Assignment #1 MGT 5064

Question 1: What is a CBA?

Solution 1:

Cost-Benefit Analysis (CBA) is a policy assessment method that quantifies the value of policy consequences

(usually called impacts) in monetary terms to all members of society. A CBA calculates net social benefits

(NSB) for each policy alternative: net social benefits equal social benefits (B) minus social costs (C):

NSB = B - C

A CBA is considered to be a subjective (as opposed to objective) assessment tool because cost and benefit

calculations can be influenced by the choice of supporting data and estimation methodologies.

Question 2: Explain the arguments against the use of CBA.

Solution 2: Two arguments against the use of CBA:

1. Dispute against the fundamental utilitarian assumptions of CBA

Some dispute the fundamental assumptions of CBA (i.e. that the sum of individual utility should be

maximized and that one can trade off utility gains and losses among people). They argue that there is no

theoretical basis for making trade-offs between one person’s benefits and another person’s costs.

2. Public policy participants disagree about specific issues in CBA,

such as how to monetize costs and benefits, what impacts are (especially over time), whether an impact

is a cost or a benefit, and how to make trade-offs between the present and the future.

Question 3: What is the purpose of using a CBA?

Solution 3: Purposes of using a CBA:

a. The broad purpose of CBA is to help social decision making and to make it more rational.
 b. More specifically, the objective is to have more efficient allocation of society’s resources.

c. Where markets fail, there is a prima facie rationale for government intervention. However, and this is

important to emphasize, it is no more NSB = B - C CHAPTER 1 Introduction to Cost-Benefit Analysis 3

than that. One must be able to demonstrate the superior efficiency of a particular intervention relative to

the alternatives, including the status quo.

Question 4: Differentiate the types of CBA (ex-ante, in medias res, ex post, and comparative CBA).

Solution 4:

Ex Ante

Ex ante CBA, which is just standard CBA as the term is commonly used, is conducted while a project or policy

is under consideration, before it is started or implemented. Ex ante CBA assists in the decision about whether

resources should be allocated by government to a specific project or policy or not. Thus, its contribution to

public policy decision making is direct, immediate, and bureau-specific

Ex post

Ex post CBA is conducted at the end of a project. At this time, all of the costs are “sunk” in the sense that they

have already been used up to do the project. The value of ex post analyses is broader but less immediate as they

provide information not only about the particular intervention but also about the “class” of such interventions.

In other words, they contribute to “learning” by government managers, politicians, and academics about

whether particular classes of projects are worthwhile.

In medias res

In medias res is performed during the course of the life of a project. In medias res analysis provides an

opportunity to directly influence the decision - whether or not to continue the project. They also provide

information that can be used to predict costs and benefits in future ex ante analyses.
Comparative CBA

Comparative CBA compares an ex ante CBA with an ex post (or in medias res) CBA of the same project. It is

most useful to policy makers for learning about the efficacy of CBA as a decision-making tool and an

evaluative tool.

Question 5: List and explain the basic steps in conducting a CBA.

Solution 5: Basic Steps in conducting a CBA:

1. Specify the set of alternative projects.

Step 1 requires the analyst to specify the set of alternative projects. CBA compares the net social benefits of

investing resources in one or more particular potential projects with the net social benefits of a project that

would be displaced if the project(s) under evaluation were to proceed. The displaced project is often called

the counterfactual. Sometimes the status quo is not a viable alternative. If a project would displace a specific

alternative, then it should be evaluated relative to the specific displaced alternative.

2. Decide whose benefits and costs count (standing).

Next, the analyst must decide who has standing; that is, whose benefits and costs should be included.

Standing is most appropriately specified at the national level. The issue of standing is sometimes

contentious. While federal governments usually take only national costs and benefits into account, critics

argue that many issues should be analyzed from a global perspective. Environmental issues that fall into this

category include ozone depletion, global climate change, and acid rain. At the other extreme, local

governments typically want to consider only benefits and costs to local residents and to ignore costs and

benefits that occur in adjacent municipalities or are borne by higher levels of government.

3. Identify the impact categories, catalogue them, and select measurement indicators.
Step 3 requires the analyst to identify the physical impact categories of the proposed alternatives, catalogue

them as benefits or costs, and specify the measurement indicator of each impact category. We use the term

impacts broadly to include both inputs (required resources) and outputs.

From a CBA perspective, analysts are interested only in project impacts that affect the utility of individuals

with standing. Impacts that do not have any value to human beings are not counted. Politicians often state

the purported impacts of projects in very general terms. For example, they might say that a project will

promote “community capacity building.” Similarly, politicians have a strong tendency to regard “growth”

and “regional development” as beneficial impacts. CBA requires analysts to identify explicitly the ways in

which the project would make some individuals better off through, for example, improved skills, better

education, or higher incomes. Of course, analysts should also include the negative environmental and

congestion impacts of growth.

