a primer on benefit-cost analysis presented to: the reclaimed water technical committee june 2, 2006...
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A Primer on Benefit-Cost Analysis
Presented to:The Reclaimed Water Technical Committee
June 2, 2006
ByBruce Flory, Ph. D.
Seattle Public Utilities
A Little History of BCA• Idea of economic accounting – France, 1848
• “Foundational” concepts - Alfred Marshall
• Practical development - Federal Navigation Act of 1936
– Required the U.S. Corps of Engineers carry out projects for the improvement of the waterway system when the total benefits of a project, to whomsoever they accrue, exceed the costs of that project.
– The Corps developed methods without economists
History - continued• Economists get in the act – 1950s
– provide a rigorous, consistent set of methods
• BCA expands into new areas -1980s – all major new regulations
• Some technical issues of BCA still unresolved
• However, the fundamentals are well established.
General Definitions• Benefit-cost analysis is a way of identifying,
portraying and assessing the factors which need to be considered in making rational economic choices.
• BCA is a method of evaluating the relative merits of alternative public investment projects in order to achieve efficient allocation of resources.
• In principle, BCA entails adjusting conventional business profit-and-loss calculations to reflect social instead of private objectives, criteria, and constraints in evaluating investment projects.
Pearls from Tom Fox
• A benefit-cost analysis is a systematic evaluation of the advantages (benefits) and disadvantages (costs) of a set of investment alternatives.
• Typically, a base case is compared to one or more alternatives.
Another Pearl
• A full social cost accounting identifies and accounts for all the benefits and costs of a potential action, including economic, environmental and social costs and benefits, even those that do not have readily observable market values.
Some Useful Concepts
• Externalities
• Public Goods– Non-rival
– Non-excludable
– Non-rejectable
BenefitsCosts
Costs and Benefits of Project X
BenefitsCosts
Private Interests
Private Costs and Benefits
BenefitsCosts
Private Interests
Public Interest
Public Costs and Benefits
Benefits Costs
Private Interests
Public Interest
The Reverse Case
Example
• Getting to work
More Useful Concepts
ScarcityChoice
Opportunity Cost
Opportunity cost:What we forego when we make a choice
Inefficient Use of Resources
Scarce community resources
Valuable community services
Community well-being
Scarce community resources
Valuable community services
Community well-being
Improved Efficiency(Most Bang for the Buck)
And More Still
• Sunk Costs
• Common Unit of Measure• Present Value (Discounting the Future)
Ignore Sunk Costs
• Sunk costs are sunk, – they cannot be recovered
• Do not include them in BCA
• Do not use them to justify project
Common Metric
• Apples and Oranges– Capital costs ($)– Revenue ($)– Reduced traffic congestion (driver hours)– Reduced cancer risk (deaths per million) – Improved habitat for endangered species
(spotted owls per acre)
• Ideal: Quantify all in $ terms
Present $ vs. Future $
• Not all dollars are equal
• $1 a year from now < $1 now– Time preference– Risk– Opportunity cost of capital
• Discount future values to obtain…
Present Value
Present ValueYear @ 0% @ 3% @ 5% @ 7%
0 $1,000 $1,000 $1,000 $1,0001 $1,000 $971 $952 $9355 $1,000 $863 $784 $713
10 $1,000 $744 $614 $50820 $1,000 $554 $377 $25830 $1,000 $412 $231 $13140 $1,000 $307 $142 $6750 $1,000 $228 $87 $34
Tot $50,000 $26,502 $19,169 $14,767
Present Value Formula(for those so inclined)
PV =
FV(1+r)t
Putting It All Together
• Identify the problem to be solved
• Define Baseline
• Identify Alternatives
• Identify All Benefits and Costs for Each Alternative
Putting It All Together – cont.
• Quantify All Benefits and Costs in $
• Calculate Present Values
• Calculate Net Present Value
• Rank by NPV
Net Present Value for One Option TOTAL 2006 2007 2008 2009 2010
TOTAL BENEFITS $60,000 $0 $0 $0 $780 $858Financial $53,040 $680 $748Social $0Environmental $6,960 $100 $110
TOTAL COSTS $40,000 $300 $25,000 $5,225 $276 $277Capital $27,800 $300 $22,000 $5,000O&M $1,600 $50 $50Social $3,000 $3,000Environmental $7,380 $225 $225 $225Risk $220 $1 $2
PV of BENEFITS $24,166 $0 $0 $0 $674 $706PV of COSTS $33,171 $300 $23,810 $4,739 $238 $228
NPV (3%) -$1,374NPV (5%) -$9,005NPV (7%) -$13,784 OPTION A
Net Present Value (NPV) Table
Option A Option B Option C
PV of Benefits $24,166 $42,750 $215,025
PV of Cost $33,171 $15,575 $204,842
Net Present Value -$9,005 $27,175 $10,183
Problems with BCA
#1 Problem: Difficulty of quantifying all benefits and costs in $
• Non-Market Valuation Methods– Stated Preference
• Contingent Valuation• Conjoint Choice Analysis
– Revealed Preference• Hedonic Pricing• Travel Cost Method
– Benefits Transfer “Method”
So, What Do You Do?
• 80-20 Rule
• Sensitivity Analysis
• Cost Effectiveness Analysis
Cost Effectiveness (another pearl)
• The phrases cost effectiveness analysis and benefit-cost analysis are often confused.
• Cost effectiveness analysis involves specifying a set of benefits or level of service, then comparing the costs of various alternatives that can deliver those benefits.
• The alternative with the lowest life-cycle costs is the most cost effective.
Perspectives Analysis
• Who gains, who pays?
• BCA doesn’t answer this question– “Compensation Principle”
• Ideally, design financing scheme to:– charge those who benefit– compensate those who lose
Summary (+s)
• BCA useful tool to help public agencies
– Ask the right questions
– Make good investment decisions
– Avoid costly mistakes
– Get the most “Bang for the Buck”
Summary (–s)
• BCA is not the only tool– Necessary but not sufficient
– Measurement issues
– Susceptible to abuse
– Doesn’t do distribution
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