Download The Concept of Opportunity Cost

The Concept of Opportunity Cost
• The concept of opportunity cost is used in
CBA to place a dollar value on the inputs
required to implement policies
– The opportunity cost of using an input to
implement a policy is its value in its best
alternative use
• It measures the value of what society must forgo to use
the input to implement the policy
• Example:
– A police dept decides to pay tuition for police officers
– To pay for tuition, the dept might have to keep its patrol
cars an extra two months each
– Opportunity costs = additional repair cost because of the
older automobiles
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Opportunity Cost and Pareto
Efficiency
• Following the same 3-people policy example
– Recall that the aggregate willingness-to-pay was $50
– Assume that the policy requires inputs that have an
opportunity cost of $75
• If so, some other members of society would have to give up
goods valued at $75
• In this case, the policy does not generate enough benefits to
the 3 persons to allow them to compensate those who must
forgo the $75
– The net benefits to society are negative 50 + (-75) = -25
– The policy is not Pareto efficient
– If opportunity costs were only $20…
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The Link between Net Benefits and
Pareto Efficiency
• As long as analysts value all impacts in terms of
willingness-to-pay and all required inputs in terms of
opportunity costs, then the sign of the net benefits
indicates whether or not it would be possible to
compensate those who bear costs sufficiently so that no
one is made worse off
– Positive net benefits indicate the potential for compensation to
make the policy Pareto efficient
– Negative net benefits indicate the absence of this potential
• Adopting only policies that are actually Pareto efficient is
impractical
• Bounded rationality / too costly to administer / people would
overstate their costs and understate their benefits
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Potential Pareto Efficiency—an
alternative decision rule
• Based on the Kaldor-Hicks criterion
– A policy should be adopted if and only if those
who will gain could fully compensate those
who will lose and still be better off
• Adopt only policies that have positive net benefits
– If policies are always adopted on the basis of net positive
benefits, society maximizes aggregate wealth
• Richer societies more willing to redistribute wealth
– Costs and benefits would tend to average out across
society
– Minimizes concentrating benefits on interest groups at
the expense of unorganized groups
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(6) Discount Benefits and Costs to
Obtain Present Values
– Needed because capital projects incur cost in the
present and benefits in the future—the net benefit
stream will be negative for a period of time and then
positive
• to produce a summary measure of the net benefits of a
project all values are converted to values at a common point
in time (usually the present)
• Recall that PV = FVn / (1 + r) n
– The present value amount (PV) invested at discount
rate r will grow to future value FVn at the end of n
years
– Both benefits and costs are converted to their present
value
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(7) Compute the Net Present Value
of Each Alternative
• Present value of the benefits = PV(B)
• Present value of the costs = PV(C)
• The net present value of an alternative,
NPV, equals the difference between
present value of the benefits and the
present value of the costs
NPV = PV(B) – PV(C)
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Decision Rules
• A single alternative to the status quo
– Adopt the project if NPV > 0; which means PV(B) >
PV(C)
• More than one alternative to the status quo
– Select the project with the largest NPV
• Assuming that at least one alternative is positive
• In the highway example, the no-tolls alternative has higher
NPV than the tolls alternative
– The largest NPV rule recommends the more efficient
of the alternatives compared; but there’s no
assurance that the most efficient alternative is being
recommended
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Other Criteria—Benefit Cost Ratio
• Benefit-Cost Ratio (BCR)
– The present value of benefits divided by the present value of
costs
– When BCR = 1; the present value of benefits are equal to
present value of costs
• As the ratio increases, the benefits accruing have increased
– An analyst would recommend
• A BCR > 1 if comparing one alternative to status quo
• The largest BCR if comparing more than one alternative to the
status quo
– BCR could be the wrong choice
• When alternatives are of different scale (some cost a lot more than
others)
• Depending on whether negative willingness-to-pay amounts are
subtracted from benefits or added to costs
• When the benefits stream changes signs more than once
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Other Criteria—Internal Rate of
Return
• The discount rate at which the NPV is zero is also called the internal
rate of return
– Is that rate of discount applied to benefit and cost streams which sets
PV(B) = PV(C), or NPV = 0
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(8) Perform Sensitivity Analysis
• Recognizing that predicting and monetizing
impacts is difficult, sensitivity analysis
reassesses the appropriateness and
quantification of:
– the discount rate selected
– The level of standing selected (whose benefits and
costs really count?)
– Other relevant questions:
• How accurate is the estimate of the lives saved by the
shorter and safer proposed highway?
• How accurate is the dollar value placed on a statistical life
saved?
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(9) Make a Recommendation
• Generally, the alternative with the largest NPV is
recommended
– In the highway example,
• Option A is better than C
• Option B is better than D
– The no-tolls alternative is superior
• Option D has a negative NPV
– Compared to the status quo, It would be more efficient not to
build the highway
– The tolls lower the NPV because they deter people
from using the highway, and so fewer people enjoy
the benefits
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Strengths and Weaknesses of CBA
• Strengths
• Weaknesses
– Versatile
– Empirical difficulties
• Applies to many project types
– Provides a useful framework
in which to consider issues
• A systematic approach
• Uses economic principles
• Data availability
• Reliability of data sources
– Monetizing difficult
– Methodological difficulties
• Still used as efficiency
analysis and not as
distributional tool
• Still an incremental approach
– Does not account for all
possible alternatives
• Utilitarian in nature
– Places monetary value on
all aspects of life
• May pre-empt political
decision making
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Practicality of Efficiency
Analyses
• Impractical if
– Required technical procedures are beyond the scope of the
evaluation project
– Required resources too high
– Methodological requirements may be outside the staff’s expertise
– Political or moral controversies by placing economic values on
outcome measures
– The methodology may be too confusing for the stakeholders
– Data may not be available
• Private entities conduct cost-benefit analysis on a purely
financial objective—profit maximization
– Issues relevant to government are not applicable to the private
sector
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