1 Efficiency, Surplus and Doing Benefit-Cost Analysis How can economics help determine the optimal size of a project or extent of a regulation?

2 Motivating Group Project 2001 Actual Group Project (Advisors— Profs. McAusland and Kendall): A Cost-Benefit Analysis of Public Law : Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties 2001 Actual Group Project (Advisors— Profs. McAusland and Kendall): A Cost-Benefit Analysis of Public Law : Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties 2001 Actual Group Project (Advisors— Profs. McAusland and Kendall): A Cost-Benefit Analysis of Public Law : Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties

3 A few other examples What should be the CO concentration standard in tailpipe emissions? What is the appropriate level of GHG emission reduction worldwide? How large should the Channel Islands marine reserve be? Can we measure loss to recreationists of the Forest Adventure Pass? Add another lane to Hwy 101? Close Mission Canyon to cyclists? What habitat to buy to protect endangered species (eg, Least Bell’s Vireo – bird)

4 Generic Problem Characterize an Environmental Policy or Action (or multiple policies or actions) Estimate the Consequences of that policy or action Estimate the pluses (benefits) and minuses (costs) of that policy or action Reach conclusions

5 CBA: main principle Quantify all costs and benefits in a common measure (usually $) Common metric need not be $ eg, health- health analysis, with health as metric Benefits directly measured in terms of lives saved Costs indirect: costs increase deaths since Regs make people poorer lower incomes lead to higher mortality ($13 million in extra costs results in 1 statistical death) Eg, Compare risks in lower and higher income countries Compare projects based on net effects on health.

6 What others method to use? Cost-effectiveness Analysis Weighted cost-benefit analysis Multigoal analysis

7 Basic measure of value is willingness-to-pay Demand curve is marginal willingness to pay Quantity of water MWTP First units very valuable Last units less valuable

8 Consumers Surplus (CS) D(x) x $ q p CS(q)

9 Calculating benefits from MWTP Demand, D(x), measures MB. Consumers Surplus is the total benefit to consumers minus their cost.

10 Example – gross value of water from new dam (excluding costs) Acre-feet of water Price Demand for water New dam Add’l Value

11 What about nonmarket goods? Air quality Price Suppose there were a market: Demand for air quality BUT, NO MARKET: price similar to MWTP

12 Environmental goods Demand for env goods just as real as demand for market goods – just harder to measure Demand is a measure of intensity of preferences

13 Costs are simpler Some units are cheap to produce “Marginal” units are most expensive Costs consist of Fixed costs Marginal costs

14 Marginal costs plus fixed costs add up to total costs Quantity MC First units cheapest Last units pricey

15 Producer Surplus (PS) x $ p q PS(q) MC(x)

16 How are costs calculated? Supply, S(x), is same thing as MC. Producer Surplus is the total revenue to producers minus their cost.

17 Put it together Q P Total Surplus

18 Where is CS+PS maximized? Demand, D(x) Supply, S(x) q1q1 q* p x $ CS PS Tension: Too little produced At too high price. CS low, PS high

19 Suppose goods supplied in fixed amount Land Price Supply of land Producer surplus (goes to land owners) Consumer surplus Demand for land Market Price

20 Example: Add a dam Q Water Price Status quo water availability XXXXXXXXXXXX ################## PS: Before: # and X After: CS: ??

21 Example: Add a dam Q Water Price Supply of water increases; price falls. What happens to PS? CS? XXXXXXXXXXXX $$$$$ ################## PS: Before: # and X After: X and $ CS: ??

22 If captured all costs & benefits Then we want to maximize CS + PS which would occur where Supply = Demand. Challenge is to capture all costs and benefits to accurately measure MC & MB.

23 Costs come in different flavors: Private, external and social In principle, need to capture all costs and benefits. Social costs may exceed private costs. Difference is the “external cost” – the monetized cost of the externality. $/gal Gallons Of Gasoline MPC Q0Q0 P0P0

24 Social vs. Private Costs In principle, need to capture all costs and benefits. Social costs may exceed private costs. Difference is the “external cost” – the monetized cost of the externality. $/gal Gallons Of Gasoline MPC MEC Q0Q0 P0P0

25 Social vs. Private Costs In principle, need to capture all costs and benefits. Social costs may exceed private costs. Difference is the “external cost” – the monetized cost of the externality. $/gal Gallons Of Gasoline MSC MPC MEC Q* P* Q0Q0 P0P0

26 First Theorem of Welfare Economics In a competitive market Surplus is maximized at a market equilibrium Implications Can rely on market if we are sure of competitive market

27 Implicit Assumptions: Distribution Distributional consequences ignored Compensation Principle

28 Implicit Assumptions: Income Restaurant meals Price Y=$30,000 per year Y=$50,000 per year Demand and thus surplus depend on income distribution Therefore: Change in income distribution will change results of CBA TO USE CBA, MUST BELIEVE INCOME DISTRIBUTION IS OK

29 Implicit Assumptions: Completeness What happens with difficult to monetize benefits? Eg, clear view of Santa Cruz Islands Difficult to monetize benes often omitted Results in bias against env. benes

30 Implicit Assumptions: Other Moral and political dimensions omitted Should we do a cost-benefit analysis on executing someone who has committed a crime? Are there other issues when lives are at stake? Are intergenerational issues adequately treated by CBA?

31 Ten Steps to doing and using a CBA 1.Decide whose benefits and costs count 2.Select the portfolio of alternative projects 3.Catalog potential physical impacts and determine how they are measured 4.Predict quantitative physical impacts over life of project 5.Monetize all impacts 6.Discount for time to find present values 7.Sum: add up all benefits and costs 8.Perform sensitivity analysis 9.Choose alternative with largest social benefits 10.Make policy recommendation, using CBA only as part of guidance