstantive differences in the interpretation ofthe two terms and they will be usedinterchangeably. This would not be anappropriate use of the terms in a morerigorous economic context.

The significance of incremental ormarginal costs lies in its role in marginalanalysis. Marginal analysis is used to identifythe optimal or best action. This is usuallydone by making something as large as possible(e.g., net benefits) or as small as possible(e.g., costs) subject to certain constraints. Inthe case of water resources planning theeconomic analysis seeks the plan thatmaximizes net NED benefits. From aneconomic perspective this is the best plan.

The best plan is found by applyingmarginal analysis, which is briefly summarizedby the decision rules shown in Figure 5 . The13

rules, expressed in terms of marginal values,could be just as easily expressed in terms ofincremental values. From some starting point,usually the without project condition, we beginto consider the incremental benefits andincremental costs of varying levels

national economic development (ned) procedures manual ... · national economic development (ned)...

Documents