Townley Chapter 7

Problems in Project Evaluation

• • This lecture discusses some of the practical problems involved in a cost benefit analysis.

This highlights some of the potential pitfalls as well as the errors that should be avoided when conducting a cost benefit analysis

Inflation

• • • • Always treat discount rate that is used in evaluation projects as “real” Social discount rate is net of inflation Nominal interest rate has two components a real rate of return and an adjustment for price level changes In cost benefit analysis all benefits and costs are measured in real (constant) dollars and net present values are computed using a real discount rate

Starting Dates, Planning Horizons and Scrap Values

• • • Example 1 : consider a dam, which can be started in any of the next 3 years, it will have same economic life regardless of when it is built.

– No change in value of project Example 2: Suppose population changes and there is a change in aggregate willingness to pay out that could change net present value; e.g., suppose as the population ages there are more preferences for health care and benefits for seniors Example 3: Suppose technological change reduces costs associated with a project then this could affect present value

• Termination date of project is not usually an issue but can be sometimes (for example, on text p. 146, a private sector firm would operate/collect tolls on a bridge for 35 years, after which it transfers control to the Federal government who would operate it for the rest of its economic life; the project has an economic life of 100 years, but the private sector firm might use a planning horizon of 40 years (5 years to build + 35 years it operates ) if not aligning termination date with economic life of project scrap values – determined by its worth in its next-best alternative use. • For a steel bridge, can use girders as scrap metal

Depreciation and Interest Charges

• • • In evaluating a project only concerned with resource costs, not with how it’s financed.

Interest payments and transfers between borrowers and lenders and shouldn’t be part of the calculation. Depreciation allowances are the same sort of issue, used for tax purposes.

Spillovers and Secondary Effects

• • Easiest to illustrate these with an example.

Suppose a multipurpose dam is built which will provide flood protection, irrigation, recreational water use. Other potential impacts might include: 1.

2.

Enhancing productivity of nearby agricultural land and increases farm profits.

Increase in agricultural production would lead to increases in profits to firms that supply farmers. 3.

4.

5.

6.

Increased recreational facilities might expand tourist industry in a region. Altered flow of water might cause more downstream dredging to be used more frequently than otherwise for navigation Altered flow of water will be conducive to fish breeding Increases in demand for construction workers will raise wages of other workers

• • • Which Impacts should count?

– Only 1, 4, and 5 should be counted in a cost benefit calculation. The rationale for this is discussed below.

Only impacts which result in changes to physical production should be counted.

Impacts that result in redistribution of income should be ignored.

Impacts to Count

•

Benefits

–

Direct impacts

• (1) is an increase in farm output that is directly attributable to enhanced water supplies; it is a change in physical output should count (changes in profits or value of land induced by this shouldn’t) –

Positive Technological Spillovers

• 5) increases the productivity of downstream fishing industry and is an improvement in the real output of the economy. •

Costs

–

Negative Technological Spillovers

• 4) Dredging the river is a real resource cost to the economy

Impacts to Count

• • All of the impacts on the previous slide are direct effects Only direct effects should be counted in a cost benefit analysis

Impacts That Should Not Be Counted

• Secondary impacts that are purely redistributive, or are accounted for somewhere else or are offset in the analysis should be excluded, i.e., (2), (3), (6)

Multiplier Effects

• • • • • Multiplier effects should not be included in a cost benefit analysis Why? – Multiplier effects are basically like secondary effects except they are not specifically identified.

A multiplier is applied to the aggregate project expenditure to capture aggregate secondary effects Almost all of the effects captured by the multiplier will be redistributive and not involve real resource costs.

As above only costs/benefits should be included in an evaluation