Introduction to Cost-Benefit Analysis:
Using Market Prices
Presentation by Dr. Benoit Laplante
Environmental Economist
Consultant
Asian Development Bank
Bangkok
September 30 to October 4, 2013
Outline of Presentation
1. Cost-benefit analysis: 8 steps
2. Quantifying the impacts of a project
3. Concept of economic value
4. Methodologies to evaluate impacts
5. Using market prices
2
Outline of Presentation
1. Cost-benefit analysis: 8 steps
2. Quantifying the impacts of a project
3. Concept of economic value
4. Methodologies to evaluate impacts
5. Using market prices
3
Cost-benefit analysis: 8 steps
Step 1: Define the scope of analysis.
Step 2: Identify all potential physical impacts of the project.
Step 3: Quantify the predicted impacts.
Step 4: Monetize impacts.
Step 5: Discount to find present value of costs and benefits.
Step 6: Calculate net present value.
Step 7: Perform expected value and/or sensitivity analysis.
Step 8: Make recommendations.
4
Cost-benefit analysis: 8 steps
Step 1: Define the scope of analysis.
Step 2: Identify all potential physical impacts of the project.
Step 3: Quantify the predicted impacts.
Step 4: Monetize impacts.
Step 5: Discount to find present value of costs and benefits.
Step 6: Calculate net present value.
Step 7: Perform expected value and/or sensitivity analysis.
Step 8: Make recommendations.
5
Quantifying the impacts of a project
• This is perhaps the most important and most common failure in
CBA.
6
Quantifying the impacts of a project
Suppose the following (hypothetical) situation:
In a specific region of the country, agricultural yield has been
going down for the last few years (which may or may not be
related to climate change).
Projected increases in air temperature is expected to have an
adverse effect on agricultural yield.
Suppose a project (for example a supplementary irrigation
project) which aims to offset some or all of this adverse
affect.
How would one assess the impact of the project on agricultural
yield given the projected increases in air temperature? In other
words: How would one assess the benefits of this project?
Quantifying the impacts of a project
Yield (tons per
month)
Which question do we need to ask to
quantify the possible impacts of the
project?
Question 1: What is likely to happen
WITHOUT the project?
Existing
yield
Past
Today
Looking in the future
Time
Quantifying the impacts of a project
Yield (tons per
month)
Existing
yield
Suppose this is estimated
yield given projected
increases in temperature
WITHOUT project.
Past
Today
Looking in the future
Time
Quantifying the impacts of a project
Yield (tons per
month)
Question 2: What would be ag yield given
projected increases in temperature WITH
the project?
Existing
yield
Suppose this is estimated
yield given projected
increases in temperature
WITHOUT project.
Past
Today
Looking in the future
Time
Quantifying the impacts of a project
Yield (tons per
month)
Question 2: What would be ag yield given
projected increases in temperature WITH
the project?
Suppose this is estimated
yield given projected
increases in temperature
WITH project.
Existing
yield
Impact of project
Suppose this is estimated
yield given projected
increases in temperature
WITHOUT project.
Past
Today
Looking in the future
Time
Quantifying the impacts of a project
Yield (tons per
month)
Under PPCR, the baseline is the value of
the existing yield at the time the PPCR is
negotiated.
Existing
yield
Suppose one goes
back a few years
later and find this.
What will PPCR
conclude?
Past
Today
Looking in the future
Time
Quantifying the impacts of a project
Yield (tons per
month)
Under PPCR, the baseline is the value of
the existing yield at the time the PPCR is
negotiated.
Existing
yield
But in fact, if this was
without project, then
the project is a
success.
Past
Today
Looking in the future
Suppose one goes
back a few years
later and find this.
PPCR will conclude
project is a failure.
Time
Quantifying the impacts of a project
• This is perhaps the most important and most common failure in
CBA.
• We must always ask: What would happen if the project did not
take place. We must compare how the situation will be “with the
project” and how it is expected to be “without the project”.
Outline of Presentation
1. Cost-benefit analysis: 8 steps
2. Quantifying the impacts of a project
3. Concept of economic value
4. Methodologies to evaluate impacts
5. Using market prices
15
The concept of economic value
Consider an individual in an initial state of well-being W0 that
he/she she achieves with a money income Y0 and a level of
access to irrigation IR0:
W0 (Y0, IR0)
Now consider a project which would increase access to
irrigation water to IR1. This increased access to IR would
produce a new level of well-being to W1:
W1 (Y0, IR1)
Since this individual’s well-being would increase with the
project, we know that:
W1 (Y0, IR1)
>
W0 (Y0, IR0)
16
The concept of economic value
In order to assess the appropriateness of this project and
compare the costs of the project with the benefits, we would
like to know how much the well-being of this individual is
increased with increased access to irrigation, i.e. how
large is W1 minus W0?
ΔW =
W1 (Y0, IR1)
-
W0 (Y0, IR0)
How could we measure this change in well-being? How large
is W1 minus W0?
17
The concept of economic value
Determine the maximum amount of income the individual
would be willing to pay (WTP) for the change in IR.
