Cost-Benefit Analysis: The Details How can economics help determine the optimal size of a project or extent of a regulation?

A few examples What should be the CO concentration standard in tailpipe emissions? 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 (e.g., Least Bell’s Vireo – bird)

CBA: main principle Quantify all costs and benefits in a common measure (usually $) Note that we have ways of quantifying non-market, even non-use values. Common metric need not be $ -- e.g., health- health analysis, with health as metric E.g., consider a regulation that saves lives Benefits directly measured in terms of lives saved Costs indirect: costs increase deaths since lower incomes lead to higher mortality ($13 million in extra costs results in 1 statistical death) E.g., Compare risks in lower and higher income countries Compare projects based on net effects on health.

When to do CBA? Need to compare reg’s to achieve externally defined social goals – CEA Need to set a level of a reg, balancing pluses and minues: CBA Need to decide on a project with multiple goals that cannot be reduced to a single metric: multi-goal analysis

Example – issue is how big Project size, Q. Benefits = B(Q) Costs = C(Q) Maximize Net Benefits, B(Q)-C(Q) Ignore issue for time being of how to quantify B(Q) and C(Q)

TB(Q) TC(Q) Q $ Q $ Q* TB(Q)-TC(Q) One view of this problem: Maximize TB-TC

TB(Q) TC(Q) Q $ Q MB(Q) MC(Q) $ Q* is where TB-TC is maximized. Also where MB=MC. Q* xCxC

Discrete sized projects If deciding between projects A, B, C Pick one with highest net benefits (TB-TC), provided net benefits > 0. May have values that are difficult to quantify. Quantify values you can, then compare projects along as few dimensions as possible (“multi-criteria analysis”); examine tradeoffs between alternatives.

Big Questions How to measure/conceptualize benefits? How to measure/conceptualize costs? How to treat costs and benefits that occur at different points in time? How to deal with distributional issues? How to deal with risk?

Question #1: Conceptualizing Benefits Suppose a river is dead, what is the value of reducing pollution by one unit? What is the value of increasing visual range by a unit in the West? How do we value the extra units of electricity?

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

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

How are benefits calculated? Demand, D(x), measures MB. Consumers Surplus is the total benefit to consumers minus their cost.

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

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

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

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

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

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

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

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

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

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

Put it together Q P Total Surplus

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

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

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. Note Surplus Max equals CS+PS maximum

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

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

Implicit Assumptions: Distribution Distributional consequences ignored Put in dam: some win, some lose Benefits cancel losses OK if compensation occurs Compensation Principle Dam is good idea if winners can compensate losers If there is enough surplus, dam is a good idea BUT, compensation need not occur

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

Implicit Assumptions: Completeness What happens with difficult to monetize benefits? E.g., clear view of Santa Cruz Islands Difficult to monetize benefits often omitted Results in bias against environmental benefits

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?

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 (or other metric) 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 11. Identify limitations specific to your analysis