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Updated: May 16, 2007 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture 10

Updated: May 16, 2007 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture 10. MEASUREMENT OF COSTS AND BENEFITS OF TRANSPORTATION INVESTMENTS. ECONOMIC BENEFITS OF TRANSPORTATION PROJECTS. 1) Improvement of existing mode - Example of a road

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Updated: May 16, 2007 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture 10

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  1. Updated: May 16, 2007 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture 10

  2. MEASUREMENT OF COSTS AND BENEFITS OF TRANSPORTATION INVESTMENTS

  3. ECONOMIC BENEFITS OF TRANSPORTATION PROJECTS 1) Improvement of existing mode - Example of a road 2) Introducing new modes of transportation - Example of a Buenos Aires- Colonia bridge

  4. COST - BENEFIT ANALYSIS OF TRANSPORTATION PROJECTS • 1) ROAD IMPROVEMENT BENEFITS • Cost Savings for Existing Traffic • - Savings in Vehicle Operation and Maintenance Costs • - Savings of Time • Cost Savings for Newly Generated Traffic

  5. COST SAVINGS FOR EXISTING AND NEW TRAFFIC Di Cost per vehicle-mile for type i Cost Savings for Newly Generated Traffic E cit F c`it G D`i Vit V`it Traffic Volume of type i Cost Savings for Existing Traffic

  6. Cost Savings From Road Improvements • Traffic Volume with Project: number of vehicles by type that we expect each year to use the road over its life after improvement for the each year; • Traffic Volume without Project : the volume of vehicles by type that would travel on the road without the road improvement; • Vehicle Operating Costs with and without the Project: the costs incurred by road users in terms of: - consumption gasoline and oil; - The wear-and-tear on tires - The repair expenditures for vehicles

  7. Without Road Improvement With Road Improvement • Diverted Traffic: The traffic that diverted to the upgraded road from other routes as a result of the road improvement. • Generated Traffic: The traffic that will arise from people who now made the trip more frequently due to the reduction in the cost of using the road.

  8. Savings of Time • “Normal” traffic: For passengers and trucks the improved road allows their vehicles to travel at a higher speed as compared to the existing road, thus saving them time. Example: Occupants of a vehicle value time at $20 per hour, vehicle speed is 30 kph Time cost per km: 20/30= $ 0.66 If vehicle speed is 50 kph Time cost per km is 20/50= $ 0.4/km Value of Time Savings: 0.66-0.4= $ 0.26 per vehicle - km • The value of savings is tied to the value placed on occupants’ time and therefore sensitive to the level of per capita income of the country. • For Diverted and Generated passenger traffic the value of time savings is taken on average as half of the value of time savings for “normal” traffic.

  9. Savings of Costs of Road Maintenance • The annual savings in resources used for maintenance is the difference between the amount of resources spent on maintenance “without” road improvements minus the maintenance costs during the life of the road “with” the improvement. • Road improvements or new roads will affect the pattern of traffic on other roads that are complements or substitutes to the road being improved. • For complementary roads the maintenance requirements are expected to rise as the volume of traffic accessing or exiting from the improved roads increases. • The increase in maintenance costs on the complementary roads should be included as a cost associated with the road improvement project. • Substitute road maintenance expenses are expected to decrease due to the lower traffic levels. • The cost savings are a benefit to the road improvement.

  10. Accident Reduction • A road improvement can be important factor in the reduction of the number of accidents. • A road improvement may not automatically imply a substantial reduction in the rate and severity of accidents as there are other influencial aspects. Some of these factors are the geometric alignment of the road, the volume of slow traffic, effectiveness of law enforcement, vehicles mechanical conditions and drivers behavior. • Steps to assess the benefits of accidents reduction: • the rate of traffic accidents “with” and “without” the proposed improvements must be estimated. (Number of accidents per millionvehicle-kilometer) • the monetary value of accident reduction should be estimated which includes the savings in damages such as property and cargo damages. It is difficult to put a monetary value on injuries and fatalities.

