Cost-Benefit Analysis 2008

7/29/2019 Cost-Benefit Analysis 2008

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Policy Analysis Tools:

Cost-Benefit

Analysis


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Cost-Benefit Analysis

A technique for systematically estimating theefficiencyimpacts of policies

Valuable in identifying and categorizing costsand benefits for rationaldecision making inthe public arena

Used with variable success in a broad rangeof public policy areas

Success of use depends on the degree towhich cost and benefits can be monetized


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It can answer logical, rational questions such

as:

Should governmentproduce a good/service?

e.g., public housing, parking garage

Should government intervene in the market?

Regulating airline safety, automobile safety

How much of the good/service should be produced?

Superfund cleanups, public transportation



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Getting a handle on the

costs and benefits ofproposed policies


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It is a technique that can be used

to evaluate government projects

and programs. It encompasses an

appraisal of a policy based on thecosts and benefits of the project,

measured in comparable units

within and across time.


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Limitations to

Cost-Benefit

Analysis


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Most policies involve budgetallocation costs.

Limitations to Cost-Benefit Analysis

However, many policy benefitsand costs are neithertangible

noreconomically visible.


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Measurement of costs

Direct outlays are easy to determined

Private cost

Burden on taxpayers, inequities

Social costs

Concentrated highly visible costs (housing,

welfare)

Widespread invisible (tax burden)

Opportunity costs (rarely considered)

Limitations to C-B Analysis in theSocial Policy Arena


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Criterion of efficiency Bottom line for decision making?

Issues of equity Who pays, who gains?

Externalities Unintended side effect (+ and -)

Offsetting behavior

Limitations to C-B Analysis in theSocial Policy Arena


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Advantages ofCost-Benefit

Analysis


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Advantages of CBA

Provides a decision making tool thatis based on objective standards

Allows for a quantitative comparisonbetween multiple solutions forpolicy problems

Can be used to monitor the

efficiencyof existing programs


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Some central C-B

concepts beforewe start


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Central C-B Concepts

Time Value of Money

Cost of life


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Cost-Benefit Concepts

Time Value of Money:

inflation discount rate


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Inflation

A dollar today is always morevaluable than a dollar next year

Consumer Price Index An index of prices used to measure the

change in the cost of basic goods andservices in comparison with a fixed base

period Measures inflation

Considerable variation across time


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Inflation

In a cost-benefit analysis decisionsmust be made in constant dollars

You cant add apples and oranges


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How do we deal with

inflation and the valueof money over time?

How do we addapples and oranges


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Discounting

Discounting takes care of two factorsthat make it difficult to add upmonies over time: The influence of inflation The earning power of money

Using a discount rate you extract

out the inflation+interest effectfrom future costs and benefits Future dollars are worth less today


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In addition, using a discountrate you are assuming thatmoney invested today can

grow at a compound rate,producing more money in thefuture

You need less money now toproduce a specified amount ofmoney in the future

Discounting


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Cost-Benefit Concepts

Discount Rate Formula

nr

nD)1(

$

Dn = Present Value

$ = Dollars in the future

r= Discount rate (Inflation+Interest)

n = Number of Years


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Discount Rate

Choice of a discount rate is speculativeand subject to much debate

What will future inflation rate be? What will investment yields be in the future?

Discount rate= Estimate (inflation rate + bond yield rate)

E.g., 2% + 6%=8% discount rate


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An example


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Assume that you will be given exactly $1,000from Grandma on your birthday for the next 3years. How much is this 3 year b-day presentworth to you TODAY? Assume an annual

interest/discount rate of 6%.

Present Value


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Assume that you will be given exactly $1,000from Grandma on your birthday for the next 3years. How much is this 3 year b-day presentworth to you TODAY? Assume an annual

interest/discount rate of 6%.

Today

$1,000Dn

Present Value

1 2 3

$1,000 $1,000+ +?


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Cost-BenefitAnalysis Overview

How is a cost-benefitsanalysis done?


