ECON211 Public Sector Economics

Part I: Government Intervention

Lecture 4: Cost and Benefit Analysis

Christine Ho
Singapore Management University

Unauthorized distribution of course materials is strictly forbidden.

“More than 11,000 scientists have declared a ‘climate emergency.’
One of the best things we can do, they say, is have fewer children…
Our food system overall – including farming and grazing, transportation,
packaging, and feed production – produces 37% of greenhouse-gas
emissions… having one less child is a more effective way of cutting
carbon use than recycling, driving an electric car, being vegetarian, or
using renewable energy…” Business Insider US, 05.11.2019.
 Outline

• Returns to Education • Merit good

• Costs and Benefits
• Measuring returns
• Government intervention
• Private CBA
• Social CBA
• Valuation methods

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 Returns to Education

• Merit good
• Measuring returns
• Non-monetary returns

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 Education in Singapore
• “Singapore will spend close to S$200 million a year on schemes to
increase support for education, Finance Minister Heng Swee Keat said
on Monday” Source: Singapore Budget 2018

“Parents queued
overnight outside of
Nanyang
Kindergarten to get
their one-year-
olds on the
waitlist for their pre-
nursery enrolment”
Straits Times

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 Education as a Merit Good
• Is education a pure public good?
• Non-Rival?
• Non-Excludable?

• Education generates a number of positive

externalities and is viewed as a merit good
• A merit good is a good that the
government believes individuals
should consume more of what they
currently consume because
individuals do not know better
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 Private Returns to Education
• Higher education makes a person more productive
• Knowledge and creativity
• Analytical skills and critical thinking
• Social and personality attributes

• Empirical evidence
• One additional year of schooling increases wages by 7%
(Acemoglu and Angrist, 1999)
• An economics degree increases wages by 8.7% (The
Economist, 2015)
Lecture 4 Evidence-Based Economics 8
Private “Returns” to SMU Education?
Overall Basic Salary
Degree Employment Mean Median
School of Business
Business 93.3% $3,862 $3,475
Cum Laude 95.8% $4,364 $3,880
School of Economics
Economics 91.3% $4,013 $3,600
Cum Laude 93.2% $4,591 $4,000
School of Social Sciences
Social Sciences 91.3% $3,344 $3,200
Cum Laude 87.9% $3,810 $3,600
Lecture 4 Evidence-Based Economics 8
How Much to Invest in Education?

Lecture 4 Heckman (2006) 11

 Measuring the Returns to Education
• Compare earnings of individuals with different
education levels
• Simple example
• Kate has no college degree
and earns $50,000 a year
• Sam has a college degree
and earns $75,000 a year
• Returns to a college degree:
$25,000 a year or 50%
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 What is a Regression?

Lecture 4 Khan Academy 13

 Ordinary Least Squares (OLS)
• Issue: There are many other factors that may
influence earnings
• E.g., age, gender, ethnicity, work experience, etc.

• Mincer wage regression

௜ ௜ ௜ ௜
• ln(W) is log of wages and S are years of schooling
• X denote a set of controls: age, gender, ethnicity etc.
• β captures the % increase in wages as a result of a 1 unit
increase in S
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Lecture 4 SMU Classification: Restricted 10
 Endogeneity Issues
• Remaining issue: Endogeneity Issues
• E.g., more motivated people get higher education and work harder
but motivation is unobserved

• Go back to the simple example with Kate and Sam

• Suppose that Sam has higher motivation than Kate so that Sam
studies harder and works harder than Kate
• Thus, the college degree does not necessarily cause Sam to earn
more than Kate
• Instead, Sam’s higher motivation drives both his higher education
and higher salary
• We do not observe motivation and cannot control for it
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 Difference-in-Differences (DID)
• Difference-in-differences analysis
• Natural experiment based on observational data
• Exploit a policy intervention and compare the change in outcomes
of a treatment group to that of a control group
• Both groups need to have similar pre-intervention trend

