ECF5560
Winter term, 2023
Lecture 1: Introduction to CBA
Cost benefit analysis & economic decision making
Dr. Emilia Tjernstrom
1. What is CBA?
2. Key terms and ideas
What is CBA?
economics is about choice
we face trade-offs
because resources
are scarce
cost-benefit analysis is...
Project:
an activity that involves the reallocation of resources from their current use
Program:
a series of projects over time with the view of achieving an objective
identifying
measuring
comparing
benefits and costs of
a project or program
cost-benefit analysis is...
identifying
measuring
comparing
Project:
an activity that involves the reallocation of resources from their current use
SOCIAL
the complete set of
social AND private
benefits and costs of
a project or program
Program:
a series of projects over time with the view of achieving an objective
PHYSICAL CAPITAL
ENVIRONMENTAL CAPITAL
HUMAN CAPITAL
SOCIAL CAPITAL
POLICY CHANGES
Examples of public
projects involving...
Investment project
An allocation of scarce resources
(e.g. land/labour/capital) in the present, which will result in a
flow of output
in the future
Opportunity cost
The true cost of something
in economic terms
is its opportunity cost
(i.e. what you give up to get it!)
Opportunity cost
The opportunity cost of
an investment project is the
value of the resources
in their next best use
Role of the analyst
provide objective information about
level / distribution of costs and benefits
to the decision-maker for the…
-
appraisal of a project/program
(help decide whether to allocate resources)
- evaluation of a project/program
(reviewing its performance)
With and without
Measuring the impact of a project
in two states of the world
World with project
World without project
With and without
Measuring the impact of a project
in two states of the world
World with project
World without project
before
"do nothing"
status quo
Key terms
& ideas
Allocative efficiency
Pareto efficiency
CBA is a framework for measuring efficiency
Allocative efficiency
Pareto efficiency
CBA is a framework for measuring efficiency
Resources are deployed in their highest-valued use in terms of the goods and services they create
i.e., every good or service is produced until the marginal benefit of the last unit to consumers
= the marginal cost of production
NOT a moral statement
Allocative efficiency
Pareto efficiency
CBA is a framework for measuring efficiency
Given an initial allocation of goods among individuals, a Pareto improvement is a change in allocation that makes at least one person better off, without making anyone else worse off
If we can’t make any Pareto improvements, the current allocation is Pareto efficient
CBA can tell us the
relative efficiency of
alternative policies
Pareto efficiency
$100
$100
Payment
to person 1
Payment
to person 2
Disagreeement
point
Pareto frontier
Potential Pareto frontier
$20
$20
Does not help us choose between points on the Pareto frontier
A different status quo (rule / income distribution) results in different set of Pareto efficient outcomes
Pareto efficiency
Pareto efficiency depends on status quo
$100
$100
Payment
to person 1
Payment
to person 2
Pareto frontier
Examine whether winners gain enough that they could compensate losers and remain weakly better off, without actually implementing
Potential Pareto efficiency /
Kaldor-Hicks criterion
Examine whether winners gain enough that they could compensate losers and remain weakly better off, without actually implementing
Potential Pareto efficiency /
Kaldor-Hicks criterion
If benefits - costs > 0, then we can find a set of transfers that makes at least one person better off without making anyone else worse off
A project will typically involve
- costs in the present (investments)
- benefits in the future
This means there is often a negative net benefit stream
for some period where the benefits exceed the operating costs & potential capital replacement costs
Net benefits over time
$
Time
To summarize the net benefits of a project
we have to convert values over time into
values at a common point in time
(typically the present)
To compute NPV, we need to decide how to discount future values
Net present value (NPV)
$
Time
The discount rate is an inter-temporal weighting
It converts all future values of costs & benefits into present values
The discount rate illustrates what people are prepared to give up now in terms of consumption to have more in the future
A riskless rate such as a government bond rate is often stated to be a good reflection of the marginal rate of peoples' time preferences
Discount rate (r)
Whose benefits and costs are we going to measure and compare?
In other words who has "standing" in the decision making process?
Distributional effects are also part of the decision making process both for appraisal and evaluation
Referent group / standing
Costs and benefits for whom?