Dan Sacks Dan Sacks
P R
P R E P E P A A R E D R E D B YB Y
8.1
8.1 Measuring the Costs of Public Measuring the Costs of Public ProjectsProjects
8.2
8.2 Measuring the Benefits of Public Measuring the Benefits of Public ProjectsProjects
8.3
8.3 Putting It All TogetherPutting It All Together
8.4
8.4 ConclusionConclusion
Cost-Benefit Analysis Cost-Benefit Analysis
Cost Benefit analysis
Cost Benefit analysis
This chapter covers cost-benefit analysis. This chapter covers cost-benefit analysis.
•
• Cost-benefit analysis:Cost-benefit analysis: The comparison of costs andThe comparison of costs and
benefits of public goods projects to decide if they benefits of public goods projects to decide if they should be
should be undertakeundertaken.n.
•
• Cost-benefit analysis is widely used Cost-benefit analysis is widely used to evaluateto evaluate
potential public
Costs and Benefits of Highway Construction
Costs and Benefits of Highway Construction
Q
Quuaannttiittyy PPrriiccee//VVaalluuee TToottaall
C
Coossttss AsspA phhaalltt 1 1 mmiilll l bbaaggss LLaabboorr 1 1 mmiilll l hhoouurrss R
Reeppaaiirrss $$110 0 mmiilllliioonn (yearly)
(yearly) B
Beenneeffiittss TTiimme e ssaavveedd 550000k k hhoouurrss (yearly)
(yearly)
LLiivveess ssaavveedd 55 lliivvees s ((yyeeaarr))
•
• What are the costs and benefits of the What are the costs and benefits of the project? In theproject? In the
first year? Over time? first year? Over time?
How to measure costs? How to measure costs?
•
• Cash-flow Cash-flow accounting:accounting: Accounting method thatAccounting method that
calculates cos
calculates costs solely by ts solely by adding up what theadding up what the government pay
government pays for inputs to a s for inputs to a project and calculatesproject and calculates benefits solely by adding
benefits solely by adding up income or governmentup income or government revenues generated by the project.
revenues generated by the project.
•
• Opportunity cost:Opportunity cost: The social marginal cost of anyThe social marginal cost of any
resour
resource is the ce is the value of that resource in its next bestvalue of that resource in its next best use.
use.
•
• Measuring opportunities Measuring opportunities costs faces severcosts faces severalal
challenges. challenges.
Measuring Current Costs
How to measure future benefits against current costs? How to measure future benefits against current costs?
•
• Use presented discounted value, discounting at theUse presented discounted value, discounting at the
social discount
social discount ratrate.e.
•
• Present discounted value (Present discounted value (PDV PDV ):): A dollar next year isA dollar next year is
worth 1 +
worth 1 + r r times less than a dollar now because thetimes less than a dollar now because the
dollar could earn
dollar could earn rr % interest if invested.% interest if invested.
•
• Social discount ratSocial discount rate:e: The appropriate value ofThe appropriate value of rr to useto use
in computing
in computing PDV PDV for social investmenfor social investments.ts.
Measuring Future Costs
Costs and Benefits of Highway Construction: Filling
Costs and Benefits of Highway Construction: Filling
in Costs
in Costs
Q
Quuaannttiittyy PPrriiccee//VVaalluuee TToottaall C
Coossttss AsspA phhaalltt 1 1 mmiilll l bbaaggss $$110000//bbaagg 110000 LLaabboorr 1 1 mmiilll l hhoouurrss ½ ½ aat t 2200,,
½ at 10 ½ at 10 15 15 R Reeppaaiirrss $$110 0 mmiilllliioonn (yearly) (yearly) 7% discount 7% discount rate rate 43 43 B
Beenneeffiittss TTiimme e ssaavveedd 550000k k hhoouurrss (yearly)
(yearly)
•
• Suppose we can show that the time that individualsSuppose we can show that the time that individuals
save from driving faster is spent at work. save from driving faster is spent at work.
•
• Then we could value their tiThen we could value their time saved at their wage.me saved at their wage. •
• This theoretical proposition runs into some problemsThis theoretical proposition runs into some problems
in practice: in practice:
o
o IndividualsIndividuals can’can’t freely trade off leisure and t freely trade off leisure and hourshours
of work; jobs m
of work; jobs may come with hours restrictions.ay come with hours restrictions.
o
o There may be nonmonetary aspects of the There may be nonmonetary aspects of the job.job. Using Market-Based Measures to Value Time:
Using Market-Based Measures to Value Time:
Wages
An alternative approach to measure benefits is An alternative approach to measure benefits is contingen
contingent t valuation.valuation.
