Cost-benefit analysis
Cost-benefit analysis, CBA, is the social appraisal of marginal
investment projects, and policies, which have consequences over time
It uses criteria derived from welfare economics, rather than commercial
criteria.
CBA seeks to correct project appraisal for market failure
Environmental impacts of projects/policies are frequently externalities,
both negative and positive
CBA seeks to attach monetary values to external effects so that they can be
taken account of along with the effects on ordinary inputs and outputs to
the project/policy
CBA is the same as BCA Benefit-cost analysis.
Intertemporal efficiency
Given that CBA is concerned with consequences over time, and based in welfare
economics, a key idea is that of intertemporal efficiency.
U U (C , C )
A
U U (C , C )
B
(11.1)
A
C 0,c1
MRUS
C0, C1
otherwise one could be made better off without making the other
worse off
MRUS C 0,c1
MRUS
A
C0, C1
(11.2)
C1 I 0
I 0
C (C ) C C
C
1
C
C
C
1
which is the negative of the slope of the transformation frontier minus 1, which can
be written
1 s
where s is the slope of the frontier.
If each firm were investing as indicated by C01b and C02b, then period 1
consumption could be increased, without loss of period 0 consumption, by
having firm 1, where the rate of return is higher, increase investment by the
amount firm 2, where the rate of return is lower, reduced its investment.
Only where rates of return are equal is this kind of period 1 gain
impossible. For N firms, the second intertemporal efficiency condition is
i , i 1,..., N
(11.3)
If the first two conditions are satisfied, can consider representative individual and firm.
Point a corresponds to intertemporal efficiency, b and c do not as from either could reallocate
consumption as between periods so as to move on to a higher consumption indifference curve.
At a the slopes of the consumption indifference curve and the consumption ttansformation
frontier are equal. The third condition is
(11.4)
Intertemporal optimality
As in the single period situation, the intertemporal efficiency
conditions do not fix a unique intertemporal allocation.
1
U C1
1
W U C0
(11.5a)
subject to
Q0(K0) (K1 K0) = C0
(11.5b)
(11.5c)
Here the efficiency problem is trivial consumption in one period can only be
increased by reducing it in the other period.
A necessary condition is
U C1
1
UC 0
1
(11.6)
W U(C )e dt
t
t 0
(11.7a)
Subject to
K = Q(K ) - C
t
(11.7b)
UC
UC
(11.8)
W U(C )e dt
t
t 0
(11.9a)
Subject to
K Q K t , Rt Ct
.
S Rt
(11.9b)
(11.9c)
1
U C1
1
W U C0
UC0
1/ 1 U C 1
1 UC 0
UC 0
r
1
1
U C1
1/ 1 U C1
(11.10)
r g
(11.11)
where
r is the consumption discount rate
is the utility discount rate
is is the elasticity of marginal utility for
the instantaneous utility function
g is the growth rate
For g>0 r> and r would be positive for = 0
For g = 0 r =
...
2
T
1 i 1 i
1 i
PVE E0
T
Et
1 i
(11.14)
R1
R2
RT
...
2
T
1 i 1 i
1 i
(11.15)
Rt
1 i
RT
1 i
Et
1 i
(11.16)
Which for N = R - E is
NPV N 0
T
N1
N2
NT
...
2
T
1 i 1 i
1 i
Nt
1 i
(11.17)
Expenditure
Receipts
100
100
10
50
40
10
50
40
10
45.005
35.005
Year
Present value of
expected cash flow
100
100
100
40
35
38/1.075 = 35.35
40
35
38/1.0752 = 32.88
31.003/1.0753 = 24.96
(0.6 x 0) + (0.4 x 0) = 0
3
4
35.005
0
25
0
Expected
NPV
6.81
Where the firm is prepared to assign probabilities, the criterion for going ahead with the project is
the expected NPV the probability weighted sum of the mutually exclusive cash flow outcomes.
Overall
NBA,0
NBA,1
NBA,2
NBA,3
NBA
NBB,0
NBB,1
NBB,2
NBB,3
NBBB
NBC,0
NBC,1
NBC,2
NBC,3
NBC
Society
NB0
NB1
NB2
NB3
Table 11.6 Net benefit (NB) impacts consequent upon an illustrative project
NPV NB0
NB3
NB1 NB2
1 r 1+r 2 1+r 3
Generally, go ahead if
t T
NPV
t 0
NB t
0
(1 r) t
(11.19)
This is the NPV test with the consumption gain discounted at the consumption rate of interest, and compared
with the cost of the project scaled up to take account of the consumption that is lost on account of the
displaced private sector project.