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Step 1:

IdentifyingRelevantImpacts


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Identifying Relevant Impacts

Identify all relevant impacts

Classify them as costs or benefits for various

groups

Choosing geographic boundaries

e.g., flood control, public libraries, etc.

Choosing relevant groups with preferencestanding

Whose costs and benefits will be measured in a

decision to improve security in a local prison?


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Step 2:

Monetizing

RelevantImpacts


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Monetizing Relevant Impacts

Valuing inputs:

Measurable costs (objective)

Opportunity costs (subjective)


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Monetizing Relevant Impacts

Valuing outcomes:

Benefits of policy/program (objective)

Willingness to pay (subjective)


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Step 3:

Discounting for

Time and Risk


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Discounting for Time and Risk

Discounted future benefits/costs

Taking account of risk

Capital depreciation


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Step 4:

Choosing AmongAlternative Policies


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Choosing Among AlternativePolicies

Cost benefit ratio

Benefits/Costs > 1 = implement policy


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Numerical

Example


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Cost-BenefitAnalysis

An Example


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Taxing alcohol to save lives

Highway fatalities caused by alcoholimpaired drivers

Problem of younger drivers Innocent lives lost

Injury and property damage

Cost of morbidity: health care,accidents at work, loss ofproductivity, etc.


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Identifying the Costs and BenefitsOver a Specified Period of Time

Time Period: 1 year

Benefits (1) Tax revenue

30% increase in tax Consumer drink less (-16.6% in demand)

ESTIMATE = Increase of $16,739 billion


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Benefit (2) Reduction in fatalities

1,650 fewer young driver fatalities

1,270 non-driver fatalities from young drivers

861 driver and non-driver fatalities from >21year old drivers

Assume each life is worth $1million

Benefit (3) Reduction in property damage

$0.65 billion/year


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Benefit (4) Health and productivitygains

Absenteeism and workplace accidents

$4.29billion in annual health savings

$6.61billion in productivity savings



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How to count lives saved

Three estimates:

Upper bound: consumers of alcohol are totallyuninformed about increased risks of alcohol

consumption = all drivers and victims fatalitiesregarded as benefits

Lower bound: consumers of alcohol are totallyinformed about increased risks of alcoholconsumption = only victim fatalities regarded

as benefits Best guess: between the two


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Another example


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School Bus SafetyEnhancement Program

Installation of seatbelts on schoolbusses to ensurechild safety whentraveling on the bus


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Identifying the Costsand Benefits Over a

Specified Period ofTime


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Time period Assume a 20 year decision period

Benefits

Assume the only benefits are childrens livessaved

No injuries are taken into account in thisexample

Assume each childs life is worth $1,000,000

today Assume that 350 childrens lives are lost on

school buses each year in the state directly as aresult of no seat belts

Identifying the Costs and Benefits Over aSpecified Period of Time


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Costs Assume it costs it cost $4,000mill to

install the seatbelts on all school buses in

the state Assume that it costs $10mill to maintain

these seatbelts in useable order in thefirst year

Assume that after 10 years many of theseatbelts have to be replaced at a cost of$200mill in 2017 (Capital depreciation)



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Time Value of Money

Assume that the cost of a childs lifeincreases at 3% per year (inflation)

Assume that the cost of maintainingseatbelts on school buses increases by 3%per year (inflation)

Assume that money invested today in a fund

can earn 3.7% interest per year aboveinflation and that inflation is running at anaverage of 3% per year (6.7% discountrate)



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Lets recap what we know so far


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Cost-benefit analysis

Provides a rational frameworkfordecision making in the public arena

Allows us to compare multiplesolutions to problemssimultaneously

Provides an objective criterion to

base the decision on (efficiency, orat least benefits > cost)


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But..the approach has limitations

Measurement of costs and benefits

Efficiency criterion not alwaysapplicable

Cannot take into account equityissues in cost distribution

Often cannot predict externalities

that can significantly impact theanalysis


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Despite limitations still a useful tool

Time value of money

Concept of inflation

Value of the Consumer Price Index Capital depreciation

Andof course the discount rate

Lets consider the discount rate onemore time before moving on

A discount rate is a single combined


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A discount rate is a single combinednumber that estimates two components:

What the inflation rate will be infuture years

Whatpercentage interest rateabove inflation money will earn sothat it grows in future years.

