1. 1 Civil Systems Planning Benefit/Cost Analysis Scott Matthews 12-706/19-606 and 73-359 Lecture 2 - 9/1/2004

2. 12-706 and 73-3592 Benefit/Cost Analysis  Framework to systematically identify major benefits and costs associated with a particular investment or policy.  Often controversial, with different analysts coming to different conclusions or not agreeing on objectives.  BCA is a framework, not a recipe.

3. 12-706 and 73-3593 Why do we use it?  Required: Exec Order 12291 (Reagan) ex-ante  Perform RIA for agency programs over $100 M  Market failure (when used by government).  Comparison of projects/alternative policies (contribution to improved quality of information).  Explain divergence between expected and actual outcomes.

4. 12-706 and 73-3594 Steps in a CBA - Read ‘Reality’ 1. Determine standing. 2. Select portfolio of alternatives. 3. Catalogue potential (physical) impacts and select measurement indicators. 4. Predict quantitative impacts of the life of the project. 5. Monetize. 6. Timeframe and money. 7. Sum. 8. Sensitivity Analysis 9. Recommendation.

5. 12-706 and 73-3595 Graphic interpretation of CBA

6. 12-706 and 73-3596 Efficiency Definitions/Metrics  Allocative - resources are used at highest value possible  But welfare economics uses another:  An allocation of goods is Pareto efficient if no alternative allocation can make at least one person better off without making anyone else worse off.  Inefficient if can re-allocate to make better without making anyone else worse  Assumed that decisions made with this in mind?

7. 12-706 and 73-3597 A Pareto Example  Try splitting $ between 2 people  Get total ($100) if agree on how to split  No agreement, each gets only $25  Pareto efficiency assumptions:  More is better than less  Resources are scarce  Initial allocation matters

8. 12-706 and 73-3598 $100 0 Given this graph, how can We describe the ‘set of all Possible splits between 2 people That allocates the entire $100? ?

9. 12-706 and 73-3599 $100 0 Line is the ‘set of all possible splits that allocates the entire $100, Also called the potential pareto frontier. Is the line pareto efficient?

10. 12-706 and 73-35910 $100 0 No. Could at least get the ‘status quo’ result of (25,25) if they do not agree on splitting. So neither person would accept a split giving them less than $25. Is status quo pareto efficient? $25

11. 12-706 and 73-35911 $100 0 No. They could agree on splits of (25, 30) or (30, 25) if they wanted to - all the way to (25,75) or (75,25). All would be pareto improvements. Which are pareto efficient? $25 $75

12. 12-706 and 73-35912 $100 0 The ‘pareto frontier’ is the set of allocations that are pareto efficent. Try improving on (25,75) or (50,50) or (75,25)… We said initial alloc. mattered - e.g. (100,0)? $25

13. 12-706 and 73-35913 Pareto Efficiency and CBA  If a policy has NB > 0, then it is possible to transfer value to make some party better off without making another worse off.  To fully appreciate this, we need to understand willingness to pay and opportunity cost in light of CBA.

14. 12-706 and 73-35914 Willingness to Pay  Example: how much would everyone pay to build a mall ‘in middle of class’  Near middle may not want traffic costs  Further away might enjoy benefits  Ask questions to find indifference pts.  Relative to status quo (no mall)  E.g. middle WTP -$2 M, edges +$3 M  Edges could ‘pay off’ middle to build  Only works if Net Benefits positive!

15. 12-706 and 73-35915 Opportunity Cost  Def: The opportunity cost of using an input to implement a policy is its value in its best alternative use.  Measures value society must give up  What if mall costs $2 M?  Total net WTP = $1M, costs $2M  Not enough benefits to pay opp. cost  Can’t make side payments to do it

16. 12-706 and 73-35916 Wrap Up  As long as benefits found by WTP and costs by OC then sign of net benefits indicated whether side payments can make pareto improvements  Kaldor-Hicks criterion  A policy should be adopted if and only if gainers could fully compensate losers and still be better off  Potential Pareto Efficiency (line on Fig 2.1)

17. 12-706 and 73-35917 Three Legs to Stand On  Pareto Efficiency  Make some better / make none worse  Kaldor-Hicks  Program adopted (NB > 0) if winners COULD compensate losers, still be better  Fundamental Principle of CBA  Amongst choices, select option with highest ‘net’ benefit

18. 12-706 and 73-35918 What about Other Goals, non- Efficiency?  Multigoal Analysis  Economic performance  Social performance  Environmental performance  Technological performance  Flexibility  We’ll come back to this later in course

19. 12-706 and 73-35919 Distributionally weighted CBA  SW = sum of net benefits across entire population. SW =  (NB) i for all  Are there conditions under which we want to weight individuals differently when maximizing net benefit?  SW =   (NB)  for all  and    =1 where   is the weight assigned to person .

20. 12-706 and 73-35920 Welfare Economics Concepts  Perfect Competition  Homogeneous goods.  No agent affects prices.  Perfect information.  No transaction costs /entry issues  No transportation costs.  No externalities:  Private benefits = social benefits.  Private costs = social costs.

21. 12-706 and 73-35921 Discussion - WTP  Survey of students of WTP for beer  How much for 1 beer? 2 beers? Etc.  Does similar form hold for all goods?  What types of goods different?  Economists also refer to this as demand