Professional Documents
Culture Documents
Chapter 11 PowerPoints
Chapter 11 PowerPoints
Given that CBA is concerned with consequences over time, and based in welfare
economics, a key idea is that of intertemporal efficiency.
U U (C , C )
A A A
0
A
1
(11.1)
U U (C , C )
B B B
0
B
1
MRUS
A
C 0,c1
=
B
MRUS C 0,c1 otherwise one could be made better off without making the other
worse off
r A
C0, C1 MRUS A
C0, C1
1 defines As consumption discount rate
C (C ) C C C
1
0 1
1
0 1
C 0
C C
0 0
which is the negative of the slope of the transformation frontier minus 1, which can
be written
1 s
where s is the slope of the frontier.
Rate of return equality
If each firm were investing as indicated by C01b and C02b, then period 1
consumption could be increased, without loss of period 0 consumption, by
having firm 1, where the rate of return is higher, increase investment by the
amount firm 2, where the rate of return is lower, reduced its investment.
Only where rates of return are equal is this kind of period 1 gain
impossible. For N firms, the second intertemporal efficiency condition is
i , i 1,..., N (11.3)
Equality of discount rate and rate of return
If the first two conditions are satisfied, can consider representative individual and firm.
Point a corresponds to intertemporal efficiency, b and c do not as from either could reallocate
consumption as between periods so as to move on to a higher consumption indifference curve.
At a the slopes of the consumption indifference curve and the consumption ttansformation
frontier are equal. The third condition is
r (11.4)
Intertemporal optimality
Futures Markets
X at t is treated as a different commodity from X and t+1
For N commodities and M periods there are MN dated commodities. Contracts are
written at the start of the first period for trades an all commodities at all future
dates.
Then, it is effectively the static case.
Given that all ideal circumstances apply in all MN markets, the conditions for
intertemporal efficiency will be satisfied.
Futures markets are, in fact, rare standardised raw materials,
financial instruments.
Markets and intertemporal efficiency loanable funds market
P b
The optimum level of investment is at a, where the present value of the firm is
maximised, and where
i=
In the second stage the owner maximises utility, by bond market dealing, at b where
i=r
All owners so act, and the three conditions for intertemporal efficiency are satisfied.
Optimal growth modelling; discrete time
A representative individual model for two periods
Maximise
1
W U C0 U C1 (11.5a)
1
subject to
Q0(K0) (K1 K0) = C0 (11.5b)
Q1(K1) (K2 K1) = C1 (11.5c)
Here the efficiency problem is trivial consumption in one period can only be
increased by reducing it in the other period.
A necessary condition is
U C1 1
(11.6)
UC 0 1
W U(C )e dt
t t (11.7a)
t 0 t
Subject to
.
K = Q(K ) - C t t (11.7b)
W U(C )e dt
t t (11.9a)
t 0 t
Subject to
.
K Q K t , Rt Ct (11.9b)
.
S Rt (11.9c)
W U C0
1 intertemporal welfare function for panel a
U C1
1
UC0
1/ 1 U C 1 slope of WCWC in panel b
r
UC 0
1
1 UC 0
1
1/ 1 U C1 U C1 (11.10)
Utility and consumption discount rates 2
In continuous time
r g (11.11)
where
r is the consumption discount rate
is the utility discount rate
is is the elasticity of marginal utility for
the instantaneous utility function
g is the growth rate
For g>0 r> and r would be positive for = 0
For g = 0 r =
Private project appraisal the Net Present Value test 1
The present value of expenditures E is
E1 E2 ET
PVE E0 ...
1 i 1 i 2
1 i
T
T
Et (11.14)
1 i
t
0
T
Rt (11.15)
1 i
t
0
Which for N = R - E is
N1 N2 NT
NPV N 0 ...
1 i 1 i 2
1 i
T
(11.17)
T
Nt
1 i
t
0
0 100 0 100
1 10 50 40
2 10 50 40
3 10 45.005 35.005
4 0 0 0
Table 11.4 One project, two possible cash flows Table 11.5 Calculation of expected NPV
Where the firm is prepared to assign probabilities, the criterion for going ahead with the project is
the expected NPV the probability weighted sum of the mutually exclusive cash flow outcomes.
