Valuing Benefits & Costs (Part 2) +

Discounting Benefits & Costs (Part 1)

Lecture 4 SPM9716: Chapters 4 & 5 + Chapter 6 (part 1)

Dr. ir. Zenlin Roosenboom-Kwee

z.roosenboom-kwee@tudelft.nl

Challenge the future 1

Course Outline & Schedule

Challenge the future 2

Valuing Benefits in Distorted
Markets
• Distorted markets = inefficient markets projects’ benefits
are still measured as ∆ social surplus + net revenues

• Five different types of market failures

1. Monopoly & natural monopoly (refer to Lecture 3)
2. Information asymmetry
3. Externalities
4. Public goods
5. Addictive goods

Challenge the future 3

Information Asymmetry (IA)

• The two effects can be corrected if (non)governmental

sources provide the needed information

• Source of information depends on the type of good:

• Search good (e.g. notebooks) IA is unlikely to be a serious
problem
• Experience goods (e.g. movie tickets, restaurants) reduces IA
• Post-experience goods (e.g. a prescription drug) IA persists
for long periods of time

Challenge the future 4

Externalities

• An externality: an effect that production or consumption of a

good has on third parties
• Two potential effects of an externality:
• Market underestimates the social cost of a good (negative)
• Market overestimates the social benefit of the good (positive)

• What can governments do?

• Negative externalities: require producers to pay a tax on each
unit they sell
• Positive externalities: subsidize production of the good or
produce some of the good

Challenge the future 5

Public Goods

• Two key attributes:

• Nonexcludable: it is impossible (impractical) for one person to
maintain control over the use of a good free-rider problem
• Nonrivalrous: more than one person can obtain benefits from a
given level of supply at the same time free-rider problem
• Some goods are either nonrivalrous or nonexcludable (but
not both!)
• Example of nonrivalrous (but excludable): toll road
• Example of nonexcludable (but rivalrous): fishing in international
waters

Challenge the future 6

Addictive Goods

Economic models
of addictive goods
(e.g. tobacco):
today’s
consumption
depends on the
amount of previous
consumption

Challenge the future 7

Valuing Inputs: Opportunity Costs
• Opportunity costs: value of the goods and services that would have
been produced had the resources (used to implement the policy)
been used in the best alternative way
• Opportunity costs are not sunk costs
• To measure opportunity costs, direct budgetary outlay is normally
used

• Three situations where direct budgetary outlay is compared with

conceptually appropriate measures:
1. Efficient markets with negligible price effects budgetary outlay is
accurate (caution: perfectly elastic vs. perfectly inelastic supply curves)
2. Efficient markets with noticeable price effects budgetary outlay may
slightly overstate opportunity costs (see Fig. 4-13)
3. Inefficient market may substantially overstate/understate
opportunity costs

Challenge the future 8

Figure 4-13 Opportunity Costs with Price Effects
Benefits Costs

Original buyers A+B

Sellers A+B+C

Project B+C+G+E+F
expenditures
Net social cost B+G+E+F

Challenge the future 9

General rule for market distortions

• When supply is taxed, direct expenditure outlays

overestimate opportunity cost
• When supply is subsidized, expenditures underestimate
opportunity cost
• When supply exhibits positive externalities, expenditures
overestimate opportunity cost
• When supply exhibits negative externalities, expenditures
underestimate opportunity cost

• General rule: Opportunity cost = direct expenditures on the

factor minus (plus) gains (losses) in social surplus occurring
in the factor market

Challenge the future 10

Primary & Secondary Markets
• Primary (secondary) markets: markets that are directly (indirectly)
affected by a policy
• Indirect effects in secondary markets are also referred to as
secondary, second-round, spillover, side, pecuniary effects

• As government policies affects prices of goods in primary markets

the effects in secondary markets, changes of demand for:
• Complements: goods that tend to be purchased and used with
another good (e.g. hamburger buns)
• Substitutes: goods that can be used in place of another good (e.g.
hotdogs are substitutes for hamburgers)

