Cost Benefit Analysis BS ECONOMICS SEMESTER 7

BY: Zia Ud din Lecturer in Economics (GPGC, Mardan)

Lecture one

Define decision making.

Decision making is the art of choosing among the alternatives. Thus when you are making a decision you
have to consider how many options do I have?

After you put your options, find the cost and benefit of each option. (CBA)

These include a systematic categorization of impacts as benefits (pros) and costs (cons).

Valuing the all the benefits and costs. Then determine the net benefit of the proposal.

Net benefits = Benefits – costs

Individual vs. social costs:

Costs/benefits (cons and pros) to one individual person or firm also called specific cost/benefits or
individual costs/benefits.

Individual choose the option in which they have greater benefit and lower cost. The net benefit is a
positive number. Firms in making investment decisions, consider only the cost and benefits only flow to
them.

Social cost-Benefit Analysis: when all the costs and benefits to the society are considered, it is called
social cost-Benefit analysis CBA.

Two critics of CBA, One is that the Sum of individual utilities cannot be maximized and that there are
gains for some and losses for others.

Second is the monetization of the alternatives for valuation.

Purpose and uses of CBA: The key aims and uses are

 To help social decision making.

 To facilitate efficient allocation of society resources.
 In markets individual self interest will lead to efficient allocation of resources.
 In case of market failure, rationale for Govt interference.

Types of CBA:
 1. Ex ante CBA, also called standard CBA. It is done before the project begins, and it assists in the
decision about whether scare social resources should be allocated by Govt to a specific policy,
program or project.
2. Ex Post CBA, is conducted at the end of the project. In such case all the cost are sunk in.
Such analyses contribute to learning’s from the impacts by government managers and
academicians. This may lead to a policy change.
For example 1960s and 1970s of industry specific regulations showed that the costs of
regulations exceeded the benefits. This is paving the way for deregulation initiatives in 1980s.

3. A third type may be the analysis in mid (during the project) that is in medias res.

Some elements are similar to ex-ante and some to ex-post.

4. A fourth type is called comparative CBA, which compares the ex-ante with ex-post CBA.
In early stages of the project uncertainty is high, which starts to decrease as project goes on.

Ex-post studies are more accurate than ex ante or in Medias res. Policy change or any intervention in a
program comes from in medias res or ex-post analysis.

Comparison of ex ante with ex-post provides a measure of accuracy of estimates.

Steps of CBA:
The basic Steps involved in CBA (The high way example)

How to conduct a CBA?

The answer is by using the following nine steps. We take an example of a highway of 195 km to be
constructed. The said high way will reduce the travel time between two cities.

Step 1: Decide whose benefits and costs count (standing)

The first part is to identify the key stake holders, that is whose benefits and costs should be counted.

The selected categories were Texan perspective and a global perspective. This global perspective counts
all the benefits and costs to everyone, irrespective of their residence.

The state perspective refers to the costs and benefits of the local govt (Texas in this case)

Step 2: Select the portfolio of the alternative projects:

Find and select the set of alternatives. In this case it’s the two alternatives that constitute the set of
options. One with tolls and second without tolls. The toll was set by the highway department; it ranged
from $40 for large trucks to $8 for cars. Table shows the perspective with two alternatives.

Table 1.2

Step 3: Catalogue potential (physical) Impacts and select measurement indicators.

Specification and listing the impact of the project is the third step. We use the term impact to include
both required resources and outputs of the projects.
The anticipated beneficial impacts were time saved and reduced vehicle operating costs(Cost Savings)
for travelers, accidents avoided (including lives saved) due to drivers switching to the shorter, ("Safety
Benefits"); reduced congestion on the existing alternative routes ("Alternative Routes Benefits");
revenues collected from tolls ("Toll Revenues"); and benefits accruing to newly generated traffic ("New
Users").

The anticipated cost impacts were construction costs ("Construction"); additional maintenance and
snow removal ("Maintenance"); toll collection ("Toll Collection"); and toll booth construction and
maintenance ("Toll Booth Construction").

The measurement indicators in terms of benefits can be no of lives saved per year and cost of gasoline
saved etc.
Step 4: Predict quantitative impacts over the life of project

Every project has impacts over a particular period of time. The fourth task is to predict for each
alternative project the level of all impacts over the life of that project. This step is about estimation of
the users of the high ways and the benefits that will be received for a specified period.
Estimation about travel cost saved and lives saved is made. Drivers will avoid 130 million vehicle-
kilometers (vkm) of driving and evidence provided by the state suggests that, on average, there are
0.027 deaths per million vehicle-kilometers so life saving will increase.

Step 5: Monetization of all impacts.

Monetization means value in dollars or in rupees. We need to monetize time saved, a statistical life
saved, and accidents avoided. Monetization of impacts is necessary for comparison.
With monetization the benefits becomes comparable, for example
Business time saved per vehicle = $12 per vehicle-hour.

Step 6: Discount all the values (Impacts monetized)

For any project that has either costs or benefits arising over extended periods (years), we need a
method to aggregate the benefits and costs that occur at different times. Future benefits and costs are
discounted relative to present benefits and costs in order to obtain their present values.

