CBA and discounting – debriefing of exercises

Theo Jans
Exercise 1

1. Imagine that you live in a city that currently does not require bicycle riders
to wear helmets. Furthermore, imagine that you enjoy riding your bicycle
without wearing a helmet.

a. From your perspective, what are the major costs and benefits of a
proposed city ordinance that would require all bicycle riders to wear
helmets?

b. What are the categories of costs and benefits from society’s

perspective?
Exercise 1 - solution
1. Imagine that you live in a city that currently does not require bicycle riders to wear
helmets. Furthermore, imagine that you enjoy riding your bicycle without wearing a
helmet.

a. From your perspective, what are the major costs and benefits of a proposed city
ordinance that would require all bicycle riders to wear helmets?

Cost categories:
• purchase price of a helmet
• reduced pleasure of riding your bicycle
• Diminished appearance when you take the helmet off (bad hair)
• Inconvenience of keeping the helmet available
 …

Benefits categories:
• Reduced risk of serious head injury (morbidity)
• Reduced risk of death (mortality)
 …
Exercise 1 - solution
1. Imagine that you live in a city that currently does not require bicycle riders to wear
helmets. Furthermore, imagine that you enjoy riding your bicycle without wearing a
helmet.

b. What are the categories of costs and benefits from society’s perspective?

 Program enforcement (cost)

 Reduced health care costs (benefit), although this may not be as high as one might expect if cyclists ride
more aggressively because they feel safer (=off-setting behavior)
 Increased pollution, due to cyclists switching to cars (cost)
 …

 A social CBA would take account of these costs and benefits in addition to your costs.
Exercise 2
2. Suppose the government is considering an increase in the toll on a certain stretch of highway
from $0.40 to $0.50. At present, 50,000 cars per week use that highway stretch; after the toll
is imposed, it is projected that only 40,000 cars per week will use the highway stretch.

a. Assuming that the marginal cost of highway use is constant (i.e., the supply schedule is
horizontal) and equal to $.40 per car, what is the net cost to society attributable to the increase
in the toll? (Hint: The toll increase will cause the supply schedule, not the demand schedule,
to shift.)
b. Because of the reduced use of the highway, the government would reduce its purchases of
concrete from 20,000 tons per year to 19,000 tons per year. Thus, if the price of concrete were
$25 per ton, the government’s cost savings would be $25,000. However, the government’s
reduced demand for concrete causes its market price to fall from $25 per ton to $24.50 per ton.
Moreover, because of this reduction in price, the purchases of concrete by non-government
buyers increase by 300 tons per year. Assuming that the factor market for concrete is
competitive, can the government’s savings of $25,000 be appropriately used as the measure of
the social value of the cost savings that result from the government purchasing less concrete?
Or would shadow pricing be necessary?
Exercise 2 - solution
2. Suppose the government is considering an increase in the toll on a certain stretch of highway
from $0.40 to $0.50. At present, 50,000 cars per week use that highway stretch; after the toll
is imposed, it is projected that only 40,000 cars per week will use the highway stretch.

a. Assuming that the marginal cost of highway use is constant (i.e., the supply schedule is
horizontal) and equal to $.40 per car, what is the net cost to society attributable to the increase
in the toll? (Hint: The toll increase will cause the supply schedule, not the demand schedule,
to shift.)
P D Market for road usage

Benefits Costs
$0.5 S’
Buyers A+B
A B
$0.4 S Government A

Total B

40,000 50,000 Q
Exercise 2 - solution
2. Suppose the government is considering an increase in the toll on a certain stretch of highway
from $0.40 to $0.50. At present, 50,000 cars per week use that highway stretch; after the toll
is imposed, it is projected that only 40,000 cars per week will use the highway stretch.

a. Assuming that the marginal cost of highway use is constant (i.e., the supply schedule is
horizontal) and equal to $.40 per car, what is the net cost to society attributable to the increase
in the toll? (Hint: The toll increase will cause the supply schedule, not the demand schedule,
to shift.)

Deadweight Loss = . 5 * (P2 - P1) * (Q1 - Q2).

Exercise 2 - solution
2. Suppose the government is considering an increase in the toll on a certain stretch of highway
from $0.40 to $0.50. At present, 50,000 cars per week use that highway stretch; after the toll
is imposed, it is projected that only 40,000 cars per week will use the highway stretch.

a. Assuming that the marginal cost of highway use is constant (i.e., the supply schedule is
horizontal) and equal to $.40 per car, what is the net cost to society attributable to the increase
in the toll? (Hint: The toll increase will cause the supply schedule, not the demand schedule,
to shift.)

The net cost to society is the deadweight loss caused by the increased toll and the resulting fall in the number
of cars using the highway.