• The effect in primary markets may or may not affect the price in
secondary markets

Challenge the future 11

Efficient secondary market effects
without price changes
• The impacts in efficient secondary markets should be ignored
if:
• the prices in the secondary markets do not change; and
• the change in social surplus in the primary market is measured

• Example: fishing days (primary) and fishing equipment

(secondary, complement)

Challenge the future 12

Figure 5-1(a) Primary Market: Market for Figure 5-1(b) Secondary Market: Market for
Fishing Days Fishing Equipment (No Price Effect)

SS = CS = PF0abPF1 Gain in CS = efdc

Should we include this gain in the
social benefits of the primary market?

Challenge the future 13

Efficient secondary market effects
with price change
• When the price in the secondary market changes, situation is
more complex

• Example: fishing days (primary) and golfing days (secondary,

substitute)

• Efficient secondary market effects (regardless of price

changes) are ignored as long as benefits in the primary
market are measured using empirically measured (observed)
demand curves

Challenge the future 14

Figure 5-2(a) Primary Market: Market for Fishing Days Figure 5-2(b) Secondary Market: Market for
Golfing Days (Price Effects)

Increase in CS = PF0abPF1
Increase in CS (practice) = PF0acPF1 Increase in CS = PG0efPG1
Understatement of CS = abc Reduction in PS = PG0gfPG1
Net loss in SS = efg

Challenge the future 15

Case Example: Japanese vs.
American cars
• Japanese cars are substitutes for American cars
• To improve U.S. sales, there is a need to limit the imports of
Japanese cars
• Voluntary Restraint Agreement (VRA) in 1981

• What are the impacts or consequences of the limit on

imports?

Challenge the future 16

Distorted Secondary Markets

• Distorted markets: markets in which price does not equal

social marginal costs

• When there are distortions in secondary markets, effects

must be valued separately (difficult to measure in practice)

• Fortunately, these effects are usually small and can be

ignored

• Examples: negative externalities and taxes

Challenge the future 17

Exercise 5.1 Recall Exercise 4.2 (Lecture 3 slide#7) in which an
increase in the toll on a highway from $.40 to $.50 would
reduce use of the highway by 10,000 cars per week
a. Because of the reduced use of the highway, demand in the secondary market for
subway rides increases. Assuming that the price of subway rides is set equal to
the marginal cost of operating the subway and marginal costs are constant (i.e.
the supply schedule is horizontal), and no externalities result from the reduced
use of the highway and the increased use of the subway, are there additional
costs or benefits due to the increased demand for subway rides? Why or why
not?
b. Because of the reduced use of the highway, demand in the secondary market for
gasoline falls by 30,000 gallons per year. There is a stiff tax on gasoline, one that
existed prior to the new toll. Assuming that the marginal cost of producing
gasoline is $1 per gallon, that these marginal costs are constant (i.e., the supply
schedule is horizontal), that no externalities result from the consumption of
gasoline, and that the gasoline tax adds 30 percent to the supply price, are there
any additional costs or benefits due to this shift? If so, how large are they?

Challenge the future 18

Indirect effects of infrastructure
projects
• The analysis is similar to the analysis of effects in secondary
markets

• The indirect effects can be ignored if:

• The product markets in which the indirect effects occur are
undistorted
• The surplus changes that occur in primary markets are fully
measured

Challenge the future 19

The Basics of Discounting
(Projects with lives of one year)
• Three possible methods
• Future Value (FV) analysis
FV = X (1 + i) ; X = amount invested and i = interest rate
• Present Value (PV) analysis
PV = Y/(1 + i) ; Y = amount received

• Net Present Value (NPV) analysis

NPV = PV(benefits) – PV(costs)
• NPV > 0 select project
• NPV < 0 reject project; maintain status quo

Challenge the future 20

City Land Purchase Example (Figures 6-1 and 6-2)

i = 5%

PV(B) = 11,000 / (1+0.05)

