Economic Analysis in the Public

Sector

Benefit/Cost Analysis
 Introduction
• Public investment decisions involve a great deal of
expenditure, and their benefits are expected to
occur over an extended period of time
• Examples of public sector investment projects are
– public transportation systems,
– environmental regulations
– flood control programs
• Decision criteria is whether the project is in the
best public interest

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Economic Analyses Tools
Benefit/Cost analysis
– to maximize benefits for a given set of costs
– to maximize net benefits when both benefits and
costs vary
Risk-Benefit analysis
– to incorporate the risk in the benefit/cost
Cost-effectiveness analysis
– to minimize costs to achieve a certain level of
benefits

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Benefit-Cost Analysis
• Benefit-cost analysis is commonly used to
evaluate public projects.
• Benefits of a nonmonetary nature can be
quantified and factored into the analysis.
• A broad range of project users distinct from
the sponsor should be considered—benefits
and dis-benefits to all these users can (and
should) be taken into account

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Benefit/Cost Analysis Procedure
1. Identifying all the users and sponsors of the
project
2. Identify all users’ benefits expected to arise from the
project.
3. Quantify, as much as possible, these benefits in
Rupees (…or some unit of measure)
4. Identify and quantify sponsor’s costs
5. Determine study period and interest rate(at which to
discount benefits and costs to a present value)
6. Compute the benefit/cost ratio

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Benefit-Cost Ratio Criterion

Equivalent Users' Net Benefits

Benefit - Cost Ratio =
Equivalent Sponsor' s Net Cost

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 1
• State of Michigan is considering a ban on the use of
salt on highways. An alternative de-icer is sold for
$600/ton. Salt costs $14/ton.
• 2010 was a typical winter. Michigan
– spent $9.2 million on salt (=> used 657,143 tons)
– estimated
» $427 million of highway corrosion damage,
» $525 million of rust damage to vehicles,
» $98.5 million of corrosion damage to utility lines,
» $6.5 million of water supply damage
– a total of $1057 million damage due to salt

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 1 (cont’d)
• Complete ban from salt in favor of the chemical de-
icer yields
– Direct User benefits /year = $1057 million
– Direct Sponsor costs/year = ($600-$14) 657,143
= 385 million
• Yearly Benefit/Cost Ratio
– User benefits / Sponsor costs = 1057/385 = 2.75 > 1
• Indirect Benefits/Costs:
– Higher state income tax
– Unknown environmental changes
– Unknown effects of the chemical de-icer

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Selecting an Interest Rate
• When projects span multiple years, you need an
interest rate to factor in the time value of money
• In the public sector, this rate is called social discount
rate (or discount rate)
For projects without private counterparts,
– social discount rate should reflect only the public
organization's borrowing rate
For projects with private counterparts,
– social discount rate should represent the rate that could have
been earned had funds not been removed from the private
sector

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 NPW Benefit/Cost Ratio
• Given bn = benefit at time n, n = 1, ..., N
cn = expense at time n, n = 0, ..., N
i = discount rate
K = initial investment period, b n =0 for n=1, .., K
• Benefits versus Costs N
– NPW of benefits = B bn (1 i ) n

n 0 bn 0
N
– NPW of costs = C cn (1 i ) n cn 0
n 0

• Investment versus Recurring Costs

K
– Investment = I = n=0
cn(1+i) -n
N -n
– Recurring Costs = C’ = n=K+1
cn (1+i) , C = I + C’

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Investment versus Recurring Costs

K
I cn (1 i ) n Equivalent capital investment
n 0
N
C' cn (1 i ) n Equivalent O&M costs
n K 1

B B
BC(i ) , I C' 0
C I C'

