ECO4003 Public Economics

Topic 7
Cost and Benefit Analysis of Public Projects

Reading: Ch.8
。
 Cost–Benefit Analysis: Definition

 Cost–benefit analysis: The comparison of costs and

benefits of public goods projects to decide if they should
be undertaken.
 Cost–benefit analysis is widely used to evaluate potential
public programs and projects.
 Attention: We assess the cost and benefit of a project for

the society, not the government. c

ociety
s

,
publcc privale
( goremmnt)
( household ,

fims
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一
。一
Cost and Benefit for The Society (1)

 We assess the cost and benefit of a project for the

society, not the government.

 How to understand this?
 Suppose the government employ a worker to build a
highway (public good).
 Consider the following two scenarios.

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Cost and Benefit for The Society (2)

Case 1
 The market equilibrium wage for all jobs is $10 per hour.
 The government pays $10 per hour to hire a worker to
build a highway (public good).
 What is the cost of the public good for the society as a
whole?

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Cost and Benefit for The Society (3)

Case 1 (continue)
 What is the cost of the public good for the society as a
whole?
 If the worker is hired by the government, the worker gives
up $10 per hour which she can learn from other jobs.
 The society as a whole losses $10 per hour and $10 per
hour is the cost of the public good for the society.
 How about the $10 wage paid by the government?

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Cost and Benefit for The Society (4)

Case 1 (continue)
 How about the $10 wage paid by the government?
 The wage paid by the government is NOT the cost of the
public good for the society. Why?
 The government and the worker are parts of the
society.
 When the government pays $10 to the worker, does the
society lose anything? No.
 Therefore, the cost of the public good for the society
accounts for the opportunity cost only.
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Cost and Benefit for The Society (5)

Case 2
 The market equilibrium wage for all workers is $10 per
hour.
 0
The government pays $20 per hour to hire a worker to
build the highway.
 What is the cost of the public good for the society as a
=

0
whole?
still $

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Cost and Benefit for The Society (6)

Case 2 (continue)
 What is the cost of the public good for the society as a
whole?
 The cost of the public good for the society is still $10 per
hour because it is the opportunity cost.
 How about the $20 wage paid by the government?
 It is just a cash transfer from a member of the society
(government) to another member. The society as a whole
does not lose the $20 wage.

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 Measuring the Costs of Public Projects: Building Highway

 Suppose you are asked to calculate the costs and benefits for a public
project – building highway. You create the following table.
 What are the costs and benefits of the project? In the first year? Over
time?
Quantity Price/Value Total
Costs Materials 1 million bags
Labor 1 million hours
Maintenance $10 million/year
First-year cost:
Total cost over time:
Benefits
Driving time saved 500,000 hours/year
Lives saved 5 lives/year
First-year benefit:
Total benefit over time:
Benefit over time minus
cost over time:
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。一一一一一
 Labor Cost (1)

 Suppose that the minimum wage of construction jobs is $20 per

hour.
 The government has to pay $20 per hour to hire workers to
build the highway.
 The market wage is $10 per hour for all other jobs.
 Assume that if the workers are not hired by the government,

∞θ c
they will perform other jobs and receive $10 per hour.
 The labor cost of the project (for the society) is the opportunity
→

cost of the workers, $10 per hour.

 (Again, the $20 wage paid by the government is just a cash
transfer among society members)
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。
Filling The Costs

Assume the opportunity cost for materials is $100/bag.

Quantity Price/Value Total

Costs Materials 1 million bags $100/bag $100 million
Labor 1 million hours $10/hour $10 million

⑧
Maintenance $10 million/year
First-year cost:
Total cost over time:
Benefits
Driving time saved 500,000 hours/year
Lives saved 5 lives/year
First-year benefit:
Total benefit over
time:
Benefit over time
minus cost over time:
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 Maintenance Cost: Present Value

 The (expected) maintenance cost is $10 million/year.

 Assume the highway can be used forever.
 We should calculate the prevent value of the maintenance cost

yrXXX
" 3 Ass ume we slat
10 10
10 f + +⋯
1 + 𝑟 (1 + 𝑟) 址 maintenanc
fromthe
-

 PV formula for infinite time horizon is:

𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 10 zndy ed

𝑃𝑉 = =
𝑟 𝑟
 Note that the discount rate for a public project is called the social
discount rate.
时

 冒
Assume that the social discount rate is 7%.

PV of the maintenance cost is

8 .
≈ 143
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口。
 Filling in Costs
𝐹 10
𝑃𝑉 = = ≈ 143
𝑟 0.07

0
Quantity Price/Value Total
Costs Materials 1 million bags $100/bag $100 millionv
Labor 1 million hours $10/hour $10 million
Maintenance $10 million/year 7% discount rate $143 million
First-year cost: $110 million
Total cost over time:
时
$253 million

⑥ Benefits Driving time saved

Lives saved
500,000 hours/year
5 lives/year
First-year benefit:
Total benefit over time:
Benefit over time minus
cost over time:

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一
一一
Valuing Driving Time Saved (1)

 How to measure the value of time?

 One approach is to use hourly wage.
 A driver with an hourly wage of $10 saved 1 hour by
using the highway.
 The value driving time saved = $10.
 Some problems in practice:
 Wage is monetary value. Nonmonetary aspects of the
job is not counted.
 People may not spend the saved time to work.
-

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Valuing Driving Time Saved (2)

 An alternative approach is contingent valuation.

 Contingent valuation: Asking individuals, for example,
how much would you pay to save five minutes on your
drive?
 Some problems in practice:
 Changing the structure of contingent valuation surveys
can lead to widely different responses.
 Examples on the next slide.