Analysts should be on the lookout for impacts that different groups of people view in opposite ways.

Consider, for example, flooded land. Residents of a flood plain generally view floods as a cost because they

damage homes, while duck hunters regard them as a benefit because they attract ducks.

Specification of impact measurement indicators usually occurs at the same time as specification of the

impact categories. There are no particular difficulties in specifying measurement indicators of each impact

in this illustration.

4. Predict the impacts quantitatively over the life of the project.

In practice, predicting impacts is very important and very difficult! Prediction is especially difficult where

projects are unique, have long time horizons, or relationships among variables are complex. Many of the

realities associated with doing steps 3 and 4 are brilliantly summarized by Kenneth Boulding’s poem on

dam building in the Third World, presented in Exhibit 1-1. Many of his points deal with the omission of

impact categories due to misunderstanding or ignorance of cause-and-effect relationships and to prediction

errors
5. Monetize (attach dollar values to) all impacts.

The analyst next has to monetize each of the impacts. To monetize means to value in dollars. Sometimes,

the most intuitively important impacts are difficult to value in monetary terms. Valuing environmental

impacts is especially contentious. In CBA, the value of an output is typically measured in terms of

“willingness-to-pay.” f no person is willing to pay for some impact, then that impact would have zero value

in a CBA. For example, if construction of a dam would lead to the extermination of a species of small fish,

but no one with standing is willing to pay a positive amount to save that species, then the extermination of

this fish would have a value of zero in a CBA of the dam.

6. Discount benefits and costs to obtain present values.

For a project that has impacts that occur over years, we need a way to aggregate the benefits and costs that

arise in different years. In CBA, future benefits and costs are discounted relative to present benefits and

costs in order to obtain their present values (PV). The need to discount arises for two main reasons.

1. There is an opportunity cost to the resources used in a project.

2. Most people prefer to consume now rather than later.

Discounting has nothing to do with inflation per se, although inflation must be taken into account. A cost or

benefit that occurs in year t is converted to its present value by dividing it by where s is the social discount

rate. Suppose a project has a life of n years and let and denote the benefits and costs in year t, respectively.

The present value of the benefits, PV(B), and the present value of the costs, PV(C), of the project are,

respectively:
7. Compute the net present value of each alternative.

The net present value (NPV) of an alternative equals the difference between the PV of the benefits and the

PV of the costs:

NPV = PV(B) – PV(C)

The basic decision rule for a single alternative project (relative to the status quo) is simple: adopt the project

if its NPV is positive. In short, the analyst should recommend proceeding with the proposed project if its

that is, if its benefits exceed its costs:

PV(B) > PV(C)

When there is more than one alternative to the status quo and all the alternatives are mutually exclusive,

then the rule is slightly more complicated: select the project with the largest NPV. This rule assumes

implicitly that at least one NPV is positive. If no NPV is positive, then none of the specified alternatives are

superior to the status quo, which should remain in place. Thus, selecting the project with the largest NPV is

equivalent to selecting the project with the largest PV of the net social benefits

8. Perform sensitivity analysis

As the foregoing discussion emphasizes, there may be considerable uncertainty about both the predicted

impacts and the appropriate monetary valuation of each unit of the impact. For example, the analyst may be

uncertain about the predicted number of lives saved and about the appropriate dollar value to place on a

statistical life saved. The analyst may also be uncertain about the appropriate social discount rate and about

the appropriate level of standing. The analyst performed sensitivity analysis on the standing issue by

computing the NPVs from both the global perspective and the provincial perspective.

There are practical limits to the amount of sensitivity analysis that is feasible. Potentially, every assumption

in a CBA can be varied. In practice, one has to use judgment and focus on the most important assumptions
 9. Make a recommendation

Generally, the analyst should recommend adoption of the project with the largest NPV. In the highway

example, three of the alternative projects had positive NPVs and one had a negative NPV. As we have

emphasized, however, the NPVs are estimated values. Sensitivity analysis, which we have not shown in

detail, might suggest that the alternative with the largest expected NPV is not necessarily the best alternative

in all circumstances.

Finally, it is important to note that analysts make recommendations, not decisions. CBA concerns how

resources should be allocated; it is normative. It does not claim to be a positive (i.e., descriptive) theory of

how resource allocation decisions are actually made

Question 5:

a. On the Coquihalla Highway CBA example, what are the two alternatives considered?

b. Whose benefits and costs count (standing)?

c. List down the benefit impact categories and the cost impact categories.