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Ratios
• Benefit/Cost Ratio = B/C = B / (I+C’)
– Accept when this ratio is greater than 1
• Modified (Net) Benefit/Cost Ratio = (B - C’)/I
– Accept when this ratio is greater than 1
• Notes:
– B/C > 1 if and only if (B-C’)/I > 1 so the decision rule does
not change. The value of the ratio itself might change.
– B/(I+C’) > 1 if and only if NPW > 0
– You can also perform the same analysis with NAW

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 2: Power Plant Design
• Suppose the building of a 5,000-kwh power plant is being
considered. The plant would only be used at 50% of capacity.
The rest of the capacity would be lost. This would require a $5
million investment. O/M costs are estimated at $75,000 per year.
Electricity is worth $0.05/kwh. Economic life is 35 years.
Discount rate is 8%.
• NAW of Benefits =
(24hrs/day)(365 days/yr)(5,000 kw/hr)($0.05/kwh)(0.5) =
$1,095,000/yr
• NAW of Costs =
$5,000,000(A/P, 8%,35) + $75,000 = $504,016
• B/C = 1,095,000/504,016 = 2.17
• Modified B/C = (1,095,000 - 75,000)/429,016 = 2.38

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 3: Three Alternative Designs
Generator Alternative
A B C D
1,000 kw 3,000 kw 4,000 kw 5,000 kw
Investment ($000) 3,000 4,000 4,500 5,000
Annual O&M Costs 45 60 67.5 75
($000)
Load factor (%) 70 75 60 50

NAW of Inv., I $257,410 $343,213 $386,115 $429,016

Annual O&M, C’ $45,000 $60,000 $67,500 $75,000
Annual Benefit, B $306,600 $854,100 $1,051,200 $1,095,000

B/(I+C’) 1.01 2.44 2.32 2.17

(B- C’)/I 1.02 2.70 2.55 2.38

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Incremental Benefit/Cost Analysis
• When mutually exclusive alternatives exist, each
additional increase in investment should be justified
based on
– the additional benefits
– the additional costs, and
– the discount rate.
• Perform Incremental Analysis
Step 1: Ignore projects with B/C < 1
Step 2: Rank projects in increasing order of investment
Step 3: Calculate the B/C ratio of the difference between the
current alternative and the next alternative in rank order

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 3 (cont’d)
Incremental Analysis
A B C D
1,000 kw 3,000 kw 4,000 kw 5,000 kw
NAW of Inv., I $257,410 $343,213 $386,115 $429,016
Annual O&M, C’ $45,000 $60,000 $67,500 $75,000
Annual Benefit, B $306,600 $985,550 $1,051,200 $1,095,000

Incremental Analysis
B-A C-B D-C
I $85,803 $42,902 42,901
C’ $15,000 $7,500 $7,500
B $679,950 $65,650 $43,800

B/(I+C’) 6.73 1.30 0.87

Modified: (B-C’)/I 7.74 1.36 0.85

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Risk-Benefit Analysis
• Economic impact of a variety of public
projects can be differently affected by risk.
• The extension of the benefit/cost analysis to
include public -sector risk situations is called
risk-benefit analysis.
• Instead of using annual costs, we use expected
annual costs.

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Cost-Effectiveness Analysis
• Combines non-monetary factors (effectiveness) and
monetary aspects (costs)
• Three conditions where cost-effectiveness analysis is
trivial:
– effectiveness of all alternatives is the same, so rank by
decreasing costs
– costs for all alternatives are equal, so rank by decreasing
effectiveness
– For any pair of alternatives, if both the cost and
effectiveness of one dominate the other, then eliminate the
dominated alternative

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Cost-Effectiveness Analysis Procedure
1. Establish goals to be achieved by the projects
2. Identify constraints on achieving goal, such as
budget, capacity
3. Identify all alternatives
4. Determine interest rate
5. Determining life-cycle cost of each alternative
6. Use incremental analysis to choose the best
alternative

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 4
• Three ways to construct an accident barrier on a
densely populated highway are considered.
• The goal is to reduce the number of head-on
collisions. Construction and maintenance costs
therefore have to be weighed against accident rates.
• The study period is 10 years.
• The interest (discount) rate is 6%