The value of this deadweight loss is (0.5)(0.50-0.40)(50,000-40,000) = $500.

The increased toll paid by the remaining drivers -- (0.50-0.40)(40,000) -- can be viewed as a transfer from
the drivers to the government.
Exercise 2 - solution
2. Suppose the government is considering an increase in the toll on a certain stretch of highway
from $0.40 to $0.50. At present, 50,000 cars per week use that highway stretch; after the toll is
imposed, it is projected that only 40,000 cars per week will use the highway stretch.

b. Because of the reduced use of the highway, the government would reduce its purchases of
concrete from 20,000 tons per year to 19,000 tons per year. Thus, if the price of concrete were
$25 per ton, the government’s cost savings would be $25,000. However, the government’s
reduced demand for concrete causes its market price to fall from $25 per ton to $24.50 per ton.
Moreover, because of this reduction in price, the purchases of concrete by non-government
buyers increase by 300 tons per year. Assuming that the factor market for concrete is
competitive, can the government’s savings of $25,000 be appropriately used as the measure of
the social value of the cost savings that result from the government purchasing less concrete?
Or would shadow pricing be necessary?
Exercise 2 - solution
b. Graph

Market for concrete

D
P D’ S

Benefits Costs

$25 Buyers A+B

A C
$24.5 B D Producers A+B+C

Total C

D D

300 Q

1,000
Exercise 2 - solution
2. Suppose the government is considering an increase in the toll on a certain stretch of highway
from $0.40 to $0.50. At present, 50,000 cars per week use that highway stretch; after the toll is
imposed, it is projected that only 40,000 cars per week will use the highway stretch.

b. Because of the reduced use of the highway, the government would reduce its purchases of
concrete from 20,000 tons per year to 19,000 tons per year. Thus, if the price of concrete were
$25 per ton, the government’s cost savings would be $25,000. However, the government’s
reduced demand for concrete causes its market price to fall from $25 per ton to $24.50 per ton.
Moreover, because of this reduction in price, the purchases of concrete by non-government
buyers increase by 300 tons per year. Assuming that the factor market for concrete is
competitive, can the government’s savings of $25,000 be appropriately used as the measure of
the social value of the cost savings that result from the government purchasing less concrete?
Or would shadow pricing be necessary?

Part of the government's $25,000 savings from purchasing less concrete are offset by a reduction in surplus
received by the producers of concrete.
The size of the annual loss to producers of concrete (not offset by a transfer to consumers) is
(0.5)($25-$24.50)(1,000) = $250
Thus, the social value of the savings that results from the government using less concrete is $25,000 - $250
= $24,750
Exercise 3
1. A highway department is considering building a temporary bridge to cut travel time during
the three years it will take to build a permanent bridge. The temporary bridge can be put up
in a few weeks at a cost of $740,000. At the end of three years, it would be removed and the
steel would be sold for scrap. The real net cost of this would be $81,000. Based on estimated
time savings and wage rates, fuel savings, and reductions in risks of accidents, department
analysts predict that the benefits in real dollars would be $275,000 during the first year,
$295,000 during the second year, and $315,000 during the third year. Departmental
regulations require use of a real discount rate of 4 percent.

a. Calculate the present value of net benefits assuming that the benefits are realized at the end
of each of the three years.

NPV = -$740,000 + $275,000/(1.04) + $295,000/(1.04)² + $315,000/(1.04)³-$81,000/(1.04)³ = $5,192

Exercise 3
1. A highway department is considering building a temporary bridge to cut travel time during
the three years it will take to build a permanent bridge. The temporary bridge can be put up
in a few weeks at a cost of $740,000. At the end of three years, it would be removed and the
steel would be sold for scrap. The real net cost of this would be $81,000. Based on
estimated time savings and wage rates, fuel savings, and reductions in risks of accidents,
department analysts predict that the benefits in real dollars would be $275,000 during the
first year, $295,000 during the second year, and $315,000 during the third year.
Departmental regulations require use of a real discount rate of 4 percent.

b. Calculate the present value of net benefits assuming that the benefits are realized at the
beginning of each of the three years.

NPV = -$740,000 + $275,000 + $295,000/(1.04) + $315,000/(1.04)² -$81,000/(1.04)³ = $37,880

Exercise 3
1. A highway department is considering building a temporary bridge to cut travel time during
the three years it will take to build a permanent bridge. The temporary bridge can be put up
in a few weeks at a cost of $740,000. At the end of three years, it would be removed and the
steel would be sold for scrap. The real net cost of this would be $81,000. Based on estimated
time savings and wage rates, fuel savings, and reductions in risks of accidents, department
analysts predict that the benefits in real dollars would be $275,000 during the first year,
$295,000 during the second year, and $315,000 during the third year. Departmental
regulations require use of a real discount rate of 4 percent.

c. Calculate the present value of net benefits assuming that the benefits are realized in the
middle of each of the three years.

