Transcript AGEC/FNR 406 LECTURE 9 Corn growing at site of former rainforest Benefit-Cost Analysis First of two related lectures: 1.

AGEC/FNR 406
LECTURE 9
Corn growing at site of former rainforest
Benefit-Cost Analysis
First of two related lectures:
1. Overview of benefit-cost analysis
2. Specific benefit-cost tools
Remember to review the BCA packet!
Static vs. dynamic efficiency
Static efficiency is defined as maximization
of net benefits for a single time period.
Many economic decisions that occur over
time are a series of static decisions.
Example: Shopping for Food
Choose groceries each week, consume them,
then start over again next week.
Static vs. dynamic efficiency
A dynamic decision is one in which current
decisions have impacts on net benefits
arising in the future.
Many economic decisions with
environmental implications are dynamic.
Example: Forestry
If you choose to harvest trees this year,
harvesting next year is no longer an option.
Benefit-Cost Analysis
What is benefit-cost analysis?
BCA is an economic technique used to:
1.Evaluate a project or investment over time
2. Compare the merits of a set of projects
BCA is conducted by comparing economic benefits of
an activity with economic costs of an activity.
Key Point
As a tool for economic analysis, BCA
seeks to examine potential actions with
the objective of increasing well being...
…seeking an activity or use that provides
greater benefit than cost, or the greatest
benefit among competing uses.
Key Point
Decisions are typically not made on the
basis of BCA alone…
but BCA can be useful for providing
information on economic features of
projects or activities, and can therefore be
useful for informing the debate.
BCA in a timeless world
Dam construction
Costs:
Materials = $500,000
Labor =
$600,000
Total Cost = $1,100,000
BCA in a timeless world
Dam construction
Benefits:
Recreation =
$400,000
Flood control = $300,000
Electricity = $500,000
Total Benefit =$1,200,000
BCA in a timeless world
Dam construction
Total Benefit =$1,200,000
Total Cost = 1,100,000
Net Benefit =
100,000
Benefit exceeds cost, so dam appears to be a good
investment
BCA as “Approach”
To know whether society should build the
dam, other information may be needed:
1. Are there non-economic impacts?
2. What is the opportunity cost of the dam?
Time and Discounting
Often the benefits and costs of a project accrue
at different times. The technique used to deal
with this issue is discounting.
Discounting
Discounting is a technique used to convert all
benefits and costs to a common point in time,
usually the present.
The value of a project, expressed in terms of
the present, is called the Present Value.
Discounting
Discounting is based on the premise that a
dollar of benefit received today is worth more
than a dollar of benefit received in the future.
The bias arises because current resources can
be invested.
Discounting is the opposite of compounding.
Discounting
The rate at which a current value is
compounded is called the interest rate.
The rate at which a future value is discounted
is called the discount rate.
Computing a present value
PV = Pt / (1 +
PV = present value
Pt = value at time t
r = interest (discount) rate
t = year in which Pt is realized
t
r)
BCA with discounting
Dam revisited
Total Benefits accrue
when dam is finished
(t = 1)
Total Costs accrue at
start of construction
(t = 0)
Discount rate = 10%
Should the dam be built?
Dam construction revisited
Total Benefits accrue when dam is finished (t = 1), so
Pt = $1,200,000 and PV of benefit is:
$1,200,000 / (1+0.10)1 = $1,090,909
Total Costs accrue at start of construction (t = 0), so
Pt = $1,100,000 and PV of benefit is:
$1,100,000 / (1+0.10)0 = $1,100,000
PV(B) < PV(C)
The dam shouldn’t be built.
Why the reversal?
Total Benefits accrue in the future (i.e. when dam is
finished). The process of discounting reduces the
value of those benefits because they occur in the
future.
Because the merit of a project can hinge on the
choice of discount rate, it can be a source of debate.
There is no simple rule for choosing a discount rate.
Often a “well known” interest rate is used.
Key Points
Whenever benefits and costs accrue at different
points in time, amounts should be converted to
present values for comparison.
BCA is a decision-support tool, not a decisionmaking tool.
Discounting can be used regardless of the length of
time under consideration, but discounting has
implications for equity.