REGULATORY IMPACT ANALYSIS: EVALUATING COSTS

Measuring Costs The most comprehensive measure of the costs of any policy action or regulation is social cost Represents the total burden on the economy Sum of all opportunity costs society incurs as a result of the regulation, action, or policy. Society includes households, firms, government Opportunity costs are the value of the goods and services lost by society when resources are used to comply with and implement a regulation When an economist talks about costs in a benefit-cost framework, they are talking about social costs. Rather than focusing on the costs to an individual or a particular industry, this is a measure of the cost that society as a whole incurs because of an action. This is what distinguishes a benefit-cost analysis from an impact analysis. Industry and lobbying groups will often produce very focused studies which they will often label as costs analyses, but these studies are more commonly just financial impacts on that particular group rather than a more comprehensive and appropriate measure of social costs. One thing that your text does do a good job on is emphasizing that when benefit-cost analysis is done at a local level, some costs on individuals or firms do not end up being counted because they do not have standing. We discussed this in a previous week when we talked about standing and jurisdiction. However, for most benefit-cost analyses in this class, and particularly for federal actions, social costs represent the total burden on the entire economy. Note that this generally excludes the costs on other countries, but in some cases – notably for climate change – social costs may be the total burden on the world. So well will generally be measuring the economy-wide social costs. This can be defined as “the sum of all opportunity costs incurred as a result of the regulation, action, or policy.” This raises the follow-on question of: how do we define “opportunity costs.”

Opportunity Cost The value of the next-highest-valued alternative use of a resource Examples Playing tennis vs. reading a book Going to class vs. enjoying the summer If an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose for which that asset could have been used Of course, you all were exposed to a definition of opportunity cost in your first economics class. An opportunity cost is “the value of the next-highest-valued alternative use of that resource.” In other words, it is the value of what you give up. Simple examples from introductory economics include playing tennis versus reading a book, or going to class versus enjoying the summer. If you choose to play tennis, you get some pleasure from that activity. That is the benefit. But in exchange for the time spent playing tennis, you might have given up the pleasure from staying home and reading a good book. We treat the forgone benefit from reading the book as the cost so that we can compare the benefits and costs in our standard benefit-cost framework. If the pleasure of playing tennis – the benefit – is greater than the cost of the foregone pleasure from reading the book – the cost – then there are net benefits to the action and you will play tennis. If there a net costs to the action, then you won’t play tennis, you will stay home and read the book. You can even imagine that there is an opportunity cost of doing a benefit-cost analysis. This is a simplistic description of costs given to introductory economics students, but what does this mean in a regulatory context? What are the costs of requiring a firm to use some of its assets to, say, clean up hazardous waste? Here, we apply the same definition of opportunity costs to figure out the costs. If an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose that the asset could have been used for. This is true even if the firm already owns the asset. In other words, even if a firm doesn’t have to buy something new to clean up the waste, it just has to use what it already owns, that action has an opportunity cost. That cost is measured by the value of what the asset would have been used for were it not for the regulation.

Example You won a free ticket to see a concert, but you may not resell the ticket, so it has no resale value. Your favorite basketball team is playing on the same night and seeing that game is your next-best alternative activity. Basketball tickets cost $40 but on any given day, you would be willing to pay up to $50 to see them. Assume there are no other costs of attending either event. Based on this information, what is the opportunity cost of seeing the concert? A. $0 B. $10 C. $40 D. $50 While opportunity cost is covered in almost every introductory economics class, it turns out that it is sometimes a difficult concept to fully grasp. So let’s give you a little test on whether or not you understand yourself. Suppose you won a free ticket to see Coldplay in concert. Assume that the ticket is your to use, but you may not resell the ticket, so it has no resale value. Also suppose that Mumford and Sons are performing on the same night and that concert is your next-best alternative activity. In other words, in the absence of winning the free ticket to see Coldplay, you already knew that you would have gone to see Mumford and Sons. Assume that market price for tickets to see Mumford and Sons is $40. That is, it will cost you $40 if you actually choose to go to see Mumford and Sons. However, let’s say that you know in your heart that you would be willing to pay up to $50 to see them. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Coldplay? $0, $10, $40, or $50. Each of these answers seem plausible. You paid nothing for the ticket, so the opportunity cost could be zero. $10 is the difference between what you would pay for Mumford and Sons and the actual ticket price, so it could be $10. Forty dollars is what you would have to pay for Mumford and Sons, so that could be the answer. And $50 is what you would be willing to pay for Mumford and Sons, so that it also possible. Take a moment here to reread the question and think about what you thing the answer is. We will pause for 20 seconds for you to think about your answer. [ 20 second pause]