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 4 (cont’d)
Alternative
Concrete Wire-mesh Landscaped
Barrier Barrier Median
Barrier
(a) Investment $1,110,000 $680,000 $540,000
(b) Annual $30,000 $40,000 $20,000
Maintenance Costs
(c) Total Annual Costs $180,816 $122,392 $103,370
(a) (P/A, 6%,10)+(b)
(d) Annual Reduction 85 63 41
in Accidents
Cost/Effectiveness $2127/ $1943/ $2521/
accident accident accident

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Example 4 (cont’d)
• Suppose you need at least a reduction of 50 accidents
per year,
then you will select the best alternative among:
– the wire-mesh barrier with $/accident = 1943
– the concrete barrier with $/accident = 2127

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Economic Analysis in the Public Sector

• Framework of
Benefit- Cost
Analysis
• Valuation of
Benefits and Costs
• Benefit-Cost Ratios
• Analysis of Public
Projects Based on
Cost-Effectiveness

HU 501/Economics for Engineers /Prof. Aditi Ghosh

Example 1 BC Analysis

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 B = $20( P / F, 10%, 2) + $30( P / F, 1%, 3)
+$30( P / F, 10%, 4) + $20( P / F, 10%, 5)
= $71.98

C = $10 + $10( P / F, 10%, 1) + $5( P / F, 10%, 2) + $5( P / F, 10%, 3)

+ $8( P / F, 10%, 4) + $8( P / F, 10%, 5)
= $37.41
I = $10 + $10( P / F, 10%, 1)
= $19.09
C’ = C – I
= $18.3
71.98
BC(10%) 1.92 1, Accept the project.
$19.09 $18.32

HU 501/Economics for Engineers /Prof. Aditi Ghosh

Relationship between B/C Ratio & NPW

B
1
I C'

B > (I + C’)

B – (I+ C’) > 0

PW(i) = B – C > 0

HU 501/Economics for Engineers /Prof. Aditi Ghosh

Incremental Analysis Based on BC(i)

B Bk Bj
I Ik IJ
C' C' k C' j

B
BC(i ) k j
I C'

HU 501/Economics for Engineers /Prof. Aditi Ghosh

Example 2 Incremental Benefit-Cost Ratios

A1 A2 A3

I $5,000 $20,000 $14,000

B 12,000 35,000 21,000

C’ 4,000 8,000 1,000

PW(i) $3,000 $7,000 $6,000

HU 501/Economics for Engineers /Prof. Aditi Ghosh

Solution
A1 A2 A3
BC(i) 1.33 1.25 1.40

Ranking Base A1 A3 A2
I +C’ $9,000 $15,000 $28,000

$21,000 $12,000
BC(i )2 1
($14,000 $5,000) ($1,000 $4,000)
1.5 1, select A2.
$35,000 $21,000
BC(i )2 3
($20,000 $14,000) ($8,000 $1,000)
1.08 1, select A2.

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 General Procedure for Cost-Effectiveness Studies

• Step 1: Establish the goals to be achieved by the

analysis.
• Step 2: Identify the imposed restrictions on achieving
the goals, such as budget or weight.
• Step 3: Identify all the feasible alternatives to achieve
the goals.
• Step 4: Identify the social interest rate to use in the
analysis.
• Step 5: Determine the equivalent life-cycle cost of each
alternative, including research and development,
testing, capital investment, annual operating and
maintenance costs, and salvage value.

HU 501/Economics for Engineers /Prof. Aditi Ghosh

• Step 6: Determine the basis for developing the cost-
effectiveness index. Two approaches may be used;
– (1) the fixed-cost approach and
– (2) the fixed-effectiveness approach.
– If the fixed-cost approach is used, determine the
amount of effectiveness obtained at a given cost.
– If the fixed-effectiveness approach is used,
determine the cost to obtain the predetermined
level of effectiveness.
• Step 7: Compute the cost-effectiveness ratio for each
alternative based on the selected criterion in Step 6.
• Step 8: Select the alternative with the maximum cost-
effective index.

