Chapter 3. Evaluating Trade-Offs: Benefit Cost Analysis and Other Decision- Making Metrics

Transcription

1 Chapter 3 Evaluating Trade-Offs: Benefit Cost Analysis and Other Decision- Making Metrics

2 Chapter 3 Evaluating Trade-Offs: Benefit Cost Analysis and Other Decision-Making Metrics Introduction Normative Criteria for Decision Making Applying the Concepts Divergence of Social and Private Discount Rates Cost-Effective Analysis Impact Analysis 3-2

3 Introduction This chapter illustrates the use of several decision-making metrics that can assist us in evaluating options. 3-3

4 Introduction You find a mineral deposit beneath a forest. Should you destroy the forest to extract the minerals? What is the best decision? Destroy the forest: New jobs, improved economic welfare from increasing employment, rise of income etc. Keep the forest: Town has access to forest products, Species protection, CO2 reduction, No noise pollution from mining etc. 3-4

5 Introduction Does the forest grow back? What about the future? How far into the future do you consider? Are there any other alternatives to mining? Could you turn the forest to conservation park and still get some revenue? You collect cost and benefit and quantify it. Is everyone going to be better off? Economic Cost Benefit Analysis. 3-5

6 Normative Criteria for Decision Making Evaluating Predefined Options: Benefit Cost Analysis Benefit-Cost analysis provide a method for determining whether or not an action should be supported. 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 3-6

7 Normative Criteria for Decision Making Cost/Benefit Analysis computes dollar values for the costs and benefits of an action. How do we measure cost and benefits? Economic benefit and cost = human (society) centered (Anthropocentric) 3-7

8 Normative Criteria for Decision Making Total benefits or total willingness to pay, is the area under the market demand curve from the origin to the allocation of interest. Total cost is the area under the marginal cost curve. All costs should be measured as opportunity costs. 3-8

9 Normative Criteria for Decision Making Opportunity cost is the net benefit foregone when an environmental service is lost to a new use. Ex., cutting forest. Cost = net benefit forgone because the trees cannot provide services like species protection, CO2 reduction etc. 3-9

10 Normative Criteria for Decision Making Total costs is the sum of marginal opportunity costs, which is the area under the marginal cost curve. Net benefit is the excess of benefits over costs or the area under the demand curve that lies above the supply curve. This is also the consumer plus producer surplus. 3-10

11 Normative Criteria for Decision Making Consider the net benefits from preserving a stretch of river that can be used either for boating or for generating electricity. If the river is used for boating, Should that stretch be preserved? Explain why or why not? 3-11

12 Normative Criteria for Decision Making Total Benefit (TB) = Area under the demand curve: LMSO Total Cost (TC) = Area under the marginal cost curve = KNS 3-12

13 FIGURE 3.1 The Derivation of Net Benefits Society chooses to preserve 4-mile stretch, TB = LMOS TC = KNOS TNB = LMOS-KNOS =LMNK TB > TC => Preserve the river 3-13

14 Relating Optimality to Efficiency For the normative choice criterion, the objective is to maximize the net benefits area. Optimal policies maximize net benefits (TB-TC). That is identical to the economic surplus that is maximized in a static efficient allocation Maximum Economic Surplus = Maximum Net Benefit 3-14

15 Finding the optimal outcome If at an allocation, marginal cost is greater than marginal benefit, then net benefits are less than the maximum possible => inefficient If marginal benefit is greater than marginal cost, net benefit can be increased by increasing the allocation => inefficient Efficient: MC = MB 3-15

16 FIGURE 3.1 The Derivation of Net Benefits Society chooses to preserve 5 mile instead of 4, TNB = LRK > LMNK NB increases by area NMR 3-16

17 FIGURE 3.1 The Derivation of Net Benefits Society chooses to preserve 6 mile instead of 5, MC > MB Net benefits decrease by RTU compared to earlier. 3-17