PV(B) = 10,476,190

PV(C) =

NPV = $476,190

Challenge the future 21

 Compounding and Discounting
over multiple years
• Future value: FV= X (1+i)n ; (1+i)n = compound interest factor

• Present value: ; 1/(1+i)n = PV factor or discount factor

• Net present value:

When costs occur at the
beginning (t=0):

; NBi = Bi - Ci = −
(1 + )

Challenge the future 22

Figure 6-4 Time Line of the Benefits and Costs of the Library
Information System
i = 7%

Challenge the future 23

Annuity and Perpetuity
• Many CBAs contain annuities or perpetuities
• Annuity: an equal, fixed amount received (or paid) each year
for a number of years

(annuity factor)

(annuity with a constant

growth rate)

• Perpetuity: an indefinite annuity

(perpetuity with a constant

growth rate)

Challenge the future 24

Timing of Benefits and Costs

• When do benefits and costs exactly occur?

• At the beginning of the year
• At the end of the year

• If they arise throughout the year:

• Compute NPV as if the benefits/costs occurred in the middle of
the year
• Or take the average (at the beginning of the year and at the end
of the year) to compute NPV

Challenge the future 25

Exercise 6.1: A highway department is considering building a temporary
bridge to cut travel time during the three years it will take to build a
permanent bridge. The temporary bridge can be put up in a few weeks at a
cost of $750,000. At the end of three years, it would be removed and the steel
would be sold for scrap. The real net cost of this would be $81,000. Based on
estimated time savings and wage rates, fuel savings, and reductions in risks of
accidents, department analysts predict that the benefits in real dollars would be
$275,000 during the first year, $295,000 during the second year, and $315,000
during the third year. Departmental regulations require use of a real discount
rate of 4 percent.

a. Calculate the present value of net benefits assuming that the benefits are
realized at the end of each of the three years.
b. Calculate the present value of net benefits assuming that the benefits are
realized at the beginning of each of the three years.
c. Calculate the present value of net benefits assuming that the benefits are
realized in the middle of each of the three years.
d. Calculate the present value of net benefits assuming that half of each
year’s benefits are realized at the beginning of the year and the other half
at the end of the year.
e. Does the temporary bridge pass the net benefits test?

Challenge the future 26

Intertemporal Comparison of Projects
• When the time spans are different, projects are not directly
comparable

• Example: A government-owned electric utility company is

considering two new alternative sources of power
• Alternative 1: hydroelectric dam (HED), NPV 75-year project =
$30 million
• Alternative 2: cogeneration plant (CGP), NPV 15-year project =
$24 million
• Is the hydroelectric project preferable simply because it has the
large NPV?

• Two relevant methods:

1. Roll-over method
2. Equivalent annual net benefits (EANB) method

Challenge the future 27

Roll-Over Method
• If tprojectA = n * tprojectB
• Example: Project A lasts 30 years and project B lasts 15 years
• Compare NPV project A to the NPV of 2 back-to-back project B
• Project B = + where: x = NPV of one15-year
( )
project B

• Previous HED and CGP example: Suppose that in 15 years time

another new cogeneration plant is built; in 30 years another one
is built; and again in 45 and 60 years (assume i = 8%)
$ !" $ !"
5 = $24 + ++ +
( . $) ( . $)%&
$ !" $ !"
+ + = $34.94 + ,, -.
( . $)' ( . $)(&

Higher than NPV of 75-year HED

($30 million) select this option

Challenge the future 28

Equivalent Annual Net Benefits (EANB) Method
• EANB: the amount received each year for the life of the project
has the same NPV as the project itself (amortization)
• EANB = NPV/ ain
• ain is the present value of an annuity of $1 for the life of the project
1 − (1 + )0
/ =
• n = years
• i = interest rate used to compute the NPV
• Choose the project with the highest EANB

• HED and CGP example:

• EANB(HED) = $30/12.461 = $2.407 million
• EANB(CGP) = $24/8.559 = $2.804 million
If one could continuously replace each
project at the end of its life with a similar
project, choose CGP

Challenge the future 29