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Chapter 3

Evaluating Trade-Offs: Benefit–

Cost Analysis and Other Decision-Making Metrics

© 2012 Pearson Education, Inc. All rights reserved. 3-2

Chapter 3 Evaluating Trade-Offs: Benefit–Cost Analysis and Other Decision-Making Metrics

• Introduction• Normative Criteria for Decision Making• Applying the Concepts• Divergence of Social and Private Discount

Rates• Cost-Effective Analysis• Impact Analysis


Introduction

• This chapter illustrates the use of several decision-making metrics that can assist us in evaluating options.


Introduction

• You find a mineral deposit beneath a forest. Should you destroy the forest to extract the minerals? What is the best decision?

– Destroy the forest: New jobs, improved economic welfare from increasing employment, rise of income etc.

– Keep the forest: Town has access to forest products, Species protection, CO2 reduction, No noise pollution from mining etc.


Introduction

– Does the forest grow back? What about the future? How far into the future do you consider?

– Are there any other alternatives to mining?• Could you turn the forest to conservation park and still

get some revenue?

– You collect cost and benefit and quantify it.– Is everyone going to be better off?

• Economic Cost Benefit Analysis.


Normative Criteria for Decision Making

• Evaluating Predefined Options: Benefit–Cost Analysis– Benefit-Cost analysis provide a method for

determining whether or not an action should be supported.

– Let B be the benefits from a proposed action and C be the costs. Our decision rule would then be: • If B > C, support the action• Otherwise, oppose the action



• Cost/Benefit Analysis computes dollar values for the costs and benefits of an action.

• How do we measure cost and benefits?– Economic benefit and cost = human (society)

centered (Anthropocentric)


• Total benefits or total willingness to pay, is the area under the market demand curve from the origin to the allocation of interest.

• Total cost is the area under the marginal cost curve.

• All costs should be measured as opportunity costs.



• Opportunity cost is the net benefit foregone when an environmental service is lost to a new use.– Ex., cutting forest.

• Cost = net benefit forgone because the trees cannot provide services like species protection, CO2 reduction etc.



• Total costs is the sum of marginal opportunity costs, which is the area under the marginal cost curve.

• Net benefit is the excess of benefits over costs or the area under the demand curve that lies above the supply curve.– This is also the consumer plus producer surplus.



• Consider the net benefits from preserving a stretch of river that can be used either for boating or for generating electricity. – If the river is used for boating,

• Should that stretch be preserved? Explain why or why not?



• Total Benefit (TB) = Area under the demand curve: LMSO

• Total Cost (TC) = Area under the marginal cost curve = KNS



FIGURE 3.1 The Derivation of Net Benefits

• Society chooses to preserve 4-mile stretch,

• TB = LMOS• TC = KNOS• TNB = LMOS-KNOS

=LMNK

• TB > TC => Preserve the river


Relating Optimality to Efficiency

• For the normative choice criterion, the objective is to maximize the net benefits area.– Optimal policies maximize net benefits (TB-TC).

• That is identical to the economic surplus that is maximized in a static efficient allocation

Maximum Economic Surplus = Maximum Net Benefit


Finding the optimal outcome

• If at an allocation, marginal cost is greater than marginal benefit, then net benefits are less than the maximum possible => inefficient

• If marginal benefit is greater than marginal cost, net benefit can be increased by increasing the allocation => inefficient

• Efficient: MC = MB



• Society chooses to preserve 5 mile instead of 4,

• TNB = LRK > LMNK

• NB increases by area NMR



• Society chooses to preserve 6 mile instead of 5,

• MC > MB

• Net benefits decrease by RTU compared to earlier.



• Since net benefit is reduced by preserving less than 5 or more than 5 units, – Preserving 5 miles constitutes an efficient or

optimal allocation.

• First Equi-marginal Principle– Social net benefits are maximized when the

social marginal benefits from an allocation equal the social marginal costs.

– MB = MC



• The social marginal benefit is the increase in social benefits from supplying one more unit of the good or service.