Solution 5: a. Two alternatives considered are, one with tolls and one highway without tolls.

b. The analyst’s superiors in the provincial government wanted the CBA to be done from the provincial

perspective (benefits and costs that affect British Columbian residents), but asked the analyst to also take a

global perspective (benefits and costs that affect everyone).

c. Benefit impact categories:

1. time saved and reduced vehicle operating costs for travelers on the new highway (“Time and Operating Cost

Savings”);

2. the value of highway at the end of the discounting period of 20 years (Horizon Value of Highway);

3. accidents avoided (including lives saved; “Safety Benefits”);

5. revenues from tolls (“Toll Revenues”);

6. and benefits accruing to new travelers (“New Users”).

Cost impact categories: construction costs (“Construction”),

1. additional maintenance and snow removal (“Maintenance”).

2. Toll collection (“Toll Collection”),

3. Toll booth construction and maintenance (Toll Booth Construction”)

Question 7: Explain how to calculate the NPV (net present value) of an alternative. What is the decision

rule for adopting a project?

Solution 7: The net present value (NPV) of an alternative equals the difference between the PV of the benefits

and the PV of the costs:

NPV = PV(B) – PV(C)

The basic decision rule for a single alternative project (relative to the status quo) is simple: adopt the project

if its NPV is positive. In short, the analyst should recommend proceeding with the proposed project if its

that is, if its benefits exceed its costs:

PV(B) > PV(C)

When there is more than one alternative to the status quo and all the alternatives are mutually exclusive,

then the rule is slightly more complicated: select the project with the largest NPV. This rule assumes

implicitly that at least one NPV is positive. If no NPV is positive, then none of the specified alternatives are

superior to the status quo, which should remain in place. Thus, selecting the project with the largest NPV is

equivalent to selecting the project with the largest PV of the net social benefits

Question 8: Differentiate and explain the perspectives of a guardian, a spender, and a CBA analyst.
Solution 8:

Guardians

Guardians are often found in central budgetary agencies, such as the U.S. Office of Management and Budget,

and in controllership or accounting functions within line agencies. They tend to have a bottom-line budgetary

orientation. Their natural tendency is to equate benefits with revenue inflows to their agency or other

governmental coffers (at the same jurisdictional level) and to equate costs with revenue outflows from their

agency or other governmental coffers (at the same level). Guardians have a natural tendency to regard actual

CBA as naive, impractical, and, worst of all in their eyes, a tool whereby spenders can justify whatever it is they

want to do.

To guardians, all toll revenues are regarded as benefits, whether paid by the jurisdiction’s residents (in this case,

the province) or by nonresidents. Construction costs are a cost, because they require an outlay by the provincial

government. Because guardians seek to minimize net budgetary expenditures, their preference, not

surprisingly, is for the with-tolls alternative. Indeed, their gut reaction is to consider raising tolls, irrespective of

its effect on levels of use or its impact on social benefits.

How does the guardian’s perspective differ from CBA?

Most importantly, guardians ignore nonfinancial social benefits. In general, they ignore impacts valued by

consumers and producers such as time saved and lives saved. When guardians are in control of a government

service, it is easy to understand why one has to wait so long for the service. Neither your time nor anyone else’s

figures into their calculations! Similarly, guardians tend to ignore nonfinancial social costs, such as congestion

and pollution.

In the Coquihalla Highway example, all social costs happen to represent governmental budgetary costs, and so

there is no difference between the CBA cost figures and the guardians’ cost figures. In other situations,

however, there might be considerable differences between the correct social costs and guardians’ costs.

Consider, for example, the cost of labor in job-creation programs. Guardians would treat the full financial
remuneration to labor as a cost, while CBA analysts would consider only the opportunity cost (such as lost

leisure time).

Guardians ignore costs not borne by their government. Thus, they ignore the loss suffered by British

Columbians from paying tolls and treat all toll revenues as a benefit. In CBA tolls are a transfer from travelers

to the government: offsetting costs and benefits result in net benefits of zero.

Finally, guardians generally want to use a high social discount rate. Because of their financial background or

their agency’s culture, they naturally prefer to use a financial market rate, which is generally higher than the

appropriate social discount rate.

Spenders

Spenders are usually in service or line departments. Some service departments, such as transportation, are

involved with physical projects, while social service departments, such as health, welfare, or education, make

human capital investments. Some service departments, such as housing, make both types of expenditures.

Most importantly, spenders have a natural tendency to regard expenditures on constituents as benefits rather

than as costs. For example, they typically see expenditures on labor as a benefit rather than a cost. Spenders

regard themselves as builders or professional deliverers of government-mandated services. As spenders focus

on providing projects or services to particular groups in society, we characterize them as engaging in

constituency-support analysis.

Spenders treat social benefits and monetary payments received by their constituents (residents of British

Columbia in this example) as benefits. Thus, time saved, lives saved, and vehicle operating costs saved by

British Columbians are benefits. However, they also treat wages received by construction workers who build

the highway as a benefit.