18 Relating Optimality to Efficiency Since net benefit is reduced by preserving less than 5 or more than 5 units, Preserving 5 miles constitutes an efficient or optimal allocation. First Equi-marginal Principle Social net benefits are maximized when the social marginal benefits from an allocation equal the social marginal costs. MB = MC 3-18

19 Relating Optimality to Efficiency The social marginal benefit is the increase in social benefits from supplying one more unit of the good or service. The social marginal cost is the increase in cost incurred from supplying one more unit of the good or service. When MC = MB; allocations are Pareto optimal. 3-19

20 Relating Optimality to Efficiency Allocations are said to be Pareto optimal if no other feasible allocation could benefit at least one person without harming some other person. Efficient allocations are Pareto optimal. 3-20

21 Comparing Benefits & Costs Across Time Many decisions have to be made that will have consequences into the future. Fisheries or forests could be overharvested, pollution can accumulate over time.. Time is a factor. How can we make choices when benefits and costs occur at different time? 3-21

22 Comparing Benefits & Costs Across Time Present Value: The concept of present value allows us to: Incorporate time value of money Compare dollars today to dollars in some future period by translating everything back to its current worth. Discount rate is the rate at which society as a whole is willing to trade off present for future benefits. 3-22

23 Comparing Benefits & Costs Across Time In order to incorporate time, we use the present value formula which discounts the future value to the present based on a discount rate. When introducing time factor analysts need to account for the fundamental financial principle A dollar today is worth more than a dollar tomorrow A dollar today can be invested at 10% interest to get $1.10 in a year. 3-23

24 Comparing Benefits & Costs Across Time Comparing Benefits and Costs Across Time Present Value of a one-time net benefit (B n ) received n years from now is Where r is the discount rate By discounting a one-time benefit received in n years from now, analyst account for timing. 3-24

25 TABLE 3.1 Demonstrating Present Value Calculations Suppose, an allocation yields the following net benefit at the end of each year: $3000,$5000,$6000,$10000,$12000 Suppose, interest rate is 6% Year 1: 3000/{(1+0.06) 1 } = $ Year 4: 10000/{(1+0.06) 4 }=$

26 TABLE 3.1 Demonstrating Present Value Calculations 3-26

27 Normative Criteria for Decision Making The present value of a stream of net benefit {B 0,, B n ) received over a period of n years is Where r is the interest rate Total PV = $29,205; Total Benefits after 5 years = $36,

28 Normative Criteria for Decision Making The maximum net present value criterion suggests that resources should be committed to those uses maximizing the present value of the net benefits received. This is a dynamic efficiency criterion. 3-28

29 Normative Criteria for Decision Making 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. 3-29

30 Normative Criteria for Decision Making Example, PV [ cost] PV [benefit] NPV Project Project

31 Normative Criteria for Decision Making Example, Problem Set 1. Discount rates Project 1. Marine Park Years Costs (thousands of $) Construction 1250 Recurring costs Foregone recreation Benefits Increased tourist revenue Net 5% 10% 3-31

32 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 3-32

33 EXAMPLE

34 Issues in Benefit Estimation Benefit-cost analysis involves judgments on: Which effects should be included (e.g., should secondary effects be included)? How many people incur benefits and costs? Are the benefits and costs the same for each person? How do you handle intangible values or those that cannot be reliably assigned a monetary value. 3-34

35 Issues in Benefit Estimation 1. Primary Versus Secondary Effects Consider both primary and secondary consequences while implementing environmental projects Actions trigger both primary and secondary actions. Clean a lake» Increase in recreational uses of the lake (Primary effect)» Increased employment from increased users in the lake (Secondary effect). Need to account for the secondary effect as well. If the increase in demand leads to new employment, its value should be counted. 3-35

36 Issues in Benefit Estimation 2. Accounting Stance Who benefits? The accounting stance refers to the geographic scale at which the benefits are measured. Local or National? If preserving a land affects locally, account for that. If it is significant to the nation, it has a national impact. In Benefit/Cost analysis, need to account accordingly. 3-36

