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Past Exam: SPM9716 Cost-Benefit Analysis (CBA)

Question 1:
Regarding conceptual foundations of cost-benefit analysis:
a. Explain briefly the relationship between willingness to pay and distribution of
wealth.
b. Which type of CBA analysis would be the most useful for looking at the actual value
of a particular project? Briefly explain the reason of your choice.

Question 2:
Regarding natural monopolies:
a. Briefly identify two properties of a natural monopoly.
b. Briefly describe the government policy that can entirely eliminate the deadweight loss
resulting from natural monopolies.

Question 3:
Regarding social discount rate:
a. Discuss the theoretical circumstances under which selecting an appropriate discount
rate for use in cost-benefit analyses of public sector projects would be straightforward.
b. When analysing CBA projects, which particular projects would you best use the
shadow price of capital (SPC) approach to derive the social discount rate from market
rates?

Question 4:
Suppose a city would like to build a public wellness center. The estimated present values of
the effects over the expected useful life of the wellness center are shown below:

PV (million euros)
Municipality grant (one-time only for the building of the sport center) 1.5
Construction and maintenance costs (have to be done by a construction
firm resided outside the city)
9.8
Personnel costs (resources from the city itself) 4.6
Revenue from city residents 5.7
Revenue from nonresidents 2.3
Use value benefit to city residents 8.2
Use value benefit to nonresidents 3.5
Scrap value 0.7

a. Based on the perspective of a guardian in the city budget office, calculate net benefits.
Motivate your answer.
b. Based on the perspective of a spender in the city recreation department, calculate net
benefits. Motivate your answer.


Question 5:
Consider a case of a highway. At present, the highway is used by 75,000 cars per week and
the toll fee is 0.35. The government is considering increasing the toll fee to 0.50. If that
happens, it is projected that the users of the highway will be reduced to 50,000 cars per week.
Assume that the marginal cost of highway use is constant (horizontal supply schedule) and
equal to 0.35 per car.
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a. Calculate the deadweight loss (DWL) if the government implements the new toll
policy and briefly explain what causes the DWL. Illustrate the DWL graphically.
b. Calculate the amount of a transfer from the drivers to the government. Illustrate this
transfer graphically.

Question 6:
A town is considering two renewable energy projects: project Green with an expected life of
24 years and project Recycle with an expected life of 8 years. Project Green would cost
2.25 million to construct and yield net benefits of 170,000 at the end of each of the 24
years. Project Recycle would cost 180,000 to construct and yield net benefits of 40,000 at
the end of each of the eight years. Assume that both projects would have zero salvage value at
the end of their lives. Using a real discount rate of 5 percent, which project offers larger net
benefits?

*** End of Exam ***










































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Solutions:
1:
a. As the benefit measured in CBA, an individuals willingness to pay depends on the
level of the individuals wealth. The greater the wealth the individual has available,
the higher he or she is willing to pay to obtain a desired policy outcome.
b. Ex post analysis is the most useful for looking at the actual value of a particular
project, then in medias res, then ex ante. The reason is that more is learned about the
actual impacts of the project as time goes by.

2:
a. Your answer should consist of two of the following three properties of a natural
monopoly: (1) fixed costs are very large relative to their variable costs; (2) average
costs (AC) exceed marginal costs (MC) over the relevant range of output (i.e. the
range between the first unit of output and the amount consumers would demand at a
zero price); (3) One (natural monopoly) firm can provide a given amount of output at
a lower AC than several competing firms.
b. Require the monopoly to set its price where the marginal cost curve crosses the
demand curve. This eliminates deadweight loss but revenues no longer cover costs.
As a result, tax money must be used to subsidize the production of the good.
3:
a. The theoretical circumstances when choosing a discount rate is straightforward is
when there is an absence of taxes, risk, and transactions costs which would cause the
rate of return on investments and the social rate of interest would be equal and only a
single rate of interest would exist. Because the conditions listed above don't hold in
the "real world," a variety of interest rates exist and one must choose among them or
use some combination of them.
b. Deficit-financed projects or projects with regulatory impacts in which there is a need
to explicitly converts flows into and out of investment into their consumption
equivalents.
4:
a. A guardian engages in revenue-expenditure analysis. The PVs that are considered as
expenditures (thus, negative values) would be: construction and maintenance costs,
personnel costs. In addition, a guardian also ignores nonfinancial social benefits
meaning that they would not consider the use value benefits to both city and non-city
residents. Thus, net benefits based on the perspective of a city guardian = 1.5 9.8
4.6 + 5.7 + 2.3 + 0 + 0 + 0.7 = -4.2 million euros.
b. A spender engages in constituency-support analysis. In this case the constituents are
the city residents and thus from a spender perspective, monetary payments and
nonfinancial benefits received by constituents (personnel costs, revenue from
nonresidents, use value benefits to city residents) are considered as benefits. Hence,
net benefits based on the perspective of a city spender = 1.5 9.8 + 4.6 5.7 + 2.3 +
8.2 + 0 + 0.7 = 1.8 million euros.
5:
a. The value of the deadweight loss is due to the increase in the toll fee and the decrease
in the number of cars using the highway. The toll increase will cause the supply
schedule to shift from S
0
(0.35) to S
1
(0.50). The deadweight loss (DWL) is:
(0.5)(0.50-0.35)(75,000-50,000) = 1,875.
b. The amount of a transfer from the drivers to the government is the increased toll paid
by the remaining drivers: (0.5-0.35)(50,000) = 7,500.
Graphically this is shown below:
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DWL = area bde
Transfer drivers government = area abcd















6:
As only one of these projects can be implemented on the site, they are mutually exclusive. The
comparison is complicated because project Green has an expected life three times longer
than project Recycle.
Consider first the NPV of each project separately:
NPV(project Recycle) 529 , 78 $
) 05 . 0 1 (
000 , 40
000 , 180 $
8
1
=
+
+ =

=
i
i


NPV(project Green)


If we choose on the basis of this comparison, then project Green has a larger present value
of net benefits. However, this is not appropriate as the projects are of different lengths. There
are two possible correct approaches: rollover method or EANB method. Both should lead to
the same recommendation.
1. Rollover method: One could choose between one Green project and three successive
Recycle projects so that the site is used in each case for the same length of time.
NPV(three successive Recycle projects) = $79,525 + $79,525/(1+.05)
8
+ $79,529/(1+.05)
16

= $79,525 + $53,826 + $36,431 = $169,782
Thus, three successive Recycle projects offer a higher present value of net benefits
than one Green project. One should implement the recycle project.
2. EANB method: An alternative approach for comparing these projects of different
lengths is to divide each projects NPV by its appropriate annuity factor to find its
equivalent annual net benefits, an approach called "amortization." The appropriate
annuity factor in each case can be obtained by using the formula for the present value
of an annuity found in Appendix 6a.
The 8-year annuity factor = [1-(1+.05)
-8
]/(.05) = 6.4632
Annualized NB for the Recycle project = $79,525/6.4632 = $12,304
The 24-year annuity factor = [1-(1+.05)
-24
]/(.05) = 13.7986
Annualized NB for the Green project = $95,796/13.7986 = $6,942
Choose Recycle project.
P
Q
0.35
0.50
50,000 75,000
S
0

S
1

D
a
b
c d
e
769 , 95 $
) 05 . 0 1 (
000 , 170
000 , 250 , 2 $
24
1
=
+
+ =

=
i
i