Overall
UA,0
UA,1
UA,2
UA,3
UA
UB,0
UB,1
UB,2
UB,3
UB
UC,0
UC,1
UC,2
UC,3
UC
Society
U0
U1
U2
U3
Or
with an intratemporal social welfare function mapping individual utilities into a social
aggregate Ut
W = W(U0, U1, U2, U3) positive the project should go ahead
where a widely entertained particular form is
W U
0
U
U
U
1 (1 )
(1 )
1
is exponential discounting
Overall
NBA,0
NBA,1
NBA,2
NBA,3
NBA
NBB,0
NBB,1
NBB,2
NBB,3
NBBB
NBC,0
NBC,1
NBC,2
NBC,3
NBC
Society
NB0
NB1
NB2
NB3
1
U C
1
W
t 0
implies
t
1
W
C
1 r
where
T
t 0
(1 )U
U
Ct
Ct 1
(11.22)
or
or r = + g
(11.23)
1
W
C
1
t 0
(11.24)
and for W > 0 the project is welfare enhancing and should go ahead
Finance by taxation two periods
1
C
1
W I
0
(11.25)
1 r 1 r
where the rhs is NPV, positive if
W I
C
I
I
1 r
1 r
1
Years
Discount rate %
25
50
100
200
0.5
88.28
77.93
60.73
36.88
60.95
37.15
13.80
1.91
3.5
42.32
17.91
3.21
1.03
18.43
3.40
0.12
0.0001
Generally agreed that whichever way looking at CBA potential pareto improvement
or welfare enhancing should use r, the consumption discount rate.
Shadow pricing
While it is agreed that r should be used to discount, appears in the NPV criterion as
C
I
(11.21) and W I C I
I
(11.26)
1 r
1 r
1 r 1 r
1
which apply with finance by borrowing when there is crowding out is there to
adjust the initial cost, shadow price it, for the displacement of the marginal private
sector project.
At one time it was thought that, on account of crowding out, proper shadow pricing
of all inputs and outputs was important in CBA. And difficult.
Now the dominant view is that given international capital mobility, crowding out is
not a problem that the supply of capita for private sector projects could be treated
as perfectly elastic.
(11.23)
where
is the utility discount rate
is the elasticity of the marginal utility of consumption
g is the growth rate
Some economists want to get values for and from observed behaviour, some from
ethical considerations.
Much of the controversy among economists over the Stern Review of the climate change
problem focussed on the numbers used in (11.23) Stern took an ethical prescriptive
position
31-75
76-125
126-200
201-300
301+
Discount rate
3.0%
2.5%
2.0%
1.5%
1.0%
NPV
t 0
Bt Ct
1 r
Bt
1 r
Ct
1 r
Bd Cd
Denote this as NPV. Then the proper NPV taking account of environmental impacts is
NPV = Bd Cd EC = NPV EC
(11.27)
where EC is the present value of the stream of the net value of the projects
environmental impacts over the lifetime of the project.
EC stands for Environmental Cost
From (11.27) the project should go ahead if
NPV = Bd Cd > EC
(11.28)
Inverse ECBA
A wilderness development project should not go ahead if
EC NPV = Bd Cd
so that
EC* = NPV = Bd Cd
(11.29)
defines a threshold value for EC. For EC EC* the project should not go ahead.
The exercises ( Chapter 12 ) that seek to ascertain EC are typically expensive, and
sometimes controversial. Consideration of EC* can put their results in perspective.
As can consideration of EC*/N, where N is the size of the relevant affected
population, which is not necessarily restricted to visitors, and may include people
from a wider area than the host country, as with an internationally recognised
wilderness/ conservation area inscribed as world heritage.
