Fin 234
Fin 234
Fin 234
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Cost-benefit analysis (CBA analysis) is a set of practical
procedures for guiding public expenditure decisions.
It is a policy assessment method that quantifies the value of
policy consequences (usually called impacts) in monetary
terms to all members of society
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PURPOSE AND USES
• CBA is most commonly used for public
decisions– policy proposals, programs, and
projects, e.g., dams, bridges, traffic circles,
riverfront parks, libraries, drunk driving
laws, and anything else the government
might fund.
•Cont… •4
CBA measures costs and benefits to the
community of adopting a particular course of
action e.g. Constructing a dam etc.
Other issues :
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BASIC STEPS OF CBA
• Step 1 -- Specify the set of alternative projects
• Step 4 -- Predict the impacts quantitatively over the life of the project.
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Example
For private decisions, such as taking martial arts
classes or going to a movie on Saturday night, we
are often not aware of any internal process of
consideration of costs and benefits, but behave as
though we do.
• Where
– R=initial investment amount
– r=rate of return on investment
– T=years of investment
Thus, The future value (FV) of the investment is:
FV R1 r
T
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Projecting Present Dollars into the Future
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B. Projecting Future Dollars into the
Present
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Example
• You are forgoing the interest that you could earn on the
money that is being loaned.
Formula for Projecting Future Dollars
into the Present
• Define
– R=amount to be received in future
– r=rate of return on investment
– T=years of investment
• The present value (PV) of the investment is:
R
PV
1 r T
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Projecting Future Dollars into the
Present
• In previous equation, r is often referred to as the
discount rate, and (1+r)-T is the discount factor.
R1 R2 RT
PV R0 ...
1 r 1 r 2
1 r T
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Projecting Future Dollars into the Present
– $148,644 if r=.10
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Private Sector Project Evaluation
The present value criteria for project evaluation.
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Private Sector Project Evaluation
– A project is admissible only if its present value is
positive
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Private Sector Project Evaluation
• The benefit-cost ratio divides the discounted stream
of benefits by the discounted stream of costs. In this
case
• B=stream of benefits and C=stream of costs:
B1 BT
B B0 ...
1 r
1 r
T
C1 CT
C C0 ...
1 r 1 r T
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Public sector projects evaluation by the
government
Sensible decision making by the government requires present
value calculations. However, the public sector , should
compute costs, benefits, and discount rates differently than
private sector. The private individuals should reflect the rate of
return available on alternative investments. There are problems
in selecting a public sector discount rate. Public sector discount
rate based on two things .i.e.
1. Rates based on returns in the private sectors.
2. Social discount rate.
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Rates based on returns in the
private sectors.
• Funds for a given project are collected form a variety of taxes,
each of which has a different effect on consumption and
investment.
• The after tax rate of return measures what an individual
losses when consumption is reduced, dollars that come at the
expense of consumption should be discounted by the after-
tax rate of return.
• Unfortunately, in practice it is hard to determine what the
proportions of sacrificed consumption and investment
actually are for a given government project.
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Social Rate of Discount
• The rate at which society is willing to trade off
present consumption for future consumption.
• The social discount rate may be lower from market
returns because it:
– Accounts for concern about future generations
– Involves paternalism
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Concern for Future Generations
• The public sector decision makers care not only about the
welfare of current generation but future generations as well,
while the private sector cares only about its own welfare.
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Market Inefficiency
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Valuing Public sector Benefits and Costs of a project
The evaluation problem is more complicated for the
government because market prices may not reflect social
benefits and costs.
Evaluating private projects is done by comparing costs
and benefits incurred to the firm and it is
straightforward; benefits are revenues received and costs
are payments for inputs; both are measured at market
prices.
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Several Ways for measuring the benefits and costs of
public sector projects:
A. Market prices
B. Adjusted Market prices
C. Consumer Surplus.
A. Market Prices
In well functioning competitive economy, prices reflect the marginal cost
of production and its marginal value to consumers. It would appear that if
the govt. uses inputs and /or produces outputs that are traded in private
markets , then markets prices should be used for valuation. The problem is
that, in reality, markets have imperfections, (e.g. monopoly , externalities
and so on) which makes prices do not necessarily reflect marginal costs
and benefits. •30
B. Adjusted Market Prices
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C. Consumer Surplus
In contrast to the small private firms, public
sector projects are relatively large and they may
change market prices.
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B. The Labor Game
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C. The Double Counting
• Land owner can either sell it or use it, not both. Under
competition, the sale price of the land just equals the PV of
the net income from farming it. Because the farmer cannot do
both simultaneously, counting both (1) and (2) represents a
double counting of the true benefits.
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Summary of Cost-Benefit Analysis
• Cost-Benefit analysis is used to evaluate potential public sector projects
• The costs and benefits of public projects can be measured using market
CONT
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Summary (cont)
• Quantifying the value of time and life, is
necessary in measuring benefits, but using
earnings as a proxy has limitations
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