Cost-Benefit Analysis: Basic principles

Cost-Benefit Analysis: Basic principles PLCY 201

Basic idea of Cost-Benefit Analysis (CBA) • Benefits of a program: +$$$ • Costs of a program: - $$$ _______ • Net benefits: ? $$$

CBA in the legal framework • Executive order 12291 in 1981 ( by Reagan): regulatory impact analysis required for every major regulatory initiative (i.e. total effect over $100m) from government agencies • Many states now require that regulatory initiatives include benefit-cost analyses • OMB publishes guidelines how to conduct CBA and specifies parameters

CBA’s theoretical foundation: Circular No A-94: 10 “The principle of maximizing net present value of benefits is based on the premise that gainers could fully compensate the losers and still be better off. The presence or absence of such compensation should be indicated in the analysis. “

Circular No A-94 6. Identifying and Measuring Benefits and Costs. Analyses should include comprehensive estimates of the expected benefits and costs to society … . Social net benefits, and not the benefits and costs to the Federal Government, should be the basis for evaluating government programs or policies that have effects on private citizens or other levels of government. …

Circular No A-94 6. … Social benefits and costs can differ from private benefits and costs as measured in the marketplace because of imperfections arising from: (i) external economies or diseconomies where actions by one party impose benefits or costs on other groups that are not compensated in the market place; (ii) monopoly power that distorts the relationship between marginal costs and market prices; and (iii) taxes or subsidies.

6 steps of CBA 1. Decide whose benefits/costs count (standing) 2. Select portfolio of alternative projects 3. Catalogue potential (physical) impacts and select measurement indicators 4. Predict impacts over life of project; monetize impacts 5. Discount for time to present values 6. Sum [add benefits-costs over time] and recommend alternative

1. Whose benefits count? i.e. Who has standing? • International? • Tourists? • Wild life?

2. Select alternatives • Status quo • Additional lanes and separated directions

(3.) Catalogue potential impacts and select measurement indicators BenefitsMeasurement • faster -> time, gas, car saved • safer -> lives saved • Benefits to alternative routes -> lives, time etc

(3.) Catalogue potential impacts and select measurement indicators • Costs construction -> material, labor, land maintenance -> labor, material

(4.) Predict impacts over the life of project and monetize A. Predict impacts • # of vehicle-trips on the new highway • # of vehicle-trips on the old roads • Total amount of time saved • Total amount of operating costs and wear-and-tear saved • # accidents avoided • Maintenance costs based on weather

Value of life? • NB! Statistical value of life. ca $2mil • Based on what? • observing behavior: indirect estimate of price people are willing to pay to accept certain risks (e.g. wage premium in risky jobs or safer cars, smoke detectors) • Directly asking hypothetical survey questions

Time is money! • Truck drivers hourly wage ($11.80 in 2004) • Commuting 40-60% of average income • Leisure time 25% of income

4. Monetizing non-monetary benefits • Opinion surveys: Contingent Valuation (CV) surveys (ask how much willing to pay) • Hedonic price models (e.g. the value of a park next to the house) • Activity surveys – the travel cost method

6. Sum: add up benefits and costs; recommend • Net Present Value (NPV) • NPV=Benefits-Costs • Chose a project that maximizes net benefit

How to choose a project NB B/C Project 1: Costs 1 m Benefits 10 m 9m 10 Project 2: Costs 10 m Benefits 30 m 20m 3 Don’t use B/C!!

Why not to use B/C ratio? • Projects tend to be exclusive. • What is a cost and what is a lost benefit is not unambiguous.

6. Sum: add up benefits and costs; recommend • Net Present Value (NPV) • NPV=Benefits-Costs • Chose a project that has • Positive NPV • Highest NPV • However! • Budgetary constraints • Distributional constraints

6. Sum: add up benefits and costs; recommend Kaldor-Hicks: no distributional concern Modified benefit-cost analysis: introduce weights.

Challanges: • Whose benefits and costs count • Geographic, people and preferences (e.g. illegal immigrants, criminals), environment (animals) • Alternatives ->infinite • Impacts -> unpredictable • Monetize -> no monetary value • Sum->budgetary constraints, distributional concerns

Purpose of CBA • Helps to compare policy alternatives with various criteria on the same scale • Help social decision making -> efficient allocation of society’s resources • Assumption: it is possible to trade off utility gains for some against utility losses for others. (Remember Kaldor-Hicks principle!). A policy should be adopted only if those who will gain could fully compensate losers and still be better-off. i.e. produce social surplus. • Distributional effects may require special attention

Appropriateness of CBA as a decision rule depends on • Whether efficiency is the only relevant value • The extent to which important impacts can be monetized (if not, can still be useful as a component of multi goal analysis)

“Cost-Effectiveness Analysis” (CEA) • CEA obtains the maximum output for a given total cost; or • Minimizes the total cost of producing a given amount of output. • Compares levels of output: levels of cost • It does not provide any information on how the output is valued by consumers.

Cost-Effectiveness Illustrations • National Defense • x tons delivered • Highway safety • Lives Saved • Prevention Programs • Recidivism • Vaccination • Education • Graduation rates • Test scores

CE Analysis is Most Useful • When policymakers have decided on the specific measure of output and you are trying to evaluate alternatives. • When attempting to assign a $ value to the output or benefit is impossible (economically or politically). • When the program does not produce multiple/dissimilar outputs or benefits.

Cost-Benefit Analysis: Basic principles