Civil Systems Planning
Benefit/Cost Analysis
Scott Matthews
Courses: 12-706 and 73-359
Lecture 2 - 8/27/2003
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Benefit/Cost Analysis
Framework to systematically identify
major benefits and costs associated with a
particular investment or policy.
Often controversial, with different analysts
coming to different conclusions or not
agreeing on objectives.
BCA is a framework, not a recipe.
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Why do we use it?
Required: Exec Order 12291 (Reagan) ex-ante
Perform RIA for agency programs over $100 M
Market failure (when used by government).
Comparison of projects/alternative policies
(contribution to improved quality of information).
Explain divergence between expected and
actual outcomes.
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Steps in a CBA - Read ‘Reality’
1. Determine standing.
2. Select portfolio of alternatives.
3. Catalogue potential (physical) impacts and select
measurement indicators.
4. Predict quantitative impacts of the life of the
project.
5. Monetize.
6. Timeframe and money.
7. Sum.
8. Sensitivity Analysis
9. Recommendation.
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Graphic interpretation of CBA
Benef its
Costs
B(Q)
C(Q)
Maximum net
bene fit s
Q0
Q1
Q2
Q*
Qm
Output Q
Taken from Figur e 1.1 from Boardman et al
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The Policy World
Normative vs. Positive theories
N - based on ‘norms’ - ‘should be done’
P - based on ‘reality’ - ‘actually done’
This reinforces the idea of perspective
See Guardian vs. Spender mentality in chapter
 Guardians bottom-line oriented, see only tolls
Tend to underestimate costs
 Spenders see everything (inc. costs) as benefits
Tend to overestimate benefits
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Efficiency Definitions/Metrics
Allocative - resources are used at highest value
possible
But welfare economics uses another:
An allocation of goods is Pareto efficient if no
alternative allocation can make at least one
person better off without making anyone else
worse off.
Inefficient if can re-allocate to make better without
making anyone else worse
Assumed that decisions made with this in mind?
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A Pareto Example
Try splitting $ between 2 people
Get total ($100) if agree on how to split
No agreement, each gets only $25
Pareto efficiency assumptions:
More is better than less
Resources are scarce
Initial allocation matters
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$100
?
Given this graph, how can
We describe the ‘set of all
Possible splits between 2 people
That allocates the entire $100?
0
$100
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$100
Line is the ‘set of all
possible splits that
allocates the entire $100,
Also called the potential
pareto frontier. Is the
line pareto efficient?
0
$100
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$100
No. Could at least get the
‘status quo’ result of (25,25)
if they do not agree on
splitting. So neither person
would accept a split giving
them less than $25. Is status
quo pareto efficient?
$25
0
$100
$25
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$100
No. They could agree on
splits of (25, 30) or (30,
25) if they wanted to all the way to (25,75) or
(75,25). All would be
pareto improvements.
Which are pareto
efficient?
$75
$25
0
$25
$75
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$100
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$100
The ‘pareto frontier’ is
the set of allocations that
are pareto efficent. Try
improving on (25,75) or
(50,50) or (75,25)…
We said initial alloc.
mattered - e.g. (100,0)?
$25
0
$100
$25
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Pareto Efficiency and CBA
If a policy has NB > 0, then it is possible
to transfer value to make some party
better off without making another worse
off.
To fully appreciate this, we need to
understand willingness to pay and
opportunity cost in light of CBA.
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Willingness to Pay
Example: how much would everyone pay
to build a mall ‘in middle of class’
Near middle may not want traffic costs
Further away might enjoy benefits
Ask questions to find indifference pts.
Relative to status quo (no mall)
E.g. middle WTP -$2 M, edges +$3 M
Edges could ‘pay off’ middle to build
Only works if Net12-706
Benefits
positive!
and 73-359
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Opportunity Cost
Def: The opportunity cost of using an
input to implement a policy is its value in
its best alternative use.
Measures value society must give up
What if mall costs $2 M?
Total net WTP = $1M, costs $2M
Not enough benefits to pay opp. cost
Can’t make side payments to do it
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Wrap Up
As long as benefits found by WTP and
costs by OC then sign of net benefits
indicated whether side payments can
make pareto improvements
Kaldor-Hicks criterion
A policy should be adopted if and only if
gainers could fully compensate losers and still
be better off
Potential Pareto Efficiency (line on Fig 2.1)
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Three Legs to Stand On
Pareto Efficiency
Make some better / make none worse
Kaldor-Hicks
Program adopted (NB > 0) if winners COULD
compensate losers, still be better
Fundamental Principle of CBA
Amongst choices, select option with highest
‘net’ benefit
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What about Other Goals, nonEfficiency?
Multigoal Analysis
Economic performance
Social performance
Environmental performance
Technological performance
Flexibility
We’ll come back to this later in course
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Distributionally weighted CBA
SW = sum of net benefits across entire
population. SW = S(NB)i for all
Are there conditions under which we want
to weight individuals differently when
maximizing net benefit?
SW = S Qi(NB)i for all i and S Qi=1 where
Qi is the weight assigned to person i.
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Welfare Economics
Concepts
Perfect Competition
Homogeneous goods.
No agent affects prices.
Perfect information.
No transaction costs /entry issues
No transportation costs.
No externalities:
Private benefits = social benefits.
Private costs = social costs.
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Discussion - WTP
Survey of students of WTP for beer
How much for 1 beer? 2 beers? Etc.
Does similar form hold for all goods?
What types of goods different?
Economists also refer to this as demand
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