COST – BENEFIT ANALYSIS

(CBA)

OMKAR APHALE

•We want our environment to be clean and safe.

•But ‘how much’ clean and safe ?

•How to measure environmental benefits

and costs ?

•There is no free lunch.

Total Cost

Total Benefit

Maximum Net Benefit

Q1 Q*Q0 Q2

Most Efficient Resource Distribution

• Our aim is to attain the ‘most efficient’ resource distribution.

•We will select the option with the ‘maximum’ net benefit

•Net Present Value (NPV)

NPV =

•Internal Rate of Return (IRR)

=

Technical Evaluation

( b – c )t

( 1 + r )t

( b – c )t

( 1 + i )t

∑

∑ Ct

( 1 + i )t∑t= 1 t= 1

n n

n

t = 1

•Benefit – Cost ration (BCR)

Technical Evaluation continued ….

( b – c )t

( 1 + r )t

∑ n

t = 1

Ct

( 1 + i )t∑t= 1

n

= BCR

•CBA aims to value the effects of a project

as they would be valued in money terms

by individuals affected.

•2 steps,

- List all parties affected by the project

- Value the effects on their welfare as it

would be valued in money terms by them.

Cost Benefit Analysis (CBA)

• We describe a project as ‘efficient’ if,

1. Benefits gained fully compensate the losers.

2. Gainers, in principle, compensate the

losers, even if they do not.

3. Doing a small number of efficient projects

produces more benefits as a whole than

doing a collection of efficient and inefficient

projects.

An ‘Efficient’ project

•Project cost =

cost of resources + cost imposed on third

parties

•Include only incremental costs

•Do not include – interest payments,

depreciation

Project costs

•Use and Non-use values

•Use values = all use benefits to man

•Non-use values =

Direct or Indirect use benefits + option

values + existence values

Project benefits

Environmental values

•Risk is attached to all decisions

•Uncertainty about demand and supply in

future

•Pay more to insure demand or supply

•Option value =

value that an individual is willing to pay in

excess to expected use value to preserve an

asset

Option values

•Amount that people would pay to preserve

the natural environment or a species

above any use benefits

•Pure existence

•Altruistic existence

•Vicarious existence

Existence values

•Result from primary benefits of the project

•e.g. project > higher wages to employees >

higher expenditure > improve quality of life

•Not included in CBA

•Viewed as transfer between communities

rather than net addition to community income

Secondary benefits

•Value of a resource = marginal

opportunity cost = highest amount that

someone is willing to pay for it in an

alternative use

•Value of a benefit = amount that someone

is willing to pay for it

•Willingness to pay (WTP) values

Basic Valuation Principles

•WTP = P + CS

Willingness to Pay (WTP)

P0

Q0

Producer Revenues

P’

$

Quantity

Consumer

Surpluses Demand (WTP)

Q’

•Although income remains constant,

welfare changes with rise / fall in prices

•Marshallian demand curves

•Need compensation for change in price

fall or rise

•Hickinson demand curve

•M.D. curve is much easier to use

Income and welfare

•Fairer and more appropriate

•Compensating variation principle

- considers existing situation desirable

•Equivalent variation principle

- considers project situation desirable

Willingness to Accept (WTA)

•In practice, CBA studies prefer WTP

because,

- WTP more observable

- WTA have wide value ranges

- Difference between WTA and WTP values

is usually very small

- Who has the right to claim

compensation ?

WTP vs. WTA

•Quantified and Unquantified impacts

•Need to reduce risk of wild exaggerations

•Expected value approach

• ENPV =

•In risk- neutral case, project with highest

ENPV should be preferred.

Uncertainty

( Eb – Ec )t

( 1 + r )t

∑ n

t = 1

Uncertainty continued ….

Project A

Project B

ENPV

$ 1.5 MP = 1

P = 0.5

P = 0.5

$ 5 M

$ - 1 M

$ 2 M

$ 2.5 M

$ 1.5 M

$ - 0.5 M

//

•Imperfect competition

- monopoly, subsidy, govt. regulation,

taxes

•Domestic vs. International markets

•No market

•SP = MP x CF

•Surrogate or Proxy prices

Shadow Prices

•Fiscal policies fail to distribute income

fairly

•WTP values > rich get the edge over poor

•Sustainable development principle

•Need to identify social groups

•Converting WTP values into utility values

by use of weights

Distributional Issues

•People require reward for forgoing

consumption now

•Positive real rate of return

•Present value of future money

•Example,

Accept $ 100 today or $ 110 next year

If accepted $ 110 – we forgo $ 100 today

We say that the discount rate is 10%.

