GG 541

September 23, 2008

Professor T. R. Lakshmanan

Key Components of CBA

◊ User benefits (times, fares, vehicle operating costs, safety etc.)

◊ Investment costs

◊ Operator costs and revenues

◊ Impacts on government - taxation subsidies

◊ Externalities (environmental, congestion)

User Benefit Estimation

Three concepts underlying the definition of user benefit:

◊ Willingness to Pay (WTP)

◊ Consumer Surplus (CS)

◊ Generalized Cost (GC)

WTP is the maximum amount of money an individual is willing to pay for the change in his/her circumstances,e.g to make a trip from i to j using mode m.

If the price (p) of the trip is less than or equal to WPT, the individual is assumed to make the trip.

If P is > WTP, the traveler will find an alternative, which may be not the travel at all.

WTP is grounded in the acceptance of Consumer Sovereignty, so that it does not apply to goods subject to per se social or moral judgment.

WTP can still be applied to cases of externalities (negative spill overs).

However, if a community places extra value on social interactions promoted by public transit, that value will not be captured by the sum of individual willingness to pay for transit trips (only if one could also separately measure and include individual WTP for a better social milieu likely to result for more social interactions)

Note - different individuals have different levels of WTP for the same ijm trip.

One can construct the demand function for ijm trips, linking the price to number of trips demanded - a downward sloping demand curve.

Continued…

CBA is a comparative tool, involving a comparison of alternative states of the world.

A do-something scenario - Where a link or facility is included in the transport network.these will be a separate do-something scenario for each alternative version of the project.

A realistic do-minimum scenario - With the project not implemented. The do-minimum scenario will include a realistic level of maintenance and a minimum set of minor improvements to avoid the transport deterioration.

S

D

GCo

CS

Q

D

Transportation Services

Generalized Costs

The Do-Minimum Scenario

DD, the demand function represents the number of trips that would be made at different levels of generalized costs - a few trips with large economic benefit made at high costs,and less beneficial trips at lower costs.

The intersection of the supply function s yields the number of trips made. CS, consumer surplus is ameasure of the excess of willingness to pay over thegeneralized cost of the trip - the area CS under thedemand curve and above a horizontal line indicating the current price (GCo).

Operationalizing the concept in transport poses some problems. For most goods, the vertical axis indicatesprice .

In the case of transport, prices and money costs arenot only one part of the composite. Cost of transit, which in principle incorporates travel times, access times topublic transport, discomfort, perceived safety risk and others. Hence price is replaced by Generalized Cost (GC).

GC represents the money equivalent of the overallcost and inconvenience to the transport user engaged in travel between origin (i) and destination (j) by aparticular mode (m). While in principle, it includes all aspects of ‘quality’ factors, in practice GC is limited tothree elements.

GCC ijm = time cost ijm + user charges ijm + VOC ijm

Value of time costs vary among individuals and even forthe same individual depending upon the trip purpose andtheir factors.

Q’ Q

CS

D Price

D

Transportation Services

B

S

S'

A

The User Benefit

CSijm (=CSijm – CSijm) is estimated by the rule of a half(ROH) on assumption that the demand curve between (Q1GC0) and (Q1GC1) is linear approximately

∆CS= 1/2 (GCo - GC1)(Q1 - Q)

This procedure repeated for transport users as well as for freight users.

1 0

1

Components of GC will vary by mode

* Public Transport users - fare plus costs of time of travel

* Car users - costs of time, toll charges, fuel costs plus VOCs

Differences in repeated user benefits for users of different modes (e.g. Public transport users do not have VOC benefits)

Producer Surplus

PS - TR - TC

where TR is total revenue and TC is total costs

∆PS = ∆ TR - ∆ TC

In the case of diagram (a) there is a rail journey time improvement, but marginal costs and fares (whichare above marginal costs) stay constant [benefits]

The change in the producer surplus ( DPS) is “net revenue gain”

continued…

Figure 3a is the case in which the benefits are fully passed through to the travelers

Figure 3b – there is complete “pricing up” by the railway operators. Thus the size of the revenue and user benefits effects (as well as their distribution) depends upon pricing policy.

Operating Costs

Costs of infrastructure operation (e.g. signaling/traffic control)

Maintenance costs (cleaning, minor repairs, winter services)

Costs of renewals (road/rail reconstruction)

Changes in VOCs of Public Transport Services

Investment Costs

Some adjustments to Investment Costs include:

Mitigation Measures (EIS, etc.)

