Public Finance and Public Policy, 2/e Jonathan

Gruber

Cost-Benefit Analysis

8
Prepared by:
FERNANDO QUIJANO, YVONN QUIJANO,
KYLE THIEL & APARNA SUBRAMANIAN

© 2007 Worth Publishers Public Finance and Public Policy, 2/e, Jonathan Gruber
 Cost-Benefit Analysis

Chapter 8
Chapter 8 Cost-Benefit Analysis

8.1 Measuring the Costs of cost-benefit analysis The

Public Projects comparison of costs and benefits
of public goods projects to decide
8.2 Measuring the Benefits of if they should be undertaken.
Public Projects

8.3 Putting It All Together

8.4 Conclusion

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 8.1
Measuring the Costs of Public Projects
The Example
Chapter 8 Cost-Benefit Analysis

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 8.1
Measuring the Costs of Public Projects
Measuring Current Costs

cash-flow accounting Accounting

Chapter 8 Cost-Benefit Analysis

method that calculates costs solely

by adding up what the government
pays for inputs to a project, and
calculates benefits solely by adding
up income or government revenues
generated by the project.

opportunity cost The social

marginal cost of any resource is
the value of that resource in its
next best use.

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 8.1
Measuring the Costs of Public Projects
Measuring Current Costs
Imperfect Markets
Chapter 8 Cost-Benefit Analysis

rents Payments to resource

deliverers that exceed those
necessary to employ the
resource.

Economic costs are only those costs associated

with diverting the resource from its next best use.

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 8.1
Measuring the Costs of Public Projects
Measuring Future Costs
Chapter 8 Cost-Benefit Analysis

present discounted value (PDV)

A dollar next year is worth 1 + r
times less than a dollar now
because the dollar could earn r %
interest if invested.

social discount rate The

appropriate value of r to use in
computing PDV for social
investments.

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 8.1
Measuring the Costs of Public Projects
Measuring Future Costs
Chapter 8 Cost-Benefit Analysis

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 8.2
Measuring the Benefits of Public Projects
Valuing Driving Time Saved
Using Market-Based Measures to Value Time: Wages
Chapter 8 Cost-Benefit Analysis

Suppose we can show that the time that individuals save from
driving faster is spent at work.
This theoretical proposition runs into some problems in
practice:
 Individuals can’t freely trade off leisure and hours of
work; jobs may come with hours restrictions.
 There may be nonmonetary aspects of the job.

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 8.2
Measuring the Benefits of Public Projects
Valuing Driving Time Saved
Using Survey-Based Measures to Value Time: Contingent
Chapter 8 Cost-Benefit Analysis

Valuation

contingent valuation Asking

individuals to value an option
they are not now choosing or
do not have the opportunity to
choose.

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  APPLICATION
The Problems of Contingent Valuation
Two of the leading critics of contingent valuation are economists
Chapter 8 Cost-Benefit Analysis

Peter Diamond and Jerry Hausman, who point out that varying the
structure of contingent valuation surveys can lead to widely varying
responses. Examples of this problem include the following:

 Isolation of issues matters.

 Order of issues matters.

 The “embedding effect” matters.

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 8.2
Measuring the Benefits of Public Projects
Valuing Driving Time Saved
Using Revealed Preference to Value Time
Chapter 8 Cost-Benefit Analysis

revealed preference Letting

the actions of individuals reveal
their valuation.

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 EMPIRICAL EVIDENCE

VALUING TIME SAVINGS

The problem is that treatments and controls may differ in ways that lead to bias.
Chapter 8 Cost-Benefit Analysis

Suppose that homes built closer to the city are smaller, or that they have smaller
yards. This would lead their value to be lower.

In Boston, for example, the town of Everett is only 4 miles from downtown
Boston, while Lexington is 11 miles away. Yet the average home price in Everett
is $225,000, while the average home price in Lexington is nearly three times
higher at $614,000.

In such cases, we can try to control for these other attribute differences using
cross-sectional regression analysis with control variables. Indeed, in this context
there is a name for such a strategy: hedonic market analysis.

