Cost-Benefit Analysis I PAI 723 Economics for Public Decisions 11/19/2013 1

Outline Introduction to Cost-Benefit Analysis The First Three Steps in Cost-Benefit Analysis -Define the scope -Estimate the costs -Estimate the benefits 2

Introduction: Why do we need cost- benefit analysis? Cost-benefit analysis (CBA) can be used to guide several decisions for public officials: - Whether a project should be undertaken? - Which of several alternatives should be selected? -What is the appropriate scale of the projects to be undertaken? 3

Introduction: Basic Logic Basic Logic of CBA Calculate the economic benefits and economic costs of each alternative. These costs and benefits are discounted over time to reflect opportunity costs. Choose projects with the highest net benefit. The ultimate goal of CBA To ensure that society’s resources are put to their most highly valued uses. -Scarcity is also a concern for government officials. 4

Introduction: Roles of CBA in Policy Analysis CBA required by federal law for evaluating major rules since 1981 (Executive Order 12291) A tool of rational planning: -To provide answers to which choice to select -To provide a process to help decision making 5

Steps to Performing CBA 1.Define the situation 2.Estimate the costs 3.Estimate the benefits 4.Discounting 5.Interpret the results 6.Equity issues 7.Sensitivity analysis 6

Step1 Define the Situation/Scope CBA looks at how a project will change the community’s resources 1.What resources are at stake? 2. What jurisdiction should CBA be done for? -One community? Its neighbors? A state? whole country? This is a political decision! 7

Step 1 Define the Situation/Scope Example: A PUBLIC SWIMMING POOL 8

Step 2 Estimate the Costs Costs: resources that the community will use to carry out the project. The PUBLIC POOL EXAMPLE What are the possible costs for the city to have the new public pool? 9

Step 2 Estimate the Costs Types of Costs 1.Resources purchased for the project by the government -Costs of construction (materials, equipment, labor, etc.) -Costs of operating and maintenance -Overhead costs (time and resources spent by park and recreation dept., police etc.) 2. Resources owned or purchased by local residents and firms 10

Step 2 Estimate the Costs Types of Costs 1.Resources purchased for the project by the government 2.Resources owned or purchased by local residents 3.Opportunity costs -For assets owned by the government (e.g. land): the value of these assets in their next most valuable use -For assets which are underutilized by the society (e.g. labor): opportunity costs is not the full market price. 11

Step 2 Estimate the Costs Types of Costs 1.Resources purchased for the project by the government 2.Resources owned or purchased by local residents 3.Opportunity costs 4.External costs (externalities): How to monetize them? -Environmental damage -Increased congestion or traffic in the neighborhood -Other social costs (e.g. increased crime) 12

Step 2 Estimate the Costs – Shadow Price In the public arena, the “price” mechanism often fails to reflect the true social values or costs of a resource. Thus, we estimate the “shadow price” in order to monetize the social costs and benefits of those resources. The shadow price of an input or output is its value to the economy as a whole. 13

Step 2 Estimate the Costs – Shadow Price For inputs, the shadow price is the marginal opportunity cost – the value of the best alternative use of the input. Shadow prices are related to the market price, but not exactly the same because of market imperfections. 14

Step 2 Estimate the Costs – Shadow Price Monopoly (P>MC) P Pm Ps=MC Qm Q MR D MC 15

Step 2 Estimate the Costs – Shadow Price Tax (P>MC) P Pm Ps=MC Qm Q D S S’ 16

Step 2 Estimate the Costs – Shadow Price Negative Externalities(P<MSC) P Ps Pm Q* Qm Q D S=MPC MSC = MPC+MEC 17

Source: Boardman, Greenberg, Vining and Weimer, “Plug-in Shadow Price Estimates for Policy Analysis”. Annals of Regional Science,

Step 2 Estimate the Costs Distinguish between costs and transfers -When resources are not used up nor created, but just shifted from one set of individuals to another, we say the resources are transferred. e.g. Destiny USA Increased property tax from houses near the pool -A transfer does not change the total amount of resources in a community. It just changes the distribution of the resources. 19

Step 3 Estimate the Benefits Benefits: new resources made available to the community. Types of Benefits 1) Resources measurable in monetary terms: goods and services sold in the market places  Price 2) Resources measurable in physical units, but not in monetary terms. 3) Resources valued by the community, but not measurable by any means. - The shadow prices of crimes in Vining and Weimer (2010) 20

Step 3 Estimate the Benefits How to estimate the benefits? - Measured by a community’s willingness to pay (WTP) -WTP: the amount that individuals are willing to pay to receive the benefits (or the costs they are willing to pay to avoid negative effects). -The demand curve tells us the marginal willingness to pay for consumers. Total benefits are the area under the demand curve. 21

Step 3 Estimate the Benefits 22

Step 3 Estimate the Benefits Estimate the benefits using WTP The PUBLIC POOL EXAMPLE: -Capacity=2000 visits/day -The pool will open 6 days a week for 14 weeks during the summer -At a fee of $0.50, 2000 users -At a fee of $2.50, 0 user What is the total benefits of building the pool for the community? -- Total benefits are the area under the demand curve. 23

Step 3 Estimate the Benefits WTP Visits/day $2.5 $ A B Demand Total benefits/day = A+B = (2.5 – 0.5)(2000)/ (2000) = $3,000/day Total benefits in a year: $3,000 * 6* 14 = $252,000 24

Step 3 Estimate the Benefits How to get the demand/community’s WTP? Approach 1: Surveys -Ask people how much they are willing to pay for services Approach 2: Use information on demand and prices from neighboring communities Approach 3: Use information on related markets -Recreational services: differences of property values between neighborhoods with and without the service -Value of life? Average salary*average life expectancy People’s WTP on safety devices for automobiles (V=C/P) C=$180, P=4 in 10,000, V= 180/ = $450,000 25

Step 3 Estimate the Benefits Distinguish between benefits and transfers The benefits should not reflect transfers from one section of the population to another. e.g. - Tax abatement for elderly people - Creating jobs for pool construction and operation 26

Step 3 Estimate the Benefits 27

Step 3 Estimate the Benefits Distinguish between benefits and transfers: Are jobs a benefit? - If the economy is at full-employment (which is often the assumption of CBA), the opportunity cost of using workers is that they are not used somewhere else. - Thus, the new jobs are simply a transfer of workers from one sector to another. 28

Step 3 Estimate the Benefits Distinguish between benefits and transfers: Are jobs a benefit? At the local level, could there be net gains in employment locally? - Need to prove there’s significant unemployment in the region and the project hires the unemployed A better way to deal with this issue is to adjust the costs of labor. - The unemployed faces lower opportunity costs 29