Associate Professor Richard Brown [email protected] COST-BENEFIT ANALYSIS What is it? Why...

Associate Professor Richard Brown

[email protected]

COST-BENEFIT ANALYSISWhat is it? Why do it? How’s it done?

Cost-Benefit Analysis

What is CBA?

A method for evaluating projects, policies, programs

More precisely: A process of identifying, measuring and comparing the social benefits and costs of an investment project, program or policy intervention, from a public interest perspective

CBA is used for both prospective (appraisal) and retrospective (evaluation)

2Richard Brown: UQ Economics Schools' Day, July 2015


What is CBA?

Used primarily but not exclusively in public sector decision-making

Some examples:

investment in public infrastructure – roads, schools, hospitals, dams, universities, R&D

public policies and regulations: health and safety, air and water quality, smoking, speed limits



Why CBA? Why for public sector?

Why not leave all investment decisions to private sector, based on calculations of financial profitability?

Market failure!

The free market is not always capable of providing the correct price signals to guide private investment decisions in the ‘right direction’

Markets can be distorted for various reasons


Price distortions inefficient outcomes


Why CBA? Why for public sector?

Purely market-based decisions by private sector do not always deliver an outcome that is socially desirable – in the best interests of the public at large

Private sector unlikely to invest in roads, dams, schools, hospitals, defence, etc. if left completely to the free market

Why?



Three main reasons for market failure:

uncompetititve market structures eg. monopolies, oligopolies, etc.

government interventions eg. taxes, subsidies, import duties, price controls, quotas

externalities i.e. costs and benefits arising from a decision (investment) not born/received by the private investor making the decision eg. air pollution (external cost), education (external benefit)



Correcting for market failure and price distortions

Aim is to come up with interventions that would bring investment decision-making more in line with the socially desirable outcomes

Various means to steer private and public sector decisions towards more efficient, socially desirable outcomes:

regulations and penalties; eg. fines for speeding, smoking in public, noise, anti-competitive behaviour

taxes and subsidies to correct for externalities eg. ‘sin taxes’ on alcohol, tobacco, gambling



Correcting for market failure and price distortions:

Tradeable permits - where markets do not exist ‘create’ a market eg. tradeable permits for carbon trading

Application of CBA - using a different set of prices

‘Shadow Prices’ used in calculation of profitability

‘Shadow Prices’ = ‘Opportunity Cost’

We have two types of shadow prices:‘adjusted’ market prices - to offset distortions‘non-market values’ – where prices non-existent



9

What main economics principle underlies CBA methodology?

Standard CBA methodology requires the application of the core economics concept of opportunity cost

We have limited resources and unlimited wants or needs

The key economics question is how to make best use of our limited resources

By using them for the production of a given output will yield certain benefits. Using them for the production of some other good (or service) generates other benefits

Which produces the greater benefit to society?Richard Brown: UQ Economics Schools' Day, July

2015

Standard CBA Methodology: Opportunity Cost

Decision

Undertakethe Project

Do not Undertakethe Project

Scarce ResourcesAllocated to the Project

Scarce Resources Allocatedto Alternative Uses

Value of ProjectOutput

Value of Output fromResources in Alternative Uses

Project Benefit = $X Project OpportunityCost = $Y

If X>Y, recommend the project

Figure 1.1: The “With and Without” Approach to Cost-Benefit Analysis


Measure this – the difference

The ‘without’ project scenario

The ‘with’ project scenario

Project introduced

Time/years

$ net benefit

11

Comparing ‘with’ vs ‘without’ Scenarios

The ‘before’ project scenario

NOT THIS!

Richard Brown: UQ Economics Schools' Day, July 2015

What do we mean by the public interest?

A private or public sector project has implications for:

• Government revenue – taxes, charges

• Government expenditure – provision of services

• Employment

• The Economy

• The Environment

These need to be assessed as part of a CBA before project or policy approval


13

Practical Examples: Comparing ‘with’ vs. ‘without’ scenarios


14

Practical Examples: Using Opp. Cost in Place of Market Price

Remember: OC = value in alternative use

Ask: (i) How would resource otherwise be used? and(ii) What is value in alternative use?

Example 1: A project generates 100 new jobs for otherwise unemployed youth, paid say $20

In Private Profitability calculation labour would be costed at 100 x $20 = $2000

In CBA we would first ask “What is value of labour’s output in alternative use?” Assume they have casual/informal work equivalent to $5 each

In CBA labour would be costed at 100 x $5 = $500Richard Brown: UQ Economics Schools' Day, July

2015

15


So what? How would use of opportunity cost of labour in a CBA change anything?