• The social marginal cost is the increase in cost incurred from supplying one more unit of the good or service.

• When MC = MB; allocations are Pareto optimal.



• Allocations are said to be Pareto optimal if no other feasible allocation could benefit at least one person without harming some other person.– Efficient allocations are Pareto optimal.


Comparing Benefits & Costs Across Time

• Many decisions have to be made that will have consequences into the future.– Fisheries or forests could be overharvested,

pollution can accumulate over time.. – Time is a factor.

• How can we make choices when benefits and costs occur at different time?



• Present Value: The concept of present value allows us to:– Incorporate time value of money– Compare dollars today to dollars in some future

period by translating everything back to its current worth.

• Discount rate is the rate at which society as a whole is willing to trade off present for future benefits.


• In order to incorporate time, we use the present value formula which discounts the future value to the present based on a discount rate.

• When introducing time factor analysts need to account for the fundamental financial principle– “A dollar today is worth more than a dollar tomorrow” – A dollar today can be invested at 10% interest to get

$1.10 in a year.



• Comparing Benefits and Costs Across Time– Present Value of a one-time net benefit

(Bn) received n years from now is

Where r is the discount rate


• By discounting a one-time benefit received in n years from now, analyst account for timing.


TABLE 3.1 Demonstrating Present Value Calculations

• Year 1: 3000/{(1+0.06)1} = $2830.19• Year 4: 10000/{(1+0.06)4}=$7920.94

• Suppose, an allocation yields the following net benefit at the end of each year:– $3000,$5000,$6000,$10000,$12000– Suppose, interest rate is 6%


TABLE 3.1 Demonstrating Present Value Calculations


• The present value of a stream of net benefit {B0,…, Bn) received over a period of n years is

• Total PV = $29,205; Total Benefits after 5 years = $36,000

Where r is the interest rate



• The maximum net present value criterionsuggests that resources should be committed to those uses maximizing the present value of the net benefits received.– This is a dynamic efficiency criterion.



• Dynamic Efficiency–An allocation of resources across n time

periods satisfies the dynamic efficiency criterion if: • it maximizes the present value of net

benefits that could be received from all the possible ways of allocating those resources over the n periods.



• Example,


PV [ cost] PV [benefit] NPV

Project 1 100 150 50

Project 2 200 75 75


• Example,


Problem Set 1. Discount ratesProject 1. Marine Park

Years0 1 2 3 4 5 6 7 8 9 10

Costs (thousands of $)Construction 1250

Recurring costs 0 130 130 130 130 130 130 130 130 130 130

Foregone recreation 20 20 20 20 20 20 20 20 20 20 20Benefits

Increased tourist revenue 300 300 300 300 300 300 300 300 300 300 300

NetNPV @ 5%NPV @ 10%


Applying the Concepts

• Pollution Control– Benefits include, not limited to, reduced death

rate, lower incidences of chronic bronchitis and other diseases, better visibility, improved agricultural productivity and etc.

– Costs include • 1) higher costs passed to consumers such as

installing, operating and maintaining pollution control equipment

• 2) administrative costs such as designing, implementing, monitoring relevant policies


EXAMPLE 3.2


• Benefit-cost analysis involves judgments on:–Which effects should be included (e.g.,

should secondary effects be included)? –How many people incur benefits and costs?

• Are the benefits and costs the same for each person?

–How do you handle intangible values or those that cannot be reliably assigned a monetary value.

Issues in Benefit Estimation


1. Primary Versus Secondary Effects• Consider both primary and secondary consequences while

implementing environmental projects• Actions trigger both primary and secondary actions.

– Clean a lake» Increase in recreational uses of the lake (Primary effect)» Increased employment from increased users in the lake

(Secondary effect).

– Need to account for the secondary effect as well.• If the increase in demand leads to new employment, its

value should be counted.



2. Accounting Stance• Who benefits? The accounting stance refers to the

geographic scale at which the benefits are measured.

– Local or National?

– If preserving a land affects locally, account for that. If it is significant to the nation, it has a national impact. In Benefit/Cost analysis, need to account accordingly.



