AGEC 608 Lecture 18, p. 1 AGEC 608: Lecture 18 Objective: Consider the rationale for, and methods of distributional weighting of benefits and costs among groups in CBA. Readings: –Boardman, Chapter 18 Homework #5: Chapter 13, problem 3 Chapter 14, problem 3 Chapter 17, problem 1 due: today

AGEC 608 Lecture 18, p. 2 Distributional Weighting Policies and programs affect individuals differently. The Kaldor-Hicks criterion emphasizes that benefits and costs should be summed across all groups with standing, regardless of income or other characteristics. But the distribution of benefits and costs is typically of interest to decision makers. Distributional weighting is a way of modifying benefits and costs according to the individuals or groups in the analysis.

AGEC 608 Lecture 18, p. 3 Transfers + deadweight loss Transfers of income lead to deadweight losses. Even a transfer from high-income to low-income individuals cannot pass the Kaldor-Hicks test. See Figure 18.1 – tax on luxury good

AGEC 608 Lecture 18, p. 4 Arguments for income-based weighting 1. Diminishing marginal utility of income 2. Income distribution should be more equal 3. “One person, one vote” should apply

AGEC 608 Lecture 18, p Diminishing marginal utility of income U = Utility Y = income ΔU low /ΔY low > ΔU high /ΔY high One $ received by a low-income person has a greater impact on utility than one $ received by a high-income person.

AGEC 608 Lecture 18, p Income distribution should be more equal Argument is premised on the idea that social welfare would be higher if income were more equal across individuals. Reasons: 1. Inequality leads to social ills 2. There should be an “income floor” 3. Utility interdependence

AGEC 608 Lecture 18, p “One person, one vote” In most cases beneficial policies raise the incomes of high income people more than those of low-income people. Argument is that everyone should have an equal influence over public allocations. See Figure 18.2

AGEC 608 Lecture 18, p. 8 Distributional weights M = number of groups r = social discount rate b jt = benefits to group j at time t c jt = costs to group j at time t W j = weight on group j

AGEC 608 Lecture 18, p. 9 How to derive implement? Requires: 1. Average income level of each group 2.Estimate of income elasticity of demand for each good affected by the policy or program 3. Estimate of market demand curve for each good Then compute separate CSs and weight according to values. Note: there is no economic argument for determining the value of weights…judgment call.

AGEC 608 Lecture 18, p. 10 Politically-determined weights Several approaches: 1. Use taxes (e.g. marginal tax rates) 2. Use observed public expenditures 3. Use experiments to test social preferences

AGEC 608 Lecture 18, p. 11 A pragmatic approach Several approaches: 1. Display weighted and unweighted BCA results 2. Conduct sensitivity tests 3. Compute internal weights – best with only two groups if there is an efficiency-equity tradeoff: set weight of advantaged group =1 set weight of disadvantated group to a value that makes the NPV for everyone else = 0

AGEC 608 Lecture 18, p. 12 Upper bound estimates Use a transfer program as a standard to compare other programs with distributional effects Note that this still requires internal weights. Previous estimates suggest weights for disadvantaged groups between 1.4 and 2.0

AGEC 608 Lecture 18, p. 13 When to use distributional weights Two conditions should be satisfied: The weighting should be targeted as a truly disadvantaged group, and: either 2. The weighting should reduce overall social efficiency but make low-income groups better off and high-income groups worse off or 3.Weighting should offset effects of programs that increase efficiency but make low-income groups worse off.