Cost-Benefit Analysis (CBA)

What is a Benefit and a Cost?

The benefits of a change are those goods or services
that result from the change for which someone would
be willing to make sacrifices to obtain
We measure benefits in terms of Willingness to Pay
(WTP)
Cost is the value of opportunities forgone! (it could
be a Euro value, but could include much more
e.g. the value of your time).
Opportunity Cost: An activity's opportunity
cost is equal to the most net benefits that
you could have obtained from doing
something else.
1) Benefit
- marginal benefit
- total benefit
2) Cost
- marginal cost
- total cost
3) Net benefits
- marginal net benefit
- total net benefit
An efficient allocation maximizes
Total Net Benefit
minus
=
!!! !!!
Important Concepts
The distance de can be interpreted in efficiency terms.
It is a measure, in money terms, of the efficiency gain
that would come about form producing X* compared
with a situation in which non is produced.
de is equal to the triangle gfh: the area beneath a
marginal function over some range gives the value of
the change in the total function for a move over that
range.
So, X=0 to X=X* beneath MBx is the total benefits of X*
and equal to the distance ad, and
X=0 to X=X* beneath MCx is the total costs of X* and
equal to the distance ae.
Px is equal at the margin
* consumers' subjective valuations of additional units
of the good (expressed in money terms), and
* the costs of producing an additional unit of the good.
Px = MBx = MCx
Partial equilibrium
interpretation of
economic efficiency
X*
X*
X*
X*
B(X*)
C(X*)
NB(X)
NB(X*)
NB(X)
B(X)
C(X)
X
X
X
X
g
h
f
MC
x
MB
x
g'
h'
f'
D
x
= MB
x
S
x
= MC
x
P
x
(a)
(b)
(c)
(d)
NB(X*)
d
e
a
consumer
surplus
producer
surplus
net-benefits
Recent Developments
Total economic value = Use value + Intrinsic value
Use value = Actual use value + Option value + Quasi-
option value
Option value = Value in potential use by self + Value in
potential use by others + Value in potential use by
future individuals
Quasi-option value = Value of avoiding irreversibilities
in the light of expected future knowledge
Intrinsic value = Existence value
Existence Value
Existence value is unrelated to any actual or
potential use
Existence value may be related to sympathy,
or stewardship; as such, existence values
do not fit into neo-classical economics
Existence value may also be related to
"spiritual consumption", and then it does
fit
Existence value is not right-based, as rights
are absolute, and values relative
Cost-Benefit Analysis (CBA)
by 'Cost-Benefit Analysis' we mean the social appraisal of
investment projects (to appraise investments that
correct for market failure).
CBA and Environment:
1) benefits in the form of the provision of goods and
services that have environmental impacts (e.g.,
damming a river in a wilderness area; i.e. negative
environmental effects)
2) projects with beneficial environmental impacts (sewage
treatment plant; i.e. positive environmental effects)
CBA
CBA should be used for policies and projects, which unfold
over time and be assessed by calculating a Net Present
Value (NPV), or a Benefit-Cost Ratio (BCR).
4 informational inputs:
1. time horizon
2. benefit schedule
3. cost schedule
4. discount rate
Present Value Concept
Time Value of Money Concept: = a Euro today is worth more
than a Euro tomorrow
why:
* uncertainty: the future is unknown, will you be around
to spend the dollar.
* inflation: erodes the buying power of a Euro
* utility gain from consumption today versus future
consumption,
* investment opportunities: invest today, earn interest,
and have more than a Euro to spend in the future.
Basic idea is to get the present value of some future
payment to be received at time t.
Present Value Concept
Discounting: = process to obtain the present value of future
Euro amounts:

PV = present value, FV = future value, r = discount rate, and t
is the number of periods into the future.
( )
1
*
1
t
PV FV where
r
| |
= |
|
+
\ .
0 t
time
present value future value
idea of discounting
Euro
Present Value Concept
Nominal versus Real: = nominal refers to the Euro value in
current terms (not discounted), whereas real refers to
the dollar value discounted to some base Euro value
(discounted values).
Discount Rate: indicates how you value present
consumption (utility) versus future consumption (utility)
- the higher the discount rate the more you value
present consumption relative to future consumption
- the lower the discount rate the more you value future
consumption relative to present consumption.
Cost-Benefit Analysis (CBA)
In any CBA, several stages must be conducted (Hanley and
Spash, 1993):
1) Definition of the Project
2) Identification of the Project Impacts
3) Which Impacts are Economically Relevant?
4) Physical Quantification of Relevant Impacts
5) Monetary Valuation of Relevant Effects
6) Discounting of Cost and Benefit Flows
7) Applying the Net Present Value Test
8) Sensitivity Analysis
Cost-Benefit Analysis (CBA)
Private appraisal
1) The net present value test
2) The internal rate of return test
Social appraisal
1) Utility based appraisal
Problems: - no general agreed social welfare function
- interpersonal utility comparison are admissible
- utilities are not observable
2) Consumption based appraisal
( ) 0 1
T
t
t
NR
NPV
r
=
+

