Cost Benefit Analysis The Details How can economics help determine the optimal size of a project or extent of a regulation A few examples What should be the CO concentration standard in tailpipe emissions How large should the Channel Islands marine reserve be Can we measure loss to recreationists of the Forest Adventure Pass Add another lane to Hwy 101 Close Mission Canyon to cyclists What habitat to buy to protect endangered species e g Least Bell s Vireo bird CBA main principle Quantify all costs and benefits in a common measure usually Note that we have ways of quantifying non market even non use values Common metric need not be e g health health analysis with health as metric E g consider a regulation that saves lives Benefits directly measured in terms of lives saved Costs indirect costs increase deaths since lower incomes lead to higher mortality 13 million in extra costs results in 1 statistical death E g Compare risks in lower and higher income countries Compare projects based on net effects on health When to do CBA Need to compare reg s to achieve externally defined social goals CEA Need to set a level of a reg balancing pluses and minues CBA Need to decide on a project with multiple goals that cannot be reduced to a single metric multi goal analysis Example issue is how big Project size Q Benefits B Q Costs C Q Maximize Net Benefits B Q C Q Ignore issue for time being of how to quantify B Q and C Q One view of this problem Maximize TB TC TB Q TC Q Q Q TB Q TC Q Q Q is where TB TC is maximized Also where MB MC TB Q TC Q Q Q MC Q xC MB Q Q Discrete sized projects If deciding between projects A B C Pick one with highest net benefits TB TC provided net benefits 0 May have values that are difficult to quantify Quantify values you can then compare projects along as few dimensions as possible multi criteria analysis examine tradeoffs between alternatives Big Questions How to measure conceptualize benefits How to measure conceptualize costs How to treat costs and benefits that occur at different points in time How to deal with distributional issues How to deal with risk Question 1 Conceptualizing Benefits Suppose a river is dead what is the value of reducing pollution by one unit What is the value of increasing visual range by a unit in the West How do we value the extra units of electricity Basic measure of value is willingness to pay MWTP Demand curve is marginal willingness to pay First units very valuable Last units less valuable Quantity of water Consumers Surplus CS CS q p D x q x How are benefits calculated Demand D x measures MB Consumers Surplus is the total benefit to consumers minus their cost q CS q D x dx pq 0 Example gross value of water from new dam excluding costs Price New dam Add l Value Demand for water Acre feet of water What about nonmarket goods Suppose there were a market Price Demand for air quality Air quality BUT NO MARKET price similar to MWTP Environmental goods Demand for env goods just as real as demand for market goods just harder to measure Demand is a measure of intensity of preferences Costs are simpler Some units are cheap to produce Marginal units are most expensive Costs consist of Fixed costs Marginal costs Marginal costs plus fixed costs add up to total costs Last units pricey MC First units cheapest Quantity Costs come in different flavors Private external and social In principle need to gal capture all costs and benefits Social costs may exceed private costs Difference is the P0 external cost the monetized cost of the externality MPC Q0 Gallons Of Gasoline Social vs Private Costs In principle need to gal capture all costs and benefits Social costs may exceed private costs Difference is the P0 external cost the monetized cost of the externality MPC MEC Q0 Gallons Of Gasoline Social vs Private Costs In principle need to gal capture all costs and benefits Social costs may exceed private P costs Difference is the P0 external cost the monetized cost of the externality MSC MPC MEC Q Q0 Gallons Of Gasoline Producer Surplus PS MC x PS q p q x How are costs calculated Supply S x is same thing as MC Producer Surplus is the total revenue to producers minus their cost q PS q pq S x dx 0 Put it together P Total Surplus Q Where is CS PS maximized Tension Too little produced At too high price CS low PS high CS p Supply S x PS Demand D x q1 q x Suppose goods supplied in fixed amount Price Supply of land Consumer surplus Market Price Producer surplus goes to land owners Demand for land Land If captured all costs benefits Then we want to maximize CS PS which would occur where Supply Demand Challenge is to capture all costs and benefits to accurately measure MC MB Note Surplus Max equals CS PS maximum First Theorem of Welfare Economics In a competitive market Surplus is maximized at a market equilibrium Implications Can rely on market if we are sure of competitive market Example Add a dam Supply of water increases price falls What happens to PS CS P rice PS Before and X After X and CS XXXXXXXXXXXX Q Water Implicit Assumptions Distribution Distributional consequences ignored Put in dam some win some lose Benefits cancel losses OK if compensation occurs Compensation Principle Dam is good idea if winners can compensate losers If there is enough surplus dam is a good idea BUT compensation need not occur Implicit Assumptions Income Price Y 50 000 per year Y 30 000 per year Restaurant meals Demand and thus surplus depend on income distribution Therefore Change in income distribution will change results of CBA TO USE CBA MUST BELIEVE INCOME DISTRIBUTION IS OK Implicit Assumptions Completeness What happens with difficult to monetize benefits E g clear view of Santa Cruz Islands Difficult to monetize benefits often omitted Results in bias against environmental benefits Implicit Assumptions Other Moral and political dimensions omitted Should we do a cost benefit analysis on executing someone who has committed a crime Are there other issues when lives are at stake Are intergenerational issues adequately treated by CBA Ten Steps to doing and using a CBA 1 Decide whose benefits and costs count 2 Select the portfolio of alternative projects 3 Catalog potential physical impacts and determine how they are measured 4 Predict quantitative physical impacts over life of project 5 Monetize or other metric all impacts 6 Discount for time to find present values 7 Sum add up all benefits and costs 8 Perform sensitivity analysis 9 Choose alternative with largest social benefits