econ 334 lectures 7 + 8

Cost-benefit analysis (CBA)

Comparing a public project's costs and benefits to decide whether to do it

What requires federal agencies to do CBA?

Executive Order 12866, for any "significant" regulation

Why are benefits hard to measure in CBA?

It's hard to recover people's true preferences (no market price for things like time saved or lives saved)

Costs and benefits of a public road

Costs: wages and materials. Benefits (over time): less congestion (time, pollution), fewer accidents and deaths

Cash-flow accounting

Costs = payments for inputs; benefits = revenue the project brings in. Wrong for CBA

Why is cash-flow accounting wrong for CBA?

A free public road brings in $0 revenue but has real benefits, and payments don't always reflect true costs

Opportunity cost

The value of a resource in its next best use: what society gives up

Social cost of an input bought in a competitive market

Its price (e.g., asphalt at $200/ton = $200/ton)

Workers paid $20/hr, market wage $10/hr: social cost?

$10/hr (their market wage)

Economic rent

Payment above opportunity cost; a transfer (e.g., from taxpayers to workers), not a social cost

Workers paid $20/hr, market wage $10/hr: rent?

$10/hr, a transfer from taxpayers to workers

Social cost of hiring workers who'd otherwise be unemployed

The value of their foregone leisure, not their wage

Is job creation a benefit in CBA?

No. Labor is a cost; it may help redistribution but doesn't increase surplus. Otherwise government could create "benefits" by hiring people to do nothing

What should be netted out of wages for previously unemployed workers?

Foregone UI payments and other anti-poverty payments they no longer receive

Why discount future benefits?

Money today can be invested to grow, so future dollars are worth less today

Present discounted value (PDV)

What a future amount is worth today

PDV of $X received in one year

X / (1 + r)

PDV of $X received in t years

X / (1 + r)^t

PDV of $X every year forever (perpetuity)

X / r

What discount rate is used for public projects?

A social discount rate, e.g., the interest rate on a risk-free government bond

Effect of a higher discount rate

Future benefits are worth less today, so fewer long-term projects pass the CBA test

Three ways to value time savings

(1) Wages, (2) contingent valuation (surveys), (3) revealed preference

Weaknesses of valuing time at the wage

People can't always switch leisure into paid work; wages exclude other compensation like health benefits

Contingent valuation

Asking people in surveys what they'd pay (e.g., to avoid 30 extra minutes of driving)

Weakness of contingent valuation

Answers are sensitive to survey design and wording

Revealed preference (valuing time)

Watching real behavior: tolls/congestion pricing, paying more to live near work or transit

Weakness of revealed preference for time (housing)

Higher prices near transit may reflect other amenities, not just commute time (omitted variable)

Why assign a value to a statistical life?

Resources are limited, so society must prioritize which life-saving projects to fund

VSL from lifetime earnings

PDV of a person's lifetime market earnings

Pitfalls of the lifetime earnings method

Values retirees, children and stay-at-home parents at little; values rich people more; ignores non-work value of life

Pitfall of contingent valuation for VSL

People can't meaningfully answer "how much is your life worth?"

VSL formula (revealed preference)

Amount paid / reduction in probability of death (for a "1 in N" risk: payment x N)

CO detector example

Reduces death risk by 1 in 100,000; people pay $100, so VSL = $10 million

Compensating differential

Extra wage workers demand to accept a riskier job

Skyscraper steelworker example

Earn $2,000/yr more for a 1 in 5,000 higher death risk, so VSL = $10 million

Pitfalls of revealed preference for VSL

People misjudge tiny risks; richer people pay more; products may give other benefits (peace of mind)

Pitfalls of compensating differentials

Workers may not know risks; risk-tolerant people select into risky jobs (understates VSL); workers may lack bargaining power

Cost-effectiveness analysis

Comparing only costs (e.g., cost per life saved) when benefits are hard to measure or similar across projects

Cost per life saved

Total cost / lives saved

Advantage of cost-effectiveness analysis

Avoids having to put a dollar value on a life

Double-counting benefits

Counting both the direct benefits (time, safety) and the rise in property values, which already reflects them

Counting secondary benefits

Counting activity that just moved from elsewhere; only the net increase counts

Three common CBA mistakes

Double-counting benefits, counting secondary benefits, counting labor costs as benefits

Are transfers (like fees from passengers to airlines) benefits?

No. One group's gain is another's loss; only changes in total surplus count

A park gives $50,000/yr forever, r = 5%, costs $800,000. Build?

PDV = 50,000 / 0.05 = $1,000,000 > $800,000, so build

A safety feature cuts death risk by 1 in 50,000; drivers pay $200. VSL?

$200 x 50,000 = $10 million

Program A: $20M saves 10 lives. Program B: $15M saves 5 lives. More cost-effective?

A ($2M per life vs. $3M per life)