Topics Today 102108

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Topics Today (10/21/08)

• Intro to Cost-Benefit Analysis (CBA).
• CBA example development vs. preservation.
• Read 7 from outside reading list for next
  class.
• Homework 4 is due today.

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Cost-Benefit Analysis

• Cost-Benefit Analysis a comparison of total
  benefits and total costs associated with
  alternative policies.
• Net Benefits Total Benefits Total Costs.
• CBA involves computing net benefits for each
  policy alternative.
• While CBA provides useful information, in general
  it is not advisable to simply select the
  alternative with the greatest net benefits.

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Cost-Benefit Analysis

• CBA comes from an 18th century philosophy called
  utilitarianism.
• Idea is to compare outcomes on the basis of what
  gives the greatest benefit to the greatest number
  of people.
• Benefits equal utility.
• Since there is no actual measure of utility, CBA
  uses money equivalents as a proxy.

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Cost-Benefit Analysis

• Pareto improvement the situation where at least
  one person is made better off by a change and no
  one is made worse off.
• Equivalent to Pareto efficiency.
• Typically theres always someone who loses out.

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Cost-Benefit Analysis

• Potential Pareto Improvement (PPI) criterion
  could the gainers compensate the losers and still
  be better off?
• Net-benefit test are the net benefits of a
  policy or project positive? If so, then we have a
  PPI.
• Compensation does not always take place gt a PPI
  may not be fair.
• Kaldor-Hicks efficiency.

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Cost-Benefit Analysis

• CBA is similar to discounted cash flow (DCF).
• Primary difference between CBA and DCF is the
  scope of whose welfare is being considered.
• CBA considers societys welfare rather than one
  firm.
• Key point environmental values may be directly
  included and compared directly with other values.

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Cost-Benefit Analysis

• Cost of federal environmental, health, and safety
  regulation is approximately 200 billion
  annually.
• CBA in practice
• Used extensively in U.S. policy-making since late
  1970s.
• Sec. 674 of Regulatory-Right-To-Know Act of 2001
  government must issue annual reports on costs and
  benefits of Federal regulations.
• Most all major environmental agencies use some
  form of CBA to evaluate policies.

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Cost-Benefit Analysis

• Why is CBA useful?
• Addresses an important social concern efficiency
  of resource allocation.
• Wide variety of impacts (market and non-market)
  can be included.
• Used in policy/project appraisal and as a device
  for allocating scarce public money across
  competing uses.
• Takes into account the direction
  (approve/disapprove) and intensity (how much do
  you like this?) of preferences.
• Allows us to consider both the economic value and
  the opportunity cost of environmental protection.

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Cost Benefit Analysis Intro

• Opportunity Cost
• The true measure of the cost of scarce resources
  in economic analysis is their opportunity cost
  their value in their best alternative use
• Usually at the margin this cost is appropriately
  measured by price
• Sometimes OC can be easy to omit or neglect in an
  economic analysis (CBA or other analysis)

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Cost Benefit Analysis Intro

• Opportunity Cost
• Ex/ Land devoted to agriculture in a particular
  region

Should all of the land be devoted to agriculture?
Is the price of land CD (where the MC curve for
farming goes vertical because there is a physical
limit to land)?
Rural Land
B
MBFA
MCFA machines, labor, energy, seed, etc.
C
A
D
Rural land devoted to agriculture
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Cost Benefit Analysis Intro

• Opportunity Cost, cont
• Land is not free! Can be used in other
  activities, as reflected in the price P

Rural Land
MNBFA
MNBForest
B
P
C
A
D
Rural land devoted to agriculture
Rural land devoted to forestry
Q
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Cost Benefit Analysis Intro

• Opportunity Cost
• Ex/ Water devoted to irrigated agriculture in a
  particular region

Should all of the water be devoted to
agriculture?
Water Stock
B
MBWater in agriculture
MCWater in agriculture irrigation costs (energy,
labor, capital costs)
C
A
D
Water devoted to irrigated agriculture
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Cost Benefit Analysis Intro

• Opportunity Cost, cont
• Water is not free! Can be used in other
  activities, as reflected in the price P

Rural Land
MNBwater in agric
MNBInstream
B
C
A
D
Water devoted to agriculture
Water devoted to in-stream uses
Q
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Cost-Benefit Analysis (CBA)

• Process of a CBA
• Project / Policy Definition
• What is being analyzed?
• Ex/ proposed hydroelectric dam
• Ex/ policy to reduce water pollution
• Whose welfare is being considered?
• City of Madison?
• State of Wisconsin?
• U.S.?
• Over what time period?
• 2 months?
• 2 years?

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Cost-Benefit Analysis (CBA)

• Process of a CBA (cont.)
• Identify physical impacts of the policy / project
• Ex/ what are the physical impacts of protecting
  wetlands?
• Higher wildlife populations
• Higher housing prices
• Better flood control
• The precise quantification is typically not known
  with certainty.
• If prices change, the effects are typically
  measured in terms of consumer or producer
  surplus.

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Cost-Benefit Analysis (CBA)

• Process of a CBA (cont.)
• Valuing impacts
• All relevant effects are put into monetary
  values.
• Allows us to compare apples with apples.
• Environmental goods are valued through the
  techniques weve discussed.
• Stated preference.
• Revealed preference.

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Cost-Benefit Analysis (CBA)

• Process of a CBA (cont.)
• Treatment of transfer payments.
• Income transfers between the government and
  individuals are not included in CBA.
• Examples
• Green taxes tax payments from firms are not
  considered a social cost.
• Tradable pollution permits payments for permits
  between firms are not considered a social cost.

