6. Public Economics

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Cost Benefit Analysis definition:

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Most common technique for evaluating economic benefits of projects.

Compares costs and benefits associated with alternatives.

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CBA is:

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-Based on valuation principles of welfare economics;

-Values costs and benefits in monetary terms;

-Concerned with real values over time (discount rate crucial)

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Measures of Project efficiency:

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- Net Present Value

- Internal Rate of Return

- Benefit/Cost Ratio

Shows whether expected B exceed C. If NPV>0 = efficient

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Net Present Value EQ:

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b: Flow of B from time (t=0 -> t=n)

k: Capital Costs from 0-t

r: Discount Rate (social rate of time value)

c: Operating Costs from 0-t.

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NPV Details

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NO BIAS

NPV>0=efficient project = positive Net Social Benefit (NSB).

- Can rank projects by NPV if there are many to choose from.

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Internal Rate of Return EQ:

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finds value of i.

If i>r project is efficient

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IRR Details:

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Favours projects with relatively high returns in early years.

"What is the rate of return I'd have to earn to get me a NPV of 0 - is that greater than market interest rate?"

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6. Benefit/Cost Ratio EQ:

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Front 9

BCR Details:

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if BCR>1, NPV>0

Favours low capital projects.

Highlights Labour Heavy Projects

- BCR is useful when capital is restricted or

gov wants to decrease unemployment

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Market Prices:

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Good estimate of C&B but not as good as Shadow Prices when there are significant market failures

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Risk Factors:

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Society = generally risk adverse, will pay to avoid it

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Cost Benefit Analysis Steps

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1. Identify issues and objectives

2. Develop policy options (including a no-change option)

3. Identify and forecast incremental physical inputs and impacts

4. Estimate value of these effects (convert to C&B)

5. Estimate overall efficiency value of project/policy

6. Test for uncertainty and risk

7. Assess distributional issues

8. Prepare report

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Benefits of CBA

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- Easy to compare options

- Promotes efficient use of resources

- Focus on net benefit of project

- Focus on value added

- Accounts for environmental concerns (Green cost)

- Measures Opportunity Cost incl TIME

- Objective (uses monetary terms)

- Less arbitrary

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Weaknesses of CBA

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- Arguably produced using false monetary terms

- Open to manipulation by vested interests (gov)

- Assumptions are critical (time, social effects...)

- Complex and costly (must CBA to see if CBA is worth it haha)

- Possibly ignores equity (Economic focus)

- Can only use current distribution of wealth

- Poss double counting of C or B

- Secondary Costs (eg Social Effects) may be ignored/underestimated in long term

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Valuing Benefits and Costs

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CBA must be based off standard unit of measurement (usually constant (real) local prices (AUD))

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Implication of using Constant Prices

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1. Assumption that all prices change at same rate

2. Future effects should be discounted by real rate of discount

3. May have to use financial analysis to allow for expected inflation

Exchange Rate issues: Over/Undervaluating foreign currency is common

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Valuing goods?

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x

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Discount Rate

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r = rate at which future income or costs are discounted to determine their present value.

- higher the value of r the more weight placed on future costs and benefits

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3 Measures of DR

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1) PTPR: Private Time Preference Rate (Consumer Rate of Discount)

2) STPR: Social Time Preference Rate (Varient of PTPR)

3) SOC: Risk Free Social Opportunity Cost of Capital

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PTPR

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mr: Market Rate

t: Marginal Tax Rate

π: Expected Inflation Rate

Private Benefits in Current Period

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SRTP

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STPR = g x e

g: Expected growth rate of per capital consumption

e: Elasticity of marginal utility of consumption

-Protects interests of future generations, equalises social marginal utility over time.

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SOC

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Marginal return a private firm can achieve with low risk

in perfectly competitive markets PTPR = SOC;

but usually SOC>PTPR bc its measure before tax (PTPR measured after tax)

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Choosing a DR

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Most Gov agencies recommend SOC

- ends up higher than long term bond rate

- gov gets a bit of a discount, can use to repay debt

- Long Term Bond Rate is usually seen as a benchmark risk free rate of return

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Uncertainty Outcome

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The outcome is variable, but we can't determine probability distribution

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Risky Outcome

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Indifference to dispersion of outcomes - don't care about risk, just outcome.

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Risk Adverse

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Willing to pay premium than risk uncertainty (negative utility from uncertainty).

Most common in society

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Certainty Equivalent

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Certain payoff society would need to provide same level of utility as the Expected Value of uncertain NSB.

- can rank by NSB certainty if you can measure it (you can't)

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Uncertainty and Risk in Practice

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incorporated into CBA by

1) Raising discount rate to reflect risk (rarely used)

- simple but messes rate of time preference up

2) Descriptively

- map probability distributions

3) Sensitivity Analysis

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Distributional Issues of Uncertainty/Risk

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Surplus NPV can be redistributed to compensate "losers" but:

- often aren't

- Projects w/ NPV>0 may impact POOR more (airport expansion, roads through suburbs...)

- WTP estimates are based on current income distribution (implementing projects alters income distribution: Estimates should account for this)

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Benefits from Capital Expenditure:

Net Benefit of a new good

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Front 31

Benefits from Capital Expenditure:

Net Benefit of an improved service

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Front 32

Benefits from Capital Expenditure:

Net Benefit of increased capacity

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Front 33

Benefits from Capital Expenditure:

Net Benefit of lower costs

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