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Chapter 4: Cost-Benefit Analysis
Chapter 4
Cost-Benefit Analysis
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 4: Cost-Benefit Analysis
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Introduction
Cost-benefit analysis
Building a factory
Benefits from improving the safety of a highway
Mistakes to avoid
Benefits from building a highway
Reducing global warming
Paying for a costly medical treatment
Intervening militarily
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Cost-Benefit Analysis
• A project should be undertaken if its benefit to society exceeds its costs to society.
Cost-benefit analysis is the measuring of the costs and the benefits of a project to help decide:
• Whether to undertake the project• The scale of the project
Who uses cost-benefit analysis?• Private firms • Individuals• Government
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Cost-Benefit Analysis
The optimal scale of the project is Q*.
Q*
$
Scale of the project (Q)
MSB
MSC
Figure 4.1
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A Private Firm: Building a Factory
Should a firm build another factory?
Assumptions:• The factory will be built in one year (Year 0)• The factory will last one year (Year 1) before wearing out• The construction cost in Year 0 = $100,000• The profit from the factory in Year 1 = $110,000
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A Private Firm: Building a Factory
Building with borrowing:
Will the firm build if the interest rate is 5%? 15%?
The firm borrows $100,000 in Year 0 to pay for the construction cost
The present discounted value (PV) of a future amount at a future date is the amount you would need to put in the bank today to have that future amount by that future date.
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A Private Firm: Building a Factory
Multi-year profits• $55,000 in Year 1• $60,500 in Year 2• r = 10%
PV of profits = $55,000(1+r)
$60,500(1+r)2
+
= $100,000
= $50,000 + $50,000
$55,000(1.10)
$60,500(1.21)
+=
Example
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A Private Firm: Building a Factory
PV of $110,000 in Year 1 = $110,000(1+r)
Table 4.1
r = 5% r = 15%
PV of Profit $104,762 $95,652
Cost of Project $100,000 $100,000
Correct Decision Build Don’t Build
• This is true even when a firm uses their own money to finance the construction of the factory.
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Government: Building a Highway
Costs• Current construction costs• Discounted future maintenance costs
Benefits• What drivers are willing to pay to use the highway in all future years measured as the discounted dollar value of time saved
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Government: Building a Highway
Measuring benefit of time saved through Increased Output
• Estimate how much more output commuters could produce at work if they decreased commute time
Example
• Commuter is paid $20/hr • Saves 1 hour of commute time each day because of the new highway• Commuter works 250 days a year• Time savings = (250 days)(1 hour)($20) = $5000
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Government: Building a Highway
Measuring benefit of time saved through Revealed Preference
• Look at commuter location preferences and estimate how home prices differ depending on commute time.
Example
• Two identical homes in two different suburbs• One house is associated with a shorter commute• The house associated with the shorter commute costs $20,000 more than the other house.• The difference in price “reveals” the value of time saved
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Government: Building a Highway
Measuring benefit of time saved through Contingent Valuation
• Pose a hypothetical question that asks commuters how much they would be willing to pay to reduce their daily commute by one hour.
Issues• Critics argue surveys produce unreliable results because answers may be sensitive to wording, presentation, etc.• Supporters argue that actual market behavior is also subject to similar problems • Supporters argue surveys improve with experience
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Benefits of Improving the Safety of a Highway
The safer the highway, the greater the cost of building it.
Measuring the value of lives saved through Increased Output
• Estimate how much that person would have produced over the rest of his life.
Issues• If person A is paid more than person B, then person A is valued higher than person B• How do you value the surviving family’s suffering?
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Benefits of Improving the Safety of a Highway
Measuring the value of lives saved through Revealed Preference
• Estimate how much people actually pay to reduce their chance of dying
• Compensating Differential
Measuring the value of lives saved through Contingent Valuation
• Pose a hypothetical question that asks commuters how much they would be willing to pay to reduce their chance of death on the highway from 2 in 1000 to 1 in 1000
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Benefits of Improving the Safety of a Highway
• The value of the life of a person we don’t know personally
Measuring the value of lives saved through The Value of a Statistical Life
• Approximately $8 million
• Is the VSL different for a young person as compared to an old person?
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Mistakes to Avoid
• Counting job creation as a benefit
• Double counting the same benefit
• Counting secondary benefits
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Reducing Global Warming
How much should each country cut back on its emissions of greenhouse gasses?
Costs: carbon fuel use must be reduced
Benefits: reduced global warming
• Uncertainty and the risk of catastrophe
• The social discount rate is the rate analysts use to compute the present value of future benefits
• A cost-effectiveness analysis focuses on achieving the given objective at a minimum cost
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Paying for a Costly Medical Treatment
Patients and families want the best care, which tends to be costly. Should the insurer pay for the care?
A medical treatment costs $1 million, and it will extend the life of the patient by 1 year.
• What if the patient is 100?
Example
• What if the patient is 80?
• What if the patient is 20?
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Intervening Militarily
Should a particular military intervention be undertaken?
Costs: military budget cost, cost of lives lost, suffering of veterans, disability payments, etc.
Benefits: historians, military scientists, international relations experts, and political scientists will determine the benefits.
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Cost-benefit analysis
Building a factory
Benefits from improving the safety of a highway
Mistakes to avoid
Benefits from building a highway
Reducing global warming
Paying for a costly medical treatment
Intervening militarily
Summary
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Preview of Chapter 5:
Social Security
Four ways to prepare for retirement
The U.S. Social Security system
Reforming Social Security
