Chapter 4: Cost-Benefit Analysis

Chapter 4 Cost-Benefit Analysis

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 4: Cost-Benefit Analysis

Introduction
Cost-benefit analysis

Building a factory
Benefits from building a highway
Benefits from improving the safety of a highway

Mistakes to avoid
Reducing global warming
Paying for a costly medical treatment

Intervening militarily

4-2
 Chapter 4: Cost-Benefit Analysis

Cost-Benefit Analysis
Cost-benefit analysis is the measuring of the costs
and the benefits of a project to help decide:
• Whether to undertake the project
• The scale of the project

• A project should be undertaken if its benefit to

society exceeds its costs to society.

Who uses cost-benefit analysis?

• Private firms
• Individuals
• Government

4-3
 Chapter 4: Cost-Benefit Analysis

Cost-Benefit Analysis
Figure 4.1
$

MSC

The optimal scale

of the project is Q*.

MSB
Scale of the
Q* project (Q)

4-4
 Chapter 4: Cost-Benefit Analysis

A Private Firm: Building a Factory

Should a firm build another factory?

Assumptions:
• The factory will be built in one year (Year 0)
• The factory will last one year (Year 1) before
wearing out
• The construction cost in Year 0 = $100,000
• The profit from the factory in Year 1 = $110,000

4-5
 Chapter 4: Cost-Benefit Analysis

A Private Firm: Building a Factory

The firm borrows $100,000

Building with borrowing: in Year 0 to pay for the
construction cost

Will the firm build if the interest rate is 5%? 15%?

The present discounted value (PV) of a future amount at

a future date is the amount you would need to put in the
bank today to have that future amount by that future date.

4-6
 Chapter 4: Cost-Benefit Analysis

A Private Firm: Building a Factory

Example Multi-year profits
• $55,000 in Year 1
• $60,500 in Year 2
• r = 10%

PV of profits = $55,000 + $60,500

(1+r) (1+r)2

= $55,000 + $60,500
(1.10) (1.21)

= $50,000 + $50,000
= $100,000

4-7
 Chapter 4: Cost-Benefit Analysis

A Private Firm: Building a Factory

PV of $110,000 in Year 1 = $110,000

(1+r)
Table 4.1

r = 5% r = 15%
PV of Profit $104,762 $95,652
Cost of Project $100,000 $100,000
Correct Decision Build Don’t Build

• This is true even when a firm uses their own

money to finance the construction of the factory.

4-8
 Chapter 4: Cost-Benefit Analysis

Government: Building a Highway

Costs
• Current construction costs
• Discounted future maintenance costs

Benefits
• What drivers are willing to pay to use the
highway in all future years measured as the
discounted dollar value of time saved

4-9
 Chapter 4: Cost-Benefit Analysis

Government: Building a Highway

Measuring benefit of time saved through
Increased Output
• Estimate how much more output commuters could
produce at work if they decreased commute time

Example
• Commuter is paid $20/hr
• Saves 1 hour of commute time each day because of
the new highway
• Commuter works 250 days a year
• Time savings = (250 days)(1 hour)($20) = $5000

4 - 10
 Chapter 4: Cost-Benefit Analysis

Government: Building a Highway

Measuring benefit of time saved through
Revealed Preference
• Look at commuter location preferences and estimate
how home prices differ depending on commute time.

Example
• Two identical homes in two different suburbs
• One house is associated with a shorter commute
• The house associated with the shorter commute costs
$20,000 more than the other house.
• The difference in price “reveals” the value of time saved

4 - 11
 Chapter 4: Cost-Benefit Analysis

Government: Building a Highway

Measuring benefit of time saved through
Contingent Valuation
• Pose a hypothetical question that asks commuters
how much they would be willing to pay to reduce their
daily commute by one hour.
Issues
• Critics argue surveys produce unreliable results because
answers may be sensitive to wording, presentation, etc.
• Supporters argue that actual market behavior is also
subject to similar problems
• Supporters argue surveys improve with experience

4 - 12
 Chapter 4: Cost-Benefit Analysis

Benefits of Improving the Safety of a Highway

The safer the highway, the greater the cost of building it.

Measuring the value of lives saved through

Increased Output
• Estimate how much that person would
have produced over the rest of his life.
Issues
• If person A is paid more than person B, then person A is
valued higher than person B
• How do you value the surviving family’s suffering?

4 - 13
 Chapter 4: Cost-Benefit Analysis

Benefits of Improving the Safety of a Highway

Measuring the value of lives saved through
Revealed Preference
• Estimate how much people actually pay to reduce
their chance of dying
• Compensating Differential

Measuring the value of lives saved through

Contingent Valuation
• Pose a hypothetical question that asks commuters
how much they would be willing to pay to reduce
their chance of death on the highway from 2 in 1000
to 1 in 1000

4 - 14
 Chapter 4: Cost-Benefit Analysis

Benefits of Improving the Safety of a Highway

Measuring the value of lives saved through
The Value of a Statistical Life
• The value of the life of a person we don’t
know personally
• Approximately $8 million
• Is the VSL different for a young person
as compared to an old person?

4 - 15
 Chapter 4: Cost-Benefit Analysis

Mistakes to Avoid

• Counting job creation as a benefit

• Double counting the same benefit
• Counting secondary benefits

4 - 16
 Chapter 4: Cost-Benefit Analysis

Reducing Global Warming

How much should each country cut back on its
emissions of greenhouse gasses?

Costs: carbon fuel use Benefits: reduced

must be reduced global warming

• Uncertainty and the risk of catastrophe

• The social discount rate is the rate analysts use
to compute the present value of future benefits
• A cost-effectiveness analysis focuses on
achieving the given objective at a minimum cost

4 - 17
 Chapter 4: Cost-Benefit Analysis

Paying for a Costly Medical Treatment

Patients and families want the best care, which
tends to be costly. Should the insurer pay for the
care?

Example
A medical treatment costs $1 million, and it will extend
the life of the patient by 1 year.
• What if the patient is 100?
• What if the patient is 80?
• What if the patient is 20?

4 - 18
 Chapter 4: Cost-Benefit Analysis

Intervening Militarily

Should a particular military intervention be undertaken?

Costs: military budget cost, cost of lives lost,

suffering of veterans, disability payments, etc.

Benefits: historians, military scientists,

international relations experts, and political
scientists will determine the benefits.

4 - 19
 Chapter 4: Cost-Benefit Analysis

Summary
Cost-benefit analysis
Building a factory

Benefits from building a highway

Benefits from improving the safety of a highway
Mistakes to avoid

Reducing global warming

Paying for a costly medical treatment

Intervening militarily

4 - 20
 Chapter 4: Cost-Benefit Analysis

Preview of Chapter 5:
Social Security

Four ways to prepare for retirement

The U.S. Social Security system

Reforming Social Security

4 - 21