• Example
• Suppose that there are two groups: Northerners and Southerners
• Both groups have the same trends in earnings
• Suppose that the government introduces a policy that promotes
university performance in the North
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 Difference-in-Differences
Outcome
Treatment
Group
ଶ
Unobserved
Counterfactual
ଵ

Control
Group
ଵ

Pre-Intervention Post-Intervention
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 Difference-in-Differences
• T = 0 pre-intervention and T = 1 post-intervention
• G = 0 for control group and G = 1 for treatment group
• DID Regression
YGT =  + β0*G + β1*T + β2*G*T + GT
• DID coefficient
β2 = {E[Y11] - E[Y10]} – {E[Y01] - E[Y00]}
where E[Y11] =  + β0 + β1 + β2 E[Y10] =  + β0
E[Y01] =  + β1 E[Y00] = 
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 Productivity Externalities
• Education may increase coworkers
productivity (Acemoglu and Angrist, 1999;
Moretti, 2004; Rauch, 1993)
• Empirical strategy
• Exploit differences in schooling years and wages across states
• Exogenous policies: Child labor laws, compulsory school age

• Main results:
• General agreement that private returns ≈ 7%
• Mixed evidence that external returns≈ 0% to 5%

Lecture 4 Evidence-Based Economics 20

 Health and Risky Behaviour

• Improved health of individuals and their

children (Currie and Moretti, 2003, Chou
and al., 2010)

• Lower likelihood of engaging in risky

behavior such as smoking and heavy
drinking (Jensen and Lleras-Muney, 2013)

Lecture 4 Evidence-Based Economics 20

 Criminal Activity
• Lower criminal activity especially among Blacks (Lochner
and Moretti, 2004; Western and Wildeman, 2009)
 Policy Awareness and Filiality

• Increased awareness of policy debates

(Dee, 2004)

• Parents who spent more on children’s

education, receive higher instrumental
help from children, especially from
daughters in China (Ho, 2019)

Lecture 4 Evidence-Based Economics 22

 Government Intervention

• Legislation
• Public provision
• Education vouchers

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Lecture 4 SMU Classification: Restricted 25
Pr ice
Positive Externalities
S  PMC  SMC

DWL

*
Pmarket

EMB
SMB  PMB  EMB

underconsumption D  PMB
* *
Qmarket Qsocial Education
 Credit Market Failure
• Poor families may not be able to afford education for
their children if they are not allowed to borrow against
their children's future income
• If you were borrowing for
the purchase of a house, then
the house can serve as collateral
• But if you are borrowing to
pay for the education of your
children, you cannot use the
children as collateral
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 Paternalism and Equity
• Paternalism
• Parents may make inadequate
educational investments
• Not far sighted enough
• Not well-informed enough
• Not altruistic or patient enough

• Equal opportunities principle dictates that

everyone should have equal access to education
regardless of family wealth
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 Types of Intervention
• Compulsory schooling laws
• Minimum schooling days
• Mandatory schooling age
• Setting the curriculum

• Financial intervention
• Free public schooling
• Education subsidies
• Education loans
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 Free Public Schools
• Peltzman model
• Two types of schools
• Free public schools with fixed education quality
• Chargeable private schools with variable education quality

• Assumption: as parents spend more on education, the

better the quality

• Crowding-out
• Providing free public education can lower educational
attainment in terms of both quantity and quality
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Other Goods Public schooling leads
to higher education
b

a
BC Public

BCPr ivate
E free Education
Other Goods Public schooling
makes no difference

BC Public

BCPr ivate
E free Education
Other Goods Public schooling
crowds out education
e

BC Public

BCPr ivate
E free Education
 Class Exercise 1
• Suppose that Raj’s family has preferences over education x and all
other goods y
u  x, y   x y 2 3