  11. Vt=Vit Calculation of Value of Savings in Transportation Projects Step One: Estimate a projection over time of the traffic volume in the area for different types of traffic: Where Vt is the expected volume of traffic in year t, V is traffic, i is a type of traffic, t is time. i

  12. Step Two: Calculate the Average Speed Sit=ƒ(Vt), Where Sit is the average speed of the ithvehicle type. Step Three: Estimate cit which is the average cost per vehicle-mile at time t for vehicle type i on the unimproved road. cit includes vehicle operating costs, depreciation, maintenance and time cost. Step Four: Estimate c`it which is the average cost per vehicle-mile at time t for vehicle type i on the improved road.

  13. (cit - c`it)*Vit i Step Five: Estimate the benefits of savings in cost of travel due to road improvement in year t: and the present value of these benefits at discount rate r: (1+r) -t* (cit - c`it)*Vit t i Step Six: Estimate M` and M , which are the annual road maintenance costs with and without the road improvement. t t

  14. Step Seven: Estimate the benefits of savings in road maintenance cost due to road improvement in year t, in some cases maintenance costs may rise (Mt - M`t) Step Eight: Estimate the present value of total benefits due to improvement (when volume of traffic remains constant after improvement): (1+r)-t* (cit - c`it)*Vit+ (1+r)-t*(Mt - M`t) t i t

  15. COST SAVINGS WITH AN INCREASE IN TRAFFIC VOLUME GROWTH AFTER ROAD IMPROVEMENT Step Nine: There is an additional benefit in consumer surplus of generating new traffic volume due to road improvement. EFG = ½(1+r)-t*(cit - c`it)*(V`it -Vit) Di i t Cost per vehicle-mile for type i Gain in Consumer Surplus due to Improvement E cit F c`it G D`i Vit V`it Traffic Volume of type i

  16. COST SAVINGS WITH AN INCREASE IN TRAFFIC VOLUME GROWTH AFTER ROAD IMPROVEMENT Step Ten: The total present value of benefits due to road improvement with a traffic volume increase: i t + ½(1+r)-t*(cit - c`it)*(V`it -Vit) (1+r)-t*(cit - c`it)*Vit + (1+r)-t*(Mt - M`t) i t t

  17. EXTERNALITIES CONNECTED WITH ROAD PROJECTS Dit*(X`it - X0it) Need to take into account all external benefits and costs: Where: Dit is the excess of benefits over costs associated with a unit change in the level of activity, Xi at time t, X`itis that level in the presence of the project, X0it is that level in the absence of the project. i

  18. EXTERNALITIES INVOLVING TRAFFIC ON OTHER ROADS • Externalities can be: • Excess of marginal social cost over marginal social benefit for traffic on roads; • Excess of marginal social benefit over marginal social cost for traffic on other modes such as railroads. • Congestion impacts, a very important and pervasive externality.

  19. There is a negative relationship between volume of traffic, V to speed of traffic S. S = a - b*V If H is the value of the occupant’s time per vehicle hour, cost can be approximated by time per vehicle-mile, or H/S, which is also the marginal private time-cost as seen by the typical driver. The total time-cost of all users will be VH/S, and the marginal social time-cost:

  20. Excess of marginal social cost, MSC, over marginal private cost, MPC, can be expressed as: Where: MSC is the marginal social cost; MPC is the marginal private cost; S is actual speed; H is time per vehicle-hour; a is the average speed at low traffic volumes. Example: a= 80 kph s= 60 kph Thus (80-50) / 50 = 0.60 Marginal Social Cost exceeds Marginal Private Cost by 60 per cent.

  21. EXTERNALITIES (CONGESTION) IN CASE OF COMPLEMENTARY ROAD S` (social costs) External costs associated with traffic increase I Cost per vehicle-mile D` F D C` (private costs) J C1 D` E C0 C D V0 V1 Traffic Volume on Complementary Road D`D` is an increase in traffic on the complementary road EFIJ is the external costs

  22. EXTERNALITIES IN CASE OF SUBSTITUTE ROAD S` (social costs) External benefits associated with traffic decrease Cost per vehicle-mile D F C` (private costs) D* G E C0 C1 H D C D* V* V0 Traffic Volume on Substitute Road D*D* is a decrease in traffic on the substitute (competitive) road HGFE is the external benefits

  23. CALCULATION OF EXTERNALITIES FOR COMPLEMENTARY OR SUBSTITUTE ROAD Where: C0 is initial cost per vehicle-mile on the alternative road; f is a fraction of C represented by time-costs; V is the change in traffic volume; j is a type of alternative road; k is a volume interval on a road.