Individual 0 1 2 3 Overall
Table 11.6 Net benefit (NB) impacts consequent upon an illustrative project
Generally, go ahead if
t T
NB t
NPV 0 (11.19)
t 0 (1 r) t
CBA as a potential pareto improvement test
A positive NPV indicates that, with due allowance for the dating of costs and benefits, the project delivers a
surplus of benefit over cost. The consumption gains involved are greater than the consumption losses, taking
account of the timing of gains and losses. The existence of a surplus means that those who gain from the
project could compensate those who lose and still be better off.
1 r 1 r
0
(11.21)
This is the NPV test with the consumption gain discounted at the consumption rate of interest, and compared
with the cost of the project scaled up to take account of the consumption that is lost on account of the
displaced private sector project.
CBA as welfare increase test 1
Time period
Individual 0 1 2 3 Overall
Society U0 U1 U2 U3
Or with an intratemporal social welfare function mapping individual utilities into a social
aggregate Ut
1 (1 ) (1 )
0 2 3
CBA as welfare increase test 2
Utility variations consequent on going ahead with the project cannot be estimated.
But, using the methods of chapter 12, monetary equivalent gains and losses can be
estimated.
Time period
Individual 0 1 2 3 Overall
t
1
U C
T
W
1
t
t 0
implies
t
1 T
W C (11.22)
1 r
t
t 0
where
(1 )U or r = + g (11.23)
r Ct 1
1 or
U Ct
CBA as welfare increase test 3
The NPV test is interpreted as a test that identifies projects that yield welfare improvements -
positive and negative consumption changes, net benefits that is, are added over time after
discounting, so that
t
T 1
W C (11.24)
1 r
t
t 0
and for W > 0 the project is welfare enhancing and should go ahead
C I
W I (11.26) 1 0
1 r 1 r
0
C I
I
1 0
1 r 1 r
0
Choice of discount rate 1
There is disagreement about the discount rate that should be used in CBA
This matters because the result of the NPV test can be very sensitive to the number
used for the discount rate.
This is especially true where the project lifetime is long, as it often is with projects
with environmental consequences the lifetime is when the longest lasting
consequence ceases, not when the project stops yielding the benefits which were its
purpose nuclear electricity generation and waste products.
Time Horizon
Table 11.8 Present values at various
Years
discount rates
Discount rate % 25 50 100 200
For 100 at futurity shown
0.5 88.28 77.93 60.73 36.88
Generally agreed that whichever way looking at CBA potential pareto improvement
or welfare enhancing should use r, the consumption discount rate.
Shadow pricing
While it is agreed that r should be used to discount, appears in the NPV criterion as
C I
1
I 0
(11.21) and W I C I
1 0
(11.26)
1 r 1 r 1 r 1 r
0 0
which apply with finance by borrowing when there is crowding out is there to
adjust the initial cost, shadow price it, for the displacement of the marginal private
sector project.
At one time it was thought that, on account of crowding out, proper shadow pricing
of all inputs and outputs was important in CBA. And difficult.
Now the dominant view is that given international capital mobility, crowding out is
not a problem that the supply of capita for private sector projects could be treated
as perfectly elastic.
r = + g (11.23)
where
is the utility discount rate
is the elasticity of the marginal utility of consumption
g is the growth rate
Some economists want to get values for and from observed behaviour, some from
ethical considerations.
Much of the controversy among economists over the Stern Review of the climate change
problem focussed on the numbers used in (11.23) Stern took an ethical prescriptive
position
Box 11.2 Discount rate choices in practice
US Office of Management and Budget
7% as an estimate of pre-tax return on capital
US Environmental Protection Agency
For intragenerational descriptive, r as 2-3%
For intergenerational - r = + g with = 0 on ethical grounds, gives r 0.5% to 3%
HM Treasury UK
Green Book instructions based on r = + g evidence suggests = 1.5%, = 1 and g = 2%
giving r = 3.5%.
