Cost Benefit Analysis

Lesson Objectives

The identification, measurement and weighing up of the costs and benefits of a project in order to decide whether or not it should go ahead. Used to help governments decide whether or not a project should go ahead, for example the building of a new motorway, or bypass.

The Procedure 1.Social costs and benefits identified 2.A monetary value is assigned to each cost and benefit 3.The probability of the cost or benefit occuring is then taken into account (eg. If there was a 60% chance of a cost of £100 occurring, the value would be £60) 4.The timing of the cost/ benefit is taken into account. £100 of benefit today would be regarded as more desirable than having to wait 10 years to receive the benefit. Likewise, it is a greater sacrifice to pay £100 today than £100 in 10 years time. Thus future costs and benefits must be reduced in value to take this into account (known as discounting) 5.The distribution of the costs/ benefits may be taken into account, is it fair that some will lose and some will gain. Will the losers be compensated? 6.A recommendation is made. If the benefits>costs the project will go ahead.

Cost Benefit Analysis of HS2 2-economic-case-value-for-money/hs2- economic-case-value-for-money.pdf

Stage 1: Identifying Social Costs and Benefit Costs: Private (direct/ internal)- construction, operating and mainentance External –Monetary such as loss of profit to competitors eg. A tunnel under a river/ sea would cause a loss of profits to ferry operators –Non- monetary such as pollution

Benefits: Private (direct/ internal). Including revenue received from users eg. Revenue from a toll. Also consumer surplus. External- eg. Benefits to road users who do not use the toll road but receive less traffic congestion as a result.

Stage 2: Assigning monetary values Uncertainty over monetary costs and benefits (predictions need to be made, sometimes projects are delayed causing a rise in costs…) Difficulties of measuring non- monetary externalities Options? Questionnaires (problems of dishonesty and ignorance) Make inferences from peoples behaviour (look at impact of similar previous projects)

Stage 3: Risk Using a sensitivity analysis A range of possible values of uncertain costs and benefits are given to see whether the project’s desirability is sensitive to these different values. See table 11.1 Lowest estimate for pollution damage is £10m, highest is £50m In case A the project is still worthwhile, not in case B (Case B’s desirability is more sensitive)

Stage 4: Discounting 1.Work out costs and benefits for each year of the life of the project 2.Subtract the costs from the benefits for each year to give the net benefit 3.Discount each year’s net benefit to give a present value 4.Add up all the present values to get a net present values (NPV) 5.If the NPV>0 the benefits exceed the costs

Choosing a discount rate £1 of benefit today is worth less than £1 benefit in 20 years time. £1 could have been invested today and be worth a lot more in the future. Eg if the interest rate is 10% £1 today is worth £1.10 in one year’s time, £1.21 in two year’s time and £10.83 in ten years time…. The rate of interest / rate of return is the rate of discount. Difficult to choose a discount rate. Question 3

Stage 5: Distribution The strict Pareto criterion: A project is desirable only if there are some gains and no one is made worse off. A project would only go ahead if all losers were fully compensated by the gainers (never fully happens in reality)

The Hicks- Kaldor criterion A project is desirable if it leads to a potential Pareto improvement. If the gainers could, in principle fully compensate the losers and still have a net gain, even though in practice they do not pay any compensation at all

Activity