Basic steps of CBA

1. Basic steps of CBA

2. Example • River pollution is killing 300 fish per day • It would cost $10m to clean up river for one year • Should we abate river pollution?

3. Example • Air pollution is causing 300 cases of asthma per day • It would cost $1m to install air filters in factories to reduce air pollution to zero • Should we abate air pollution?

4. Example • Traffic through the Rockies is destroying bison grazing areas and reducing the bison population by 100 per year • Traffic could be diverted away from the Rockies for $1m per year • Should we abate area pollution?

5. Are the benefits greater than the costs?

6. Step 1 What are the options? What do they cost? • Specify the set of alternative, separable projects and the costs of implementing each one • Important to be clear what the alternatives are, including the status quo and next best alternatives • Consider opportunity costs (lower taxes) • Always refer to costs as the resources required to implement the policy

7. Step 2 Decide on agency and make clear standing • Specify the agency, i.e. from whose perspective the policy is to be evaluated: • Private individual • Fiscal/government agency – revenues/expenditures • Society – all costs and all benefits net of transfers • Be explicit about standing, i.e. what domains to include: • Moral/legal considerations; ease of measurement; substantive significance or policy relevance • Examples: crime, Iraq war, climate change

8. Big digression on how to estimate costs

9. Step 3 Catalog the causal impacts of the policy • Clearly, impacts have to be caused by the policy • Strictly, role of economist is later: other disciplines needed to identify impacts • E.g. medical trials, environmental impacts • Economic analysis forces evaluators to think about impacts

10. Cascade of ecological effects

11. Cascade of ecological effects

12. Step 4 Predict the impacts quantitatively over the life of the project • Easiest to think about annualized costs and benefits of a project, but sometimes this is misleading (e.g. smoking) • Distinguish between short run and long run consequences (uncertainty)

13. Step 5 Monetize all the impacts based on ‘willingness to pay’ (price); call benefits • This is the step we will spend the most time on • Simple in theory: get a price per impact and multiply it by the number of impacts • But, all the reasons why we cannot rely on market valuations also mean we cannot easily get prices for impacts • And, prices do not measure willingness to pay

14. Big digression on how to estimate benefits

15. Step 6 Discount the costs and benefits to obtain present values • Costs mainly come before benefits, so discounting is very important • Choose a discount rate d (e.g. 3.5%) • This choice is not straightforward, depends on the project at hand, and can be debated

16. Big digression on how to discount

17. Step 7 Compute the economic value of each alternative; express as an economic metric • Add up all $ costs in present values (CPV) • Add up all $ benefits (positive and negative) in present values (BPV) • Economic metrics: • Net Present Value = BPV- CPV • Benefit-Cost Ratio = BPV / CPV • Internal Rate of Return = value of d where BPV = CPV

18. Step 8 Check the sensitivity of economic metrics to impacts and prices • Three different approaches to sensitivity testing • Generate conservative estimates • Very important for credibility of CBA 

19. Step 9 Make a decision about the policy options • Simple: select all policies where the benefit exceed the costs • If B>C, then NPV > 0 and BC ratio > 1

21. Step 9 • Why is efficiency a valued criterion? • “Everyone wins” (Pareto) • “Someone loses, someone wins; but the winner can compensate the loser so the loser is better off” (Hicks-Kaldor) • Use CBA to provide information to presume a decision, not for compelling that decision • Need to consider funding issues, political pressures, irrationality, distributional implications

22. Example • River pollution is killing 300 fish per day • It would cost $10m to clean up river for one year • Fishermen can sell fish for $20 each • Should we abate river pollution?

23. Example • Air pollution is causing 300 cases of asthma per day • It would cost $1m to install air filters in factories to reduce air pollution to zero • People spend $100,000 on asthma medication and treatment over their lifetimes • Should we abate air pollution?

24. Example • Traffic through the Rockies is destroying bison grazing areas and reducing the bison population by 100 per year • Traffic could be diverted away from the Rockies for $1m per year • Societal WTP for each bison is $100,000 • Should we abate area pollution?