  24. INTRODUCTION OF NEW ROADS Since there was no traffic to the area before the new road, the whole triangle DiC`itH represents the total present value of benefits to road construction in year t. Di Cost per vehicle-mile for type i H c`it D`i V`it Traffic Volume of type i

  25. INTRODUCTION OF NEW ROADS • If a new road is for developing a new mine or new tourist hotel where there are few existing inhabitants, then road is part of the investment for the mine or hotel and should not be evaluated separately. • There are other ways to estimate the benefits of a new road in an area. • Changes in Land Values • In case of agricultural areas: the present value of incremental agricultural output less the present value of incremental costs of production. • These ways of estimating the value of transportation project are mutually exclusive not an additional benefit.

  26. INTRODUCING NEW MODES OF TRANSPORTATION “Buenos Aires Colonia Bridge Project” The BAC Bridge will introduce a new mode of traffic to the Buenos Aires-Colonia area: transportation for passengers crossing the river. There is an alternative mode of crossing the river, a ferry. Beneficiaries of the BAC bridge consist of both passengers diverted from ferry and newly induced bridge river-crossing passengers.

  27. The gross economic benefits of the diverted and induced passenger traffic is measured by the total willingness of the passenger to pay to cross the river using this new mode. If the toll level is tB, the quantity of trips demanded on the bridge should be equal to qB. At this quantity, the economic benefits of the diverted and induced traffic is equal to the consumer surplus, (CBIJ), plus the value of the tolls (OtBKqB), plus the value of any taxes or other distortions associated with vehicle operating and time costs incurred to use the bridge (NPKtB). Average Cost, $ BAC Bridge I V max GC D B J C B t VOC B R B + TC B D B P Taxes and Other N q Distortions on B K VOC and TC B B River Crossing O per Year

  28. Economic benefits or costs could arise because of the reduction in activity of the alternative modes due to the quantity of traffic diverted to the bridge. With no bridge, the demand for the alternative mode (the ferries) is shown as . With the introduction of the bridge, demand for ferries decreases and the quantity of ferry users falls from q wob to q wb . In this case, if the ferry toll were set at tA, which is above the relevant marginal cost of the ferry, there would be a loss in ferry profits of GEFH. If there were taxes (or subsidies) associated with vehicle operating and time costs incurred when using the ferry, then the reduction in this activity would create a further economic loss (or gain). $ Alternative Mode A B C A VOC A + TC A GC D E F wob t MC A G H GC D wb Taxes and Other Distortions on VOC , TC , and MC L M A A A q River Crossing q O wb wob per Year

  29. Externalities Involving Railroad Traffic • Major issue in North America, Europe, India and China where roads are replacing parts of an existing railway network. The problems involved in the relationships between road and rail transport can be complex, given the difficulty of isolating the relevant costs of rail transport.

  30. Project of Road Improvement Road Railroad DR(C1) DR(C0) M G J N F Fare on Railroad R D’4(C2) D’3(C1) O v1 v2 x2 x1 Consequences: 1) traffic is diverted from rail to road 2) the railroad no longer has to bear the marginal cost of carrying diverted traffic v1 - the initial levels of unit costs and traffic volume on the road v2 - the equilibrium levels after the road has been improved but before railway abandoned x1 - initial traffic on railroad before road is improved x2 - level of traffic on railroad after road is improved - the demand curve for services of the railroad on the assumption that there is no improvement on the road - the demand curve for services of the railroad after improvement on the road - the benefit perceived by traffic that would have used the unimproved road in any event M R - the measure of direct benefits of both existing users, v1, plus generated traffic (v2-v1) M N - represents the net benefit perceived by those who would not have used the road at unit cost of C1 , but who would have used it a unit cost of C2. MNR

