Chapter 6. Cost-Benefit Analysis

Transcription

1 Chapter 6 Cost-Benefit Analysis

2 Efficiency

3 Efficiency The Endangered Species Act Should we be concerned with efficiency when it comes to Endangered Species? Supreme Court 1978 The value of endangered species is incalculable and it is clear from the Act s legislative history that Congress intended to halt and reverse the trend toward species extinction whatever the cost

4 Pale Blue Dot and Scarcity

5 GIANT IDEA Talk with a neighbor You have $50 billion to do good in this world, what would you do?

6 Example of CBA Monorail Project Seattle Costs: Construction, equipment, buy permission from landowners, ruined views, noise near the train, traffic delays during construction Benefits: Reduced travel time, saved parking fees, reduced car maintenance, more reliable commuting times, fewer accidents/fatalities, better views for monorail passengers, reduced noise from busses Beneftis = $2.07 Billions Costs = $1.68 billion The $390 million net benefit helped swing public opinion toward the project

7 Cost-Benefit Analysis 3-step process for determining the relative merits of alternative government projects over time: 1. Determine all costs and benefits of the proposed project. 2. Evaluate all costs and benefits in dollar terms. 3. Discount future net benefits.

8 Cost Benefit Analysis 1. Determining Costs and Benefits Determining Costs In cost benefit analysis, the focus is on Economic Cost, aka Opportunity Cost and not Accounting Cost List not only direct resource costs but also any costs not reflected in the prices of inputs (such as a loss of output from another program) Determining Benefits Divided into direct and indirect benefits Direct benefits are those increases in output or productivity attributable to the purpose of the project Indirect benefits are those accruing to individuals not directly associated with the purpose of the project. Double counting of benefits should be avoided

9 Cost-Benefit Analysis 2. Evaluate all costs and benefits in dollar terms Benefits and costs come in a variety of forms. In order to be comparable, they must be in the same units. Those units are dollars Example Bread and Milk Increased agriculture output in the irrigation project

10 Cost-Benefit Analysis 3. Discount Future net benefits Net Benefits = Benefits Costs Why do we need to discount? Why do we need to find the present value?

11 Cost-Benefit Analysis 3. Discount Future net benefits We have to discount because some projects provide a stream of costs and benefits over time. In general, the present value of X dollars to be receive n years from now at simple interest rate r is obtained by solving the equation: For a project that yields benefits over a number of years:

12 Discount Rates and Projects Project 1 yields $90 in benefits immediately, Project 2 yields $100 in two years, $0 until then Main Point: The higher the discount rate, the lower the value of future benefits

13 Discount Rate and Global Warming What does the discount rate have to do with global warming and governmental policy on climate change? What role does uncertainty play in estimating benefits and costs of climate change? Do we know how to handle uncertainty?

14 Example with numbers Road Repair project

15 Control-Benefit Analysis of Highway Construction Project Quantity Price or Total The project Value requires several inputs materials, labor, and maintenance Cost Asphalt 1 million bags over time. Labor 1 million hours Maintenance Benefits Driving time speed Lives saved $10 million/year First-year cost: Total And cost it produces over time: two main benefits reduced commuting time and fewer 500,000 hours fatalities. 5 lives First-year benefit: Total benefit over time: Benefit over time minus cost over time: Cash Flow Accounting Simply add up what the government pays for all the inputs This does not represent the social marginal cost. We are going to use this pavement example to highlight this point

16 Measuring Costs The social marginal cost is its opportunity costs Value of that input in its next best use This is not necessarily its cash cost, but what else society could do with the input For asphalt, the next best use is to sell the bag to someone else. The value of the alternative use is the market price Not true for labor market when there is unemployment Working vs. sitting on the couch.

17 Control-Benefit Analysis of Highway Construction Project Quantity Price or Value Total Cost Asphalt 1 million bags $100/bag $100.0 m Labor 1 million hours ½ at $20/hr ½ at $10/hr $15 m Maintenance $10 million/year 7% disc. rate $143.0 m Benefits Driving time speed Lives saved First-year cost: Total cost over time: 500,000 hours 5 lives First-year benefit: Total benefit over time: Benefit over time minus cost over time: $115 m $258 m For a repeating value far into the future, (50 years or more) the PV can be approximated as X/r $10 million /.07 = $143 million

18 Control-Benefit Analysis of Highway Construction Project Quantity Price or Value Total Cost Asphalt 1 million bags $100/bag $100.0 m Labor 1 million hours ½ at $20/hr ½ at $10/hr $15 m Maintenance $10 million/year 7% disc. rate $143.0 m First-year cost: Total cost over time: $115 m $258 m Benefits Driving time speed 500,000 hours $17/hr $8.5 m Lives saved 5 lives $7 million/life $35.0 m First-year benefit: $43.5 m Total benefit over time: $621.4 m Benefit over time minus cost over time: $363.4 m Note that $43.5 million /.07 = $621.4 Million What do you think about putting a value on the number of lives saved?