Step 7: Compare Cost with benefits

The basic decision rule for a single alternative (relative to the status quo) is simple: Add up the present
value of benefits (B), add up the present value of costs (C) and see which is larger. If benefits exceed
costs,
Then proceed with the project. If not, stay with the status quo. In short, the analyst
Would recommend proceeding with the project if: NPV=B-C>0.
Decision rules are selecting the project with Higher Net benefit if more than one option exists.

Step 8: Perform sensitivity analysis.

Predict the uncertainty in values of impacts. Likely hood of an event and how much impact it carries
needs to be estimated.

Step 9: Selection of the best alternative or with largest net social benefit.

In this case, three of the alternative projects have positive NPVs and one has a negative NPV. Sometimes
the status quo is the best alternative. Here, however, from a global perspective both the with-tolls and
without-tolls alternatives are preferable to the status quo.
Based on the preceding analysis, the analyst will recommend the selection of A above C or B above D,
that is, the project with the largest NPV. In short, the no-toll alternatives are superior.
Home WORK/ Assignment

A. What are the costs and benefits of individuals and state Govt (for both stake holders/
perspectives) after the Establishment of eastern and western bypass in Mardan?
B. Can you monetize the predicted values?
C. Can you find cost and benefit to suggest a policy change?
Realities of CBA—some aspects
 Consider a project for which the alternatives vary along an output scale (Q). The
benefits and costs associated with alternative scales are represented by the functions
B (Q) and C (Q), respectively. The benefits increase as the scale increases, but at a
decreasing rate. On the other hand, costs increase at an increasing rate. A small-scale
project (for example, Q,) has positive net benefits. As the scale increases, the net
benefits increase up to the optimal scale, Q*. As the scale is increased beyond Q*, the
net benefits are positive but are decreasing. The net benefits are zero where the cost
curve and benefit curve intersect and are negative for larger-scale projects.
Suppose there is no program now (current output level is Q,). The analyst may
compare the status quo with only two alternative output levels Q, and Q, (These are
the alternatives of the project.) Given the benefit and cost functions, output level Q, is
preferred to output level Q,, which, in turn, is preferred to the status quo, Q,. The
analyst will therefore recommend adoption of Q,. As the figure shows, however, net
social benefits are maximized at output level Q*; this is the optimum scale. Adoption
of the optimum was not recommended because it was not among the set of evaluated
alternatives. Thus, the analyst has chosen a more efficient alternative to the status
quo, but not the most efficient alternative.
The analyst cannot be certain that she has included the optimum output level in the
set of alternatives for two reasons. First, she cannot know what the optimum is until
after she has performed the analysis. Second, even after beginning to estimate costs
and benefits, cognitive capacity limitations, often summarized as bounded rationality
problems, may hinder the analyst from even considering the optimal alternative.
These cognitive factors become an increasingly important issue when (1) project benefits and
costs vary simultaneously on many dimensions, (2) the benefit and cost functions are
discontinuous or complex (for example, with interaction terms), and (3) when there is
uncertainty about the interactions or the functional forms. In practice, these cognitive
limitations are always a factor to some extent. In the example depicted in Figure 1.1, this
problem is unlikely to be of major importance because the NPVs depend only on scale, and
the functional relationships B(Q) and C(Q) are assumed known and are relatively simple and
smooth.
Another practical reason for not considering the optimum stems from budgetary or political
constraints, which limit the choice set. In the example illustrated by Figure 1.1, projects in
excess of size Q,, including Q*, may have been excluded because of budgetary or political
considerations. We stress, however, that this should not be considered a weakness of CBA
itself, but rather of the political process that selects projects.
In practice, it is useful initially to consider an expanded choice' set. A brainstorming
Session can be very valuable at an early stage to expand the range of consideration.
Chapter no 2
Conceptual foundations of Cost- Benefit Analysis

Question: when CBA can be used as a decision rule, when it can be part of a broader analysis
and when it should be avoided.
At the heart of CBA is the allocative efficiency. Also to understand how CBA can be compared
to other analytical frameworks.
Allocative efficiency is about resource allocation deployed in their highest valued uses in
terms of Goods and services they create. CBA can be used to compare relative efficiency of
policies. Efficiency is the most important element in making policies.

Define what is efficiency?