What is the Answer? When you go to the concert, you forgo the $50 of benefits you would have received from going to the basketball game. You also forgo the $40 of costs that you would have incurred by going to the basketball game. An avoided benefit is a cost, and an avoided cost is a benefit. Thus, the opportunity cost of seeing concert, the value you forgo by not going to the basket ball game is $10 – i.e., the net benefit forgone. While opportunity cost is covered in almost every introductory economics class, it turns out that it is sometimes a difficult concept to fully grasp. So let’s give you a little test on whether or not you understand yourself. Suppose you won a free ticket to see Coldplay in concert. Assume that the ticket is your to use, but you may not resell the ticket, so it has no resale value. Also suppose that Mumford and Sons are performing on the same night and that concert is your next-best alternative activity. In other words, in the absence of winning the free ticket to see Coldplay, you already knew that you would have gone to see Mumford and Sons. Assume that market price for tickets to see Mumford and Sons is $40. That is, it will cost you $40 if you actually choose to go to see Mumford and Sons. However, let’s say that you know in your heart that you would be willing to pay up to $50 to see them. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Coldplay? $0, $10, $40, or $50. Each of these answers seem plausible. You paid nothing for the ticket, so the opportunity cost could be zero. $10 is the difference between what you would pay for Mumford and Sons and the actual ticket price, so it could be $10. Forty dollars is what you would have to pay for Mumford and Sons, so that could be the answer. And $50 is what you would be willing to pay for Mumford and Sons, so that it also possible. Take a moment here to reread the question and think about what you thing the answer is. We will pause for 20 seconds for you to think about your answer. [ 20 second pause]

Opportunity Cost in a Regulatory Context Opportunity cost is the value of all the goods and services that will not be produced and consumed if firms comply with a regulation That is, the value of all the resources that are reallocated away from production activities and towards complying with the regulation To be complete, an estimate of social cost should include The opportunity costs of current consumption that will be foregone as a result of the regulation. The losses that may result if the regulation reduces capital investment and thus future consumption So, let’s defined opportunity cost carefully in the context of a benefit-cost analysis for regulation. The same holds for other actions and policies. Opportunity cost is the value of all the goods and services that will not be produced and consumed if firms comply with the regulation. That is, it is the value of all the resources that are reallocated away from production activities and towards compliance. Note that when calculating the resources not produced and consumed, we need to consider not just current consumption, but also the value of lost future consumption. That lost future consumption also depends upon lost investment, so we also need to include the effect from any lost investment. We’ll return to this concept of measuring effects that occur in the future in detail when we discuss social discounting and the opportunity cost of capital. For the next couple of weeks, though, we will focus on a single period.

Types of Social Costs Compliance Costs Capital costs Operating and maintenance costs Regulatory and Administrative Costs Government regulatory costs Industry compliance activities Monitoring and enforcement costs Transition Costs Other Welfare Losses Quality changes Productivity losses Transaction costs

What do not Count as Costs? Transfer payments monetary payments or a shifting of resources from one group/individual to another, which does not create new value Excluded from GDP calculation For society as a whole, the sum of transfer payments across particular groups must sum to zero Examples of transfer payments Taxes and subsidies (e.g., unemployment benefits) Insurance payments Distinguishing transfers from benefits/costs can be difficult at times Transfers have equity or distributional effects

Theoretical Measure of Social Costs For a single market, the theoretically correct measure of economic costs due to a regulation is the loss in consumer and producer surplus

Compliance Costs Real resource (or direct) costs Engineering or producer costs Purchase, installation, operation, maintenance, productivity changes, changing inputs, waste management, and so on Changes in Operation and maintenance costs Capital costs Administrative costs Regulatory – local, state, federal government

Compliance Costs Alone or More? Yes, compliance costs are an appropriate estimate of social costs when we don’t expect important behavioral changes in related markets (i.e., impacts are “localized”) But if the effects of the rule are observable across multiple markets, then we need to do a more complicated analysis

Multi-Market Analysis Suppose a regulation leads to higher gas prices Demand for travel declines Reduced travel demand affects other markets: gas stations, vacation rentals, etc. Evaluate compliance costs and effects in secondary markets due to regulation Compliance costs = direct costs Costs in related markets = indirect costs Typically involves modeling the market(s) Double counting is a risk (some affected markets, like real estate markets, might simply reflect or embody primary impacts)

Employment Labor expenses are included in costs Cost of labor = opportunity cost of workers’ time Presumption that worker was previously employed and her opportunity cost is the wages she earns in new job However, if worker not previously employed, story might change; recent persistent high unemployment

Jobs: Impact, Benefit or Cost? Employment impacts regulation Labor demand and labor supply effects Impacts on regulated sector; sectors providing services to comply with the regulation; other relevant sectors Full employment (no net change) vs persistent high unemployment Wages typically represent value of worker’s time and the social cost of hiring labor Under persistent high unemployment, does changing employment affect welfare