Spenders view monetary outlays by British Columbian highway users (also their constituents) as costs; for

example, they treat tolls paid by British Columbians as costs. Spenders normally do not favor user fees, unless
their agency keeps the toll revenue within its own budget or the payers are not constituents. If spenders could

collect and keep the tolls, then they would face a dilemma: tolls would reduce constituency benefits, but would

increase the agency’s budget. Thus, they would face a trade-off between constituency-support maximization

and their budget maximization.

Spenders tend to favor large, irreversible, capital-intensive projects, such as urban rail systems, over reversible,

less capital-intensive projects, such as buses. There are immediate, significant construction job creation

benefits.

The perspective of spenders concerning market efficiency has a bearing on the way they view many aspects of

CBA. To spenders, markets are almost always inefficient. Spenders act as if unemployment is high in all labor

markets. They believe that unemployment will be reduced by the number of people used on a government

project.

Spenders generally favor using a low (even zero) social discount rate. For some, this is because they are not

familiar with the concept of discounting. For others, they know this tends to raise the project’s NPV and,

therefore, the probability of its adoption.

CBA Analysts

CBA compares the net social benefits of investing resources in one or more particular potential projects with the

net social benefits of a project that would be displaced if the project(s) under evaluation were to proceed. The

displaced project is often called the counterfactual. Usually, the counterfactual is the status quo, which means

there is no change in government policy.

CBA analyst decides who has standing; that is, whose benefits and costs should be included. In this example,

the analyst’s superiors in the provincial government wanted the CBA to be done from the provincial

perspective, but asked the analyst to also take a global perspective. The provincial perspective measures only

the benefits and costs that affect British Columbian residents, including costs and benefits borne by the British
Columbian government. The global perspective includes the benefits and costs that affect everyone, irrespective

of where they reside.

From a CBA perspective, analysts are interested only in project impacts that affect the utility of individuals with

standing. Impacts that do not have any value to human beings are not counted. (The caveat is that this applies

only where human beings have the relevant knowledge and information to make rational valuations.) Politicians

often state the purported impacts of projects in very general terms. For example, they might say that a project

will promote “community capacity building.” Similarly, politicians have a strong tendency to regard “growth”

and “regional development” as beneficial impacts. CBA requires analysts to identify explicitly the ways in

which the project would make some individuals better off through, for example, improved skills, better

education, or higher incomes. Of course, analysts should also include the negative environmental and

congestion impacts of growth.

CBA analysts do not reinvent these wheels but instead draw upon previous research: they use “plug in” values

whenever possible. Although catalogues of impact values are not comprehensive. If no person is willing to pay

for some impact, then that impact would have zero value in a CBA.

Question 9: What are the consequences of the guardian perspective?

Solution 9: Consequences of the guardian perspective

1. Guardians tend to treat these resources as free because using them for a project does not entail additional

budgetary outlay. They ignore the value of these resources in other uses.
 2. Guardians ignore costs not borne by their government. Thus, they ignore the loss suffered by British

Columbians from paying tolls and treat all toll revenues as a benefit. In CBA tolls are a transfer from

travelers to the government: offsetting costs and benefits result in net benefits of zero.

3. Guardians generally want to use a high social discount rate. Because of their financial background or

their agency’s culture, they naturally prefer to use a financial market rate, which is generally higher than

the appropriate social discount rate.

4. It treats subsidies from other levels of governments as “benefits” (they are a revenue inflow).

5. It interprets the meaning of “costs” idiosyncratically (and incorrectly!); e.g., regarding the cost of labor –

guardians focus on actual wage remuneration, while CBA focuses on the opportunity cost of the labor).

Question 10: Your county is considering building a public swimming pool. Analysts have estimated the

present values of the following effects over the expected useful life of the pool:

PV (million dollars)

State grant: 2.2

Construction and maintenance costs: 12.5

Revenue from county residents: 8.6

Revenue from nonresidents: 2.2

Use value of benefit to county residents: 16.6

Use value benefit to nonresidents: 3.1

Scrap value: 0.8

The state grant is only available for this purpose. Also, the construction and maintenance will

have to be done by an out-of-county-firm.

a. Assuming national-level standing, what are the social net benefits of the project?

b. Assuming county-level standing, what are the social benefits of the project?

c. How would a guardian in the county budget office calculate net benefits?

d. How would a spender in the county recreation department calculate net benefits?

Solution 10:

Monetized Social CBA Social CBA County County

Effect
Category (million National County Guardians Spenders

dollars) Standing Standing

costs
Personnel costs 8.2 -8.2 -8.2 -8.2 8.2
Revenue from county residents 8.6 0 0 8.6 -8.6
Revenue from non-residents 2.2 0 2.2 2.2 2.2
Use value to county residents 16.6 16.6 16.6 0 16.6
Use value to non-residents 3.1 3.1 0 0 0
Scrap value 0.8 0.8 0.8 0.8 0.8
Net Benefits (million dollars) -0.2 1.1 -6.9 8.9