Pareto efficiency is the allocation if no alternative allocation can make at least one person
better off without making any one else worse off.
So an allocation is inefficient if an alternative allocation can be found to make at least one
person better off without any else worse-off.
Every rational person wants Pareto efficiency.
Assume an example of allocation of $100 between two persons if they agree. If they don’t
agree they will receive $ 25 each as a fixed payment. To split the said amount we need to
check Pareto allocation.
If the entire amount is allocated to one person it will be $100 shown as a point on the either
axis.
The vertical axis measures the amount received by one person (person 1) and the horizontal
axis that of other (person 2).
The Line that connects the two extremes shows all the possible combination of allocation,
called as potential Pareto frontier.
Point S ($25, $25) represents the status Quo and segment of the Pareto frontier that gives
each person at least as equal as Status Quo ($25) is called Pareto frontier.
The shaded triangle represents the allocation which is Pareto efficient which shows that at
least one person can be made better off than the status quo without making another worse.
The status Quo is not a Pareto efficient allocation and an improvement is possible. Moving to
any point of improvement is called Pareto improvement.
Any point which is not laying on the potential Pareto frontier an improvement is possible.
Figure 2.1

The portion of the Pareto potential frontier that gives at $25 to each represents all the
Pareto efficient allocation.
Net benefits and Pareto Efficiency:
If a policy has a positive net benefit, than it is possible through set of transfer or payment to
make one person better off without making any one else worse off.
To do this, willingness to pay will be used as measuring rod of valuing impacts and
opportunity cost to value resources required.

Willingness to pay:
Suppose a proposed policy that would produce impact on three people. All three people
make honest revelations of their impacts is also supposed.
The revelations are about payments made or to be received so that the person is indifferent
between the policy and status Quo.
Person one reveals that he will be indifferent between paying $100 and status Quo.
Person two revelations were that he will be indifferent between paying $200 and status Quo.
These values are WTP for the person one and two.
Unlike the first two persons, person three has a different impact. This third person will
receive $250 if the policy is implemented to be indifferent between the status Quo and
policy.
This $250 is the cost of the policy which converts into (-$250) and is the willingness to pay for
the person third.
The algebraic sum of the three WTP amounts will give us the net benefit.
What is the net benefit, given the values?
The net benefits are positive ($50).If these were the only three people impacted by the policy
and no resources are required than $50 is the measure from the perspective of CBA.
The positive net benefit shows that the situation is Pareto in-efficient and is a case for Pareto
improving.
Altering the policy can make the situation Pareto improved, as person one and second will
have to pay $75 and $175 to person three respectively.
Person one is better-off by gaining ($25= 100-75), so as person second as ($25= 200-175).
Considering person third which will receive $75+175=$250 with implementation of policy due
to which the policy Net benefit will become zero. And the person is not worse off.
Conclusion: if and only if the aggregate net benefit is positive the situation is Pareto
improving and policy can be altered.
Given the condition that the benefits are measured by the willingness to pay.

Opportunity cost:
Related to the use of resources opportunity cost is an important concept. This concept is
related to valuing the input used in terms of dollars.
To build a bridge what resources are required, do you know?
The opportunity cost of using a resource is the value in its best alternative use. Opportunity
cost measure the value of what society must for go to use the input to implement the policy.
Considering the previous example, where three people were impacted by the policy and
generated a net benefit of $50.
Suppose an opportunity cost of $75 (Understand what this $75 means).
Than the net benefit to the society is negative and the situation is not Pareto improving. The
policy cannot be made Pareto efficient as all who bear cost cannot be compensated.
If the opportunity cost is $20, than calculate the net benefits.
Can you suggest values of Pareto improving?

Application of decision rules for practice.

 Limitations of CBA.
Two types of circumstances make CBA inappropriate.
1. Technical Limitation 2. Goals other than efficiency.
CBA requires all impacts relevant to efficiency be quantified and Commensurate through
monetization. For calculating Net benefits all costs and benefits needs to be expressed in
money terms. Limitations in theory, data or analytical resources may be the constraints on
the valuing and monetization. It may pave the way for Qualitative CBA.
For QUALTATIVE CBA the analysts monetize as many of the impacts as possible. And the
remaining costs and benefits are estimated by attaching a relative importance.
For small projects it is unlikely to estimate all the costs and benefits rather those costs and
benefits which cannot be measured easily, needs a guesstimate.
Most analysts use econometric studies rather than people’s WTP. Predication about how
many dolphins saved in policy regulation is used as in comparison to WTP. Which when
added/multiplied to the available data on the WTP of people for dolphins saved will make it
feasible.
Another way is cost-effectiveness which is used when all impacts can be quantified, but not
all can be monetized. Than the analysts can, however, construct a ratio involving the
quantitative, but non monetized, benefit and the total dollar costs. A comparison of this ratio
across alternative policies is the basis of cost –effectiveness analysis. The comparison allows
the analyst to rank policies and make a choice.
But notable that highest ratio doesn’t directly contribute to greater efficiency.
Assume a policy with an aim to avoid dolphin’s deaths. Further assume that n d be the number
of avoided deaths and c dollars be net the cost. Than n d/c is the cost effectiveness ratio which
is average number of dolphins saved per dollar of opportunity cost borne. And c/nd is the
average dollars cost per dolphin saved. For comparison a number of other policies C-E ratios
may be calculated.
However in case of constraints or policy objectives requires some additional information. If
the objective is to save as many dolphins as possible with a net cost of no more than C*, than
the analyst should select the most effective policy of less than C* .Alternatively if the
objective is to save at least nd* dolphins, then the analyst should select the regulation with
the lowest cost from among those regulations saving at least nd *.This is not necessarily the
alternative with the best cost-effectiveness ratio.