•
• ContingenContingent t valuation:valuation: Asking individuals to value anAsking individuals to value an
option they are not now choosing
option they are not now choosing or do not have theor do not have the opportunity to choose.
opportunity to choose.
•
• This approach relies on This approach relies on answeranswers to hypotheticals to hypothetical
questions. questions.
•
• Straightforward, inexpensive to apply.Straightforward, inexpensive to apply.
Using Survey-Based Measures to Value Time:
Using Survey-Based Measures to Value Time:
Contingent
Critics of contingent point out
Critics of contingent point out that contingent valuationsthat contingent valuations are very sensitive to the survey.
are very sensitive to the survey.
•
• Isolation of issues:Isolation of issues: DiffeDifferent value for sum of rent value for sum of singlesingle
issues or issues asked in combination. issues or issues asked in combination.
•
• Order of issues mattersOrder of issues matters: Asking about an issue first or: Asking about an issue first or
second changes its reported value. second changes its reported value.
•
• TheThe “embedding effect” matters“embedding effect” matters: Asking about one,: Asking about one,
two, or three sites does not affect answers. two, or three sites does not affect answers.
APPLICA
APPLICATION: The TION: The Problems of CProblems of Contingentontingent
Valuation
An alternative to contingent valuation is to use
An alternative to contingent valuation is to use revealedrevealed preference.
preference.
•
• Revealed preference:Revealed preference: Letting the actions of individualsLetting the actions of individuals
reveal their valuation. reveal their valuation.
•
• Market prices potentially reveal preferMarket prices potentially reveal preference: If ence: If peoplepeople
are willing to pay
are willing to pay PP for something, then it ifor something, then it is worth ats worth at least
least PP to them.to them.
Using Revealed Preference to Value Time
Saving lives is a
Saving lives is a central benefit of many interventions.central benefit of many interventions.
•
• VValuing human lives ialuing human lives is the single mos the single most difficult issue inst difficult issue in
cost-benefit analysis. cost-benefit analysis.
•
• Many would say that human life is priceless.Many would say that human life is priceless. •
• By this argument, valuing life is By this argument, valuing life is a reprehensiblea reprehensible
activity; there is no
activity; there is no waway to put a y to put a value on such avalue on such a precious commodity.
precious commodity.
•
• EvEvery possible intervention has a ery possible intervention has a chance of savingchance of saving
lives. T
lives. To decide o decide which to finance which to finance requires valuing lives.requires valuing lives.
V
In October 1999, a
In October 1999, a commuter train crash atcommuter train crash at London’London’ss Padding
Paddington Station killed ton Station killed 31 people.31 people.
•
• Outraged public for more investment in rail safety.Outraged public for more investment in rail safety. •
• Safety advocates proposed measures that cost $3−9Safety advocates proposed measures that cost $3−9
billion and would save 1−3 lives/year for 30−50 years. billion and would save 1−3 lives/year for 30−50 years.
•
• At best: $20 millioAt best: $20 million per life saved.n per life saved. •
• At worsAt worst: $300 t: $300 million million per life saved.per life saved.
APPLICA
How to value saved lives? How to value saved lives?
•
• UsiUsing ng WWageages ts too VValualue ae a LifLifee
o
o Life’s value is the Life’s value is the present discounpresent discounted value of theted value of the
lifetime stream of earnings. lifetime stream of earnings.
•
• ContContingeingentnt VValuataluationion
o
o Ask individuals what their lives are worth.Ask individuals what their lives are worth.
V
•
• WWe can value e can value life by estimating how much indilife by estimating how much individualsviduals
are willing to pay for something
are willing to pay for something that reduces theirthat reduces their odds of dying.
odds of dying.
•
• The extra safety is called The extra safety is called a compensating differentiala compensating differential
because it compensates workers for lower wages. because it compensates workers for lower wages.
•
• Compensating differCompensating differentials:entials: Additional (or reduced)Additional (or reduced)
wage payments to workers to compensate them for wage payments to workers to compensate them for the negative (or positive) amenities of a
the negative (or positive) amenities of a job, such asjob, such as increased risk of mortality (or a ni
increased risk of mortality (or a nicer office).cer office).
•
• This approach suggests value of life of $9.3 millThis approach suggests value of life of $9.3 million.ion.