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Cost-Benefit Analysis (CBA)

• Process of a CBA (cont.)
• Treatment of transfer payments.
• Transfers change the distribution of the economic
  pie, not the total size of the pie.

A
A
B
B
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Cost-Benefit Analysis (CBA)

• Process of a CBA (cont.)
• Net benefit test?
• Do the benefits exceed the costs?
• Are net benefits positive for some groups and
  negative for other groups?

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Cost-Benefit Analysis (CBA)

• Process of a CBA (cont.)
• Sensitivity Analysis
• Performed when the calculated value of some
  impact is not known with certainty (e.g. future
  gas prices).
• Involves varying some parameters by certain
  amounts to see the effect of different numbers on
  net benefits
• Goal of sensitivity Which parameters is the net
  benefit outcome most sensitive to?

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CBA Example 1 Preservation vs. Development in
the Birds-of-Prey Natural Area

• This example illustrates
• Value of sensitivity analysis
• Opportunity cost (two instances where this
  arises)
• Not always necessary to estimate all costs and
  benefits.

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CBA Example Preservation vs. Development in the
Snake River Birds-of-Prey Natural Area

• An area in southwestern Idaho.
• The river lies within a deep canyon that is
  surrounded by a vast plateau. Cliffs towering up
  to 700 feet above the river
• 24 raptor species use the area, including 16
  species that nest there. one of the premier spots
  in the U.S. for observing raptor migrations.

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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• 1971
• Secretary of Interior Rogers C.B. Morton
  dedicated 26,714 acres along the Snake River as
  the Snake River Birds of Prey Natural Area
  (Public Land Order (PLO) 5133).

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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• 1972
• Researchers found that the Natural Area
  encompassed only a portion of the major nesting
  habitat and very little of the hunting territory
  used by raptors.
• Researchers also noted that every year, more land
  was being planted to crops under the Desert Land
  Act and Carey Act programs.
• Researchers found no jackrabbits or ground
  squirrels inhabiting these newly developed farms,
  and raptor populations began to decrease.

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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• 1975
• BLM issued a temporary moratorium on processing
  Desert Land and Carey Act applications on almost
  280,000 acres of public land adjacent to the
  Natural Area to keep the lands in a natural state
  while the research continued.
• The original raptor research project was
  broadened into an integrated team project to
  investigate the ecology of raptors and their prey
  within a larger Birds of Prey Study Area.

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CBA Example 1 Preservation vs. Development in
the Birds-of-Prey Natural Area

• Research results irrigated agriculture would
  sufficiently change the local ecology to have a
  significant effect on raptor species
• Livestock owners and environmentalists on the
  same side of the debate about what to do with the
  Natural Area

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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• A Identify project alternatives agricultural
  development vs. preservation.
• B Enumerate benefits and costs
• Benefits of development net benefits of
  irrigated agriculture
• Costs of development
• foregone grazing.
• lost raptor habitat
• Use values recreational birdwatching
• Non-use values existence value.

Hyde, W.F., Dickerman, A., and D. Stone. 1982.
Development versus preservation in the Snake
River Birds of Prey Conservation Area. American
Journal of Agricultural Economics, 64 756-760.
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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• C.1 Quantify the lost grazing value
• Earnings (revenues minus costs).
• 1.31 - 2.41 per acre.
• C.2 Quantify the benefits of irrigated
  agriculture
• pricequantity-production costs (complicated by
  the fact that there are 6 possible crops, so to
  get a per acre value, must weight net benefits by
  the relative proportion of each crop)
• Crops wheat, barley, alfalfa, beans, sugar
  beets, potatoes.

Hyde, W.F., Dickerman, A., and D. Stone. 1982.
Development versus preservation in the Snake
River Birds of Prey Conservation Area. American
Journal of Agricultural Economics, 64 756-760.
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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• Sensitivity analysis - Net benefits of irrigated
  agriculture calculated for
• Several soil classes.
• Several different crop rotations.
• Several different crop price sets.
• Several different energy costs for pumping water
  from the Snake River.

Hyde, W.F., Dickerman, A., and D. Stone. 1982.
Development versus preservation in the Snake
River Birds of Prey Conservation Area. American
Journal of Agricultural Economics, 64 756-760.
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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area

• Net benefit per acre of irrigated agriculture can
  be greater than 1.31 per acre (NB of grazing) if
  all of the following hold
• High price of crops (well above 30-yr average
  price)
• Soil-intensive crop rotation (heavy in sugar
  beets, not sustainable in the long run)
• Medium to high soil quality (medium to high
  yields)
• Occurs in 24 of 181 scenarios.
• Conclusion net benefit of irrigated agriculture
  is typically negative even when ignoring the
  non-market values associated with raptor habitat.

Hyde, W.F., Dickerman, A., and D. Stone. 1982.
Development versus preservation in the Snake
River Birds of Prey Conservation Area. American
Journal of Agricultural Economics, 64 756-760.
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CBA Example Preservation vs. Development in the
Birds-of-Prey Natural Area
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Similar Public Land Issues (preservation vs.
development)

• The Roadless Area Conservation Rule a policy
  to set about 58 million acres of roadless
  National Forest land off limits to future road
  construction.
• Drilling for oil and gas on public lands managed
  by the Bureau of Land Management (BLM) and Forest
  Service.