COST-BENEFIT ANALYSIS CHAPTER 8 COST-BENEFIT ANALYSIS

Projecting Present Dollars into the Future RT = R0*(1+r)T one click per line

Projecting Future Dollars into the Present RT = R0*(1+r)T 5 lines visible 1st click – 6th line 7th click – “Present Value” 8th click – “discount rate” 9th click ‘ discount rate arrow disappears, bracket appears, “discount factor” Present Value R0 = RT/(1+r)T discount rate discount factor

Present Value of a Stream of Money

Inflation

Private Sector Project Evaluation Annual Net Return PV Year R&D Advertising R = $1,000 -$1,000 $150 $200 1 600 0.01 128 165 2 0.03 86 98 3 550 1,200 0.05 46 37 0.07 10 -21 Admissible Preferable Present Value Criteria

Internal Rate of Return Project Year 0 Year 1 ρ Profit PV X -$100 $110 10% $4 3.77 Y -$1,000 $1,080 8% $20 18.87

Benefit-cost ratio = B/C

Problems with the Benefit-cost Ratio Method B C B/C I $250 $100 2.5 II $200 2.0 I: Subtract $40 mistake from B $210 2.1 I: Add $40 mistake to C $140 1.79

Discount Rate for Government Projects Returns in Private Sector Social Discount Rate Concern for Future Generations Paternalism Market Inefficiency Government Discounting in Practice

Valuing Public Benefits and Costs Pounds of avocados per year Price per pound of avocados Market Prices Adjusted Market Prices shadow price Monopoly Taxes Unemployment Consumer Surplus e b d Sa $2.89 c g Sa’ 1st click – left-hand side text line-by-line 2nd click - axes and labels, D, S, A, d, and g 3rd click – S’, A1 $1.35 Da A0 A1

Inferences from Economic Behavior The Value of Time The Value of Life Lost earnings Probability of Death

Valuing Intangibles Subverting cost-benefit exercises Reveal limits on intangibles Cost-effectiveness analysis

Games Cost-Benefit Analysts Play The Chain-Reaction Game The Labor Game The Double-Counting Game

Distributional Considerations Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences Government costlessly corrects any undesirable distributional aspects Weighted benefits

Uncertainty Certainty Equivalent Project Benefit Probability EV X $1,000 1.00 Y 0.50 $2,000 Certainty Equivalent

Are Reductions in Class Size Worth It? Discount rate Costs Benefits The Bottom Line and Evaluation

Use (and Nonuse) by Government Using Cost-Benefit Analysis Not Using Cost-Benefit Analysis Clean Air Act Endangered Species Act Food, Drug and Cosmetic Act

Calculating the Certainty Equivalent Value Utility U U(E + y) U* U(E) Certainty Equivalent Expected income E C I* E + y Income per year