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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.