ppa 723: managerial economics lecture 21: benefit/cost analysis 2, valuing benefits and costs the...

PPA 723: Managerial Economics

Lecture 21:

Benefit/Cost Analysis 2,

Valuing Benefits and Costs

The Maxwell School, Syracuse UniversityProfessor John Yinger

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Outline

Where to Look for Benefits and Costs

Valuing Benefits and Costs

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Collapsing Across Outcomes

Today we investigate the B/C tools that help combine program impacts in different markets or on different outcomes.

This “collapsing across outcomes” has 2 steps:

Identify the relevant outcomes.

Express the outcomes into dollar terms, that is, in terms of willingness to pay.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Where to Look for Program Impacts

In most cases, government projects are supposed to correct some market failure or inequity.

So the best way to start a B/C analysis is to identify this “correction” and determine what impacts it involves.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Resources Gained and Lost

A project takes resources out of the private sector (costs) and returns them in the form of government services (benefits).

A good project obviously generates more benefits than costs.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Project

Costs:

Resources Used

Benefits:

Resources Gained

Difference = Net benefits

Resources Gained and Lost, 2

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Selecting an Accounting System

A word of caution: do not get hung up on the labels assigned to various program impacts.

Project-induced pollution, for example, could be a negative benefit or a cost.

As long as the signs are correct, these labels have no impact on the final net benefits.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Ripple Effects

A project’s effects generally are not confined to the obvious. For example,

Taxpayers change their spending habits and spend less for certain goods.

Participating firms may have more profits.

The farther from the circle you get the more nervous you should be about claiming B or C.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Ripple Effects, 2

Project

CostsBenefitsRipple Effects Ripple Effects

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Managing Complexity

How do we handle all this complexity, short of modeling the whole world?

The key is to recognize that

In almost all cases, these ripple effects represent a shuffling of the benefits or costs;

That is, they transfer resources from one group to another

And are important only to the extent that they influence equity.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Introduction to Transfers Consider this B/C table:

Group Costs Benefits Net

Taxpayers Program Cost =C Y -C

Participants Y Participant benefits = B1 B1

Other Citizens Spillover benefits = B2 B2

Group 4 X -X

Group 5 X X

Total C+ X+ Y B1 + B2 + X+ Y B1 + B2 - C

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Looking Ahead

So X and Y don’t affect the (unweighted) total but do affect outcomes for particular groups.

We will return to these “transfers” and how to handle them in the next lecture.

Today we focus on the benefits and costs in the main circle.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Consumer Surplus and Cost/Benefit

A demand curve indicates the quantity demanded at a given price or the willingness to pay for another unit at each quantity.

The latter interpretation leads to the notion of consumer surplus, which is the aggregate willingness to pay for some quantity above the price paid.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Total Willingness to Pay

Similarly, total willingness to pay is the area under the demand (=MB) curve:

$

Q

D = MB

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Valuing a New Good

Some government programs provide a new good, such as visits to a (new) park.

The benefits equal the total willingness to pay up to Q*, the quantity provided.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Valuing a New Good, 2

$

QQ*

D = MB

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Valuing a Price Change

Sometimes a project lowers the price of a good from P1 to P2.

A dam might lower the price of water for irrigation, for example.

The benefits equal the change in consumer surplus.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Valuing a Price Change, 2

P1

P2

D = MB

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Other Ways to Obtain WTP

Other methods for obtaining a measure of WTP include

Valuing goods at their market price Using adjusted market prices Estimating Cost Savings Using property value effects

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Using Market Prices

If a government program adds products that already are sold in a market,

And if the number of units added is small relative to the existing market,

Then the products can be valued at the market price, which is a measure of marginal willingness to pay.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Use Adjusted Market Prices

Sometimes these conditions for using market price are met, but the market price is not an accurate measure of marginal benefits because the market has an externality of a monopoly.

In this case, raise the observed price to account for a negative externality or monopoly and lower it to account for a positive externality.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Use Cost Savings

Many government programs or projects result in cost savings.

A program to remove rats or mice lowers the costs of treating asthma.

Cleaning up lead paint saves the cost of treating lead-paint disorders.

A new highway saves commuters time.

Cost savings are benefits because people are willing to pay $1 for $1 of cost savings.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Use Changes in Property Values

If you cannot measure benefits directly, you may be able to pick them up in property value changes.

People pay more for houses (or apartments) to capture the benefits of shorter commutes or better access to a park.

But be careful; one cannot use a direct measure of benefits (time savings, park benefits) and property values. (More on this in the next class.)

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Economic Rent

Another type of benefit refers to factors of production, not consumption.

Economic Rent (another name for Producer Surplus) is the amount a supplier of labor, capital, and entrepreneurship receives over and above the minimum needed to get him or her to work.

Managerial Economics, Lecture 21: Valuing Benefits & Costs

W

Market Wage = W*

Economic Rent

SL

L

Economic Rent in the Labor Market

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Changes in Economic Rent as a Benefit

• Changes in economic rent are legitimate benefits from a program.

• WARNING: If a market is in equilibrium, changes at the margin do not generate economic rent.

• In equilibrium, the marginal worker is indifference between work & leisure; hiring that worker brings benefits (wages) just equal to her costs (lost leisure).

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Economic Rent and Unemployment

With unemployment, there is potential economic rent, even at the margin.

Economic Rentat the Margin

L = Employment

Market Wage = W*

WSL

Managerial Economics, Lecture 21: Valuing Benefits & Costs

Jobs Benefits in B/C

• Hence, a program might be able to generate jobs benefits (= economic rent) at the margin.

• This is the only sense in which creating jobs yields benefits in B/C

• However, unemployment does not guarantee such benefits because of possible displacement, which is discussed next class.