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 Valuing Driving Time Saved (3)

①How much would you be willing to pay to save five minutes on

⑥

sieone
your drive each day?
 Respondents might think about the convenience and time
时

savings.
 Reduced stress, more leisure time, or increased productivity.
② How much compensation would you require to0
0
endure an
additional five minutes on your daily drive? 忍受
 Respondents might focus on the negative aspects of a
—

longer commute.
 时
Inconvenience, increased fuel costs, or reduced leisure time

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一
。
一。。。
一
 Valuing Driving Time Saved (4)

 An alternative to contingent valuation is to use revealed

preference.
 Revealed preference: Letting the actions of individuals
reveal their valuation.
 Housing prices in CBD are higher than non-CBD  might
reflect the value of commuting time.
 Some problems in practice:
 Difference in housing price may not purely due to
commuting time, e.g., better view.

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。。一
Valuing Saved Live: GM Case (1)

 We must value a life if we want to compare which

⑤
project/option to fund.
 Real world example:
 Some General Motors pickup trucks produced between
1973 and 1987 had a dangerous gas tank.
 1993: Consumer groups demanded GM recall five
models. $1000 Wp
&

lives.
时
Recall would cost $1 billion and would save at most⑧
32

 The cost per life saved would be 时

$31.25m.
←

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 Valuing Saved Live: GM Case (2)

 Alternatively, GM proposed to provide $50m to buy child

←

safety seats for low-income families, promoting safety

drive, etc.
 The safety seats alone were estimated to save 50 lives.
 O
The cost per life saved would be $1m
 GM reached aA
settlement with the government.
←

cost lifesaved

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小
。
 APPLICATION: Valuing Life: Covid-19

 In 2020, governments faced a trade-off between limiting harm of

disease and slowing the economy.
 Let’s compare the following policies in terms of life saved.

[
 Aggressive testing cost $6 million per 100,000 people
but estimated to have prevented 14 deaths (Cutler and
Summers, 2020)  cost per life saved = $0.43m.
 Social distancing measures cost the US $7.2 trillion in
foregone economic output, but saved 1.24 million lives, for
estimated cost of $5.8 million per life saved (Thunstrom et
al., 2020).

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一一。
How to value saved lives? (1)

 In general, how to value saved lives?

 Lifetime Wages
 Life’s value is the present discounted value of the
lifetime stream of earnings.
 Contingent Valuation
 Ask individuals what their lives are worth.
 Revealed Preferences
 Estimate the extra cost that consumers pay for a
product that reduces the risk of death.

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How to value saved lives? (2)

 Compensating differentials: Additional wage payments

曲

to compensate workers for the negative amenities of a job,

such as increased risk of mortality.
X7 8 .

 This approach suggests value of life of $10.5 million.

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Discounting Future Benefits

 After determining the value of time and life in each year,

we must discount these future benefit.
 Choosing the proper discount rate is difficult.
 Since many projects have benefits that last long into the
future, the discount rate matters a lot. 7
 High discount rate  benefit will die out quickly.
→

 Reducing global warming will bring benefits hundreds

of years into the future.

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 Putting It All Together

Quantity Price/Value Total

Costs Asphalt 1 million bags $100/bag $100 million
Labor 1 million hours $10/hour $10 million
Maintenance $10 million/year 7% discount rate $143 million
First-year cost: $110 million
Total cost over time (7% $253 million
discount rate):
Benefits
Driving time saved 500,000 hours/year $22.70/hour $11.4 million
Lives saved 5 lives/year $10.5 million/life $52.5 million
First-year benefit: $63.9 million
Total benefit over time (7% $912.9 million
discount rate):
Benefit over time minus $659.9 million
⇌
cost over time:

𝐹 63.9
𝑃𝑉 = = ≈ 912.9
𝑟 0.07
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。。
 Simple Question
→

City A is considering whether to build a new public swimming pool. This pool
would have a capacity of 900 swimmers per day, and the proposed admission
fee is $6 per swimmer per day. The estimated cost of the swimming pool,
averaged over the life of the pool, is $4 per swimmer per day.
City A has hired you to assess this project. Fortunately, the neighboring
identical town already has a pool, and the town has randomly varied the price
of that pool to find how price affects usage. The results from their study follow:
Swimming pool price per day Number of swimmers per day

12 0

10 300

8 600

6 900

4 1200

2 1500
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Simple Question

A. If the swimming pool is built as planned, what would be the

profit per day from the swimming pool? What is the
consumer surplus for swimmers?
B. Is a 900-swimmer pool the optimally sized pool for City A
to build? Explain.

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 Simple Question: Answers
( Profit )
A. If the swimming pool is built as planned, what would be the net benefit
per day from the swimming pool? What is the consumer surplus for
swimmers? pricecost
—
The profit is ($6 - $4) x 900 = $1,800
~ Q
We can draw the demand curve to find the consumer surplus.
The proposed admission fee is $6 per swimmer  P = $6
When P = 6, Q = 900.
When Q = 0, P = 12. 12
CS = (6 x 900)/2 =-
2700
{ 6
CS

profit
price
4 µ c

Goo 900
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。
一
 Simple Question: Answers

B. Is a 900-swimmer pool the optimally sized pool for City A to build?

庶 -

Explain.
←
The competitive equilibrium is the social optimum, where P = MC.
时

MC is $4 according to the question.

MC < P  It is not the social optimum.
The government should set P = $4 to achieve the social optimum.
This implies to build a1200-swimmer pool.

12

CS
6
4

900
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END

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