6.benefit Cost

Evaluating Trade-Offs:
Benefit–Cost Analysis
Normative Criteria for Decision Making
• Evaluating Predefined Options: Benefit–Cost Analysis

• Let B be the benefits from a proposed action and C be the costs. Our
decision rule would then be:
• If B > C, support the action
• Otherwise, oppose the action
• Total benefits are the value of total willingness to pay, which is

the area under the market demand curve from the origin to
the allocation of interest.
• Opportunity cost is the net benefit lost when specific

environmental services are forgone in the conversion to the
new use.
• Total costs is the sum of marginal opportunity costs, which is

the area under the marginal cost curve.
EXAMPLE 3.1
• Consider the net benefits from preserving a stretch of river using
Figure 1. Let’s suppose that we are considering preserving a four-mile
stretch of river and that the benefits and costs of that action are
reflected in Figure 1. Should that stretch be preserved? Explain why
or why not?
FIGURE 1 The Derivation of Net Benefits
• Comparing Benefits and Costs Across Time
• Present Value of a one-time net benefit (Bn)
received n years from now is
Bn
PV [ Bn ] 
(1  r ) n
Where r is the interest rate

• The present value of a stream of net benefit {B0,…, Bn)

received over a period of n years is
n
Bi
PV [ B0 ,..., Bn ]  
i 0 (1  r ) i
Where r is the interest rate

TABLE 1 Demonstrating Present Value Calculations
TABLE 2 Interpreting Present Value Calculations
• Relating Optimality to Efficiency

• An allocation of resources is said to satisfy the static
efficiency criterion if the economic surplus from the use of
those resources is maximized by that allocation.
• First Equimarginal Principle (the “Efficiency Equimarginal

Principle”):
• Net benefits are maximized when the marginal benefits
from an allocation equal the marginal costs.
• Pareto optimality:
• Allocations are said to be Pareto optimal if no other
feasible allocation could benefit at least one person
without any deleterious effects on some other person.
• Dynamic Efficiency
• An allocation of resources across n time periods satisfies the dynamic
efficiency criterion if it maximizes the present value of net benefits that
could be received from all the possible ways of allocating those resources
over the n periods.
Applying the Concepts
• Pollution Control
• Benefits include, not limited to, reduced death rate, lower
incidences of chronic bronchitis and other diseases, better
visibility, improved agricultural productivity and etc.
• Costs include
• 1) higher costs passed to consumers such as installing, operating and
maintaining pollution control equipment
• 2) administrative costs such as designing, implementing, monitoring
relevant policies
EXAMPLE 2
TABLE 3 Summary Comparison of Benefits and Costs from the Clean Air Act-
1990–2020 (Estimates in Million 2006$)
• Preservation Versus Development

• Benefits include improved economic welfare from increasing
employment, rise of income and etc
• Costs include degradation of ecosystem.
• Example of mining in Kakadu Conservation Zone
EXAMPLE 3
• Issues in Benefit Estimation

• Primary Versus Secondary Effects
• Considering both primary and secondary consequences
while implementing environmental projects
• Accounting Stance
• Who benefits? The accounting stance refers to the
geographic scale at which the benefits are measured.
• Issues in Benefit Estimation (contd.)

• With and Without Principle
• The “with and without” principle states that only those
benefits that would result from the project should be
counted, ignoring those that would have accrued anyway.
• Tangible Versus Intangible Benefits

• Tangible benefits can reasonably be assigned a monetary
value.
• Intangible benefits cannot be assigned a monetary value.
• Approaches to Cost Estimation
• The Survey Approach
• Involves asking polluters about their control costs
• The Engineering Approach
• Using engineering information to estimate the technologies available and the
costs of purchasing and using those technologies.
• The Combined Approach
• Combining both survey and engineering approaches
• The Treatment of Risk
• A dominant policy is one which confers the higher net benefits in every
outcome.
• The expected value of net benefits is the sum over the possible
outcomes of the present value of net benefits of that outcome weighted
by its probability of occurrence. The policy selected should be the one
with the highest expected present value of net benefits.
•
I
EPVNB j   PPVNB
i ij , j  1,..., F
i 0
•
• The evaluation of irreversible decisions requires extra caution.
• Distribution of Benefits and Costs
• Economic impact analysis
• a broad characterization of who gains and who loses from a given policy
• An equity analysis
• Impacts on disadvantaged groups or sub-populations
• Choosing the Discount Rate
• The appropriate rate to use will depend on the nature and expected
lifetime of the project, who is doing the financing and the level of risk
Divergence of Social and Private Discount
Rates
• Risk-free cost of capital
• The rate of return is earned when there is absolutely no risk of earning
more or less than the expected return.
• Risk premium
• It is the amount required to compensate capital owners for potential
differences between expected and actual returns.
• Time preference
• It affects both private and social discount rates, as well as across
countries.
EXAMPLE 4
EXAMPLE 3
(cont.)
Application
• You are asked to undertake a study assessing the benefits and costs
of smoking cessation programs.
• As a first step list out as many of the possible benefits as you can and
explain why the item may be a benefit.
• List down the possible costs.
Exercise
• A private firm wishes to examine the profitability of constructing a
phosphate fertilizer plant. The project will produce 10,000 tons of
fertilizer per year, which will be sold in the domestic market for $350
per ton. It is expected to have a 20 year life.
• Investment in plant and equipment will cost $7.5 million, spread evenly
over 3 years and land will cost $1 million. At the end of the project, the
land will be sold for its purchase price. The plant will depreciate in value
by 4% per year and can be sold for its depreciated value after 20 years.
• The plant will need 100 workers and 20 office and managerial staff. The
average wage for production workers is $800 per month, while that for
management staff is $2000 per month. Raw materials will be $20 per
ton of output produced while utilities will cost $5 per ton of output.
• The firm has a private discount rate of 12%.
• Calculate net present value and benefit cost ratio. Given your results,
should the private firm continue with the project?

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6.benefit Cost

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Evaluating Trade-Offs:

• Evaluating Predefined Options: Benefit–Cost Analysis

• Total benefits are the value of total willingness to pay, which is

• Opportunity cost is the net benefit lost when specific

• Total costs is the sum of marginal opportunity costs, which is

Where r is the interest rate

• The present value of a stream of net benefit {B0,…, Bn)

Where r is the interest rate

• Relating Optimality to Efficiency

• First Equimarginal Principle (the “Efficiency Equimarginal

• Preservation Versus Development

• Issues in Benefit Estimation

• Issues in Benefit Estimation (contd.)

• Tangible Versus Intangible Benefits

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