In effect, the individual is asked to consider two combinations
of income and access to irrigation water that both yield the
same level of well-being:

One combination in which his/her income is reduced and
access to IR is increased; and

Another combination in which income is not reduced and
access to IR remains the same as it is (no change).
W0 (Y0, IR0) = W0 (Y0 – WTP, IR1)
18
The concept of economic value
W0 (Y0, IR0)
=
W0 (Y0 – WTP, IR1)
WTP is defined as the amount of money that makes these two
combinations of income and traffic congestion yield the same
level of well-being. This is the maximum the individual would
be willing to pay for the positive change in welfare resulting
from a greater access to irrigation water.
This maximum WTP is defined as the economic value of the
change in well-being resulting from the increased access to
irrigation water from IR0 to IR1.
All economic valuation methodologies aim to measure this
maximum WTP. Some methodologies do this well, some not
so well.
19
The concept of economic value
Total economic value
Use
value
Indirect
use
value
+
Consumptive
direct use value
Direct
use
value
+
Bequest
value
+
Existence
value
Non-consumptive
direct use value
Among use value, we also add:
Relatively easy to
measure
Non-use
value
+
Option value
Relatively difficult to
measure
20
Outline of Presentation
1. Cost-benefit analysis: 8 steps
2. Quantifying the impacts of a project
3. Concept of economic value
4. Methodologies to evaluate impacts
5. Using market prices
21
Methodologies to evaluate impacts
22
Methodologies to evaluate impacts
Use value
Direct use
value
Consumptive
direct use value
Non-consumptive
direct use value
Indirect use
value
Group 1: Change of
productivity
methodology
Group 2 (Revealed
preferences) and
Group 3 (Stated
preferences)
Non-use
value
Bequest
value
Existence
value
Group 3 (Stated
preferences)
Methodologies to evaluate impacts
Use value
Direct use
value
Consumptive
direct use value
Non-consumptive
direct use value
Indirect use
value
Group 1: Change of
productivity
methodology
Group 2 (Revealed
preferences) and
Group 3 (Stated
preferences)
Non-use
value
Bequest
value
Existence
value
Group 3 (Stated
preferences)
Outline of Presentation
1. Cost-benefit analysis: 8 steps
2. Quantifying the impacts of a project
3. Methodologies to evaluate impacts
4. Using market prices
25
Using market prices
Group 1: ‘Change of productivity’ methodology
This methodology is generally applied in the specific case where
the environmental impact represents a change in a component of
the environment (or ecosystem) which has a direct consumptive
value.
This impact will be measured by a change in the production of a
good for which there is already a market, and therefore market
prices.
Market prices or shadow prices will be used to assess the
economic impact of this change in productivity.
Using market prices
Group 1: ‘Change of productivity’ methodology
Examples where appropriate to use this methodology:
• Water pollution may impact fisheries yield;
• Reservoir sedimentation may impact power production;
• Floods may impact agriculture production;
• Increases in temperature may reduce agricultural yield.
Using market prices
Group 1: ‘Change of productivity’ methodology
Proceeds in two steps:
Step 1: Establish the link or the relationship that exists between
a change in environmental quality and the resulting impact on
production.
This is generally called a dose-response function.
Examples of dose-response functions:
• Relationship between fisheries yield and water pollution;
• Relationship between reservoir sedimentation and
power production;
• Relationship between temperature and agricultural
production.
Using market prices
Group 1: ‘Change of productivity’ methodology
Proceeds in two steps:
Step 2: Once the change in production is established,
market prices (or shadow prices which are market prices
corrected for the presence of subsidies, taxes or for any other
market imperfections) are then used to estimate the economic
value of the estimated change in production.
Using market prices
Group 1: ‘Change of productivity’ methodology
Proceeds in two steps:
Step 1: Establish the link or the relationship that exists between
a change in environmental quality and the resulting impact on
production.
Step 2: Once the change in production is established,
market prices (or shadow prices which are market prices
corrected for the presence of subsidies, taxes or for any other
market imperfections) are then used to estimate the economic
value of the estimated change in production.
Step 1 is the difficult step.
Cost-benefit analysis: 8 steps
Step 1: Define the scope of analysis.
Step 2: Identify all potential physical impacts of the project.
Step 3: Quantify the predicted impacts.
Step 4: Monetize impacts.
Step 5: Discount to find present value of costs and benefits.
Step 6: Calculate net present value.
Step 7: Perform expected value and/or sensitivity analysis.
Step 8: Make recommendations.
31
Steps and expertise
IDENTIFICATION OF
IMPACTS
Task of technical and
scientific experts
QUANTIFICATION OF
IMPACTS
Task of technical,
scientific and economic
experts
ECONOMIC VALUATION
OF IMPACTS
Task of economists
Need multi-disciplinary team
Introduction to Cost-Benefit Analysis:
Using Market Prices
Presentation by Dr. Benoit Laplante
Environmental Economist
Consultant
Asian Development Bank
Bangkok
September 30 to October 4, 2013