19 Valuing a Statistical Life

20 Value of a Statistical Life Through our actions as human beings, we reveal how much we value small changes in the probability of living. REVEALED IN BEHAVIOR! People typically reveal that they are willing to pay $6-$10 million per statistical life saved

21 Value of a Statistical Life GM in 1993 Consumer Groups wanted a recall of 5 million pickup trucks made between Gas tank was located in an unsafe spot Crashes involving the truck lead to 150 deaths during the period Costs of Recall = $1 billion Benefits of Recall = 32 lives saved Should the trucks be recalled? $1 billion / 32 = $31.25 million per life saved. Isn t that expensive?

22 Value of a Statistical Life GM s Settlement $50 million to: support education programs about seat belts and drunk driving Undertake research into burn and trauma treatment Buy 200,000 child safety seats for low income families. The most unprecedented buyout of law enforcement officials by a culpable corporation in regulatory history.

23 Value of a Statistical Life Which was better for society? $1 billion settlement, or the $50 million dollar settlement? The cars seats would save 50 lives. If that were the only benefit, the cost of a statistical life saved would be $1 million Compare that to the 32 lives saved and $31.25 million per life saved. Ralph Nader apparently did not want more lives saved?

24 Value of a statistical life Implied by various governmental Projects

25 An Alternative To CBA Cost Effective Analysis Find the minimum cost way to achieve a given objective. Notice the Difference between CBA and CEA. CBA recommends which projects to undertake CEA receives recommendations on projects from the political process and then tries to do them with the lowest cost possible. CBA is the Economically preferred option Imagine if the government decided that it wanted to save as many lives as possible by requiring landfills to meet certain requirements $1 billion per life saved

26 Contingent Valuation Billboard

27 Contingent Valuation What is Value? Based in Trade-offs Market Price a special case of a trade-off ratio Money given up to buy milk represents quantities of other goods you could have purchased with that money. In Some cases Market Prices are not available.

28 Contingent Valuation When do traditional markets fail to accurately values goods and services? Scenic views on the way to work National Security Erosion control Public goods and externalities

29 Contingent Valuation Contingent Valuation Survey approach designed to create the missing market for goods and services. Captures individual s TOTAL by asking them what they are WILLING TO PAY for particular goods and services Examples Grand Canyon Pristine Alaskan Coastline Wetlands

30 Contingent Valuation Key Element of contingent valuation THE VALUATION QUESTION

31 Contingent Valuation What is the good being valued? Grand Canyon Road Removal, Air Pollution Alaskan Coastline Buddy ship program How is payment made Through taxes, Voluntary Contribution, Utility Bills (Wind Electricity, Recycling) Writing the Survey Testing the Survey Focus Groups Pilot Testing Sample Selection Response Rate

32 Contingent Valuation Main Concern: Hypothetical Bias Willingness to pay in hypothetical situations > willingness to pay in real situations Believed to occur because respondents do not have to face monetary consequence of hypothetical choices To avoid Hypothetical Bias Certainty Statements, 0-10 Scale Certainty Statements, Probably Sure-Definitely Sure Scale

33 Contingent Valuation Outline of Typical Survey Introduction/Warm-up Valuation Description of Valuation Scenario Cheap Talk if in cheap talk Treatment Referendum Vote Certainty Elicitation Demographics

34 Contingent Valuation 80,000 students, over 50 campuses in KY 96 programs from nuclear medicine to auto repair Good to be valued is a 10 percent increase in the size of the system as measured by the number of programs.

35 Contingent Valuation - An Example Is the application of the contingent valuation method appropriate for education? Yes! Spillover Benefits Wage of Non-attendees Health Informed voting populace Contingent Valuation captures the total benefit

36 Contingent Valuation Example Referendum Style Elicitation Would you vote for the referendum to expand the Kentucky Community and Technical College System by 10% here and now if you were required to pay a one time $T out of your own household budget? T : {400, 250, 200, 150, 125, 100, 75, 25 }

37 Contingent Valuation An Example Certainty Statements Are you probably sure or definitely sure that you would contribute $T for the expansion of the Kentucky Community and Technical College System? Probably Sure Definitely Sure 1 2 You answered YES to the referendum vote, on a scale from 0 to 10, how certain are you of your answer? Please select your answer on the scale below Very Uncertain Very Certa n

38 Contingent Valuation An Example Results Best Estimate Using CV = $92 million For Kentucky Private returns to KCTCS using traditional labor market methodology = $61 million What does this tell you about the education externality? Social Return is bigger than the private return!