Costbenefit analysis CBA

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Cost-benefit analysis(CBA)
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Outline

• CBA definition
• What is CBA for?
• When a project is valuable?
• Valuing public benefits and costs
• Present value (key concept)
• Distributional considerations
• Uncertainty

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Introduction

• Cost-Benefit Analysis
• measure costs and benefits of a public
  project/policy
• Key concept Present value
• Project evaluation usually requires comparing
  costs and benefits from different time periods.
  Dollars across time periods are not immediately
  comparable
• The present value of a future amount of money is
  the maximum amount you would be willing to pay
  today for the right to receive the money in the
  future.

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COST-BENEFIT ANALYSIS
CBA is usually defined as the evaluation of the
costs and benefits of undertaking specific
projects or alternative economic
policies. Purpose Assess whether an public
project is economically justified. EX. projects
Railroad, bridge, tunnel, health-program,
preservation of forests etc CBA decision
rule BgtC gt YES BltC gt NO where
Bbenefits and Ccost.
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The CBA procedure in 6 steps

• Identify all costs and benefits
• Make costs and benefits comparable
• - Need to be expressed in the same unit of
  measurement (Money)
• 3) Consider risk and uncertainty
• - How large? Do they really occur?
• 4) Translate future values into todays value
  (present value)
• - Discount future benefits and costs
• 5) Distributional effects
• 6) Recommendation

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1. Identify all benefits and costs
Whos benefits and costs should be included? We
want the social value! gt All agents (firms and
individuals) in the society, somehow affected by
the project, have to be included. The agents
can be roughly divided into three groups a)
The operator b) Users c) Non-users. Cost and
benefits roughly into two groups Monetary
(expressed in money right away) Non-monetary
(Utility gt needs to be translated)
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• a) The operator
• Costs construction, operating and maintenance
  costs.
• Benefits Revenues from the users. (road-tariff)
• b) The users
• Costs Equal to Zero. Using the project is
  voluntary. Money mean of
• exchange.

Benefits Consumer surplus (non-monetary) EX.
The fee for passing a public bridge is SEK 20.
Some individual are willing to pay 40, if
necessary.
P
Consumer surplus
P
D
Q
Q
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c) Non-users These are the agents not using the
project, but never the less affected by
it. Non-monetary benefits Higher life
quality EX. (subwaygtreduce traffic on roadsgt
cleaner air and less congestion on
roads) Monetary benefits Higher profitsEX.
(Wider road between Ö-vik and Umeå gt better
business for Statoil in Nordmaling).
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2. Moneterize all costs and benefits
N.B. Not easy! Identify ? Monetarize Problems
Future changes in demand and price are
difficult to predict (uncertainty regarding
consumption and price) gt Revenues are uncertain
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Moneterize all costs and benefits (cont.)
It is difficult to measure consumer surplus (and
externalities) Shape and location of demand
curve? Depends on P,Q and the P of the goods
substitutes. If the project free of charge gt
cannot reveal the D-curve from looking at P and Q
for other similar project, which most likely also
are free of charge. One possible way is to study
non-monetary benefits related to consumer
surplus EX. How much time does users of a new
bridge save? Problem what is the value of
time? Working time hourly wage rate Leisure
time fraction of hourly wage rate?
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3. Consider risk and uncertainty in costs and
benefits
Risk can be measured in terms of probabilities.
If we know the probability that a specific
benefit will occur we can calculate the expected
benefit E ( B ) Pr ( B Y ) Y Pr (
B Z ) Z
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Consider risk and uncertainty in costs and
benefits (cont.)

• Risk can be measured in terms of probabilities.
  If we know the probability that a specific
  benefit will occur we can calculate the expected
  benefit
• E ( B ) Pr ( B Y ) Y Pr ( B Z )
  Z
• EX. Pr ( B 1000 ) 50
• Pr ( B 2000 ) 50
• (0.50 1000) (0.50 2000) SEK 1500.
• Some costs and benefits do not always
  occur. If we have no information about
• probabilitiesgt uncertainty ? risk.
• gt Sensitivity analysis what happen if?

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Consider risk and uncertainty in costs and
benefits (cont.)
Some costs and benefits do not always occur. If
we have no information about probabilitiesgt
uncertainty ? risk. gt Sensitivity analysis
what happen if? If only one specific
benefit/cost is uncertain Is this benefit
of crucial importance for the project? If
many benefits/costs are uncertain Calculate
best, worst and likely case scenario. Likely
case closest to best or worst case?
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Uncertainty

• Costs and Benefits are not always know with
  certainty, especially if their estimation
  involves future values variables going into the
  analysis.
• The results of many projects are uncertain (e.g.,
  AIDS vaccine research or defense research).

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4. Discount future costs and benefits
Projects may give rise to benefits and costs in
the future. Usually Benefits (costs) today are
valued higher (lower) than benefits in the
future. EX1. SEK 100 in the hand today is
better than SEK 100 next year EX2. Cost of SEK
100 in the future valued less that cost of SEK
100 today (put money in the bank and receive
interest inflation lowers value of benefits in
the future). It is convenient to express B-C in
terms of present value gt Discounting
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Net present value
n number of time periods d discount rate
reflects the preferences for present benefits
over future ones. d gt 0 gt future values scaled
down The choice of the rate of discount is
problematic and somewhat arbitrary. If d is
high, quick return is favored, i.e. future net
benefits is valued relatively lower.
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Net present value
What should be done today to mitigate the climate
change? It depends on the discount rate
Do we know anything about the discount
rate? Companies d market interest (alternative
to investments are saving) Government d dS
Social discount rate The government has (?) a
responsibility for future generations gt d gt dS.
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Project Evaluation

• The benefit-cost ratio divides the discounted
  stream of benefits by the discounted stream of
  costs. In this case
• Bstream of benefits and Cstream of costs
• Admissibility using the benefit-cost ratio
  requires
• This ratio is virtually useless for comparing
  across admissible projects, however.
• Ratio can be manipulated by counting benefits as
  negative costs and vice-versa.

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Project Evaluation

• Suppose there are two projects, X and Y.
• Need to ask
• Admissible Are the benefits greater than the
  costs?
• Preferable Are the net benefits the highest?
• The present value of project i is
• BiBenefits from project i at time n
• CiCosts from project i at time n

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Project Evaluation

• The present value criteria for project evaluation
  are that
• A project is admissible only if its present value
  is positive.
• When two projects are mutually exclusive, the
  preferred project is the one with the highest
  present value.
• The discount rate plays a key role in deciding
  what project to choose, because the cash inflows
  occur at different times.

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5. Consider distribution effects
Kaldor-Hicks criteria (potential Pareto
improvement criteria) Is it fair? Efficient?
Democratic? As long as the present value is
positive, the gainerscan compensate the loosers
and still enjoy a net increase in utility. This
notion is called the Hicks-Kaldor criterion which
bases project selection on the wether there is a
potential Pareto improvement.
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Potential Pareto Kaldor-Hicks criterion

• Pareto-efficiency efficiency is reached when
  no one can get better of without hurting someone
  else.
• gt A project will never be Pareto-efficient if
  it impose a cost (direct or indirect) to someone.
• The foundation of CBA is the Kaldor-Hicks
  criteria If it is possible for the winners to
  fully compensate the losers than the project is a
  potentially Pareto-improvement. However,
  compensation is not needed in practice.
• Hence, what matter is benefits versus costs.

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6. Recommendation
Is the project worthwhile? Yes if NVP gt 0 A
project is admissible only if its present value
is positive. When two projects are mutually
exclusive, the preferred project is the one with
the highest present value.