For example: if you accept a rate of return on your bank investmentthat is under the average inflation rate (< 2.4% apr in 2008) you willbe losing money in every subsequent year. If the rate is at inflation,youll be simply protecting your money, not making your money workfor you.


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So..

If inflation is running at 3.5% and youvemanaged to get a rate of return on yourinvested money from the bank of 6.3%you are beating inflation by 3% and your

money is working for you. The concept of a discount rate assumes

that the rate of return on invested moneythat isgreater than inflation on

average. How much greater depends on the value

of the discount rate you choose to use inyour cost-benefit analysis.


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Now..onto the next question


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Federal Aviation Administration(Flight TWA 800)


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TWA Flight 800 was a TWApassenger flight that disintegratedwhile flying from John F. Kennedy

International Airport (New York) toCharles de Gaulle InternationalAirport (Paris) in 1996, killing all

230 aboard. The incident has beenone of the most investigatedcrashes in aviation history.
http://en.wikipedia.org/wiki/Trans_World_Airlineshttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/New_York_Cityhttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/Parishttp://en.wikipedia.org/wiki/Parishttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/New_York_Cityhttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/Trans_World_Airlines


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The aircraft was flying more than eightmiles off the coast ofEast Moriches, NewYork (on Long Island) when the plane'scenter wing fuel tank exploded. The aircraft

developed cracks around the nose as aconsequence of the explosion, and thefront part of the aircraft broke off(including the cockpit and first class

section). The left wing ruptured, and theleaking fuel from the left wing tank ignitedin the air, triggering a second explosion.
http://en.wikipedia.org/wiki/East_Moriches%2C_New_Yorkhttp://en.wikipedia.org/wiki/East_Moriches%2C_New_Yorkhttp://en.wikipedia.org/wiki/Long_Islandhttp://en.wikipedia.org/wiki/Long_Islandhttp://en.wikipedia.org/wiki/East_Moriches%2C_New_Yorkhttp://en.wikipedia.org/wiki/East_Moriches%2C_New_York


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A four-year investigation by theU.S. National Transportation SafetyBoard, the only official investigation

to date, concluded that fumes insidethe center wing tank ignited,causing the explosion. The NTSB

concluded that the spark wascreated by faulty wire insulation andan electrical arc.
http://en.wikipedia.org/wiki/National_Transportation_Safety_Boardhttp://en.wikipedia.org/wiki/National_Transportation_Safety_Boardhttp://en.wikipedia.org/wiki/National_Transportation_Safety_Boardhttp://en.wikipedia.org/wiki/National_Transportation_Safety_Board


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The NTSB contends that theexplosion could have beenprevented by use of a system to

smother flammable vapors insidefuel tanks, rather than the industrystandards of the time that focused

on eliminating ignition sources thatcould enter them from the outside.

The Cost of


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The Cost of

Saving a Life

C bl


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Can we reasonably

value a life?

And, are all lives lost ofequal value?


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An alternative method

LIFE YEARS SAVED


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LIFE YEARS SAVED

Avoiding a particular risk of deathtoday means that you are more likely

to live the statistically average lifespan.

The difference between this averagelife span and a premature death is the

number of life years saved.


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Consider the case of

mammograms.

If we gave every woman in the

U.S. an annual mammogram wewould detect some breastcancers in the early stages and

prevent some women from dyingprematurely


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Mammogram screening

But, since the number of women whose liveswould be saved is small, the cost per lifesaved would be high since wed be screeninglots of women who never get breast cancer.

Besides, in the absence of a mammogramwomen would most likely get an annualphysical breast exam, which might detect thecancer anyway.