37 Issues in Benefit Estimation 2. Accounting Stance Example, Colorado Big Thompson Project. Federal Water diversion project from Colorado River to the plains» Howe (1986): Cost-Benefit Analysis» National net benefits: -$341.4 billion» regional net benefits: $766.9 billion» The local political pressure secured this project, although it is really inefficient. 3-37

38 Issues in Benefit Estimation 3. 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. Example, if increased tourism did not occur because of the clean river, but rather because there was a new park built then you cannot account for the secondary effect in the B/C analysis for river cleaning. 3-38

39 Issues in Benefit Estimation 4. Tangible Versus Intangible Benefits Tangible benefits can reasonably be assigned a monetary value. Intangible benefits cannot be assigned a monetary value. If ignored, the results are biased. Intangible benefits should be quantified to the full extent possible. 3-39

40 Approaches to Cost Estimation Estimating cost is typically more straightforward than estimating some types of benefits. Difficulties involve estimating expected future costs and getting reliable cost information from firms. 3-40

41 Approaches to Cost Estimation 1. The Survey Approach Ask those who bear the cost to provide a perspective E.g., Involves asking polluters about the control costs estimates. Incentive to not be truthful/overestimate Overestimating the cost could provide less strict regulations. 2. The Engineering Approach Considers the technologies that would be needed, then draws conclusions regarding the cost to meet the objective. There might be unique circumstances in different firms that would not be captured by this approach. 3-41

42 Approaches to Cost Estimation 3. The Combined Approach Combining both survey and engineering approaches The survey collects info on technology needed and special circumstances while the engineering approach estimates the cost of technology. 3-42

43 Treatment of Risk For many environmental issues, scientific uncertainty complicates benefit-cost analysis. Eg., most scientists agree on the potential damage of climate change, such as sea level rise and species losses. However, the timing and the extent of those losses are not certain. 3-43

44 Treatment of Risk Two dimensions to the treatment of risk: Identify and quantify the risks. (scientific) Decide how much risk is acceptable. (normative) Since it is very tedious and sometimes unfeasible to do a benefit-cost analysis for every possible outcome, we usually must utilize expected values. 3-44

45 The Treatment of Risk The Treatment of Risk A dominant policy is one which confers the higher net benefits in every outcome. In this case, the existence of risk concerning the future is not relevant for the policy choice. However, if there is no dominant policy, use the expected value. 3-45

46 The Treatment of Risk 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. 3-46

47 The Treatment of Risk You want to select a policy with the highest expected present value of net benefits. 3-47

48 The Treatment of Risk In Cost Benefit analysis, it is important to define whether the party is risk neutral, risk averse or risk loving. Suppose there are two options. You either receive $50 right now or enter into a lottery with a 50/50 chance that either you win $100 or $0. Risk-loving = lottery Risk-averse = $50 (cash right now) Expected Value = (100*50%) + (0*50%) = $50 Risk-neutral = indifferent between two The above approach assumes risk neutrality. Whether or not it makes sense for the government to assume that society on the whole is risk neutral (versus risk loving or risk averse) should be discussed. 3-48

49 Applying the Concepts: Choosing the Discount Rate One of the critical assumptions when conducting a cost-benefit analysis is the discount rate used in the PV calculation. 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 E.x., During the early 1970s the office of management and budget ensured all government used a discount rate of 10% in their B-C analysis. Now, it has been revised to 7%. 3-49

50 Applying the Concepts: Choosing the Discount Rate The discount rate is defined as the social opportunity cost of capital. The discount rate will have two components: 1. The riskless cost of capital 2. And The risk premium. 3-50

51 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. (Rate on long term govt. bonds.) Risk premium It is the amount required to compensate capital owners for potential differences between expected and actual returns. 3-51

