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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
Cost-Benefit Analysis
8
Introduction: California Transportation Problem
The state’s transportation problem:
Travel on California’s highway system is increasing 5 times faster than its capacity increases.
Population is expected to increase by 20 million over the next 30–40 years.
The state has proposed the first high-speed rail system in the United States, covering 800 miles.
Voters opted to pay for the projected $68 billion cost through bonds, federal funding, private investment, and revenue from carbon dioxide permits.
Analysts concluded the net benefits of rail system were over $133 billion.
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Cost-Benefit Analysis
This chapter covers cost-benefit analysis.
Cost-benefit analysis: The comparison of costs and benefits of public goods projects to decide if they should be undertaken.
Cost-benefit analysis is widely used to evaluate potential public programs and projects.
8.1
Example: Cost-Benefits Analysis of Highway Construction Project
What are the costs and benefits of the project In the first year Over time
8.1
How to measure costs
Cash-flow accounting: An accounting method that calculates costs solely by adding up what the government 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 is the value of that resource in its next best use.
Measuring opportunity costs faces several challenges.
Measuring Current Costs
8.1
Economic costs are only those costs associated with diverting the resource from its next best use.
Rents: Payments to resource deliverers that exceed those necessary to employ the resource.
If labor is efficiently employed, then wages are a social cost.
If some workers are unemployed, then we value their time at the value of leisure, not the wage.
The value of their leisure is likely to be above the equilibrium wage for most workers, but there are also some instances where it would be below the equilibrium wages.
Imperfect Markets
8.1
Suppose that the minimum wage of construction workers is $20/hour.
The market wage is $10/hour for all other workers.
The opportunity cost of this project is the next best alternative for the construction workers who join the project, which is the $10 they could have earned elsewhere. The cost is:
$10/hour × (1 mill hours) = $10 million
Of the $20 million actually paid, $10 million is transfer of rents from government to workers and is not counted as a true economic cost of the project.
Imperfect Markets: Measuring the Cost of Labor
8.1
How to measure future benefits against current costs
Use presented discounted value, discounting at the social discount 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: The appropriate value of r to use in computing PDV for social investments.
Measuring Future Costs
8.1
Example: Cost-Benefits Analysis of Highway Construction: Filling in Costs
8.2
Suppose we can show that the time that individuals save from driving faster is spent at work.
Then we could value their time saved at their wage.
This theoretical proposition runs into some problems in practice:
Individuals can’t freely trade off leisure and hours of work; jobs may come with hour restrictions.
There may be nonmonetary aspects of the job.
Measuring the Benefits of Public Projects:
Using Market-Based Measures to Value Time: Wages
8.2
An alternative approach to measure benefits is contingent valuation.
Contingent valuation: Asking individuals to value an option they are not now choosing, that they do not have the opportunity to choose, or that is not yet available to them.
This approach relies on answers to hypothetical questions.
Straightforward, inexpensive to apply.
Valuing Driving Time Saved:
Using Survey-Based Measures to Value Time: Contingent Valuation
8.2
Critics point out that contingent valuations are very sensitive to the survey.
Isolation of issues: 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 different location sites or variances in the scope of the project does not affect answers.
APPLICATION: The Problems of Contingent Valuation
8.2
An alternative to contingent valuation is to use revealed preference.
Revealed preference: Letting the actions of individuals reveal their valuation.
Market prices potentially reveal preference: If people are willing to pay P for something, then it is worth at least P to them.
Valuing Driving Time Saved:
Using Revealed Preference to Value Time
8.2
How much do commuters value reductions in commuting time
Price differences between houses close and far from downtown might reflect the value of commuting time.
But treatments and controls may differ, leading to bias.
Everett is only 4 miles from downtown Boston, while Lexington is 11 miles away.
Average home price in Everett: $353,000.
Average home price in Lexington: $776,600.
EVIDENCE: House Prices and Commuting Time
8.2
One solution is to control for house characteristics.
Lot size, number of bedrooms, square footage.
But some features are hard to observe, such as granite countertops.
In order to provide a more convincing estimate of the value of time savings, a quasi-experimental approach can be used.
Deacon and Sonstelie (1985) looked at how much people save by standing in line to buy price-controlled gasoline—about $21 hour.
EVIDENCE: House Prices and Commuting Time: Solving the Problem of Bias
8.2
Saving lives is a central benefit of many interventions.
Valuing human lives is the single most difficult issue in cost-benefit analysis. Yet, many would say that human life is “priceless.”
By this argument, valuing life is a reprehensible activity; there is no way to put a value on such a precious commodity.
However, every possible intervention has a chance of saving lives.
Scarcity of resources means we cannot afford to pursue all projects.
This means we must value a life if we want to compare how many lives each competing project can save and choose the best options to fund.
Valuing Saved Lives
8.2
Some General Motors pickup trucks produced between 1973 and 1987 had a dangerous, side-mounted gas tank.
1993: Consumer groups demanded GM recall 5 models of cars.
Recall would cost $1 billion and would save at most 32 lives.
Using these estimates, the cost per life saved by the recall would have been $1 billion/32 = $31.25 million.
APPLICATION: Valuing Life
8.2
In October 1999, a commuter train crash at London’s Paddington Station killed 31 people.
Outraged public demanded 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.
At best: $20 million per life saved.
At worst: $300 million per life saved.
APPLICATION: Valuing Life
8.2
How to value saved lives
Lifetime Wages
Life’s value is the present discounted value of the lifetime stream of earnings.
Contingent Valuation
Ask individuals what their lives are worth.
Revealed Preferences
Estimate the extra cost consumers pay for a product that reduces the risk of death by a quantifiable amount.
Valuing Saved Lives
8.2
We can value life by estimating how much individuals 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: 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 office).
This approach suggests value of life of $9.6 million.
Revealed Preference Approaches to Valuing Lives: Compensating Differentials
8.2
Government Revealed Preference
8.2
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.
Reducing global warming will bring benefits hundreds of years into the future.
Discounting Future Benefits
8.2
Cost effectiveness is an alternative to cost-benefit analysis.
Cost-effectiveness analysis: For projects that have immeasurable benefits, or are viewed as desirable regardless of the level of benefits, we can compute only their costs and choose the most cost-effective project.
Finding the cost of a life saved—and choosing projects with the lowest costs—avoids making judgments about the value of life saved.
Cost-Effectiveness Analysis
8.3
Putting It All Together
Present discounted value of benefits is more than 3 times the cost of project.
8.3
Common Counting Mistakes
Counting secondary benefits
Counting labor as a benefit
Double-counting benefits
Distributional Concerns
Costs and benefits may not go to the same people.
Uncertainty
Costs and benefits are often highly uncertain.
Other Issues in Cost-Benefit Analysis
8.4
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 becomes quite complicated when resources cannot be valued in competitive markets.
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 projects.
Conclusion

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