Lecture 6

Valuation of Non-Market Goods: Cost-Benefit Analysis

We looked at: Is there a motive for governmental intervention? Now we ask: Is the benefit of the intervention covering its costs?
Should the government : Build a road? If yes, how many kilometers of road? Increase minimum requirements for car safety? Extend the London underground system? Ban hunting with dogs in England and Wales? The government needs an evaluation procedure

Private Cost-Benefit Analysis

Before we analyse public project evaluation, let us understand how private firms evaluate projects
Identify the set of alternative projects Identify the full consequences of each alternative: inputs required, quality of output, quantity of byproducts (waste) Estimate costs of inputs over the lifetime of the project and costs of waste disposal and price of output Sum up the costs and benefits to estimate total profitability: Choose project with highest positive profits after properly accounting for the opportunity costs

Private Discounted Value

The benefits and costs of a project are spread over an extended period of time How are the costs and benefits that accrue at different time periods evaluated? Is 1 today the same with 1 in 10 years from now? Cost-benefit analysis starts from the premise that 1 today is more valuable than 1 tomorrow Suppose banks offer a 10% interest rate on deposits: then 1 today is equivalent to 1+[(10/100)X1]=1.10 one year from now If the interest rate does not change, and we put 1.10 in the bank next year, we will have 1.10+[(10/100)X1.10]=1.21 in two years from now If we keep calculating this way (at a constant interest rate of 10%) we find that 1 today equals 2.59 in 10 years from now

Private Discounted Value

If money today is not the same with money tomorrow we need to choose a benchmark to make the comparison: we can evaluate money from todays perspective Our previous calculation indicates that with an interest rate of 10% - 1.21 tomorrow equals 1 today and 2.59 in 10 years is equal to 1 today Looks like we need to multiply money tomorrow by something less than 1 to obtain their value today: we multiply by a discount factor Using our previous calculation, we can see that 1 next year is equal to

1 1 0.9 today, where r is the interest rate 1 r 1 10 100

Private Discounted Value

Likewise, we can see that 1 in two years is equal to
1 today 0 . 82 2 2 10 (1 r ) (1 ) 100 A project would run for several years and in each there would be money to be paid out and money to be received Let Rn be the net amount received from the project in year n, where n=0,1, 2 ....N for a project which runs for N years Year 0 corresponds to today (or the current period) and is used as the benchmark: we assess the project from the perspective of year 0

Private Discounted Value

Then, the present discounted value of the project (PDV) is given by

Rt RN R1 R2 PDV R0 ... .... 2 t 1 r (1 r ) (1 r ) (1 r ) N

where r is the interest rate.
Notice that there is a difference between PDV and the sum of the undiscounted net gains from the project This will partcularly larger for long-lived projects, where the benefits occur later in time while the costs occur early on

Social cost-benefit analysis

Same procedure with some differences:
A private project is evaluated from the perspective of the firm (profit maximization), whereas a public project needs to consider other factors such as environmental impact or impact on groups whose interests are not directly linked to the project A public project might need to evaluate non-market goods (e.g., time, human lives, clean air, endangered species) for which there is no market price A public project might need to use prices which reflect the market failures when the actual market prices do not reflect the social benefits or costs

Social cost-benefit analysis

For a project to be undertaken, the benefit should exceed the cost (B>C) which is equivalent with having a ration of benefits to costs higher than one (B/C>1) Total benefit includes consumer surplus When choosing between alternative projects, the government should choose the one with highest net benefit and not with the highest ratio of benefit to cost. Recall bridge example from public goods: consumer surplus to be consider on the benefit side

How can the value of non-market goods be measured?

Make inferences about individuals valuations from market data or observed behaviour in other contexts : hedonic pricing Use survey techniques: contingent valuation All are controversial techniques Examples:
Inferences Valuing Time Valuing Life Valuing Natural Resources

Inference From Market Behaviour

Hedonic Pricing: Use differences in market prices to impute a value for a hidden variable. (Shadow Pricing) House prices Travel Costs: the time and travel cost expenses that people incur to visit a site represent the price of access to the site. peoples willingness to pay to visit the site can be estimated based on the number of trips that they make at different travel costs.

Hedonic Pricing
The hedonic pricing method is used to estimate economic values for ecosystem or environmental services that directly affect market prices. Most commonly applied to variations in housing prices that reflect the value of local environmental attributes. It can be used to estimate economic benefits or costs associated with:
environmental quality, including air pollution, water pollution, or noise environmental amenities, such as aesthetic views or proximity to recreational sites

The basic premise of the hedonic pricing method is that the price of a marketed good is related to its characteristics, or the services it provides.

Hedonic pricing
Example: Agency staff want to measure the benefits of an open space preservation program in a region where open land is rapidly being developed. Why Use the Hedonic Pricing Method? The hedonic pricing method might be selected in such case because: Housing prices in the area appear to be related to proximity to open space. Data on real estate transactions and open space parcels are readily available, thus making this the least expensive and least complicated approach. How do we use it? Several steps.

Hedonic pricing
Step 1: collect data on residential property sales in the region for a specific time period selling prices and locations property characteristics that affect selling prices, surface, number and size of rooms, etc neighborhood characteristics that affect selling prices, such as property taxes, crime rates, and quality of schools accessibility characteristics that affect prices, such as distances to work and shopping centers, and availability of public transportation environmental characteristics that affect prices: in this case, proximity to open space.

Hedonic pricing
Step 2: with the data collected and compiled, statistically estimate a function that relates property values to the property characteristics, including the distance to open space. The function measures the portion of the property price that is attributable to each characteristic. How Do We Use the Results? Specific parcels may be under consideration for protection. The hedonic value function can be used to determine the benefits of preserving each parcel, which can then be compared to the cost.

Valuing time
First, this is useful for instance when assessing the desirability of a public transportation project: better roads, better underground system Steps:
What is the wage rate of those who would benefit from the project Ideally, the wage rate provides a monetary valuation of individuals own (leisure) time Then, if the proposed improvement to public transportation reduces by 30 min the commuting time of a person who works for 10 per hour, the value of the time saved is 5. We can calculate for all individuals and aggregate to obtain the total value of time saved.

Valuing time
Why is the wage rate linked to the value of time saved? Economic models assume that an individual chooses how to allocate his limited time between work and leisure If he gives up one hour of leisure it works one hours extra and can spend the extra hourly wage on consumption He will give up hours of leisure until the utility from the addition consumption is exactly equal to the utility from leisure At that point he is indifferent between work and leisure, and the wage rate gives also the value of time to the individual

Valuing natural resources

Contingent valuation techniques:
Individuals are asked questions which try to elicit how much they value, for instance, environmental damage or protection of endangered species People are willing to pay for the protection of nature or species even if they do not have direct contact with the preserved area Their willingness to pay gives the existence values While individual values might be low, aggregate value might be very high