Disruption (effect of disruptions on traffic revenues and on service quality)

Consistent Account(Market prices or factor costs basis)

Travel Time Savings

- Dominant item of benefits, especially for air travel, urban community and surface freight shipping

- Big time savings occur when there is

A new high speed rail service A new highway through previously underdeveloped land Congestion relief from expanding capacity Improved rail switching facilities Upgrade a line haul facility to permit higher speeds

An extensive literature based on demand modelssuggests that people and firms make reasonably predictable trade-offs between travel time and other factors when they make travel choices. From these studies, attempts to estimate WTP for travel time savings, a quantity known as the ‘Value of Time’ (VOT).

- population subgroups and also on individual circumstances

e.g. people WTP more on average to avoid time walking to a bus stop or waiting there than they are willing to pay to avoid the same amount of time riding on the bus.

Also willing to pay more to avoid driving in congested conditions.

VOT Varies Across

These variations not surprising as time is not fungible:time saved in one circumstance cannot be automaticallyused in another – examples:

These variations must be considered:

Predicting travel time savings often complicated by offsetting behavioral shifts as a result of unpriced congestion.

The case of latent demand

Amount of travel time savings overstated

The Case of Land Use Distortions

Failure to price highway congestion leads to the citybeing inefficiently decentralized. New highwaysexacerbate this effect by creating housing locationswhich create longer trips and more traffic. Socongestion will be reduced by a project less than predicted.

In estimating VOT, distinction is made between:

1. travel in working time

2. travel in non-working time (e.g. shopping, commuting, education, personal business,

leisure)

3. freight travel time

Working time value is easy to analyze because there is a market (labor market) where working time is valued

Two approaches

Adapt the gross wage rate (wage plus employee - related overheads) as a measure of the marginal product of labor

VOT = gross wage/min X

minutes of travel time savingsin working time

Second approach by Hensher qualifies the previous approach in two ways:

1) The ability to work while traveling (varies by mode)

2) The ability to use productively any travel time saved also varies, depending upon the extent to which work tasks are divisible and flexible.

No market exists

A WTP value based on market research

Both revealed preference (RP) and stated preference (SP methods used for VOT in different situations - including route choice, mode choice etc.

Non-working Time Savings Value

Value of Non-working Time Varies with Disposable Income

- Disposable income

- Employment status

- Type of activity (walk and wait higher than in vehicle time, congestion) and with mode (comfort, privacy)

- Journey purpose and journey lengths

- Pragmatic use of standard values

Most important savings in drivers time

Not only VOC savings but those resulting from trip rescheduling which leads to total labor cost reduction

Also the ability to adapt more efficient logistics - the process and service innovations and the resulting productivity in access.

Freight Travel Time Savings

Appraisal Values for Travel Time Savings - an example: UK Official Values

Trip Purpose Value ($ per minute) (a)

Working timeRoad Car driver 0.44 Car passenger 0.36 Light goods vehicle driver 0.34 Other good vehicle driver (b) 0.32 PSV driver © 0.33 PSV passenger 0.36Rail 0.55All modes 0.43

Non-working timeStandard appraisal value 0.11

Notes: (a) all values have been converted to 1999 US$, (b) Other goods vehicles includeheavy goods vehicles. c) PSVs are public service vehicles, principally buses. (d)Walking,waiting and, cycling in non-working time are given double this value.

CBA with Externalities

Transport provision often leads to a variety of negative or positive external effects (e.g. Air pollution, congestion, accidents and fatalities and airport noises are negative externalities. External economies of agglomeration is an example of positive externalities.

Q'Q

DPrice

D

TransportationServices

E

S+e

S'+e

S

S'

Here the private cost of travel is increased by an external cost e.

CBA with Externalities

Because of the upward sloping nature of the s + e functions, the estimated benefit (a social benefit here) willbe lower than the user benefit (in the simple user benefit case)by the amount E, which represents the extra external costimposed by the increase in trips. If one wants to reducepollution, a positive adjustment is needed.

To implement this adjustment, it must be possible to calculate the net change in external cost in monetary terms andsubtract it from the calculated user benefits.

Q' Q

P

D Price

D

Transportation Services

P'

S

S'

Congestion Effects

Congestion is a reciprocal externality. When the traffic exceeds design capacity, all vehicles experiencecongestion. As congestion increases, travel time is an increasing function of the number of users of thetransport link. As a consequence, the horizontal supplyfunction is to be replaced by an upward sloping segment.