So, we need to focus on the additional cost of

the mammogram policy and compare it to thenet additional benefit (additional life yearssaved) of adding the mammogram policy.

Remembering that policy benefits will differfor women of different ages.

Hill R dh Cli t did j t


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Hillary Rodham Clinton did justthat in 1993/94 in an attempt to

reform the U.S. health care system

She devised the Clinton health care planin which it was decided notto cover acost for a life year saved that exceeded$100,000.

Thats why the plan provided regular mammograms forwomen in their 50s ($108,401) but not for women in

their 40s ($186,635).


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But, even additional years of

life are not of equal value:

Need a measure that captures

quality of remaining life years

Quality Adjusted Life Years (QALY)

Concept of morbidity


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Lets consider an example


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Quality-adjusted Life Year (QALY)

Patient Option 1: No Surgery

10 remaining years of lifeQuality = .6

QALY = 6 years


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Patient Option 2: Surgery

15 remaining years of life

Quality = .8

QALY = 12 years

Where do those extra 6 years of life come from?


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Patient Option 2: Surgery

15 remaining years of life

Quality = .8

QALY = 12 years

longevity effect (5 X .8) = 4yrs

QOL effect = (10 X (.8 - .6)) = 2years


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Alternatives to Cost-

Benefit Analysis

..that assist policy makers

in their decision making

Alternatives to Cost-Benefit


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Alternatives to Cost-BenefitAnalysis

Cost-effectiveness analysis

Risk-Risk analysisHealth-Health analysis


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Makes programs with identical types ofoutcomes comparable

Shows which program yields the greatest

outcome per dollar spent DOES NOT indicate whether a particular

policy has positive net benefits overall

Example: Effectiveness of medicationversus diet in preventing heart attackscompared to the costs of the twoprograms

Other examples of how cost-


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Other examples of how cost-effectiveness analysis is used:

Feb 2000 JAMA: Study concluded that annualretinal screening for individuals with Type 2 diabetesmay not be warranted on cost-effectiveness grounds(QALY=$150,000).

Vijan et al. 2000 JAMA: Compared with biannual

screening, annual retinotherapy screening for low-risk patients with diabetes cost more than $100,000for each QALY

NEJM 2000: Extending hospital stays beyond 4days for patients with uncomplicated myocardialinfractions was economically unattractive since itcost more than $105,000 per QALY

Annals of Internal Medicine 2000: Viagra is acost effective treatment for erectile dysfunction,producing an incremental QALY for the relatively lowcost of $11,000


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Risk-Risk Analysis

Policy analysts have long realized thatreducing one risk may unintentionally raiseanother risk

Risk-Risk analysis can be used to yield a countof desired/undesired outcomes in differentunits

Does not take account of the costs andbenefits of a policy

Example: treating drinking water withchlorine reduces the incidence of infectiousdiseases, but exposure to chlorine raises therisk of cancer


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Health-Health Analysis

An analyst who knows how thecosts of a program are distributedforecasts the number of adverse

health outcomes induced by theprogram

The analyst then compares a countof the fatalities averted by a

program versus a count of fatalitiesinduced by an alternative program

H l h H l h A l i


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E.g., Passenger-side airbags: For everyfive lives saved by passenger-side airbags,a life (usually a child) is lost. Thats a 5:1health-health ratio.

Program beneficiaries (adults) aredifferent from those who bear the cost(children), yielding DISTRIBUTIONALdifferences.

Disadvantage?

It confines the analysis to a tally of mortalitycosts.

Health-Health Analysis


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In summary

Comparing methods


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Methods comparing cost and benefits

Cost-benefit analysis

$benefits - $costs (sameunits)


$costs compared to desirable(adverse) outcomes

Methods comparing cost and


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Risk-Risk analysis Measures only probabilities of

outcomes

Health-Health analysis Lives saved-lives lost

Measures only mortality risks

Methods comparing cost andbenefits


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Documents

Cost-Benefit Analysis 2008