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APPLIED WELFARE ECONOMICS AND COST-BENEFIT ANALYSIS (CBA) Definition: CBA is a systematic way of comparing benefits and costs for a "projekt", where the concept of project should be understod as widely as possible. Structure of the lecture: -Social decision rules -History behind CBA -Motives for CBA -Analytical steps -Benefits and benefit components -Consumer surplus measures -Costs -Discounting -Risk and uncertainty Social decision rules The Pareto criterion: A project should be carried through if at least one person gaines from it and no one looses. Rests on three basic value judgements: i. An individualistic conception of social welfare - To make society better off, one must first make individuals better off. ii. Non-economic causes of welfare can be ignored - The extent of freedom and democracy is not something that economists ususally need to consider when evaluating a project. iii. Consumer sovereignty - Individuals are there own best judges of there own welfare. Kaldor-Hicks criterion: A project should be carried through if the size of the benefits are such that the "winners" could compensate the "losers". In practice the welfare economic foundation for CBA. Critique: -The criterion defines a hypothetical change. The compensation does not actually have to be carried through. -To limit to the monetary dimension is to implicitly assert that everyone has the same marginal valuation of money. -History behind CBA The "father" of Cost-Benefit Analysis: Harold Hotelling: Jules Dupuit -1844, paper on the benefits and costs of building a bridge (De la Mesure de l'Utilite des Travaux Publics). -Introduced the concept of consumer surplus. -"reinvented" CBA 1938 and formulated it in modern welfare theoretic terms (The General Welfare in Relation to Problems of Taxation and of Railway and Utility Rates). Empirical application: U.S. Flood Control Act, 1936 Control flooding of major rivers "If the benefits to whomsoever they may accrue are in excess of the estimated costs". Post World War II: New methods to value non-market priced goods. Burton Weisbrod: "Option Value", paper 1964 (Collective Consumption Services of IndividualConsumption Goods). John Krutilla: "Existence Value", paper 1967 (Conservation Reconsidered). 1980s and -90s: -CBA well established in the United States (Reagan's Executive Order 12291) -Less used in Europe - usually, environmental effects are not valued in monetary terms within the European Union. -Limited interest in Sweden – only Vägverket, Banverket and SIKA use CBA on regular basis. -Motives for CBA Under a perfect market economy it holds, in principle, that what is good for the company is good for society. However, no perfect market economy exists. Five motives for CBA: *Externalites *Public goods *Disequilibrium conditions *Imperfect competition *Taxes, Allowances & Subsidies -Analytical steps in CBA *Specification of the project and choice of alternatives. *Description of the physical effects of the project and quantification of benefits and costs. *Possible weighting of benefits and costs using distributional weights. *Discounting of future benefits and costs. *Considerations with respect to risk and uncertainty. -Benefits and Willingness-To-Pay (WTP) *Market priced goods -Marginal project, i.e. the supply of of a market priced good change only a little Use the market price after adjustments for taxes, allowances etc. -Non-marginal project, i.e. the project changes the price of a market priced good Benefit = area under demand curve * Non-market priced goods -The good exists but the project changes the supply - see above -The good did not exist previously but is provided by the project Benefit = area under demand curve up to the level which is provided by the project. For a public good this is equal to the sum of WTP. -Value components Why do we value environmental commodities? Broad classification: -Use values -Option values -Existence values -Costs *The most fundamental cost concept is opportunity cost. Definition: The opportunity cost of using resources in a certain way is the highest valued alternative use to which the resources might have been put. *Often the opportunity cost is equal to the monetary expenditure however, the opportunity cost of using idle resources (like an otherwise unemployed person) is zero *Does the project lead to physical quantity increase? Cost = area under Marginal Cost (MC) curve, where the cost is defined as opportunity cost. *How to practically go about measuring costs? -Survey method - May give overestimated answers. -Engineering method - Only gives estimates for an example company. -Distributional weights *CBA with a positive net value increases "the social cake". *Society does, however, not only care about the size of the cake but also about how it is distributed. *To acknowledge this, benefits and costs that accrue to a poor person can be weighted up. *Arguments against distributional weights: -Tax and allowance systems, not specific projects (like infrastructural projects), should be used to reach the desired distribution of income. -Inefficient project should not be motivated on pure distributional grounds. *Arguments in favor of distributional weights: -Administratively costly to use tax/allowance systems. -Projects may some times provide in natura benefits. -Distributional issues important for the possibility to conduct efficient policy. -Discounting *Analogous problem to distributional weights. A discount rate is a weighting over time and between generations. *Why use a positive discount rate in CBA? *How should a social discount rate be chosen? In theory: MRTP + EMUI*GPCI MRTP: Marginal rate of time preference. “How impatient we are.” EMUI: Elasticity of Marginal utility of income. “Percent increase in utility from 1 precent increase in income.” GPCI: Growth in per capita income. Reflects that a poor man today should not make sacrifices for a rich man tomorrow. *Discounting and future generations - The tyranny of discounting. *Falling discount rates – British government list of falling rates to be used in public projects: 3,5 % from year 1 to year 30. 3 % from year 31 to year 75. 2,5 % from year 76 to year 125. 2 % from year 126 to year 200. -Risk and uncertainty Risk: A situation where we have some understanding about the probabilities of different outcomes. Uncertainty: We do not know anything about the probabilites of different outcomes. Expected value: The sum of possible outcomes weighted by their probability. The Certainty Equivalent: The Cost of Risk: The certain sum which gives the individual the same utility as a lottery with the same expected utility. The difference between Expected Value and The Certainty Equivalent. Risk Aversion: The Cost of Risk is positive. Risk Preference: The Cost of Risk is negative, i.e. the risk has a value. Risk Neutral: The Cost of Risk is zero.