Infrastructure improvement leads to an increase in design capacity, thus shifting the upward sloping segment to theright as in previous figure.

continued…

Calculation of congestion costs must not be on a link basis but on a transport network basis.

Please note that trips induced by the transport improvement may negate much of the benefit that might otherwise have accrued to freight users.

Value of Safety Impacts

Some of the safety projects are market driven, while some safety proposals are government mandated.

Changes in the risk of injuries, fatal or otherwise can be assessed based on WTP.

Decisions are made implicitly placing values on additionalrisks incurred.

A reliable method to value risk of death appears to be comparing wages for jobs that are similar in all respects except occupational risk.

Review of such studies suggest that on average people in affluent industrialized countries are willing to pay (early 1990s) $3 - $7 for each reduction of one in a million in the risk of death.

Take $5, and a million people, their aggregate WTP for saving one life is $5 million.

- “value of life” (VOL) 5 million

Most government agencies use a value of VOL of much less than $5 million.

Canada $1.4 million (Canadian) (1991).

[Even this amount is higher than those the average person’s personal wealth or the discounted sum of future earnings]

No one is paying to avoid a sure death; rather people are paying to lower the probabilities slightly.

Risk of serious injuries or illnesses evaluated in a similarfashion.

WTP to reduce the risk of typical serious (but non fatal) traffic injury is 10% of WTP (for traffic fatality).

Note that the government borne costs of medical treatment must be added.

Some Countries Public Official Values for CBA Purposes

Environmental Impacts of Transport

The challenge for CBA is to find ways to bring these impacts (air pollution, noise, or regional long run problems such as acid rain and global warming) into the CBA framework in a consistent way, given the greater uncertainty associated with environmental problems.

Noise: Hedonic analysis of rental property to get the impact of noise.

Values generated by the approach are typically of the orderof 30 Euros/person per dB per annum in year 2000 prices (Grant-Muller).

This value adjusted to other countries using PPP exchangerates

Damage costs much higher /unit mass of pollutant emittedin urban (US non urban areas) - 50 times as much in London vs. rural areas.

46-740 Euros/kgm.High level of uncertainty - sensitivity testing necessary.

Particulates most Significant Air Pollutant

The CBA Process

CBA Process

Inputs - modeling & forecasting all inputs (time, cost and time). Estimates of investment costs, safety and environmental impacts.

Consistent Benefit Estimation - Use ROH for user benefits and simple do-minimum vs. do-something comparison for other cost and benefit items initially for one or two years.

Interpolation and Extrapolation - using growth rates for quantities and unit values, to arrive at cost and benefitstreams over the entire appraisal period.

Discounting - Discount future costs and benefits in linewith public sector conventions on discount rates.

Summary Measures - over all measure in CBA terms.

continued…..

Discounting the Future

Valuing future benefits less because of

* People’s impatience or

* The productive possibilities for investing their money

Discount rate related to the interest rate on financial assets.

continued…

Departures from perfectly competitive markets result in wedges between interest rates faced by different economic factors.

Take a risk-free government bond with real after-tax-interest rate rc (usually 4%).

Investment earns a real net social rate of return(marginal product of capital) ri (9.6% in 1989).

How about a weighted average of rc and ri. In US, OMB (Office of Management & Budget) uses since1993, a social discount rate of 7% (Australia 7%, Canada 10%).

Main summary measure of net social benefit is the Net Present Value (NPV)

NPV = ∑Bt-Ct-Kt

l-r

t=n

t=0

Where Bt are the benefits in year tCb the recurring costs in year tkt the investment costs in year tr the social discount rate

[reflecting the social opportunity cost of capital]n number of years in the appraisal period

Decision Rules

- Accept all projects with a positive NPV

- Accept the highest project option with the highest NPV, when there are mutually exclusive alternatives

Under budget constraints use B/C ratio.

BCR= ∑t=n

t=0

Bt-Ct

(l+r)t ∑t=n

t=0

Kt

(l+r)t

Accept projects based on a marginally acceptable B/C ratio.

Presentation format of CBA analysis

The previous table shows the aggregate social costs and benefits as well as the benefits accruing todifferent incidence groups - identifying gainers and losers.

Discuss the case.

Issues in CBA

Projected estimates are required of:

up front capital costs

the future operating costs

the future demand for travel on the facility

Projections of Capital Costs & Travel Demand

Record on these projections very choppy.

