Economic concepts and methods underlie some of the most powerful tools available to highway decision makers. These tools are particularly applicable to selecting among competing projects, or determining the best means to mitigate the effects of construction work zones. I will give a brief summary of some of these concepts and methods, and demonstrate an application of economic analysis to a pavement/work zone decision.
Actions taken by highway agencies will result in different mixes of benefits and costs. One project may cost $1 million and save 2 million travel hours over 20 years. Another may cost $1 million and reduce the chance of fatality by one person over 20 years. Which, if either, project should be pursued. Which should be pursued first if funds are limited? Economic analysis offers the most objective method of evaluating these potential actions, using the common unit of the dollar.
EA contributes important information to the critical questions of decision making. It helps answer “why,” e.g., does a project’s performance warrant the resources it consumes. Regarding “what,” the alternative with the great net benefit is likely the solution to pursue. “When” to do a project is affected by the sufficiency of future benefit streams. Net benefit streams also affect the “where” of a project. “How” can be influenced by work zone costs for users and other factors.
To be compared fairly, costs and benefits must all be in dollar units. The concept of a multiyear analysis period, corresponding to the project life cycle, is essential to meaningful comparisons among project alternatives. Costs and benefits may vary significantly among alternatives over this analysis. Finally, future dollars flows must be converted into what they are worth to an agency today, i.e., they must be discounted to their present value.
The above graph is a fairly typical profile of the monetized cost and benefit flows of a transportation project. The initial cost spike represents the capital cost of the project. Subsequent costs are attributable to maintenance (smaller bars) and periodic rehabilitations (medium height bars). Benefits build over time as traffic grows, due in large part to the effect of the project in reducing future congestion and delay.
The formula above is the most basic calculation of present value. The term which incorporates the discount rate “r” is called the discount factor. Multiplying a future sum by the appropriate discount factor for that future year will yield the present value of that sum at time zero.
Application of the discounting formula is easy to demonstrate. In this example, we want to learn what a $1,000 in resources to be realized 30 years from now would be worth to us today at a 3% discount rate. The substitution of these values into the discounting formula is shown on the next slide.
The bracketed term in the above equation is often referred to as the discount factor. In our example is equal to 1/(1.03)^30 or 0.41199. When $1,000 is multiplied by this amount, the present value of $1,000 in 30 years is revealed to be $412 in today’s dollars.
To selection of an appropriate discount rate is important. The present values of costs and benefits 30 years in the future can be changed by more than a factor of 5 depending on the discount rate used. Due to the importance of the discount rate, care should be taken to select one that reflects a State’s actual time value of resources.
The principal method of economic analysis applied to transportation projects is benefit-cost analysis. A cost-only subset of benefit-cost analysis is life-cycle cost analysis. The results of benefit-cost analysis are more informative and accurate if combined with other analytical tools, including risk analysis, traffic modeling, and economic impact analysis.
BCA attempts to capture all benefits and costs accruing to society from a project or course of action, regardless of which particular party realizes the benefits or costs, or the form these benefits and costs take. Used properly, BCA reveals the economically efficient investment alternative. BCA is not the same thing as financial analysis, which is concerned with how to fund a project over its lifespan.
The above formula shows the BCA formula, which is a direct expansion of the multi-year discounting formula discussed in the module on economic fundamentals. The formula is applied to each design alternative or project being evaluated for identical analysis periods.
BCA has many applications to highway decision making. It can be used at the project planning stage, selecting among potential designs or operations strategies. It can be used to evaluate equipment purchases, or to evaluate the costs and benefits of a proposed regulation. BCA can be applied to a comprehensive set of investment alternatives to develop a transportation program.
LCCA is applied when an agency has already decided to undertake a project and is seeking to determine the means with the least present value of costs to accomplish the project’s objectives. LCCA enables the analyst to make sure that the selection of a design alternative is not based solely on the lowest initial costs. LCCA is used to select from among design alternatives that would yield the same level of performance to the project’s users during normal operations.
The LCCA formula is a direct application of the discounting formula discussed above. The Sigma sign indicates the summation of the present value of the cost in each year of the analysis period (0 to year N). The formula is applied to each design alternative being evaluated. The above formula is incorporated in the LCCA RealCost software, which I will describe in more detail in a few minutes.
LCCA is an excellent tool for analyzing actions to rehabilitate or preserve facilities, such as pavements or bridges. Such actions will generally not change the capacity or level of service of the facility in question. However, were alternative actions to result in different level of service to users, a strict comparison of life-cycle costs using LCCA would not be appropriate. Rather, the appropriate economic tool would be BCA.
Only when all reasonable alternatives are evaluated can the analyst be confident that LCCA will reveal the most cost-effective transportation solution. Because the costs of competing alternatives can only be compared fairly if the alternatives yield the same benefits, the analyst must compare the project alternatives over the same operational time period. Only costs that differ between alternatives need to be compared—all others will wash out in a comparison.