52 Applying the Concepts: Choosing the Discount Rate Private and social rates differ, mainly because of: Differences in private v/s public risk premiums. Differences in time preferences. It affects both private and social discount rates, as well as across countries. 3-52

53 Applying the Concepts: Choosing the Discount Rate If firms use higher discount rate, they would extract and sell resources faster than would be efficient. If firms use lower discount rate, they would be excessively conservative. When discount rates differ, market decisions are not efficient. 3-53

54 Normative Criteria for Decision Making Example, Problem Set 1. Discount rates Project 1. Marine Park Years Costs (thousands of $) Construction 195 Recurring costs Foregone recreation Benefits Increased tourist revenue Net % % NPV at 5% = NPV at 10% =

55 EXAMPLE

56 Applying the Concepts: Choosing the Discount Rate The importance of discount rate (Example) 1950 s: USA and Canada discussed the possibility of constructing a tidal power project in Passamaquoddy Bay between Maine and New Brunswick. Cost benefit analysis was conducted. USA concluded that the project should be built. Canada concluded the project should not be built because the net benefit would be negative. 3-56

57 Applying the Concepts: Choosing the Discount Rate Why? USA used 2.5 % discount rate while Canada used 4.125%. USA used a lower discount rate so the initial costs weighed less heavily in their calculation. In the USA calculation, the lower future operating costs weighed heavily. Canada used a higher discount rate which means high initial costs, and they saw the net benefit as negative. 3-57

58 Common proxies for discount rate In the 1970s the OMB (Office of Management and Budget) required all government agencies to use a discount rate of 10% in cost-benefit analysis.) Now, Normative Criteria for Decision Making NOAA (National Oceanic and Atmospheric Administration) uses 3% discount rate. FEMP (Federal Energy Management Program) uses 3% discount rate. OMB (Office of Management and Budget) uses 7% discount rate. Many developing nations use (8-15%) discount rate. 3-58

59 Benefit Cost Analysis Example Example: Should govt. establish a national marine sanctuary? Assume that a marine ecosystem is threatened by polluted runoff from development; waste from sewage, detergents, and fertilizers; destructive fishing methods; and offshore oil drilling Threatens the viability of reefs and seagrass beds, and threatens the long-term sustainability of the fish and other seafood harvests In response, the federal government is considering establishing a NMS to provide comprehensive protection of the marine environment Taken from:

60 Benefit Cost Analysis Example List the benefits Direct economic benefits: more ecotourism enhanced seafood harvests better bird watching a fishing catch that is sustainable in the longterm Indirect economic benefits preservation of cultural and historic sites (e.g., lighthouses and ship wrecks) Taken from:

61 Benefit Cost Analysis Example List the costs productivity losses incurred by industry as a result of the prohibition on off-shore drilling, waste dumping, and net fishing private industry could be required to purchase costly equipment to comply with new regulations related to the treatment of industrial waste products (abatement cost) Taken from:

62 Taken from:

63 Cost-Effective Analysis Cost-effectiveness analysis is a useful alternative to benefit-cost analysis when the measurement of benefits is impossible, or estimates are unavailable. 3-63

64 Cost-Effective Analysis Second Equimarginal Principle (the Cost- Effectiveness Equimarginal Principle): Involves minimizing the costs of achieving a policy target (e.g, emission standard). The least-cost means will be achieved when the marginal costs of all possible alternatives are equal. E.g., the least cost way of supplying electricity or water to a community. 3-64

65 Impact Analysis Useful when data needed for either C-B analsysis or cost effective analysis is unavailable. An impact analysis attempts to quantify the consequences of various actions. It attempts to assign a monetary value to who gains and who loses from a given policy. Impact analysis places a large amount of relatively undigested information at the disposal of the policy-maker. 3-65

66 Summary Environment: a composite asset Benefit cost analysis Cost-effective analysis Impact analysis Static versus dynamic efficient allocation 3-66