2. Accounting Stance• Example, Colorado Big Thompson Project.

– Federal Water diversion project from Colorado River to the plains

» Howe (1986): Cost-Benefit Analysis» National net benefits: -$341.4 billion» regional net benefits: $766.9 billion» The local political pressure secured this project, although

it is really inefficient.



3. With and Without Principle• The “with and without” principle states that only

those benefits that would result from the project should be counted, ignoring those that would have accrued anyway.

– Example, if increased tourism did not occur because of the clean river, but rather because there was a new park built then you cannot account for the secondary effect in the B/C analysis for river cleaning.



4. Tangible Versus Intangible Benefits• Tangible benefits can reasonably be assigned a

monetary value.• Intangible benefits cannot be assigned a

monetary value.– If ignored, the results are biased.

– Intangible benefits should be quantified to the full extent possible.



• Estimating cost is typically more straightforward than estimating some types of benefits. – Difficulties involve estimating expected

future costs and getting reliable cost information from firms.

Approaches to Cost Estimation


1. The Survey Approach• Ask those who bear the cost to provide a perspective• E.g., Involves asking polluters about the control costs

estimates.• Incentive to not be truthful/overestimate

– Overestimating the cost could provide less strict regulations.

2. The Engineering Approach• Considers the technologies that would be needed, then

draws conclusions regarding the cost to meet the objective.

– There might be unique circumstances in different firms that would not be captured by this approach.



3. The Combined Approach• Combining both survey and engineering approaches• The survey collects info on technology needed and

special circumstances while the engineering approach estimates the cost of technology.



• For many environmental issues, scientific uncertainty complicates benefit-cost analysis. – Eg., most scientists agree on the potential

damage of climate change, such as sea level rise and species losses.

– However, the timing and the extent of those losses are not certain.

Treatment of Risk


• Two dimensions to the treatment of risk:– Identify and quantify the risks. (scientific)– Decide how much risk is acceptable.

(normative)

• Since it is very tedious and sometimes unfeasible to do a benefit-cost analysis for every possible outcome, we usually must utilize expected values.

Treatment of Risk


• The Treatment of Risk– A dominant policy is one which confers the

higher net benefits in every outcome. • In this case, the existence of risk concerning the

future is not relevant for the policy choice.

– However, if there is no dominant policy, use the expected value.

The Treatment of Risk


– The expected value of net benefits is the sum over the possible outcomes of the present value of net benefits of that outcome weighted by its probability of occurrence. The policy selected should be the one with the highest expected present value of net benefits.




• You want to select a policy with the highest expected present value of net benefits.


• In Cost Benefit analysis, it is important to define whether the party is risk neutral, risk averse or risk loving.

• Suppose there are two options. You either receive $50 right now or enter into a lottery with a 50/50 chance that either you win $100 or $0.– Risk-loving = lottery– Risk-averse = $50 (cash right now)

• Expected Value = (100*50%) + (0*50%) = $50– Risk-neutral = indifferent between two– The above approach assumes risk neutrality. Whether or not it makes sense for

the government to assume that society on the whole is risk neutral (versus risk loving or risk averse) should be discussed.



– One of the critical assumptions when conducting a cost-benefit analysis is the discount rate used in the PV calculation.

– The appropriate rate to use will depend on the nature and expected lifetime of the project, who is doing the financing and the level of risk

– E.x., During the early 1970s the office of management and budget ensured all government used a discount rate of 10% in their B-C analysis. Now, it has been revised to 7%.

Applying the Concepts:Choosing the Discount Rate


– The discount rate is defined as the social opportunity cost of capital. The discount rate will have two components: 1. The riskless cost of capital2. And The risk premium.



Divergence of Social and Private Discount Rates

• Risk-free cost of capital– The rate of return is earned when there is

absolutely no risk of earning more or less than the expected return. (Rate on long term govt. bonds.)

• Risk premium– It is the amount required to compensate capital

owners for potential differences between expected and actual returns.


– Private and social rates differ, mainly because of:• Differences in private v/s public risk

premiums.• Differences in time preferences.