  31. Figure 1. Figure 2. Unit Cost of Travel on road Fare M G J MCR F R N D’3(C1) D’4(C2) Volume of traffic on road x2 O x1 Traffic level on railroad If MCR = F no adjustment is necessary to evaluation of benefits of road improvement • the demand curve for services of the road on the assumption that the railroad is operating and charging the fare level OF (from Figure 2.) c1*v1 - the initial levels of unit costs and traffic volume on the road c2*v’2 - the equilibrium levels after the road has been improved but before railway abandoned x1 - initial traffic on railroad before road is improved x2 - level of traffic on railroad after road is improved MCR - marginal costs of supplying railway service If MCR = F then at each point from J to G the lost fare is equal to MCi

  32. Measuring Marginal Cost for Railroads: • The marginal costs of carrying additional freight on trains which are in any event running are very low – MC1 • The marginal costs of running additional trains where the track and station facilities will in any event be kept in working condition are at an intermediate level – MC2 • The marginal costs of providing rail service on a stretch of track as against the alternative of abandoning that stretch are higher still – MC3 • The Fare charged by the railroad will be set to cover at least average costs. • The net external effect will therefore almost certainly be negative, and will be measured by: - is the fare or freight rate for the type of rail traffic - is the marginal cost associated with carrying that traffic on railroad - is the change in the volume in railroad, induced by the road improvement - type of traffic on the railroad

  33. Unit Cost of Travel on road Fare G J (Pd) F M N D’3(C1) R L K (Ps) MC D’4(C2) x2 O x1 Traffic level on railroad Volume of traffic on road Lose of GJKL on railroad must be deducted from Road Benefits Disregarding the impact of the road improvement project on the railway, the benefits of the road improvement is: …………(1) -is the value of railway service to users who switched to use the road x2GJx1 -is the costs saved when users of railroad switched to use the road x2LKx1 -is the economic loss when railway users switch to road because their valuation of service is F/unit but by resources saved is only MC per unit. is an external loss. This amount has to be deducted from direct benefits of road improvement equation (1). LGJK

  34. Figure 1. Benefits of Road when it causes Railway to be abandoned Unit Cost of Travel on road • the private average unit costs of travel on the road • before the improvement M - after the improvement P N R • the demand curve for services of the road on the assumption that the railroad is operating and charging the fare level OF • the demand curve for the services of the road • assuming the railroad has been abandoned Volume of traffic on road • the equilibrium levels of costs and road traffic after the road has been improved and the railroad abandoned Figure 2. -represents cost in incurred on the road by traffic that had been involuntarily generated on road because of the abandoned of the railroad. This does not cause net benefits of road improvement change because D2D’2 for road assumes cost of railway is F. Any other changes in welfare is measurement in railway market. NPv2v’2 Fare Loss J G (Ps) MC (Pd) F D’3(C1) L K Even in case where F= MC, there is an additional loss in railway market is of loss in consumer surplus, FD4G when railway abounded and people forced to use road. This loss in consumer surplus should be subtracted from net benefits of road. D’4(C2) x2 O x1 Traffic level on railroad

  35. Figure 1. Benefits of Road Improvement of Railway Abandoned Unit Cost of Travel on road SUMMARY M P N R a) The present values of cost savings to the user of the road (represented by area ) M N lessb)The present value the loss in the private consumer surplus associated with abandonment of the railroad (represented byFD4G ) Volume of traffic on road less c) The present value of the excess of rail fares over the direct marginal costs of operation (MCFGL) plus d) The present value of the savings stemming lower equipment, maintenance, station operation costs, and so forth, for the railroad pluse) The current market value in alternative uses of the properties to be abandoned Figure 2. Fare Loss J G (Pd) F Loss D’3(C1) L K (Ps) MC D’4(C2) x2 O x1 Traffic level on railroad

  36. A Case of Upgrading a Gravel Road

  37. The three expenditure decisions that need to be made by a Road Agency: • Selecting new roads for construction; • Allocating funds between road maintenance and new road construction; • Selecting the roads to be maintained, the type, and timing of treatment.