By costing labour at lower opportunity cost, projects that generate relatively more jobs would be ranked higher - prefered

Example 2:

A project requires 100Mwh of electricity per day. The power company charges $5 per Mwh

In private profitability calculation electricity costed at $500/day

In CBA we need to ask first, where would that additional power supply come from, and, at what opportunity cost?


16


Example 2 (cont.):

Case A: If the power supply system is already operating at full capacity, we would have to divert it from other users

The opportunity cost would be the loss of output to them

Assume lost output = $8, then opportunity cost = $800

Case B: If there is spare capacity, we would price it at the marginal cost of producing more output

Assume marginal cost = $3, then opportunity cost = $300

CBA shows higher net benefit when there is spare capacity


17

Practical Examples: Using Opp. Cost Where No Market Price

Example 3:A proposed coal-fired power project generating additional electricity is expected to make a profit of $1250

But, the production of power also produces 50 tonnes of carbon pollution for which the producer is not charged

In CBA we include the cost to society of the carbon pollution

If the economists value this at, say, $30 per tonne the CBA would recalculate the ‘economic profitability’ at $1250-1500 ($30x50) = -$250 (ie. from an economic point of view there would be a loss)

The implication is that a less financially profitable project which produces less or no carbon would appear more profitable in the CBA and thus preferred from a public interest perspective


18

Practical Examples: Using Opp. Cost Where No Market Price

Example 4:A proposed health sector project is expected to reduce human fatalities by 10 persons per annum

As there is no ‘market price’ for an avoided fatality (a saved human life) a financial profitability calculation would show no $ benefits for this

In CBA we include the value to society of each human life saved

Moral and ethical issues/objections?

A thought experiment using universal speed limit of 10km/hour which eliminates all road fatalities. For or against?


• The underlying principle of CBA is that net benefits should be positive for a project to be considered worthwhile– Total Benefits – Total Costs > $0

• BUT… this does not necessarily mean that all stakeholders gain – some will but others will no doubt lose

• We need to look at the distribution of net benefits among stakeholders - who gains and who loses, and how much?

• In some instances the project will not succeed if the costs and benefits are unevenly distributed – complementary policies might be recommended to compensate the losers

Comparing Costs & Benefits Among Stakeholders


• We cannot compare dollar values that accrue at different points in time

• To compare costs and benefits over time we apply the concept of “discounting”

• The reason is that $1 today is worth more than $1 tomorrow

WHY?

Comparing Costs and Benefits Over Time


• Inflation – purchasing power of $ declines in real terms as prices rise

• ‘Opportunity cost’ – you could have earned some income (eg. interest)

• Risk – some unforeseen event in the future


21

• ‘Pure time preference’ – more distant objects appear smaller



Year 0 1 2 3

Project A -100 +50 +40 +30

Project B -100 +30 +45 +50

WHICH PROJECT OPTION: A or B ?

22

Cannot say until we convert all future values into present day equivalent values – discounting using ‘discount factors’


Cost-Benefit Analysis: Further Thoughts

Decision-support vs. decision-making?

CBA cannot remove from the decision-maker ultimate responsibility for a decision

In this sense I prefer to think of CBA as a decision-support rather than a decision-making process: its ultimate purpose is to better inform the decision-making process rather than replacing it

In many respects it is also the process of applying the principles of CBA, using a coherent framework and ‘thinking like an economist’ that is more important than the numbers generated by a CBA



I’ve been teaching and practicing CBA for almost 40 years!

“What’s different today, I am often asked?”

Two major innovations in recent decades affecting the practice of CBA - one technological and one methodological

invention of the PC and electronic spreadsheet (Excel), and,

development of non-market valuation methods and techniques for valuation of environmental and other non-market, ‘intangible’ costs and benefits


Do a CBA of a CBA!



26

CBA can be applied to any decision/situation, but beware ... it could get you into trouble if taken too far!



27

Benefit-Cost Analysis: financial and economic appraisal using spreadsheets

H.F. Campbell and R.P.C. Brown Cambridge University Press, 2003

(2ND Edition Routledge, 2015, in press)

Companion website has a number of worked case studies:

www.uq.edu.au/economics/bca

Login to “Other Users” username=user; password=abc2004

My contact: [email protected]

PRIMARY REFERENCE


Questions and CommentsThank you

Date post:	24-Dec-2015
Category:	Documents
Upload:	erica-cannon
View:	215 times
Download:	1 times

Associate Professor Richard Brown [email protected] COST-BENEFIT ANALYSIS What is it? Why...

Documents