2. Static vs. Dynamic Efficiency
Static Efficiency
When the efficient or optimal policy in one time period
is independent of the policies in all other periods.
Benefits and costs occur in the same time frame.
i.e., same year.
Dynamic Efficiency:
When the optimal policies are correlated across periods.
Benefits and costs accrue over time.
i.e., over different years.
3. Benefit-Cost Analysis in Practice
Make time adjustments
Benefits and costs must be adjusted to account
for how their values change over time
Assess relative values
Benefits and costs must be systematically
compared.
Determines feasibility
Use a “decision rule” to choose among feasible
options.
5. A Regulatory Impact Assessment was done for the revised lead in gasoline ruling .
Using the data below, mathematically confirm that the estimate of the Present Value of
Net Benefits (PVNB) is approximately $5.9 billion, as stated. Social discount rate is
stated as 10%.
Year Net Benefits (NB)
1983 $’s (millions)
1985 $264
1986 $1,316
1987 $1,241
1988 $1,125
1989 $1,096
1990 $1,079
1991 $1,090
1992 $1,079
Present value of Net Benefits:
Source: US EPA, Office of Policy, Planning, and Evaluation
6. Consider:
Why does a lower social discount rate increase costs?
Lower discount rate implies a lower time value of money.
There is less of a difference between the PV and FV of
monies
This causes the total present value of the operating costs
over the 5-year period to be higher.
7. Suppose that the state of Pennsylvania is proposing an environmental policy plan aimed at reducing
smog in its urban centers, particularly Pittsburg and Philadelphia. An economist estimates the
present value of benefits (PVB) of the proposed policy to be $4.2 billion and the present value of
costs (PVC) to be $5.6 billion. Is this proposal feasible?
Editor's Notes
It is much more common for environmental benefits as well as costs to add up over time. So, when we consider a new policy in the current time period, we need to make sure that we are considering all the values of the benefits and costs in today’s dollars. It wouldn’t do to consider the costs 5 years from now to be the same as today. Due to inflation, the cost or the benefit will actually be valued higher than it is today. To be as accurate as possible about the decision that is chosen these differences in time have to be considered. So we can “add” up all our costs and benefits on a yearly basis and assume some level of inflation occurs. So, when considering which policy to choose we have to use some sort of “decision rule” relating to have MB = MC and maximizing net benefits. Let’s continue on to see how this is done.
Time value of Money:The value of $1 today will not have the same value (purchasing power) as $1 in the future. For example, because of inflation, it will take more dollars in the future to buy the same gallon of milk you bought the other day. So, to know the real worth of the dollar 5 years from now, we have to “Discount,” “deflate,” or remove the amount that is inflation only, to understand the “real” price of our gallon of milk. The equation we use is : Discount factorT and rR is the discount rate. We could use it to deflate the future price of milk to today’s dollars OR we can use what is called the social discount rate. The social discount rate accounts for the rate of return that we may have been able to make in some other investment. Let’s think about this more closely. We will want to make sure that the money we spend on our investment in some environmental policy or action is going to be greater than our next best use of that money. This process ensures that the rate of return on our investment (benefits) outweighs the benefits (returns) that we could have otherwise received in the monies had been invested elsewhere. The social discount rate then accounts for the rate of return we would have received in another investment. This ensures the value of the benefits (or costs) are more accurately portrayed. I.e. future benefits may not hold the same social value as it does for us now.
Likewise, we will want to make sure that the money we spend on our investment in some environmental policy or action is going to be greater than our next best use of that money. This process ensures that the rate of return on our investment (benefits) outweighs the benefits (returns) that we could have otherwise received in the monies had been invested elsewhere.