  38. Benefits of Road Improvement • Ideally, five types of benefits should be counted: (1) reduction in resource costs on maintenance by the Roads Agency; (2) reduction in vehicle operating costs for road users due to improved road surface; (3) time savings for road users due to increase in the average speed of vehicles; (4) possible reduction in the costs of accidents; and (5) other fiscal externalities.

  39. Economic Costs • Convert all financial expenditures into their corresponding economic costs. • This implies that all the taxes, subsidies, market imperfections, impact of foreign exchange premium, and labor market distortions must be removed from the financial expenditures to arrive at economic costs.

  40. Decision Criterion • If the economic NPV of the project is greater than zero, the project is potentially worthwhile to implement. • On the other hand, if the NPV is less than zero, the project should be rejected on the ground that the resources invested could be put to better use if they were left to be allocated by the capital market. • When selecting among several alternatives, the economic NPV criterion makes it possible to choose the best combination of roads. • Alternative road projects with the highest NPV’s should be selected first in order to maximize the net economic benefits over time.

  41. Roads Management System • All existing roads are catalogued in a database that contains a detailed description of roads, their condition, and user traffic. • Graphical interface and allows the analyst to examine the whole network. • The location of a particular road link is referenced relative to other roads. • A total count of annual average daily traffic (AADT) is recorded and proportion of heavy vehicles traffic. • Condition of a road link is assessed through a number of criteria: cracks, poth, patching, rutting. • Two summary measures of physical condition are stated: international roughness index (IRI), and visual condition index (VCI).

  42. Example of Gravel Road Upgrading • There are a few potential sources of such forecasts: a) a study by specialized consultants; b) a traffic flow movement software system for the province (no such system exist at the RAL as of now); or c) building own traffic forecast by using all of the available information. • Traffic count suggests that in 2005 there will be an annual average of 600 vehicles a day (AADT), with 10% being heavy vehicles. • Suppose that a 20 km existing gravel road is being considered for tarring. • It is expected that “normal” traffic will grow at a rate of 2.0% per annum and share of heavy traffic will not change over time. • It is expected that due to lower user costs some “additional” traffic will appear on the road in year 2006 with an AADT of 40 vehicles and 5% of heavy vehicles. • This new traffic flow consisting from “diverted” and newly “generated” users is assumed to grow at 2.0% per annum.

  43. Traffic Forecast “With” and “Without” Project (2005-2025)

  44. Project Costs

  45. Financial Cashflow Profile (R2005, million)

  46. Financial Expenditures • The incremental financial PV criterion could wrongly suggest that it is better to continue with the existing gravel road than to upgrade it to a tarred surface. • A decision based on undiscounted sum of the budget expenditures over a number of years may be incorrect, because it does not account for the time value of money.

  47. Project Benefits • Economic Maintenance Resource Savings. The estimated present value of economic resource maintenance savings due to road improvement amounts to R2005 23.1 million. • Vehicle Operating Costs (VOC) Savings. The present value of economic VOC resource savings is estimated to be R2005 70.6 million. • Time Savings. The total PV of time savings to all road users is estimated as R2005 15.1 million.

  48. Economic Resource Flow Statement (R2005, million) • Incremental Statement (= “With Project” – “Without Project”) • Financial flows have been converted into economic equivalents by using economic conversion factors.

  49. Economic Assessment • The proposed project appears to be economically feasible as it generates a positive NPV of R2005 71.4 million. • In order to compare this particular road upgrading investment to other alternative road improvement alternatives, the Roads Agency must conduct their assessment and estimate what NPV each other project will generate. • A relative ranking of all projects then could be done by the size of their estimated NPV’s.

  50. Distributive Analysis • The relative distribution of benefits among the three stakeholder groups is such that the owners of light vehicles stand to benefit the most from the proposed road improvement. • The owners of heavy vehicles are the second main beneficiary group. • For the RAL, the R2005 23.1 million amount of total maintenance resource costs savings is overwhelmed by the investment costs of road upgrading, R2005 37.3 million, and the net impact on RAL is net economic cost with a PV of R2005 14.2 million.

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