There will be instances where some of the cost elements shown above need not be quantified when comparing alternatives using LCCA. This is because alternatives that accomplish identical objectives often have many costs in common. Costs that are identical among all alternatives need not be quantified. Of agency cost elements, construction and rehabilitation typically vary the most among alternatives and must be quantified.
Many people are puzzled about how economists assign values to highway project benefits and costs. This is particularly true about travel time. Travel hours associated with business trips are usually valued at traveler wage plus overhead. Personal travel time is usually valued as a percentage of personal wage based on what travelers would be willing to pay to save travel time. People do value their time, as is evident by their avoidance of work zones when given advance notice.
Some agencies have been reluctant to include work zone user costs with agency costs in LCCA calculations. Project design alternatives that reduce work zone user costs often entail higher agency expenses—not welcome in times of tight highway budgets. However, by placing dollar values on user costs, the costs of strategies to maintain traffic flow can be evaluated and compared. In some cases, agencies may overspend.
BCA and LCCA are most effective if coordinated with other analytical tools. Accurate traffic forecasts, supported by travel demand modeling, yield more realistic BCA and LCCA findings (particularly regarding traffic diversion). Risk analysis is able to address the uncertainty that underlies variables used in BCA and LCCA. Economic impact analysis can translate the direct benefits and costs of projects into indirect effects, such as jobs and business growth.
There are numerous models available for modeling traffic effects. Work zones in rural areas, or where no detour routes exist, can make use of basic queuing models (as in RealCost or Quewz-98). In urban and suburban areas where road networks are more complex and detour opportunities exist, traffic diversion can be modeled using traffic simulation models (including Corsim, QuickZone, and proprietary models). Very large projects in urban areas may require travel demand models.
Typically, the analyst is faced with a number of uncertainties when evaluating a highway investment. This uncertainty can be measured as risk and mitigated using risk analysis techniques. Once risks have been identified and quantified, the next step is to evaluate potential actions to mitigate them. Many actions may be taken to reduce risk.
Economists generally hold that the direct benefits and costs of transportation improvements measured using EA are converted into wider, indirect economic impacts through the operation of the marketplace. These indirect effects are not additive in value to the effects measured by EA. In many cases, however, these final impacts (jobs, etc.) are important to decision makers. For instance, travel delay caused by work zones may translate into reduced sales for businesses.
The application of Economic Analysis to construction work zone strategies can be very helpful in informing decision makers about effective impact mitigation strategies. LCCA, in particular, can be used to incorporate user cost into the decision making process. RealCost is an LCCA model well-suited to measuring work zone impacts over many years in rural areas.
A wide range of options exists to minimize the impacts of construction on road users and the agency, all of which will have some consequence of cost that can be evaluated using economic methods.
The use of LCCA can inform a highway agency if steps taken to reduce construction work zone impacts are worthwhile in terms of reduced costs to highway users. More broadly, economic analysis can reveal which of several design options for an improvement is the best overall, not only in terms of avoided user delay during construction, but also in terms of total agency costs and user cost savings over the life of the project.
Consider a relatively simple example. Two materials will be considered to rehabilitate a road periodically over a 35 year period with a 2” mill and fill, lanes and shoulders. Stone matrix asphalt and dense graded hot mix asphalt (Superpave) are under consideration, and, due to traffic concerns, nighttime work zone restrictions are being considered. The project is 5 miles in length, with traffic at 25,000 ADT in 2004, building to 60,000 ADT in 35 years.
The RealCost model uses a verified methodology to allocate traffic according to peak hours and then to estimate delays associated with work zones due to lower speeds, acceleration and deceleration, and queuing in front of the work zone. These estimates can be developed by the user as well. In this example, we will use a 4 percent discount rate over a 35 year analysis period.
SMA costs are assumed to be 20 percent higher than Superpave per overlay, but last 20 percent longer between rehabilitations. Nighttime work conditions are assumed to add ten percent to installation expenses. These estimates are for illustration purposes only; the experiences of individual States will vary.
The results of the analysis above show the tradeoffs between agency costs and user costs. To simplify the presentation of results, risk analysis has not been performed. Note: If user costs are high it is essentially a red flag indicating that the alternative may have some problems and other engineering solutions should be considered
The results of the analysis show that the use of SMA will slightly increase agency cost but reduce user cost. Its higher installation cost is partially compensated by the need for fewer rehabilitations due to its longer life. However, the biggest impact of user costs is nighttime work. The agency may find that the big savings in user delay justify the higher agency expenses for such work. Also, nighttime work would minimize the secondary impact of work zones on retail business establishments.
