Public Finance and Public Policy Jonathan

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 Cost-Benefit Analysis 8
8.1 Measuring the Costs of Public Projects
8.2 Measuring the Benefits of Public Projects
8.3 Putting It All Together
8.4 Conclusion

PREPARED BY

Dan Sacks

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8
Cost Benefit analysis

This chapter covers cost-benefit analysis.

• Cost-benefit analysis: The comparison of costs and
benefits of public goods projects to decide if they
should be undertaken.
• Cost-benefit analysis is widely used to evaluate
potential public programs and projects.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Costs and Benefits of Highway Construction

Quantity Price/Value Total

Costs Asphalt 1 mill bags
Labor
1 mill hours
Repairs
$10 million
(yearly)
Benefits Time saved 500k hours
(yearly)
Lives saved 5 lives (year)
• What are the costs and benefits of the project? In the
first year? Over time?

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Measuring Current Costs

How to measure costs?

• Cash-flow accounting: Accounting method that
calculates costs solely by adding up what the
government pays for inputs to a project and calculates
benefits solely by adding up income or government
revenues generated by the project.
• Opportunity cost: The social marginal cost of any
resource is the value of that resource in its next best
use.
• Measuring opportunities costs faces several
challenges.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Imperfect Markets

Economic costs are only those costs are associated with

diverting the resource from its next best use.
• Rents: Payments to resource deliverers that exceed
those necessary to employ the resource.
• If labor is efficiently employed, then wages are a social
cost.
• If some workers are unemployed, then we value their
time at the value of leisure, not the wage.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Imperfect Markets: Measuring the Cost of Labor

• Suppose that the wage of construction workers is

$20/hour.
• But half the construction workers for the project are
unemployed and value their leisure at $10/hour.
• Then the true labor cost of the project is
$20/hour × (500,000 hours) + $10/hour × (500,000
hours)
• $15 million, not the $20 million accounting price.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Measuring Future Costs

How to measure future benefits against current costs?

• Use presented discounted value, discounting at the
social discount rate.
• Present discounted value (PDV): A dollar next year is
worth 1 + r times less than a dollar now because the
dollar could earn r % interest if invested.
• Social discount rate: The appropriate value of r to use
in computing PDV for social investments.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Costs and Benefits of Highway Construction: Filling
in Costs

Quantity Price/Value Total

Costs Asphalt 1 mill bags $100/bag 100
Labor 1 mill hours ½ at 20, 15
½ at 10
Repairs
$10 million 7% discount 43
(yearly) rate
Benefits Time saved 500k hours
(yearly)
Lives saved 5 lives (year)

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Using Market-Based Measures to Value Time:
Wages

• Suppose we can show that the time that individuals

save from driving faster is spent at work.
• Then we could value their time saved at their wage.
• This theoretical proposition runs into some problems
in practice:
o Individuals can’t freely trade off leisure and hours
of work; jobs may come with hours restrictions.
o There may be nonmonetary aspects of the job.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Using Survey-Based Measures to Value Time:
Contingent Valuation

An alternative approach to measure benefits is

contingent valuation.
• Contingent valuation: Asking individuals to value an
option they are not now choosing or do not have the
opportunity to choose.
• This approach relies on answers to hypothetical
questions.
• Straightforward, inexpensive to apply.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
APPLICATION: The Problems of Contingent
Valuation

Critics of contingent point out that contingent valuations

are very sensitive to the survey.
• Isolation of issues: Different value for sum of single
issues or issues asked in combination.
• Order of issues matters: Asking about an issue first or
second changes its reported value.
• The “embedding effect” matters: Asking about one,
two, or three sites does not affect answers.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Using Revealed Preference to Value Time

An alternative to contingent valuation is to use revealed

preference.
• Revealed preference: Letting the actions of individuals
reveal their valuation.
• Market prices potentially reveal preference: If people
are willing to pay P for something, then it is worth at
least P to them.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
EVIDENCE: House Prices and Commuting Time

How much do commuters value reductions in commuting

time?
• Price differences between houses close and far from
downtown might reflect the value of commuting time.
• But treatments and controls may differ, leading to bias.
o Everett is only 4 miles from downtown Boston,
while Lexington is 11 miles away.
o Average home price in Everett: $345,000.
o Average home price in Lexington: $798,000.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
EVIDENCE: House Prices and Commuting Time:
Solving the Problem of Bias

• One solution is to control for house characteristics.

o Lot size, number of bedrooms, square footage.
o But some features are hard to observe, such as
granite countertops.
• In order to provide a more convincing estimate of the
value of time savings, a quasi-experimental approach
can be used.
• Deacon and Sonstelie (1985) look at how much people
save by standing in line to buy price-controlled
gasoline—about $20/hour.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Valuing Saved Lives

Saving lives is a central benefit of many interventions.