–It affects both private and social discount rates, as well as across countries.



– If firms use higher discount rate, they would extract and sell resources faster than would be efficient.

– If firms use lower discount rate, they would be excessively conservative.

– When discount rates differ, market decisions are not efficient.



• Example,

• NPV at 5% = 11.16• NPV at 10% = -0.65


Problem Set 1. Discount ratesProject 1. Marine Park

Years0 1 2 3

Costs (thousands of $)Construction 195

Recurring costs 0 20 20 20

Foregone recreation 10 10 10 10Benefits

Increased tourist revenue 80 80 80 80

Net -125 50 50 50NPV @ 5% -125 47.61 45.35 43.19NPV @ 10% -125 45.45 41.32 37.56


EXAMPLE 3.4


• The importance of discount rate (Example)1950’s: USA and Canada discussed the possibility of constructing a tidal power project in Passamaquoddy Bay between Maine and New Brunswick. Cost benefit analysis was conducted.

– USA concluded that the project should be built.– Canada concluded the project should not be

built because the net benefit would be negative.



Why?USA used 2.5 % discount rate while Canada used 4.125%.

USA used a lower discount rate so the initial costs weighed less heavily in their calculation. In the USA calculation, the lower future operating costs weighed heavily. Canada used a higher discount rate which means high initial costs, and they saw the net benefit as negative.



Common proxies for discount rate• In the 1970s the OMB (Office of Management and

Budget) required all government agencies to use a discount rate of 10% in cost-benefit analysis.)

• Now,– NOAA (National Oceanic and Atmospheric Administration)

uses 3% discount rate.– FEMP (Federal Energy Management Program) uses 3%

discount rate.– OMB (Office of Management and Budget) uses 7%

discount rate.– Many developing nations use (8-15%) discount rate.



• Example: Should govt. establish a national marine sanctuary?

• Assume that a marine ecosystem is threatened by polluted runoff from development; waste from sewage, detergents, and fertilizers; destructive fishing methods; and offshore oil drilling

• Threatens the viability of reefs and seagrass beds, and threatens the long-term sustainability of the fish and other seafood harvests

• In response, the federal government is considering establishing a NMS to provide comprehensive protection of the marine environment

Benefit Cost Analysis Example

Taken from: http://webspace.pugetsound.edu/facultypages/kburnett


• List the benefits• Direct economic benefits:

– more ecotourism– enhanced seafood harvests– better bird watching– a fishing catch that is sustainable in the long-

term

• Indirect economic benefits– preservation of cultural and historic sites (e.g.,

lighthouses and ship wrecks)




• List the costs• productivity losses incurred by industry as

a result of the prohibition on off-shore drilling, waste dumping, and net fishing

• private industry could be required to purchase costly equipment to comply with new regulations related to the treatment of industrial waste products (abatement cost)






Cost-Effective Analysis

• Cost-effectiveness analysis is a useful alternative to benefit-cost analysis when the measurement of benefits is impossible, or estimates are unavailable.


Cost-Effective Analysis

• Second Equimarginal Principle (the Cost-Effectiveness Equimarginal Principle): – Involves minimizing the costs of achieving a policy target

(e.g, emission standard).– The least-cost means will be achieved when the marginal

costs of all possible alternatives are equal.

• E.g., the least cost way of supplying electricity or water to a community.


Impact Analysis

• Useful when data needed for either C-B analsysisor cost effective analysis is unavailable.

• An impact analysis attempts to quantify the consequences of various actions.– It attempts to assign a monetary value to who gains and

who loses from a given policy.

• Impact analysis places a large amount of relatively undigested information at the disposal of the policy-maker.


Summary

• Environment: a composite asset• Benefit–cost analysis• Cost-effective analysis• Impact analysis• Static versus dynamic efficient allocation

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chapter 3sbkunwar.weebly.com/uploads/1/0/9/8/109848430/chapter_3.pdf · Chapter 3 Evaluating Trade-Offs: Benefit– Cost Analysis and Other Decision-Making Metrics •Introduction