Cost Benefit Analysis


Published on

Published in: Economy & Finance
No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Cost Benefit Analysis

  2. 2. “It is best to think of the cost-benefit approach as a wayof organizing thought rather than as a substitute for it.” — Michael Drummond 2 Wali Memon
  3. 3. Cost-Benefit Analysis Cost-benefit analysis (CBA) is the implicit or explicit assessment of the benefits and costs (i.e., pros and cons, advantages and disadvantages) associated with a particular choice. Benefits and costs may be monetary (pecuniary) or non-monetary (non-pecuniary, “psychic”).3 Wali Memon
  4. 4. For private decisions, such as taking martial arts classes or going to a movie on Saturday night, we are often not aware of any internal process of consideration of costs and benefits, but behave as though we do. An individual will choose an action if: Benefits (B) > Costs (C) or Net Benefits (NB) = B - C > 0.4 Wali Memon
  5. 5. Joan will smoke if B > C.For Joan, B’s are: taste/oral satisfaction, relaxation,diet control, and improved work performance.C’s are: expense, health consequences, value of timespent, discomfort/inconvenience of “smoking-allowed areas”, and disapproval of others.For the continuous choice of how many cigarettes tosmoke, Joan will smoke the number of cigaretteswhich yield the greatest net benefits. 5 Wali Memon
  6. 6. CBA is most commonly used for public decisions– policy proposals, programs, and projects, e.g., dams, bridges, traffic circles, riverfront parks, libraries, drunk driving laws, and anything else the government might fund. CBA can be used to rank alternative projects as well as evaluating the social value of one particular project.6 Wali Memon
  7. 7. Even if CBA is not explicit, any decision, public or private, reveals a cost-benefit calculus consistentwith the observed choice.Example: Ashenfelter, Orley and Michael Greenstone, “Using Mandated Speed Limits to Measure theValue of a Statistical Life,” National Bureau of Economic Research Working Paper w9094, August2002 ( 7 Wali Memon
  8. 8. Raising the maximum speed limit from 55 to 65increased travel speed by about 2 mph (people oftenexceed posted speed) saving 45 million hourstravel time per year, and inducing about 360 deathsper year (125,000 hours of life).Our collective decision to drive faster infers that 45million hours of travel time is worth more that 360deaths.Our decisions lead to changes in benefits and costs 8regardless of whether we make them explicit. Wali Memon
  9. 9. Example: Knee Injury: Getzen, Thomas E., Health Economics, Second Edition New York:Wiley and Sons, 2004.Playing soccer, you injure your knee. Do you go to the emergency room (ER)?CBA usually takes the form of an explicit and formal presentation of a balance sheet, i.e., isit worth taking 3 hours and possibly $80 to go to the ER so that a doctor can alleviate painand check for serious damage? 9 Wali Memon
  10. 10. Outlining benefits and costs assists rational decision-making.1. Enumerate benefits and costs. (Handout, Table 3.1)2. Quantify each benefit and cost as accurately aspossible (usually expressed in dollars), given theinformation at hand. (Handout, Table 3.2)Previously set appointment for Thursday means theproper comparison is treatment today vs. treatmentThursday (not treatment vs. no treatment). 10 Wali Memon
  11. 11. Time lost - opportunity cost of time commonlymeasured by the wage, e.g., $7/hour.Value of athletic image - what you are willing to payto preserve your image, e.g., $40 for crutchesValue of stopping pain with certainty -the highestamount you would pay to stop the pain for 10 days,e.g., by buying painkillers.Expected value of stopping pain by going to the ER= probability that the ER visit will result in stoppingthe pain times the value of stopping the pain with 11 Wali Memoncertainty.
  12. 12. Expected ValueWhen values of costs or benefits are not known withcertainty, but are known with probability, expected valuesare used.Expected value of a benefit is:E(B) = i prob(B=bi) biwhereprob(B=bi) is the probability that the benefit is worth $ bi . 12 Wali Memon
  13. 13. Knee InjuryCost of visit to ER=$50, $100 or more; expected value = 80$80 is a weighted average, where the weights are theprobabilities that alternative cost values will occur.That is, if$50 will occur with probability 0.6,$100 will occur with probability 0.2, and$150 will occur with probability 0.2, then E(C)=.6 (50)+.2 (100)+.2 (150)= 80 13 Wali Memon
  14. 14. Example: Mauskopf, J.A. et. al, “Economic Impact ofTreatment of HIV-Positive Pregnant Women and theirNewborns with Zidovudine: Implications for HIVScreening,” JAMA 276: 2, 132-8, July 10, 1996.Probability of maternal-to-fetal transmission when themother is HIV-positiveNo Treatment = 25.5%With Zidovudine Treatment = 8.3%Lifetime cost of treatment of an infected child from birth 14 Wali Memon = $98,915