(11.30)
where Bd,t, Cd,t and ECt are the annual, undiscounted, amounts for t = 1, 2,..., T, and where T is the project
lifetime, corresponding to the present values Bd, Cd and EC. The environmental costs of going ahead with the
project, the ECt, are at the same time the environmental benefits of not proceeding with it. Instead of EC t we
could write B(P)t for the stream of environmental benefits of preservation.4 If we also use B(D)t and C(D)t for
the benefit and cost streams associated with development when environmental impacts are ignored, so that
B(D)t C(D)t is what gets discounted to give NPV, then equation 11.30 can also be written as:
NBt = B(D)t C(D)t B(P)t
(11.31)
NPV {B D t C D t B P t }/ 1 r
we use
T
NPV {B D t C D t B P t }e rt dt
0
NPV {B D t C D t }e rt dt B P t e rt dt
(11.32)
(11.33)
which with B and C for constant flows of development benefits and costs, and Peat as the growing
flow of preservation benefits, can be written
T
NPV NPV Pe r a t dt
0
(11.34)
For given NPV, a>0 reduces NPV a development is less likely to pass the NPV test
if the Krutilla-Fisher arguments hold
For a = r means preservation benefits effectively not discounted
a>r means effective negative discounting on preservation benefits
(11.35)
For r = 0.05
For r = 0.075
20
13.33
0.01
25
15.37
0.02
33.33
18.18
0.03
50
22.22
0.04
100
28.57
0.05
40
0.06
66.67
0.075
NPV {B C} e dt P e
rt
(r a)t
dt
NPV D e dt P e
rt
(r a)t
dt
D
P
r r a
(11.36)
D
P
r r a
(11.37)
Some question the ECBA agenda at the level of practice can Chapter 12
methods actually deliver the necessary information?
Evaluation of consequences
Not to be left to experts
Multi-criteria analysis
Deliberative polling
Citizens juries
C. Railway
250
300
500
10000
8000
6000
1000
800
200
Bad
Bad
Moderate
Cost 106
C. Railway
250
300
500
10000
8000
6000
1000
800
200
Bad
Bad
Moderate
Cost 10
6
Bad
Moderate
Slight
A. Highway
Cost 106
Time Saving 106 hours per year
CO2 Emissions 103 tonnes per year
Wildlife and Amenity Qualitative
C. Railway
250
300
500
10000
8000
6000
1000
800
200
1.0000
Highway and
Buses
0.8333
Time Saving
1.0000
0.8000
0.6000
CO2 Emissions
0.2000
0.2500
1.0000
0.6667
0.6667
1.0000
For weights
Railway
0.5000
Costs
0.3
Time Saving
0.3
CO2 Emissions
0.2
0.2
Highway and
Buses
Railway
Cost
0.3000
0.2500
0.1500
Time Saving
0.3000
0.2400
0.1800
1. Highway
CO2 Emissions
0.0400
0.0500
0.2000
0.1333
0.1333
0.2000
Sum
0.7733
0.6733
0.7300
2. Railway
3. Highway and buses
0.2
Time Saving
0.2
CO2 Emissions
0.4
0.2
get
Highway
Highway and
Buses
Railway
Cost
0.2000
0.1667
0.1000
Time Saving
0.2000
0.1600
0.1200
CO2 Emissions
0.0800
0.1000
0.4000
0.1333
0.1333
0.2000
Sum
0.6133
0.5600
0.8200
Deliberative polling
1. Run an opinion poll
2. Get respondents to a meeting to collectively consider the issues by hearing and
questioning expert witnesses, and debating ( deliberation )
3. Get respondents to respond again to original survey
Given that the idea is to poll a random sample of sufficient size to produce results of
standard expected in opinion polling, 100s, the deliberative part of the exercise is
expensive.
Deliberative polling is rare.
Citizens juries
Citizens juries involve the public in their capacity as ordinary citizens with no
special axe to grind. They are usually commissioned by an organisation which
has power to act on their recommendations. Between 12 and 16 jurors are
recruited, using a combination of random and stratified sampling, to be broadly
representative of their community. Their task is to address an important question
about policy or planning. They are brought together for four days, with a team of
two moderators. They are fully briefed about the background to the question,
through written information and evidence from witnesses. Jurors scrutinise the
information, cross-examine the witnesses and discuss different aspects of the
question in small groups and plenary sessions. Their conclusions are compiled in
a report that is returned to the jurors for their approval before being submitted to
the commissioning authority. The jurys verdict need not be unanimous, nor is it
binding. However, the commissioning authority is required to publicise the jury
and its findings, to respond within a set time and either to follow its
recommendations or to explain publicly why not.
As compared with deliberative polling, a major advantage of the citizens jury is
cost.