• Raj’s family income is m=10 and prices are py=1 and px=2.
1. How much education would Raj’s family choose?
2. Suppose that the government introduces free public schooling of 1
unit. Families can either send their children to the free public school
or to private schools which offer varying degrees of education. How
much education would Raj’s family now choose?
3. If the free public schooling were financed by a lump sum tax equal to
the cost of public schooling and imposed only on families who use the
public school, how much education would Raj’s family now choose?
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Suggested Solution to Class Exercise 1
• Raj’s family utility maximization problem
max u  x, y   x y 2 3

s.t. 2 x  y  10
• Lagrangian
L  x y   10  2 x  y 
2 3

• First order conditions

x : 2 xy  2
3
 y  3x
y : 3x y  
2 2

• Substitute into the budget constraint to get x  2

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Suggested Solution to Class Exercise 1
• Without free public schooling, Raj’s family chooses

x  2 and y  6
yielding utility
u 2,6   2 6  864 2 3

• Suppose that with free public schooling, the family chooses to take
advantage of the free public schools and therefore consume one unit
of free education. This leaves income m=10 to be spent on other
goods. This option would yield utility
u 1,10   1 10  1000
2 3

• The family will choose to send Raj to public school since the latter
option yields the highest utility level  crowding out of education
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Other Goods Lump Sum Tax
BC Public
10
The family would choose
x=2 units of education
8 with a lump sum tax
BCTax

6
IC2

IC1

BCPr ivate
1 2 5 Education
 Education Vouchers
• Education vouchers are provided to pay for tuition at
any qualified school

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Other Goods Vouchers leads to
higher education
b

a e

d
f

BCVouchers
BCPr ivate
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Education
 Empirical Evidence on Vouchers
• USA - Milwaukee voucher program
• Targeting low income families
• Over-subscribed private schools admit students by lottery
• Rouse (1998) finds that vouchers help improve maths test scores

• Evidence in other countries

• Angrist and al (2002) find that vouchers in Columbia lead to a
lower probability of repeating a grade and to improved wages
• Neilson (2013) finds lower achievement gaps in Chile
• Muralidharan and Sundararaman (2015) find improvements in test
scores in India
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 School Accountability
• Rewarding or penalising teachers and administrators on the
basis of student exam performance
• Advantages
• Improvement in student test scores

• Disadvantages
• Schools and teachers may focus on teaching
purely for exam purposes rather than for
developing students critical thinking skills
• Teachers may set easier exams or inflate scores

• Does not take into account long-term effects of education

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 Cost-Benefit Analysis

• Private Costs and Benefits

• Social Costs and Benefits
• Valuation Methods

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 Cost-Benefit Analysis (CBA)
• Cost-Benefit Analysis consist of measuring costs
and benefits of public projects
• Monetarized costs and benefits
• Current e.g. setting up cost
• Future e.g. maintenance cost
• Non-monetarized costs and benefits
• Value of life
• Value of nature

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 Private Cost and Benefit Analysis
• Private firms investment decisions
1. Identify the set of possible alternatives
2. Identify the full consequences of each alternative
3. Assign a value to each input and output
4. Estimate profits
• Undertake the project with the highest positive profits

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 Private Discounting
• $1 today is worth more than $1 tomorrow
• E.g. if I put $1 in a bank today and earn interest of 10%
• In one year, I would earn $1.1 and in two years $1.21

• To compare the value of $1 received next year in

terms of today’s money, we discount it
• E.g. suppose that the interest rate is 10% i.e. r = 0.1
1
• $1 received next year is worth  $1  $0.91 today
1 r
1
•  is the one period discount factor
1 r
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 Present Discounted Value
• The net present discounted value (NPDV) of a project is the
sum of discounted benefits minus costs of the project in
present value terms
R1 R2 RT
NPDV  R0    ... 
1  r 1  r 2
1  r T

where Rt is the yearly net return of the project and T is the

final year of the project
• The benefit-cost ratio (BCR) is the ratio of the sum of
present value of benefits to the sum of present value of costs

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 Class Exercise 2
• Suppose that you make an investment of $100 and that the
investment yields a return of $30 per annum for 5 years.
Assume that the interest rate is 10%. What is the
1. Net present discounted value
2. Benefit-cost ratio
of the investment?