For lifetimes greater than 30 years
Years ahead 31-75 76-125 126-200 201-300 301+
Bd Cd
Denote this as NPV. Then the proper NPV taking account of environmental impacts is
NPV = Bd Cd EC = NPV EC (11.27)
where EC is the present value of the stream of the net value of the projects
environmental impacts over the lifetime of the project.
EC stands for Environmental Cost
From (11.27) the project should go ahead if
NPV = Bd Cd > EC (11.28)
Inverse ECBA
A wilderness development project should not go ahead if
EC NPV = Bd Cd
so that
EC* = NPV = Bd Cd (11.29)
defines a threshold value for EC. For EC EC* the project should not go ahead.
The exercises ( Chapter 12 ) that seek to ascertain EC are typically expensive, and
sometimes controversial. Consideration of EC* can put their results in perspective.
As can consideration of EC*/N, where N is the size of the relevant affected
population, which is not necessarily restricted to visitors, and may include people
from a wider area than the host country, as with an internationally recognised
wilderness/ conservation area inscribed as world heritage.
Box 11.3 Mining at Coronation Hill?
In 1990 there emerged a proposal to develop a mine at Coronation Hill in the Kakadu national park,
which is listed as a World Heritage Area. The Australian federal government referred the matter to
the Resource Assessment Commission, which undertook a very thorough exercise in environmental
valuation using the Contingent valuation Method, implemented via a survey of a sample of the
whole Australian population. This exercise produced a range of estimates for the median
willingness to pay, WTP, to preserve Coronation Hill from the proposed development, the smallest
of which was $53 per year. If it is assumed, conservatively, that the $53 figure is WTP per
household, and this annual environmental damage cost is converted to a present value capital sum
in the same way as the commercial NPV for the mine was calculated, the EC to be compared with
the mine NPV' is, in round numbers, $1500 million. This 'back of the envelope' calculation assumes
4 million Australian households, and a discount rate of 7.5%.
It was pointed out that given the small size of the actual area directly affected, the implied per
hectare value of Coronation Hill greatly exceeded real estate prices in Manhattan, whereas it was
'clapped out buffalo country' of little recreational or biological value. In fact, leaving aside
environmental considerations and proceeding on a purely commercial basis gave the NPV' for the
mine as $80 million, so that the threshold per Australian household WTP required to reject the
mining project was, in round numbers, $3 per year, less than one-tenth of the low end of the range
of estimated household WTP on the part of Australians. Given that Kakadu is internationally famous
for its geological formations, biodiversity and indigenous culture, a case could be made for
extending the existence value relevant population, at least, to North America and Europe.
In the event, the Australian federal government did not allow the mining project to go ahead. It is
not clear that the CVM application actually played any part in that decision.
The Krutilla-Fisher model 1
NPV is the result of discounting and summing over the projects lifetime an annual net benefit stream
which is
where Bd,t, Cd,t and ECt are the annual, undiscounted, amounts for t = 1, 2,..., T, and where T is the project
lifetime, corresponding to the present values Bd, Cd and EC. The environmental costs of going ahead with the
project, the ECt, are at the same time the environmental benefits of not proceeding with it. Instead of EC t we
could write B(P)t for the stream of environmental benefits of preservation.4 If we also use B(D)t and C(D)t for
the benefit and cost streams associated with development when environmental impacts are ignored, so that
B(D)t C(D)t is what gets discounted to give NPV, then equation 11.30 can also be written as:
we use
T
NPV {B D t C D t B P t }e rt dt
0
which with B and C for constant flows of development benefits and costs, and Peat as the growing
flow of preservation benefits, can be written
T
NPV NPV Pe r a t dt (11.34)
0
For given NPV, a>0 reduces NPV a development is less likely to pass the NPV test
if the Krutilla-Fisher arguments hold
For a = r means preservation benefits effectively not discounted
a>r means effective negative discounting on preservation benefits
The Krutilla-Fisher model 3
Let T for two reasons
0 20 13.33
0.01 25 15.37
0.03 50 22.22
0.05 40
0.06 66.67
0.075
Discount rate adjustment?
