APPLIED WELFARE ECONOMICS AND COST-BENEFIT ANALYSIS (CBA)

Definition: CBA is a systematic way of comparing benefits and costs for a "projekt", where the concept of project should be understod as widely as possible.

Structure of the lecture: -Social decision rules -History behind CBA -Motives for CBA -Analytical steps -Benefits and benefit components -Consumer surplus measures -Costs -Discounting -Risk and uncertainty

Social decision rules

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The Pareto criterion: A project should be carried through if at least one person gaines from it and no one looses.

Rests on three basic value judgements: i. An individualistic conception of social welfare - To make society better off, one must first make individuals better off.

ii.

Non-economic causes of welfare can be ignored - The extent of freedom and democracy is not something that economists ususally need to consider when evaluating a project.

iii. Consumer sovereignty - Individuals are there own best judges of there own welfare.

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Kaldor-Hicks criterion: A project should be carried through if the size of the benefits are such that the "winners" could compensate the "losers".

In practice the welfare economic foundation for CBA.

Critique: -The criterion defines a hypothetical change. The compensation does not actually have to be carried through.

-To limit to the monetary dimension is to implicitly assert that everyone has the same marginal valuation of money.

-History behind CBA

The "father" of Cost-Benefit Analysis: Jules Dupuit -1844, paper on the benefits and costs of building a bridge (De la Mesure de l'Utilite des Travaux Publics). -Introduced the concept of consumer surplus. Harold Hotelling: -"reinvented" CBA 1938 and formulated it in modern welfare theoretic terms (The General Welfare in Relation to Problems of Taxation and of Railway and Utility Rates). Empirical application: U.S. Flood Control Act, 1936 Post World War II: Control flooding of major rivers "If the benefits to whomsoever they may accrue are in excess of the estimated costs". New methods to value non-market priced goods. Burton Weisbrod: John Krutilla: 1980s and -90s: "Option Value", paper 1964 (Collective Consumption Services of Individual- Consumption Goods). "Existence Value", paper 1967 (Conservation Reconsidered). -CBA well established in the United States (Reagan's Executive Order 12291) European Union. -Less used in Europe - usually, environmental effects are not valued in monetary terms within the -Limited interest in Sweden – only Vägverket, Banverket and SIKA use CBA on regular basis.

-Motives for CBA

Under a perfect market economy it holds, in principle, that what is good for the company is good for society. However, no perfect market economy exists.

Five motives for CBA: *Externalites *Public goods *Disequilibrium conditions *Imperfect competition *Taxes, Allowances & Subsidies

-Analytical steps in CBA

*Specification of the project and choice of alternatives.

*Description of the physical effects of the project and quantification of benefits and costs.

*Possible weighting of benefits and costs using distributional weights.

*Discounting of future benefits and costs.

*Considerations with respect to risk and uncertainty.

-Benefits and Willingness-To-Pay (WTP)

*Market priced goods -Marginal project, i.e. the supply of of a market priced good change only a little Use the market price after adjustments for taxes, allowances etc

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-Non-marginal project, i.e. the project changes the price of a market priced good Benefit = area under demand curve * Non-market priced goods -The good exists but the project changes the supply - see above -The good did not exist previously but is provided by the project Benefit = area under demand curve up to the level which is provided by the project. For a public good this is equal to the sum of WTP.

-Value components

Why do we value environmental commodities?

Broad classification: -Use values -Option values -Existence values

-Costs

*The most fundamental cost concept is opportunity cost.

Definition: The opportunity cost of using resources in a certain way is the highest valued alternative use to which the resources might have been put.

*Often the opportunity cost is equal to the monetary expenditure however, the opportunity cost of using idle resources (like an otherwise unemployed person) is zero *Does the project lead to physical quantity increase?

Cost = area under Marginal Cost (MC) curve, where the cost is defined as opportunity cost.

*How to practically go about measuring costs?

-Survey method - May give overestimated answers.

-Engineering method - Only gives estimates for an example company.

-Distributional weights

*CBA with a positive net value increases "the social cake". *Society does, however, not only care about the size of the cake but also about how it is distributed. *To acknowledge this, benefits and costs that accrue to a poor person can be weighted up. *Arguments against distributional weights: -Tax and allowance systems, not specific projects (like infrastructural projects), should be used to reach the desired distribution of income. -Inefficient project should not be motivated on pure distributional grounds. *Arguments in favor of distributional weights: -Administratively costly to use tax/allowance systems. -Projects may some times provide in natura benefits. -Distributional issues important for the possibility to conduct efficient policy.

-Discounting

*Analogous problem to distributional weights. A discount rate is a weighting over time and between generations. *Why use a positive discount rate in CBA? *How should a social discount rate be chosen? In theory: MRTP + EMUI*GPCI MRTP: Marginal rate of time preference. “How impatient we are.” EMUI: Elasticity of Marginal utility of income. “Percent increase in utility from 1 precent increase in income.” GPCI: Growth in per capita income. Reflects that a poor man today should not make sacrifices for a rich man tomorrow. *Discounting and future generations - The tyranny of discounting. *Falling discount rates – British government list of falling rates to be used in public projects: 3,5 % from year 1 to year 30. 3 % from year 31 to year 75. 2,5 % from year 76 to year 125. 2 % from year 126 to year 200.

-Risk and uncertainty

Risk: A situation where we have some understanding about the probabilities of different outcomes.

Uncertainty: We do not know anything about the probabilites of different outcomes.

Expected value: The sum of possible outcomes weighted by their probability.

The Certainty Equivalent: The certain sum which gives the individual the same utility as a lottery with the same expected utility.

The Cost of Risk: The difference between Expected Value and The Certainty Equivalent.

Risk Aversion: The Cost of Risk is positive.

Risk Preference: The Cost of Risk is negative, i.e. the risk has a value.

Risk Neutral: The Cost of Risk is zero.