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Suggested Solution to Class Exercise 2
Year Benefits Costs DF DB DC NPDV
0 -100 1 -100
1
1 30 1 r
 0.909 27.27
2 30 1
1  r 2
 0.826 24.79
3 30 1
1  r 3
 0.751 22.54
1
4 30 1  r 4
 0.683 20.49
1
5 30 1  r 5
 0.621
18.62
13.71
5

 PV Benefits  113.71
BCR  t 0
5
  1.137
100
 PV Costs 
t 0
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 Social Cost-Benefit Analysis
• Social cost-benefit analysis takes into account a
wider range of impacts and not just profits
• These may include
• Monetarized costs and benefits
• Non-monetarized costs and benefits
• Impacts on future generations

• Projects whose social benefits exceed social costs are

worth undertaking
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 Valuing Time
• Market-based measure: wage rate
• In a perfectly competitive labor market where individuals
can choose hours of work and leisure, the wage is the right
measure of time
• However, markets are not perfect so that the wage rate
may not be the right measure of time
• Involuntary unemployment
• Fixed work contracts
• Non-monetary aspect of the job
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 Valuing Time cont’d
• Survey-based measure: contingent valuation
• Asking individuals to value an option that they have not
chosen yet

• Revealed preference measure

• Letting the actions of the individuals reveal their
valuation
• E.g. if individuals choose to pay more to live closer to their
place of work, the difference in rent would reflect the value of
commuting time assuming that the two homes are identical
except for commuting time
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Pinto Madness Case Study
1971 Ford Pinto
“They shoot horses, don't they? Well, this is
fish in a barrel. Of course the Pinto goes on
the Worst list, but not because it was a
particularly bad car — not particularly —
but because it had a rather volatile nature.
The car tended to erupt in flame in rear-end
collisions. The Pinto is at the end of one of
autodom's most notorious paper trails, the
Ford Pinto memo, which ruthlessly
calculates the cost of reinforcing the rear
end ($121 million) versus the potential
payout to victims ($50 million).
Conclusion? Let 'em burn.”
Source: The 50 Worst Cars of All Time. Time Magazine
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 Valuing Life
• It is tempting to say that the value of a life is infinite
• But as economists, we know that scarcity of
resources prevents us from devoting all of our
resources to safety only
• Market-based constructive measure: wage rate
• Estimate what the individual would have earned had
he/she remained alive
• Method fails to distinguish between the value of life and
livelihood
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 Valuing Life cont’d
• Survey-based measure: contingent valuation
• E.g. asking individuals how much they more would be
willing to pay to purchase a less risky car that would
decrease the probability of death by 1%

• Revealed preference measure

• Based on the observed actions of individuals

• Estimate how much extra income an individual requires

to compensate him/her for an increase in the probability of
death as reflected by the individual choosing a riskier job
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 Class Exercise 3
• Compensating differentials are higher salaries paid for jobs
with greater danger or disutility
• Consider the following scenario:
• A job in a coal mine offers a salary of $50,000. There is a
probability of 0.5% of death.
• A safe job in a clothing factory offers a salary of $20,000.
• Calculate the value of one human life based on the above.

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Suggested Solution to Class Exercise 3
• Salary in risky job = Probability (safe) x Salary in safe job
+ Probability (dead) x Death benefit

50,000 = 0.995 x 20,000 + 0.005 x Death benefit

Death benefit = $6,020,000

• The value of a human life is $6,020,000.