( ) 0
0
1
T
t
t
NR
x
=
+

NPV>0
IRR=0
( ) 0 1
T
t
t
NB
NPV
r
=
+

Cost-Benefit Analysis (CBA)

NPV test is a potential compensation test => is concerned
with allocative efficiency (select projects that move the
economy toward an efficient allocation of its resources).
The proper time horizon for the appraisal of a project is
the date at which its impacts cease, not the date at which
it ceases to serve the purpose for which it was intended.
e.g., for a nuclear fission plant the time horizon is not the
40 years to the time when it ceases to generate electricity
but the time over which it is necessary to devote
resources to storing the plant's waste products - 100s of
years.
Choice of discount rate
time horizon in years
discount rate 25 50 100 200
2 60.95 37.15 13.80 1.91
4 37.51 14.07 1.98 0.04
6 23.30 5.43 0.29 0.0009
8 14.60 2.13 0.05 0.00002
The Present Values of 100 Euros arising from 25 to 200 years
ahead at discount rates from 2 -8 %
=> need for judgements
however, there is universal agreement among economists such that the
real rates should be taken not nominal rates in CBA.
Environmental Cost-Benefit Analysis
( ) 0 1
T
t
t
NB
NPV
r
=
+

( ) ( ) ( ) 0 0 0 1 1 1
T T T
t t t t
t t t
B C B C
NPV
r r r

= =
+ + +

d d
B C =
where B
d
/C
d
is the discounted of benefit/cost stream over the
project lifetime. NPV ignores environmental impacts => NPV'.
'
d d
NPV B C EC NPV EC = =
'
d d
NPV B C EC = >
EC = environmental cost
ECBA decision rule!!!
Environmental Cost-Benefit Analysis
EC = UV + EV + OV +QOV
UV = Use Value and arises from the actual and/or planned use
of the service by an individual, for recreation for example;
EV = Existence Value and arises from knowledge that the
service exists and will continue to exist, independently of any
actual or prospective use by the individual;
OV = Option Value and relates to willingness to pay to
guarantee the availability of the service for future use by the
individual;
QOV = Quasi-Option Value and relates to willingness to pay to
avoid an irreversible commitment to development now, given
the expectation of future growth in knowledge relevant to the
implications of development.
Direct Benefit Estimation
In private CBA it it usually relatively easy to perform because
prices are readily observed.
Often this is not the case (no price exist) or prices are socially
biased due to externality, public good, or market power
considerations.
This problem is particularly apparent for non-use values which
tend to be more intangible.
intangible = cannot be valued
if intangibles remain in our analysis, then NPV and BCR are
incomplete.
So, what can we do when prices and demand information is
absent or is clearly biased?
Alternative Approaches
1. Contingent Valuation
- use surveys that ask
- widely applicable
2. Travel-Cost Method
- obtain a demand curve by examining how participation
varies with the cost of getting there.
- primarily useful for recreation benefits.
3. Property value and Wage differentials (hedonic prices)
- statistically investigate how these prices vary with
property of job conditions
- more limited application possibilities than for CV.
Indirect (Secondary) Benefits
= Ripple effects due to economic linkages
We have all heard public projects and policies being touted for
their employment and income generating effects.
In a full employment economy, however, these inputs were
necessarily reallocated away from other productive uses.
!! Do not count secondary effects in a full employment
economy!!
also no transfer payments should be included, e.g,
unemployment payments
Overall Appraisal of CBA
Cons:
- intangibles
- BC analysts and information sources are often biased
- distributional Issues occasionally objectionable
* weighs same period impacts equally
* weighs future impacts less
Pros:
- help prevent bad decisions which would otherwise be
undiscovered
- counters rent-seeking (which might normally be
successful in the political process).
Analytical Styles other than CBA
Cost Effectiveness Analysis
- = try to achieve a non-economic target at least cost
- often practical when there is an intangible physical quantity in
need of enhancement; if it was tangible, we could just use CBA.
Impact Analysis
- usually employed in lieu of or as a complement to CBA because
either
* there are many intangible impacts of the policy/project and
they need to be described, or
* the impacts are tangible but not allowed into CBA (such as
secondary economic impacts)
Multi Criteria Analysis
CBA Example
Someone has proposed a 4-period pollution control project
that will cost EUR 100.000 to construct in the initial
period. After that, the project will cost EUR 10.000 to
operate in each following period. After the construction
is completed, the benefits of this project will be EUR
40.000 in the first period, EUR 45.000 in the second, and
EUR 50.000 in the last period. The facility is expected to
be non-functional for any future periods. There are no
intangibles to be considered for this project.
Calculate Net Present Value (NPV), and Benefit-Cost Ration
(BCR) using a discount rate of 5%.
CBA- Example
t B
t
C
t
NB
t
0 0 100 -100
1 40 10 30
2 45 10 35
3 50 10 40
totals
( )
1
t
t
B
r +
( )
1
t
t
C
r +
( )
1
t
t
NB
r +
r = 5%
NPV = ???
BCR = ???