Pertemuan 8 Gruber

Cost-Benefit Analysis

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8.1 Measuring the Costs of Public Projects 8.2 Measuring the Benefits of Public Projects 8.3 Putting It All Together 8.4 Conclusion

P RE PAR E D

Dan Sacks

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Cost Benefit analysis

This chapter covers cost-benefit analysis. •

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Cost-benefit analysis: The comparison of costs and benefits of public goods projects to decide if they should be undertaken. undertaken.

Cost-benefit analysis is widely used to evaluate potential public programs programs and projects.

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Costs and Benefits of Highway Construction Quantity

Costs

Asphalt

1 mill bags

Labor

1 mill hours

Repairs

$10 million (yearly)

Price/Value Total

Benefits Time saved 500k hours (yearly) Lives saved 5 lives (year) •

What are the costs and benefits of the project? In the first year? Over time?

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Measuring Current Costs

How to measure costs? •

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Cash-flow accounting: Accounting method that calculates costs costs solely by adding up what the government pays pays for inputs to a project and calculates benefits solely by adding up income or government revenues generated by the project. Opportunity cost: The social marginal cost of any resource resource is the value of that resource in its next best use.

Measuring opportunities costs faces several several challenges.

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Measuring Future Costs

How to measure future benefits against current costs? •

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Use presented discounted value, discounting at the social discount rate. rate. Present discounted value ( PDV ): ): A dollar next year is worth 1 + r times less than a dollar now because the dollar could earn r % interest if invested. Social discount rate: rate: The appropriate value of r to use in computing PDV for social investments. investments.

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Costs and Benefits of Highway Construction: Filling in Costs

Costs

Quantity

Price/Value

Total

Asphalt

1 mill bags

$100/bag

100

Labor

1 mill hours

½ at 20, ½ at 10

15

Repairs

$10 million (yearly)

7% discount rate

43

Benefits Time saved 500k hours (yearly) Lives saved 5 lives (year)

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Using Market-Based Measures to Value Time: Wages •

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Suppose we can show that the time that individuals save from driving faster is spent at work. Then we could value their time ti me saved at their wage. This theoretical proposition runs into some problems in practice: o

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Individuals can’t can’t freely trade off leisure and hours of work; jobs may m ay come with hours restrictions. There may be nonmonetary aspects of the job.

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Using Survey-Based Measures to Value Time: Contingent Valuation An alternative approach to measure benefits is contingent contingent valuation. •

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Contingent Contingent valuation: Asking individuals to value an option they are not now choosing or do not have the opportunity to choose.

This approach relies on answers answers to hypothetical questions. Straightforward, inexpensive to apply.

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 APPLICATION: The Problems of Contingent  APPLICATION: Contingent Valuation Critics of contingent point out that contingent valuations are very sensitive to the survey. •

Isolation of issues: Different Different value for sum of single

issues or issues asked in combination. •

Order of issues matters : Asking about an issue first or

second changes its reported value. •

The “embedding effect” matters: Asking about one,

two, or three sites does not affect answers.

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Using Revealed Preference to Value Time

An alternative to contingent valuation is to use revealed preference. •

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Revealed preference: Letting the actions of individuals reveal their valuation.

Market prices potentially reveal preference: preference: If people are willing to pay P for something, then it is i s worth at least P to them.

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Valuing Saved Lives

Saving lives is a central benefit of many interventions. •

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Valuing human lives is i s the single most mo st difficult issue in cost-benefit analysis. Many would say that human life is priceless. By this argument, valuing life is a reprehensible activity; there is no way way to put a value on such a precious commodity. Every Every possible intervention has a chance of saving lives. To To decide which to finance requires valuing lives.

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 APPLICATION:  APPLICA TION: Valuing Valuing Life

In October 1999, a commuter train crash at London’s London’s Paddington Paddington Station killed 31 people. •

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Outraged public for more investment in rail safety. Safety advocates proposed measures that cost $3−9 billion and would save 1−3 lives/year for 30−50 years.

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At best: $20 million millio n per life saved.

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At worst: worst: $300 million per life saved.

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Valuing Saved Lives

How to value saved lives? •

Using Using Wages ages to to Value alue a Life Life o

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Life’s Life’s value is the present discounted discounted value of the lifetime stream of earnings.

Continge Contingent nt Valuation aluation o

Ask individuals what their t heir lives are worth.

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Revealed Preference Approaches to Valuing Lives: Compensating Differentials •

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We can value life by estimating how much individuals indi viduals are willing to pay for something that reduces their odds of dying. The extra safety is called a compensating differential because it compensates workers for lower wages. Compensating differentials: differentials: Additional (or reduced) wage payments to workers to compensate them for the negative (or positive) amenities of a job, such as increased risk of mortality (or a nicer ni cer office).

This approach suggests value of life of $9.3 million. mill ion.

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Government Revealed Preference?

Regulation Concerning

Year

Agency Cost per life

Childproof lighters

1993

CPSC

0.13

Food labeling

1993

FDA

0.5

Reflective devices for trucks 1999

NHTSA

1.2

Asbestos

OSHA

7.2

1972

Value of statistical life

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Benzene

1987

OSHA

28.2

Asbestos ban

1989

EPA

99.9

Solid waste disposal

1991

EPA

128.1

Cattle Feed

1979

EPA

217.7

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Discounting Future Benefits

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In addition to finding the value of lives saved in each year, a cost-benefit analysis must discount these future benefits. Choosing the proper discount rate is difficult. Since many projects have benefits that last long into the future, the discount rate matters enormously. o

Reducing global warming will bring benefits hundreds of years into the future.

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Cost-Effectiveness Analysis

Cost effectiveness effectiveness is an alternative to cost-benefit analysis. •

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Cost-effectiveness Cost-effectiveness analysis: a nalysis: For projects that have immeasurable benefits, or are viewed as desirable regardless regardless of the level of benefits, we can compute only their costs and choose the most cost-effective cost-effective project.

Finding the cost of a life saved saved— —and choosing projects wit the lowest costs— costs—avoids making judgments about the value of life saved.

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Putting It All Together  Together 

Costs

Quantity

Price/Value

Total

Asphalt

1 mill bags

$100/bag

$100

Labor

1 mill hours

½ at $20, ½ at $10

15

Repairs

$10 million (yearly)

7% discount rate

43

$19/hour

9 .5

$7 million/life

35

Benefits Time saved 500k hours (yearly) Lives saved 5 lives (year)

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Other Issues in Cost-Benefit Analysis

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Common Counting Counting Mistak Mistakes es o

Counting secondary benefits.

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Counting labor as a benefit.

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Double-counting benefits.

Distributional Concerns o

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Costs and benefits may not go to the same people.

Uncertainty o

Costs and benefits are often highly uncertain.

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Conclusion

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Turning the abstract notions of social costs and benefits into practical implications for public project choice is challenging. What at first seems to be a simple accounting exercise exercise becomes quite complicated when resources cannot be valued in competitive markets. Economists Economists have developed a set of tools that can take analysts a long way toward a complete accounting of the costs and benefits of public publi c projects.