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 Valuing the Environment
• Survey-based measure: contingent valuation
• Individuals are asked how much they value the
preservation of endangered species
• Issues with survey-based measure

• Isolation of issues matters

• Order of issues matters
• The “embedding effect” matters

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 Common Mistakes in CBA
• Counting secondary benefits
• E.g. increased trade along a newly improved motorway would also
imply decreased trade elsewhere

• Counting labor as a benefit

• E.g. a project that “creates employment” might not be employing
only previously unemployed workers but taking away workers from
other jobs

• Double counting benefits

• E.g. newly improved farming land would increase both annual
return and its price but price increased because annual return
increased
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 Other Issues in CBA
• Distributional concerns
• Some policies may benefit a group of
people while being detrimental to others
• There may be scope for redistribution
from one group to another
• E.g. En-bloc sales favor the majority

• Uncertainty
• Risk averse individuals prefer projects
with certain outcomes as opposed to
uncertain outcomes

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 Class Exercise 4
• Bill rides the subway at a cost of 75 cents per trip but would switch if
the price were any higher. His only alternative is a bus that takes 5
minutes longer, but costs only 50 cents. He makes 10 trips per year.
The city is considering renovations of the subway system that would
reduce the trip by 10 minutes, but fares would rise by 40 cents per trip
to cover the costs. The fare increase and reduced travel time both take
effect in one year and last forever. The interest rate is 25%.
1. As far as Bill is concerned, what are the present values of the
project’s benefits and costs?
2. The city’s population consists of 55,000 middle class people, all of
whom are identical to Bill, and 5,000 poor people.

Lecture 4 [RG] Chapter 8 Ex 5 62

 Class Exercise 4 cont’d
Poor people are either unemployed or have jobs close to their homes,
so they do not use any form of public transportation. What are the
total benefits and costs of the project for the city as a whole? What is
the net present value of the project?
3. Some members of the city council propose an alternative project that
consists of an immediate tax of $1.25 per middle class person to
provide “free” legal services for the poor in both of the following
two years. The legal services are valued by the poor at a total of
$62,500 per year. (Assume that this amount is received at the end of
each of the two years.) What is the net present value of the project?
4. If the city must choose between the subway project and the legal
services project, which should it select?

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Suggested Solution to Class Exercise 4
1. PV(Benefits) = $20 and PV(Costs) = $16
• Bill values 5 minutes at 25 cents  10 minutes at 50 cents
• In one year, Bill travels 10 times, so that the time saved would be
worth $5 per year while the annual extra cost would be $4 per year

5 5 5
PV Benefits      ...  20
1  r 1  r  1  r 
2 3

4 4 4
PV Costs      ...  16
1  r 1  r  1  r 
2 3

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Suggested Solution to Class Exercise 4
2. PV(Benefits) = $20 X 55,000 = $1,100,000
PV(Costs) = $16 X 55,000 = $880,000
NPDV = PV(Benefits) – PV(Costs) = $220,000
3. PV(Costs) = $1.25 x 55,000 = $68,750
62500 62500
PV Benefits     $90,000
1 r 1  r 2

NPDV = PV(Benefits) – PV(Costs) = $21,250

4. If a dollar value to the poor is valued the same as a dollar value to the
middle class, the subway project should be undertaken since it yields
the highest net present discounted value

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 Take Home

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 Main Lessons
• Education is a merit good that generates positive externalities
• Publicly provided education may crowd out educational attainment
• Empirical evidence suggests that education vouchers increase
educational attainment
• Measuring the returns to education can be tricky
• The social marginal cost of a good or service is it's opportunity cost
• Measuring non-pecuniary costs and benefits
• Market-based measure
• Survey-based measure
• Revealed preference measure
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 Next
• Required readings: [RG] Ch: 7, 8
• Review, read, and write down your own notes
• Reinforce and check your understanding are important early on
• A good exercise is to draw graphs and do the mathematical
derivations on your own, and write down explanations in your own
words complemented with the required readings.

• Next Lecture: Social Insurance Theory

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