  15. 15. Expected value of cost of a lifetime pediatric HIV infection = probability of transmission lifetime treatment costsNo Treatment = .255 98,915 = $25,223With Treatment = .083 98,915 = $ 8,210Expected benefits of treatment = Expected costs averted by treatment = 25,223 - 8,210 = $17,013Cost of Zidovudine treatment = $1,045Expected Net Benefits = 17,013 - 1,045 15 Wali Memon= $15,968 per HIV-positive pregnant woman
  16. 16. If medical expenses are paid privately, the woman will optfor the treatment.If the child will be on public assistance for medical care(e.g., Medicaid–OHP), it benefits society to treat themother with Zidovudine. 16 Wali Memon
  17. 17. Theory of Cost-Benefit Analysis Public Policy Objective: Choose the level of output of a good or service to maximize net social benefits (NSB) NSB = TSB – TSC where TSB = total social benefits TSC = total social costs17 Wali Memon
  18. 18. Marginal Social Benefit (MSB) = additional social benefits from one more unit of outputMarginal Social Cost (MSC) = additional social costs of producing one more unit of outputMSB = d TSB/d QMSC = d TSC/d QQ = quantity of a publicly provided good or serviceNSB are max when MSB = MSCSocial Decision Rule: Choose Q for which MSB = MSC 18 Wali Memon
  19. 19. Present Value Future, as well as present, benefits and costs must be included in the analysis. But costs and benefits that accrue in the future are worth less than costs and benefits today. Economic agents and society as a whole will maximize the present value of expected net benefits. 19 Wali Memon
  20. 20. Costs and benefits may occur over different periods oftime, e.g., costs for a dam built today may be spentprimarily during the initial period of the project, butbenefits will accrue over the lifetime of the dam.To account for all costs and benefits in the same unitsacross time periods, we calculate the present value ofnet benefits: PV(NB) = t NB/(1+r)t20 Wali Memon
  21. 21. Present Value Worksheet$100 invested today at an annual interest rate (r) of 4%will be worth $104 in 1 year.Present value (PV) of $104 next year when r=.04 is $100.That is, $104 tomorrow is worth $100 today.PV = F/(1 + r),where F is a fixed sum of money to be received next year. 21 Wali Memon
  22. 22. Discount RateWhat value of r should be used?r = rate of discount of future consumption or rate oftime preferenceThe higher the social discount rate, the higher thesocial value of consumption today relative toconsumption tomorrow.22 Wali Memon
  23. 23. Conventional to use 3-5% or the T-Bill interest ratesince it represents the cost of borrowing at virtuallyno risk.Results can be sensitive to the discount rate chosen.Researchers often conduct a sensitivity analysis tosee how sensitive the results are to changes inassumptions about the discount rate, costs, andbenefits.23 Wali Memon
  24. 24. Value of lifeDoes society view life as infinitely valuable?24 Wali Memon
  25. 25. Many public programs and projects involve the prevention of loss of life: dams, maintaining roads, traffic signs, provision of health care, employment of firefighters, etc. How do economists value a life saved (death averted) in the cost-benefit calculus?25 Wali Memon
  26. 26. 1. Human Capital ApproachValue of life = present value of lifetime earnings (= lifetime productivity in competition)•represents productivity gains from extending life(benefit side) or• productivity losses from early death (cost side)•for society as a whole, represents a loss in nationaloutput due to mortality26 Wali Memon
  27. 27. Method often used in court cases, e.g., court awardsthe family of a man who dies at 35 in a car accidentthe amount of his expected PV of lifetime earnings =$650,00027 Wali Memon
  28. 28. Problems with human capital approach:•People who are not working for pay (e.g.,homemakers, students, retirees) are valued at 0!(Even for the employed, time away from the job isvalued at 0.)•Implies that people with higher wages have highersocial value.•Does not account for labor market imperfections,e.g., discrimination.28 Wali Memon
  29. 29. 2. Willingness-to-pay (WTP) ApproachValue of life is estimated from the amounts thatpeople are WTP to reduce the probability of dying.29 Wali Memon
  30. 30. Suppose the cost of a safety device (e.g., smoke detectors,seat belts, radon gas detectors) which reduces theprobability of death by 1 in 10,000 is $100, and people areWTP the $100.• Recall net benefits are maximized when marginal benefit (MB) = marginal cost (MC).• Benefit of 1 more safety device (MB) = (change in probability of dying) (value of life)• Cost of 1 more safety device = MC• Assuming people are maximizing NB, MB = MC MC = (change in probability of dying) (value of life)• Value of life = MC/(change in probability of dying) = 100 (1/10,000) Value of life = $1 million 30 Wali Memon
  31. 31. Advantages.•Measures total value of life (not just labor marketvalue)•Includes foregone earnings and nonmarket value oflifeDisadvantages.•Estimates vary widely•Price may be less than true WTP, value will be 31understated Wali Memon