In order to provide a more convincing estimate of the value of time savings, a

quasi-experimental approach can be used.

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 8.2
Measuring the Benefits of Public Projects
Valuing Saved Lives

Valuing human lives is the single most difficult issue in cost-benefit analysis.
Chapter 8 Cost-Benefit Analysis

Many would say that human life is priceless, that we should pay any amount of
money to save a life. By this argument, valuing life is a reprehensible activity;
there is no way to put a value on such a precious commodity.

We could claim that virtually any government expenditure has some odds of
saving a life.

To escape the impotence that would be imposed by the “life is priceless”

argument, one needs to be able to place some value on a human life.

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  APPLICATION
Valuing Life

The sticky ethical problem of valuing life arises in many instances in public
Chapter 8 Cost-Benefit Analysis

policy, as shown by these examples.

1. In 1993, consumer groups demanded that General Motors recall about
5 million pickup trucks it had manufactured between 1973 and 1987.
This recall would cost $1 billion and would, according to government
calculations, save at most 32 more lives (since the trucks were slowly
falling out of use). Using these estimates, the cost per life saved by the
recall would have been $1 billion/32 = $31.25 million.
2. In October 1999, a commuter train crash at London’s Paddington
Station killed 31 people and prompted calls by an outraged public for
more investment in rail safety measures. At best ($3 billion to save
three lives per year for 50 years), this would mean spending $20
million per life saved; at worst ($9 billion to save one life per year for
30 years), it would mean $300 million per life saved.

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 8.2
Measuring the Benefits of Public Projects
Valuing Saved Lives
Using Wages to Value a Life
Chapter 8 Cost-Benefit Analysis

As with valuing time, the market-based approach to valuing

lives is to use wages: life’s value is the present discounted
value of the lifetime stream of earnings.

Contingent Valuation
Another approach to valuing a life uses contingent valuation.
One way to do this is to ask individuals what their lives are
worth.

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 8.2
Measuring the Benefits of Public Projects
Valuing Saved Lives
Revealed Preference
Chapter 8 Cost-Benefit Analysis

As with valuing time savings, the method preferred by economists for

valuing life is to use revealed preferences. We can value life by estimating
how much individuals are willing to pay for something that reduces their
odds of dying.

compensating differentials
Additional (or reduced) wage
payments to workers to compensate
them for the negative (or positive)
amenities of a job, such as increased
risk of mortality (or a nicer office).

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 8.2
Measuring the Benefits of Public Projects
Valuing Saved Lives
Government Revealed Preference
Chapter 8 Cost-Benefit Analysis

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 8.2
Measuring the Benefits of Public Projects
Discounting Future Benefits

A particularly thorny issue for cost-benefit analysis is that many projects

Chapter 8 Cost-Benefit Analysis

have costs that are mostly immediate and benefits that are mostly long-term.

Cost-Effectiveness Analysis
cost-effectiveness analysis For
projects that have unmeasurable
benefits, or are viewed as desirable
regardless of the level of benefits, we
can compute only their costs and
choose the most cost-effective project.

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 8.3
Putting It All Together
Chapter 8 Cost-Benefit Analysis

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 8.3
Putting It All Together
Other Issues in Cost-Benefit Analysis
Common Counting Mistakes
Chapter 8 Cost-Benefit Analysis

When analyzing costs and benefits, a number of common

mistakes arise, such as:
 Counting secondary benefits.
 Counting labor as a benefit.
 Double-counting benefits.

Distributional Concerns
The costs and benefits of a public project do not necessarily accrue
to the same individuals.

Uncertainty
The costs and benefits of public projects are often highly uncertain.

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 8.4
Conclusion

Government analysts at all levels face a major challenge in attempting to turn the
abstract notions of social costs and benefits into practical implications for public
Chapter 8 Cost-Benefit Analysis

project choice.
What at first seems to be a simple accounting exercise becomes quite complicated
when resources cannot be valued in competitive markets.
Nevertheless, economists have developed a set of tools that can take analysts a
long way toward a complete accounting of the costs and benefits of public projects.

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