Efficiency Surplus and Doing Benefit Cost Analysis How can economics help determine the optimal size of a project or extent of a regulation 1 Motivating Group Project 2001 Actual Group Project Advisors Profs McAusland and Kendall A Cost Benefit Analysis of Public Law 99 625 Sea Otter Shellfishery Conflicts i n Santa Barbara and Ventura Counties 2 A few other examples 3 What should be the CO concentration standard in tailpipe emissions What is the appropriate level of GHG emission reduction worldwide 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 eg Least Bell s Vireo bird Generic Problem Characterize an Environmental Policy or Action or multiple policies or actions Estimate the Consequences of that policy or action Estimate the pluses benefits and minuses costs of that policy or action Reach conclusions 4 CBA main principle Quantify all costs and benefits in a common measure usually Common metric need not be eg health health analysis with health as metric Benefits directly measured in terms of lives saved Costs indirect costs increase deaths since Regs make people poorer lower incomes lead to higher mortality 13 million in extra costs results in 1 statistical death Eg Compare risks in lower and higher income countries Compare projects based on net effects on health 5 What others method to use Cost effectiveness Analysis Weighted cost benefit analysis Multigoal analysis 6 Basic measure of value is willingness to pay MWTP Demand curve is marginal willingness to pay First units very valuable Last units less valuable 7 Quantity of water Consumers Surplus CS CS q p D x q 8 x Calculating benefits from MWTP Demand D x measures MB Consumers Surplus is the total benefit to consumers minus their cost q CS q D x dx pq 0 9 Example gross value of water from new dam excluding costs Price New dam Add l Value 10 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 11 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 12 Costs are simpler Some units are cheap to produce Marginal units are most expensive Costs consist of Fixed costs Marginal costs 13 Marginal costs plus fixed costs add up to total costs Last units pricey MC First units cheapest 14 Quantity Producer Surplus PS MC x PS q p q 15 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 16 Put it together P Total Surplus 17 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 18 q1 q x Suppose goods supplied in fixed amount Price Supply of land Consumer surplus Producer surplus goes to land owners Market Price Demand for land 19 Land Example Add a dam Status quo water availability Price PS Before and X After CS XXXXXXXXXXXX 20 Q Water Example Add a dam Supply of water increases price falls What happens to PS CS Price PS Before and X After X and CS XXXXXXXXXXXX 21 Q Water 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 22 Costs come in different flavors Private external and social 23 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 24 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 25 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 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 26 Implicit Assumptions Distribution 27 Distributional consequences ignored Compensation Principle 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 28 TO USE CBA MUST BELIEVE INCOME DISTRIBUTION IS OK Implicit Assumptions Completeness What happens with difficult to monetize benefits Eg clear view of Santa Cruz Islands Difficult to monetize benes often omitted Results in bias against env benes 29 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 30 Ten Steps to doing and using a CBA 1 2 3 4 5 6 7 8 9 10 Decide whose benefits and costs count Select the portfolio of alternative projects Catalog potential physical impacts and determine how they are measured Predict quantitative physical impacts over life of project Monetize all impacts Discount for time to find present values Sum add up all benefits and costs Perform sensitivity analysis Choose alternative with largest social benefits Make policy recommendation using CBA only as part of guidance 31