• Valuing human lives is the single most difficult issue in
cost-benefit analysis.
• Many would say that human life is priceless.
• By this argument, valuing life is a reprehensible
activity; there is no way to put a value on such a
precious commodity.
• Every possible intervention has a chance of saving
lives. To decide which to finance requires valuing lives.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
APPLICATION: Valuing Life: Car Recalls

Some General Motors pickup trucks produced between

1973 and 1987 had a dangerous, side-mounted gas tank.
• 1993: Consumer groups demanded GM recall 5 trucks.
• Recall would cost $1 billion and would save at most 32
lives.
• Using these estimates, the cost per life saved by the
recall would have been $1 billion/32 = $31.25 million.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
APPLICATION: Valuing Life

In October 1999, a commuter train crash at London’s

Paddington Station killed 31 people.
• Outraged public for more investment in rail safety.
• Safety advocates proposed measures that cost $3−9
billion and would save 1−3 lives/year for 30−50 years.
• At best: $20 million per life saved.
• At worst: $300 million per life saved.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Valuing Saved Lives

How to value saved lives?

• Using Wages to Value a Life
o Life’s value is the present discounted value of the
lifetime stream of earnings.
• Contingent Valuation
o Ask individuals what their lives are worth.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Revealed Preference Approaches to Valuing Lives:
Compensating Differentials

• We can value life by estimating how much individuals

are willing to pay for something that reduces their
odds of dying.
• The extra safety is called a compensating differential
because it compensates workers for lower wages.
• Compensating differentials: Additional (or reduced)
wage payments to workers to compensate them for
the negative (or positive) amenities of a job, such as
increased risk of mortality (or a nicer office).
• This approach suggests value of life of $9.3 million.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Government Revealed Preference?

Regulation Concerning Year Agency Cost per life

Childproof lighters 1993 CPSC 0.13
Food labeling 1993 FDA 0.5
Reflective devices for trucks 1999 NHTSA 1.2
Asbestos 1972 OSHA 7.2
Value of statistical life 9.3
Benzene 1987 OSHA 28.2
Asbestos ban 1989 EPA 99.9
Solid waste disposal 1991 EPA 128.1
Cattle Feed 1979 EPA 217.7

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Discounting Future Benefits

• In addition to finding the value of lives saved in each

year, a cost-benefit analysis must discount these
future benefits.
• Choosing the proper discount rate is difficult.
• Since many projects have benefits that last long into
the future, the discount rate matters enormously.
o Reducing global warming will bring benefits
hundreds of years into the future.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.2
Cost-Effectiveness Analysis

Cost effectiveness is an alternative to cost-benefit

analysis.
• Cost-effectiveness analysis: For projects that have
immeasurable benefits, or are viewed as desirable
regardless of the level of benefits, we can compute
only their costs and choose the most cost-effective
project.
• Finding the cost of a life saved—and choosing projects
wit the lowest costs—avoids making judgments about
the value of life saved.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.1
Putting It All Together

Quantity Price/Value Total

Costs Asphalt 1 mill bags $100/bag $100
Labor 1 mill hours ½ at $20, 15
½ at $10
Repairs
$10 million 7% discount 43
(yearly) rate
Benefits Time saved 500k hours $19/hour 9.5
(yearly)
Lives saved 5 lives (year) $7 35
million/life

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.3
Other Issues in Cost-Benefit Analysis

• Common Counting Mistakes

o Counting secondary benefits.
o Counting labor as a benefit.
o Double-counting benefits.
• Distributional Concerns
o Costs and benefits may not go to the same people.
• Uncertainty
o Costs and benefits are often highly uncertain.

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 CHAPTER 8 ■ COST–BENEFIT ANALYSIS
8.4
Conclusion

• Turning the abstract notions of social costs and

benefits into practical implications for public project
choice is challenging.
• What at first seems to be a simple accounting exercise
becomes quite complicated when resources cannot be
valued in competitive markets.
• Economists have developed a set of tools that can take
analysts a long way toward a complete accounting of
the costs and benefits of public projects.

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