Revealed Preference Approaches to Valuing Lives:
Revealed Preference Approaches to Valuing Lives:
Compensating Differentials
Government Revealed Preference?
Government Revealed Preference?
R
Reegguullaattiioonn CCoonncceerrnniinngg YeYeaarr AAggeennccyy CCoosstt ppeer r lliiffee
C
Chhiillddpprrooooff lliigghhtteerrss 11999933 CCPPSSCC 00..1133 FFooood d llaabbeelliinngg 19199933 FFDDAA 00..55 R
Reefflleeccttiivve e ddeevviiccees s ffoor r ttrruucckkss 11999999 NNHHTTSSAA 11..22 A
Assbbeessttooss 11997722 OOSSHHAA 77..22
V
Vaalluue e oof f ssttaattiissttiiccaal l lliiffee 99..33
B
Beennzzeennee 11998877 OOSSHHAA 2288..22 A
Assbbeessttooss bbaann 11998899 EEPPAA 9999..99 SSoolliidd wwaasstte e ddiissppoossaal l 19199911 EEPPAA 112288..11 C
•
• In addition to finding the value of lives saved in eachIn addition to finding the value of lives saved in each
year, a cost-benefit analysis must discount these year, a cost-benefit analysis must discount these future benefits.
future benefits.
•
• Choosing the proper discount rate is difficult.Choosing the proper discount rate is difficult. •
• Since many projects have benefits that last Since many projects have benefits that last long intolong into
the future, the discount rate matters enormously. the future, the discount rate matters enormously.
o
o Reducing global warming will bring benefitsReducing global warming will bring benefits
hundreds of years into the future. hundreds of years into the future.
Discounting Future Benefits
Cost effectiv
Cost effectiveness is eness is an alternative to an alternative to cost-benefitcost-benefit analysis.
analysis.
•
• Cost-effCost-effectiveness aectiveness analysis:nalysis: For projects that haveFor projects that have
immeasurable benefits, or are viewed as
immeasurable benefits, or are viewed as desirabledesirable reg
regardless of the ardless of the level of benefits, level of benefits, we can computewe can compute only their
only their costs and choose the costs and choose the most cost-effmost cost-effectiveective project.
project.
•
• Finding the cost of a Finding the cost of a life savlife saveded——and choosing projectsand choosing projects
wit the
wit the lowest costslowest costs——avoids making judgments aboutavoids making judgments about the value of life saved.
the value of life saved.
Cost-Effectiveness Analysis
Putting
Putting It All TIt All Together ogether
Q
Quuaannttiittyy PPrriiccee//VVaalluuee TToottaall C
Coossttss AsspA phhaalltt 1 1 mmiilll l bbaaggss $$110000//bbaagg $$110000 LLaabboorr 1 1 mmiilll l hhoouurrss ½ ½ aat t $$2200,,
½ at $10 ½ at $10 15 15 R Reeppaaiirrss $$110 0 mmiilllliioonn (yearly) (yearly) 7% discount 7% discount rate rate 43 43 B
Beenneeffiittss TTiimme e ssaavveedd 550000k k hhoouurrss (yearly)
(yearly)
$
$1199//hhoouurr 99..55 LLiivveess ssaavveedd 55 lliivvees s ((yyeeaarr)) $$77
million/life million/life
35 35
•
• CommonCommon CounCounting ting MistMistakakeses
o
o Counting secondary benefits.Counting secondary benefits. o
o Counting labor as a benefit.Counting labor as a benefit. o
o Double-counting benefits.Double-counting benefits.
•
• Distributional ConcernsDistributional Concerns
o
o Costs and benefits may not go to the same people.Costs and benefits may not go to the same people.
•
• UncertaintyUncertainty
o
o Costs and benefits are often highly Costs and benefits are often highly uncertain.uncertain.
Other Issues in Cost-Benefit Analysis
•
• TTurning the abstract notions of urning the abstract notions of social costs andsocial costs and
benefits into practical implications for public project benefits into practical implications for public project choice is challenging.
choice is challenging.
•
• What at first seems to be What at first seems to be a simple a simple accounting exaccounting exerciseercise
becomes quite complicated when resources cannot be becomes quite complicated when resources cannot be valued in
valued in competitive markets.competitive markets.
•
• EconomisEconomists have developed a ts have developed a set of tools set of tools that can takethat can take
analysts a long way toward a complete accounting of analysts a long way toward a complete accounting of the costs and benefits of publi
the costs and benefits of public projects.c projects.
Conclusion