In affluent countries record is not very encouraging.

- For ten rail transit systems recently built in the US. Capital costs underestimated (up to 1/3) in nine cases (Don Pickrell); in eight cases ridership was overestimated (by a factor of 3).

- Even for toll highways (bond financed) 10 out of 14 had less toll revenues well below projections.

- Similar experience for 7 large Danish highway bridges.

continued….

Case of toll road near Vancouver, BC. Ex post CBAshowed that ex ante CBA drastically underestimated both actual construction costs and actual traffic - offsettingerrors but still humbling.

Is there a strategic bias in these ex ante CBAs?

The Case of CBA in LDCs - quite different

The World Bank experience in LDCs ($50 billion in transportprojects).

Type of Project Number of Projects Annual Rate of Return

Airports 8 21%

Highways 306 26%

Rail 72 14%

Ports 96 20%

All Transport Projects 482 22%

All Sectors n.a. 15%

-------------------------------------------------------------------------------------

Source: Eno, 1997, p.24

Estimated Returns from World Bank Projects

Extensions of CBA

Logistics Cost Effects

Facilities Consolidation

Other Location Effects

Total Logistics Costs

Total Logistics Costs (TLC) = PC + C + TC

Where PC = Procurement Costs C = Carrying Costs TC= Transport costs

PC and TC (Unit Costs) will be lower , the larger the shipment

C, which includes storage cots, interest on inventory andInsurance, will be proportional to shipment size

P+T and C are grouped against the average shipmentsize B, optimal B is where TLC (T+P+C) is a minimum.

Given the tradeoff between TP and C. Logistical systemssuch as Just-in-time (JIT) ----***

TLC'

TLC

P+T

P+T'

B' B Shipment Size

Costs

C

Total Logistics Costs

Logistics cost savings as % of sales

Industry Logistics cost / travel time elasticity 20% reduction in

travel time 45% reduction in travel time

Retail Food .055 .04% N/A Automotive Parts .234 .20% .45% Telecommunication Equipment

.103 .02% .05%

Medical / Surgical Instruments

.548 .88% 1.98%

Measures of Travel Time Reduction Impacts on Costs (Hickling, Lewis, Brod, 1995)

Elasticity of logistics costs el with respect to traveltime reduction.

Compare the high el for a high value added industrycompared to retail food.

[caution: result of a limited survey]

Provision of Infrastructure & Industry Levels

Shirly and Winston (2001) using the Census Bureau’sLogitational Research Database find support for theview that lower transportation costs and higherreliability allow firms to maintainlower inventories.

Facility Consolidation

Reduced freight costs allow a multifacility firm to concentrate its production and distribution facility locations in fewer locations to take advantage of scale economies.

Substantial savings in logistical costs

Case study of a firm in medical surgical products with $1.8 billion sales in 1990.

BeforeConsolidation

AfterConsolidation

Savings

Distribution Facilities 16 6

Costs ($Millions)

Transportation 22 18 18.2%

Warehousing 9 7 22.2%

Inventory Carrying 11 9 18.2%

Total Logistics Costs 42 34 19.0%

Logistics Cost Savings due to Facilities Consolidation, Medical and Surgical Products Case Study

Hickling (1995)

Location Effects

Transport improvements contribute to productivitygrowth through mechanisms that involve the location choice of the firm.

The Case of Agglomeration Economies several types:

* Urbanization Economies (scale economies in the provision of public infrastructure in concentrated areas of public demand)

* Juxtaposition Economies (reduction in the cost of transferring intermediate goods among diverse firms linked together in the production chain)

* Localized Economies (spillovers of knowledge and labor skills that occur when firms in the same industry cluster together)

Significant productivity benefits to economic agglomeration promoted by lowered transport costs.

continued….

Interstate System and the “greenfield” production sites in peripheral areas.

Transportation promotes productivity both ways: through clustering and also by spreading at the urban periphery.

- Different firms need different locations - The product life-cycle model

Benefits of agglomeration offset at some point bycongestion.

A new project often reduces the congestion.

Transport and Value Added

Adding value to the output of either the freight using firms or the transportation service provider.

The case of fresh fish with transport improvements.It is possible to get fish from Maine to St. Louis in less than a day after catch. Fish can be produced only in a few places & has a scarcity value elsewhere. Now the fish producing firm expands its market, and reaches markets where its output has a higher value than its local market.