Working with a lower discount rate does not always favour preservation.
T T
NPV {B C} e dt P e
rt (r a)t
dt
0 0
NPV D e dt P e
rt (r a)t
dt
0 0
D P
NPV= (11.36)
r r a
With X for start-up costs
D P
NPV X (11.37)
r r a
Some question the ECBA agenda at the level of practice can Chapter 12
methods actually deliver the necessary information?
Limits to applicability of ECBA -sustainability and
environmental valuation
Evaluation of consequences
Not to be left to experts
Multi-criteria analysis
Deliberative polling
Citizens juries
An illustrative transport problem
The results of the impact assessment are
Table 11.10 Options for reducing traffic delays
A. Highway B. Highway and Buses C. Railway
3 2 1
For weights
Costs 0.3
Time Saving 0.3
CO2 Emissions 0.2
Wildlife and Amenity 0.2
Costs 0.2
get
Highway Highway and Railway
Buses
Cost 0.2000 0.1667 0.1000
Given that the idea is to poll a random sample of sufficient size to produce results of
standard expected in opinion polling, 100s, the deliberative part of the exercise is
expensive.
Citizens juries involve the public in their capacity as ordinary citizens with no
special axe to grind. They are usually commissioned by an organisation which
has power to act on their recommendations. Between 12 and 16 jurors are
recruited, using a combination of random and stratified sampling, to be broadly
representative of their community. Their task is to address an important question
about policy or planning. They are brought together for four days, with a team of
two moderators. They are fully briefed about the background to the question,
through written information and evidence from witnesses. Jurors scrutinise the
information, cross-examine the witnesses and discuss different aspects of the
question in small groups and plenary sessions. Their conclusions are compiled in
a report that is returned to the jurors for their approval before being submitted to
the commissioning authority. The jurys verdict need not be unanimous, nor is it
binding. However, the commissioning authority is required to publicise the jury
and its findings, to respond within a set time and either to follow its
recommendations or to explain publicly why not.
As compared with deliberative polling, a major advantage of the citizens jury is
cost.
Box 11.4 Deliberative polling and nuclear power in the UK
In the early years of the twenty-first century the UK government came to the view that, on account of the age of
the existing nuclear plant, security of supply issues, and the climate change problem, it was necessary to re-visit
the question of whether new nuclear plant was desirable.
The UK government initiated a consultation process and subsequently, in July 2006, it issued a report giving its
view that nuclear power had a continuing role in the electricity supply system, and that it would look favourably on
projects to build new nuclear power stations. Consequent upon a legal challenge by Greenpeace, the High Court
ruled that the government's decision making process had been unlawful in as much as it had failed to engage in
adequate consultation.
Following this decision, in May 2007 the UK government initiated a new consultation process, one element of
which was a deliberative polling exercise. This took place in September 2007. The report on this exercise written
by the market research firm, Opinion Leader.
On most questions, the change in the response percentages as between the initial and the final polls was small.
Greenpeace looked at the information provided to the participants and took the view that it was biased in
favour of nuclear power. In October 2007, Greenpeace complained about the work of Opinion Leader to the
Market Research Standards Board The MRSB considered the Greenpeace complaint against B14 of the MRS
code of conduct, which states that MRS members 'must take reasonable steps to ensure that Respondents are
not led to a particular answer.' The MRSB found that Opinion Leader had not complied with B14, noting that
'deliberative research is a relatively new technique and that there are no current MRS guidelines on preparation
or review of research materials specific to deliberative research'.
The UK government published Meeting the Energy Challenge: A White Paper on Nuclear Power in January in
2008, in which it drew on the results of the consultation exercise, and in which it stated its conclusion that 'it
would be in the public interest to allow energy companies the option of investing in new nuclear power stations'
and that ' the government should take active steps to facilitate this'.