Cost-Benefit Analysis: Additional Considerations

1. Cost-Benefit Analysis: Additional Considerations Environmental Economics, Lecture 16

2. Outline • Limitations of Cost-Benefit Analysis • Discount rates • Option values • Appropriate use of cost-benefit analysis

3. Limitations of Cost-Benefit Analysis • Equity & distributional considerations • Focus on total costs & benefits, not marginal • Possible to manipulate cost-benefit analyses. • Sensitive to analysts assumptions on • Discount rate • Treatment of risk/uncertainty

4. Distorting a cost-benefit analysis • The “jobs game” • Example: the British Olympic Association argues that a “benefit” of London Olympics is job creation (9000 full time jobs). • What are the people who will take these jobs doing now? • Direct wage costs are a cost, not a benefit. • Reallocation of currently productive labor is also an opportunity cost, not a benefit.

5. Discount Rates • How should a cost-benefit analysis value future benefits. • Present value (example) • I offer you $105 next year • The risk-free interest rate is 5%. • $105 is just as good as getting $100 now and putting it in the bank. • Present value of $105 next year is $100. • See Tietenberg, pp 24-25.

6. If present value, what is the right discount rate? • Market rate gives indication of our social willingness to tradeoff current and future benefits. • Can use comparisons between risk-free and risky assets to impute “market cost” for risk. • Traditional approach. Use long term rates on govt. bonds as “risk-free” measure and then adjust for risk. • The size of adjustment varies by analysis • Assumptions about interest rate can make a big difference (see example 3.5 and Barrett)

7. Considerations on discount rate • Should tradeoffs between present and future observed in private markets drive our public choices? • Private risks can be “hedged” or diversified. • Possibility of catastrophic changes • Public values vs. private values • If public sector uses a lower discount rate, then more projects with longer payoff periods pass cost-benefit analysis.

8. Evidence on discount rates for environmental goods • Observed behavior on energy efficiency(high implicit discount rates) • Some survey experimental evidence points to higher discount rates.

9. Option Value • Value of Flexibility (See class notes) • Value of new information (Example from Jinhua Zhao, Iowa State)

10. Example: New information • Example: risk neutral planner. Will get further information about environmental benefits next year • Expected payout = $10/year • Expected NPV = (10/0.1)-84=$16 • Go ahead: invest now

11. Example cont’d • Consider waiting till next year to decide? • If unfavorable ($5), 5/.1 < 84 (Don’t invest!) • If favorable ($15), 15/.1-84= $66 (Invest) • Expected payoff = (.5)(66)/1.1=$30 • Should not invest now! (30 > 16) • Delay helps avoid unfavorable investment that you will regret given the new information.

12. What is the story? • Hysteresis: waiting has value when • There is uncertainty in payoff of investment • You can learn in the future by delaying • Investment is irreversible or costly reversible • The value is called option value • Much like financial option value • Example: call option: opportunity to invest in year two • Value is $30 • Investment now kills this option • Invest now only if ENPV ¸ OV, or if the benefit can cover both the cost and the OV • Investment now competes not only with no-investment, but also with investment later.

13. Applications • Global Warming • Argument for research or learning by doing • Argument for waiting for new infromation. • Krutilla-Fisher (Pearce and Turner, ch 10) • Development decisions are irreversible. Should include value of new information.

14. Policy Recommendations from Economists • See Arrow et. al