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Cost-Effectiveness Decision Criterion
• Fixed Cost Approach • Fixed Effectiveness
Approach

Maximize Effectiveness Minimize Cost

Subject to: Subject to:

Budget Constraint Must meet the

Minimum effectiveness

HU 501/Economics for Engineers /Prof. Aditi Ghosh

Case Study - Selecting an
Weapon System

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Weapon System Alternatives

Alternative Aj Advantage Disadvantage Probability

of Kill
A1: Inertial navigation Low cost, mature Accuracy, target 0.33
system technology. recognition
A2: Inertial navigation Moderate cost, nature Target recognition 0.70
system: Global technology
positioning system
A3: Imaging infrared Accurate, target High cost, bunkered 0.90
(I2R) recognition target detection
A4: Synthetic aperture Accurate, target High cost 0.99
radar recognition
A5: Laser Accurate, target High cost, technical 0.99
detection/ranging recognition maturity
A6: Millimeter wave Moderate cost, Target recognition 0.80
(MMW) accurate

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Life-Cycle Costs for Weapon Development
Alternative
Expenditures in Million Dollars
Phase Year A1* A2 A3 A4 A5 A6
0 $15 $19 $50 $40 $75 $28
FSD 1 18 23 65 45 75 32
2 19 22 65 45 75 33
3 15 17 50 40 75 27
4 90 140 200 200 300 150
5 95 150 270 250 360 180
IOC 6 95 160 280 275 370 200
7 90 150 250 275 340 200
8 80 140 200 200 330 170
PW(10%) $315.92 $492.22 $884.27 $829.64 $1,227.23 $612.70

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Cost-Effectiveness Index
Type Cost/Unit Probability Cost/Kill Kill/Cost
of Kill
A1 $31,592 0.33 $95,733 0.0000104

A2 49,220 0.70 70,314 0.0000142

A3 88,427 0.90 98,252 0.0000102

A4 82,964 0.90 83,802 0.0000119

A5 122,723 0.99 123,963 0.0000081

A6 61,370 0.80 76,713 0.0000130

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 $130,000 Unacceptable
region A5

120,000

110,000
Cost/kill

Fixed cost
100,000
A1 A3
90,000
Maximize
effectiveness A4
80,000
A6
A2
70,000
300 400 500 600 700 800 900 1000 1100 1200 1300
Present value of life cycle cost ($ million)

HU 501/Economics for Engineers /Prof. Aditi Ghosh

 Summary
• Benefit-cost analysis is commonly used to evaluate
public projects:
• Difficulties involved in public project analysis
include the following:
1) Identifying all the users who can benefit from
the project.
2) Identifying all the benefits and disbenefits of the
project.
3) Quantifying all benefits and disbenefits in
dollars or some other unit of measure.
4) Selecting an appropriate interest rate at which to
discount benefits and costs to a present value.

HU 501/Economics for Engineers /Prof. Aditi Ghosh

• The B/C ratio is defined as:

B B
BC(i ) ,I C' 0
C I C'

The decision rule is if BC(i) > 1, the project is

acceptable.
• The net B/C ratio is defined as
B C ' B'
B / C(i ) ,I 0
I I'
The net B/C ratio expresses the net benefit expected
per dollar invested. The same decision rule applies
as for the B/C ratio.

HU 501/Economics for Engineers /Prof. Aditi Ghosh

• The cost-effectiveness method allows us to
compare projects on the basis of cost and
nonmonetary effectiveness measures.
• We may either maximize effectiveness for a
given cost criterion or minimize cost for a
given effectiveness criterion.

HU 501/Economics for Engineers /Prof. Aditi Ghosh