NPV = -$740,000 + $275,000/(1,04)6/12 + $295,000/(1.04)18/12 + $315,000/(1.04)30/12 -$81,000/(1.04)³ = $21,376

Exercise 3
1. A highway department is considering building a temporary bridge to cut travel time during the
three years it will take to build a permanent bridge. The temporary bridge can be put up in a
few weeks at a cost of $740,000. At the end of three years, it would be removed and the steel
would be sold for scrap. The real net cost of this would be $81,000. Based on estimated time
savings and wage rates, fuel savings, and reductions in risks of accidents, department
analysts predict that the benefits in real dollars would be $275,000 during the first year,
$295,000 during the second year, and $315,000 during the third year. Departmental
regulations require use of a real discount rate of 4 percent.

d. Calculate the present value of net benefits assuming that half of each year’s benefits are
realized at the beginning of the year and the other half at the end of the year.

NPV = -$740,000 + $137,500 + $137,500/(1,04) + $147,500/(1.04) +$147,500/(1.04)2+

$157,500/(1.04)² + $157,500/(1.04)³ -$81,000/(1.04)³ = $21,536

OR NPV= ($5,192+$37,880)/2 = $21,536

Exercise 3

e. Does the temporary bridge pass the net benefits test?

The present value of net benefits depends on when the benefits are assumed to accrue. In this case, they
accrue as various savings throughout the year, so either method is most appropriate, and the temporary
bridge passes the net benefits test.

Note that even more accurate methods of discounting would involve estimating the benefits on a monthly,
weekly, or even daily basis. Such refinement in the specification of the timing of benefits, however, would
usually amount to false precision, given uncertainties in their measurement and the appropriate social
discount rate.
Exercise 4
3. A town’s recreation department is trying to decide how to use a piece of land. One option is
to put up basketball courts with an expected life of 8 years. Another is to install a swimming
pool with an expected life of 24 years. The basketball courts would cost $180,000 to
construct and yield net benefits of $40,000 at the end of each of the 8 years. The swimming
pool would cost $2.25 million to construct and yield net benefits of $170,000 at the end of
each of the 24 years. Each project is assumed to have zero salvage value at the end of its life.
Using a real discount rate of 5 percent, which project offers larger net benefits?
Exercise 4

Consider first the NPV of each project separately:

NPV(one basketball court project)

8
40,000
= − $180,000 + ∑ = $78,529
i =1 (1 + 0.05) i

NPV(one swimming pool project)

24
170,000
= − $2,250,000 + ∑ i
= $95,769
i =1 (1 + 0.05)
If we choose on the basis of this comparison, then the swimming pool has a larger present value of net
benefits.
A proper comparison, however, would be between 1 swimming pool and 3 successive basketball court
projects so that the site is used in each case for the same length of time (24 years).
Exercise 4

NPV(three successive basketball court projects)

NPV = $78,529 + $78,529/(1,05)8 + $78,529/(1.05)16 = $167,655

Thus, three successive basketball court projects offer a higher present value of net benefits than the
swimming pool project. One should build the basketball court.
Exercise 4

An alternative approach for comparing these projects of different lengths is to divide each project’s NPV by
its appropriate annuity factor to find its equivalent annual net benefits, an approach called "amortization“.

The 8-year annuity factor = [1-(1.05)-8]/(0.05) = 6.463212759

Annualized NB for the basketball court = ($78,529)/6.463212759 = $12,150

The 24-year annuity factor = [1-(1+0.05)-24]/(0.05) = 13.79864179

Annualized NB for the swimming pool = ($95,769)/(13.79864179) = $6,940

The basket ball court project offers net benefits equivalent to an annuity paying $12,150 each year over its
life. The swimming pool offers net benefits equivalent to an annuity paying $6,940 each year over its life.
Spartacus case
a. Which Flemish stakeholders are involved in the tramway Hasselt-Maastricht project?

 Flemish Government, local governments and administrations, society, businesses, horeca, shops, students, etc

b. Describe the costs and the benefits for each of these stakeholders.

a. Flemish government:
• Costs: investment costs, operational costs
• Benefits: proceeds from ticket sales (as a proxy for value creation tram users), light
rail line horizon value
Local governments:
• Costs: investment costs
• Benefits: Tourism
Society:
• Costs: external effects of the tram line (noise, pollution?, collapse/demolitions of
properties)
• Benefits: increased opportunity to go shopping, eat out, cultural institutions, parks.
Businesses, restaurants, shops:
• Costs: ///
• Benefits: increased revenues