To promote greater understanding and use of economic analysis techniques in the highway community, the Office of Asset Management of the FHWA has released the Economic Analysis Primer . Copies of the document are available from the Office of Asset Management and on our website. We will supplement information in the primer with occasional issue papers and web links to data resources.
The FHWA has a special initiative to promote the use of LCCA for pavement design, including a team composed of Resource Center experts who will provide instruction in the use of FHWA’s RealCost LCCA model. This initiative is described in the Life-Cycle Cost Analysis Primer . Copies of the materials above are also available from the Office of Asset Management and on our website.
Other information on economic analysis methods, including the Highway Economic Requirements System model, is available on the Office of Asset Management website.
Economic Analysis: Applications to Work Zones March 25, 2004
Economic Analysis What Is It? <ul><li>Benefits and/or costs of competing investment options are compared in common unit of the dollar </li></ul><ul><li>Makes non-like performance measures comparable </li></ul>
<ul><li>Why? Performance </li></ul><ul><li>What? Greatest net benefit </li></ul><ul><li>When? Optimal timing </li></ul><ul><li>Where? Best alignment </li></ul><ul><li>How? Best implementation strategy </li></ul>Economic Analysis Addresses Key Project Questions
Economic Analysis Issues and Concepts <ul><li>Costs and benefits can be valued in dollars </li></ul><ul><li>Project life cycle is basis for comparison </li></ul><ul><li>To be compared, dollars in different years must be “discounted” to their present value amounts </li></ul>
Economic Analysis Adjusting for Present Value where PV = present value at time zero (base year) r = discount rate t = time (number of year) A = amount of benefit or cost in year t
<ul><li>What if we want to determine how much a $1,000 benefit in 30 years is worth to us today? </li></ul><ul><ul><li>$1000 is in “real” dollars (i.e., in dollars with today’s purchasing power) </li></ul></ul><ul><ul><li>Discount rate is 3% </li></ul></ul>Economic Analysis Example of Discounting
<ul><li>Plug values into discounting formula: </li></ul><ul><li>Do calculations: </li></ul>Economic Analysis Example (continued)
Economic Analysis Discount Rate Is Important <ul><li>Higher the discount rate, the lower the present value of a future dollar </li></ul><ul><ul><li>At 3%, $1,000 30 years from now is worth only $412 today </li></ul></ul><ul><ul><li>Worth $231 at 5% and $57 at 10% </li></ul></ul><ul><li>Discount rate can influence project selection or design </li></ul>
EA Methods <ul><li>Benefit-Cost Analysis </li></ul><ul><li>Life-Cycle Cost Analysis </li></ul>
EA Methods Benefit Cost Analysis (BCA) <ul><li>BCA compares discounted value of project’s benefits to discounted value of its costs </li></ul><ul><ul><li>The blue and red bars on the life cycle profile </li></ul></ul><ul><li>BCA is different from financial analysis, which focuses on how to fund a project </li></ul>
EA Methods BCA Formula <ul><li>BCA is done using the basic multi-year discounting formula: </li></ul>
EA Methods Applications of BCA <ul><li>Project-level analysis </li></ul><ul><li>Selecting ITS or operations technologies </li></ul><ul><li>Highway program-level analysis </li></ul><ul><li>Regulatory analysis </li></ul>
EA Methods Life-Cycle Cost Analysis (LCCA) <ul><li>Subset of BCA </li></ul><ul><ul><li>The “blue bars” on the life cycle profile </li></ul></ul><ul><li>LCCA reveals lowest life-cycle cost alternative for a project </li></ul><ul><li>Used only when all design alternatives yield same benefits </li></ul>
EA Methods LCCA Formula <ul><li>LCCA is done using the basic multi-year discounting formula: </li></ul><ul><li>where “Cost” equals the cost for design alternative in year t </li></ul>
EA Methods Applications of LCCA <ul><li>Evaluation of pavement preservation strategies </li></ul><ul><li>Project planning and implementation, especially the use and timing of work zones </li></ul><ul><li>Value Engineering </li></ul>
EA Methods How to Get Best LCCA Results <ul><li>Evaluate all reasonable design alternatives for the project </li></ul><ul><li>Analyze alternatives over identical analysis periods </li></ul><ul><li>Evaluate all relevant costs that vary among the alternatives </li></ul>
EA Methods Cost Items Used in LCCA Agency Costs Design and engineering Land acquisition Construction Reconstruction/Rehabilitation Preservation/Routine Maintenance User Costs At Work Zones Delay Crashes Vehicle Operating
