AGEC 608 Lecture 02, p. 1 AGEC 608: Lecture 2 Objective: Review conceptual foundations of CBA Readings: –Boardman, Chapter 2 –Kankakee, Sections I and II (pp. 1-21) Homework: Chapter 1, problem 1 Chapter 2, problem 2 Chapter 2, problem 4 due: Feb. 27

AGEC 608 Lecture 02, p. 2 What is Efficiency? Allocative efficiency: - are resources deployed in their “highest and best” use? Pareto efficiency asks: - could winners compensate losers? Any allocation is Pareto efficient if no alternative allocation can make at least one person better off without making anyone else worse off (see Figure 2.1). Transfers are required! CBA is a method for measuring allocative efficiency

AGEC 608 Lecture 02, p. 3 Pareto Efficiency $100 Potential Pareto frontier Payment to 1 Pareto frontier $25 status quo 0 $25 $100 Payment to 2 Area of Pareto improvements

AGEC 608 Lecture 02, p. 4 Operationalizing efficiency If Net Benefits are positive, then the test of Pareto Efficiency is satisfied Willingness to Pay (WTP) is the payment one would have to make or receive so as to be indifferent between the status quo and the policy with payments. Sum of WTP = Net Benefits of a policy Opportunity cost = dollar value of the best alternative use of a resource.

AGEC 608 Lecture 02, p. 5 Potential Pareto Efficiency Also called “Kaldor-Hicks” criterion Key: It is impractical to implement only Pareto efficient policies. So adopt policies with positive net benefits. Redistribution is not necessary, only that society as a whole is better off in aggregate.

AGEC 608 Lecture 02, p. 6 Decision rule in practice 1.Adopt all policies with positive net benefits 2.Benefit Cost Ratio (BCR) = Benefits/Costs 3.Assess both BCR and Net Benefits, choose policies with largest net benefits 4.If policies interact, choose combination that maximizes net benefits

AGEC 608 Lecture 02, p. 7 Limitations on WTP 1.The theoretical “rule” for creating a social ranking of alternatives is not fully satisfactory 2.Scitovsky reversals (A → B → A) can occur 3.WTP depends on distribution of wealth (WTP ≠ ability to pay) 4.Measure of NB depends on ones definition of “standing.”

AGEC 608 Lecture 02, p. 8 Jurisdictional Standing 1.Jurisdictional boundaries What are the boundaries of the project? Are there important spillovers? 2.Jurisdictional membership Whose utility should be counted? Is anthropocentrism OK? 3. Exclusion of unacceptable preferences How are social values included? 4. The “future generations” problem How do we measure WTP of future generations?

AGEC 608 Lecture 02, p. 9 Limitations of CBA Monetization may not be possible Two alternatives: 1. Conduct a qualitative CBA 2. Perform cost-effectiveness analysis (a good option if the benefit can be quantified but not monetized) Goals other than efficiency may matter Two alternatives: 1. Multi-goal analysis 2. Distributionally weighted CBA

AGEC 608 Lecture 02, p. 10 CBA and the Political Process Two major criticisms of the use of CBA for pubic policy making: 1. Monetization may be possible but not desirable Example: valuing human life 2. Reliance on a single value of efficiency may be inconsistent with democratic values