Discount Rates

• Based on WTP values

• 3 ways

1. Observe prices in various markets

2. Observe individual expenditures of

money and time

3. Ask people what they are willing to pay

for goods

Valuation of benefits and cost

1. Market Price Method (MPM)

2. Hedonic Pricing Method (HPM)

3. Travel Cost Method (TCM)

4. Contingent Valuation Method (CVM)

5. Contingent Choice Methods (CCM)

6. Contingent Ranking Method (CRM)

Valuation methods (Market based)

•Environmental change causes change in

outputs or inputs

•Market based approach

•Uses economic values of ecosystem

products and services for evaluation

•e.g. soil erosion > output falls > input

increases

•Only used for market goods and services

Market Price Method (MVM)

•Evaluation based on housing prices

•e.g. reduction in noise> increase in residential property prices

•Reflects value of local environmental attributes

•Only measures environmental benefits related to housing prices

Hedonic Pricing Method (HVM)

•Cost of access

•How much people are willing to pay to

travel or visit the site

•To value recreation sites

•Example,

Evaluation of annual preservation value of

a park

Travel Cost Method (TCM)

Zone

Trips per 1000 persons per annum

Average consumer costs ($)

Average consumer surplus ($)

Population (thousand)

Trips per annum

Total consumer surplus ($)

X 150 5.0 7.5 10 1500 11250

Y 100 10. 5.0 20 2000 10000

Z 50 15.0 2.5 50 2500 6250

all 100 10 5.0 80 6000 30,000

TCM continued….

Maximum Travel Cost = $ 20

•Relies on survey techniques

•Hypothetical change in environmental

resources

•Elicitation methods include,

I. Open ended / Direct Questions

II. Bidding Game

III. Dichotomous Choice Method

IV. Double Bonded Dichotomous Choice Method

•Useful for marketed and non-marketed goods

Contingent Valuation Method (CVM)

•Asks people the WTP values for an

environmental asset

•Most widely used for non-market goods

•Exxon Valdez case

CVM continued ….

•Prone to bias

•Types of Biases

I. Strategic Bias

II. Information Bias

III. Starting Point Bias

IV. Hypothetical Bias

V. Sampling Bias

VI. Non-response Bias

CVM continued ….

•Trade-offs between environmental

systems

•Used for use and non-use values

•Example,

Wilderness or Hospital ?

Scenic beauty or Mobile network ?

•Difficult for some respondents to respond

Contingent Choice Method (CCM)

•Referendum method•Ranking of environmental attributes•Easy for the respondent •Example,

•Confusion if too many choices

Contingent Ranking Method (CRM)

Choice #

Savings in travel time (in minutes)

Cost of saving (in dollars)

1 10 0.50

2 20 1.50

3 30 2.20

4 40 3.00

•Government judgments

•Example,

I. Compensation for accidental death

II. Zoning regulations

•Inconsistent with individual preferences

•Basis of decision not clearly stated

•Need more research

Valuation based on public decisions

•Precautionary expenditure

•Corrective expenditure

•e.g. Smoke detectors, seatbelts

•Routinely included in project

expenditures

•Marginal cost of pollution

Valuation based on defensive expenditure

•Present value of future output or

consumption forgone = human capital

method of evaluation

•U.S. = 350 000 $ (1990s)

•Depends on age and earnings

•Value of life of a newborn = 0 $

•Risk of death – accept or reject ?

•Hedonic wedge equation

W = W (S, X, R)

Value of life

•Risk of death – how to calculate ?

•0.44 million – 14.9 million US dollars

•Wedge / Risk studies should be combined

with other valuation methods like CVM

•Value depends on

I. Individual preferences

II. Risk aversion

III. Level of risk assumed

Value of life continued ….

•Cost – effectiveness analysis

- Useful finding option with the least cost

•Environmental Impact Assessment

- Describes physical & social impacts of the

project

•Multi-criteria Decision Analysis

- Identifies and apply weights to likely

impacts to determine a preferred option

Alternatives to CBA

•Morally unacceptable to put value on

nature

•Not practical – how to measure visual

beauty ?

•CBA does not deal with social values

•Based on income, thus biased

• Individuals have different preferences

•Narrow outlook to environment

Criticisms to CBA

•CBA provides systematic and consistent evaluation method

•CBA gives clear results

•CBA highlights trade-offs and opportunity cost

• ‘One person one vote’ is more preferred ‘over one dollar one vote’

Conclusion

1. Project Appraisal and Valuation of the

Environment - Peter Abelson, Chp. 2, 3, 4

2. Cost-Benefit Analysis and the

Environment – Cass R. Sunstein

3. Cost Benefit Analysis of Environmental

Systems by Applying Contingent

Valuation Method – S.U Ahmed, K. Gotoh

References

Thank You !