EA Methods Valuation of User Time <ul><li>Business travel valued at wage plus benefits </li></ul><ul><li>Personal travel valued at what travelers are willing to pay to reduce travel time </li></ul><ul><ul><li>Usually a percentage of wage </li></ul></ul><ul><li>People do value their time </li></ul>
EA Methods Inclusion of User Costs in EA <ul><li>Some agencies resist valuation of user delay caused by construction </li></ul><ul><li>However, agencies seeking to reduce work zone impacts without user cost data may overspend or underspend </li></ul>
Linking EA to Other Tools <ul><li>Other tools increase the usefulness of BCA and LCCA </li></ul><ul><ul><li>Traffic Forecasting </li></ul></ul><ul><ul><li>Risk Analysis </li></ul></ul><ul><ul><li>Economic Impact Analysis </li></ul></ul>
Linking EA to Other Tools Traffic Forecasting <ul><li>Queuing models </li></ul><ul><ul><li>Included in RealCost LCCA Software </li></ul></ul><ul><li>Traffic simulation models </li></ul><ul><ul><li>Corsim </li></ul></ul><ul><ul><li>QuickZone </li></ul></ul><ul><li>Travel demand models </li></ul>
Linking EA to Other Tools Risk Analysis <ul><li>Uncertainty can be measured and mitigated </li></ul><ul><li>Sensitivity and probabilistic methods </li></ul><ul><li>Risk can be mitigated using alternative engineering, contractual methods, etc. </li></ul>
Linking EA to Other Tools Economic Impact Analysis <ul><li>EA focuses on direct benefits and costs of highway projects </li></ul><ul><ul><li>Time savings, safety, externalities </li></ul></ul><ul><li>EIA “translates” EA results into indirect economic effects </li></ul><ul><ul><li>Delays affect business and jobs </li></ul></ul><ul><ul><li>Not additive to value of direct benefits and costs </li></ul></ul>
LCCA Applied to Work Zones <ul><li>LCCA can be used to compare construction/work zone mitigation strategies </li></ul><ul><li>FHWA’s RealCost LCCA software can measure agency costs (construction, rehabilitation, maintenance) and user costs over multi-year periods </li></ul>
LCCA Applied To Work Zones Mitigation Strategies <ul><li>There are many ways to mitigate construction impacts </li></ul><ul><ul><li>TMP and work zone strategies </li></ul></ul><ul><ul><li>Innovative contracting </li></ul></ul><ul><ul><li>Design features and materials </li></ul></ul><ul><li>Does value of mitigation justify costs? </li></ul>
LCCA Applied To Work Zones Comparing Strategies <ul><li>Each construction/WZ strategy involves trade-offs </li></ul><ul><ul><li>Agency vs. user costs </li></ul></ul><ul><ul><li>Initial vs. long-term costs </li></ul></ul><ul><li>LCCA approach permits comparison of cost trade-offs </li></ul>
Application to Work Zones Example <ul><li>Consider Stone Matrix Asphalt (SMA) vs. Superpave (SP), each with 24 hour vs. nighttime work zones </li></ul><ul><li>5 mile, 4 lane road mill & fill </li></ul><ul><ul><li>25,000 vehicles Average Daily Traffic, rising to 60,000 ADT in 35 years </li></ul></ul><ul><ul><li>One lane closed each way </li></ul></ul>
Application to Work Zones Example (Continued) <ul><li>ADT is allocated by RealCost model to peak/off-peak times </li></ul><ul><li>RealCost model calculates user delay caused by work zones </li></ul><ul><li>35 year analysis period </li></ul><ul><li>4 percent real discount rate </li></ul>
Application to Work Zones Example (Continued) <ul><li>SMA costs 20 percent more than SP per overlay but lasts longer 20 percent longer between rehabilitations </li></ul><ul><li>Nighttime work zones increase agency cost by 10 percent </li></ul>
LCCA Applied To Work Zones Example Results (Continued) <ul><li>Least cost option for the agency (SP/24 hours) is highest cost for travelers </li></ul><ul><li>Using SMA reduces traveler cost due to fewer rehabs </li></ul><ul><li>Nighttime work zones eliminate most of delay for SP and SMA at little additional cost to the agency </li></ul>
For Further Information Economic Analysis Primer FHWA IF-03-032, August 2003 <ul><li>Contents: </li></ul><ul><li>Economic Fundamentals </li></ul><ul><li>Life-Cycle Cost Analysis </li></ul><ul><li>Benefit-Cost Analysis </li></ul><ul><li>Forecasting Traffic </li></ul><ul><li>Risk Analysis </li></ul><ul><li>Economic Impact Analysis </li></ul>
For Further Information Life-Cycle Cost Analysis Materials RealCost Software and workshops– call your Division Office Life-Cycle Cost Analysis Primer
For Further Information Other Economic Materials <ul><li>FHWA’s Office of Asset Management, Evaluation and Economic Investment Team: </li></ul><ul><li>www.fhwa.dot.gov/infrastructure/asstmgmt/invest.htm </li></ul>