Cost Benefit Analysis Budget by ztw74696


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									        Chapter 6

Cost-Benefit Analysis and
Government Investments

Economic Analysis for the Budget Process:
      Achieving the Least-Cost Means of
    Accomplishing an Authorized Objective
   A Program is a combination of government activities
    producing a distinguishable output.

   Program Budgeting is the system of managing government
    expenditures that attempts to compare the program
    proposals of all government agencies authorized to
    achieve similar objectives.

   The mission of a government agency is comparable to a
    business firm’s product.

   Cost-Effectiveness Analysis is a technique for determining
    the minimum-cost combination of government programs to
    achieve a given objective
Cost-Effectiveness Analysis:
In the Example of Saving Lives
   Cost-Effectiveness Analysis requires
       stating an objective (saving lives)
       recognizing the alternative means of
        meeting the objective (inoculations and
        smoke detectors)
       choosing the mix of alternatives that
        meet the objective in the least cost

Inoculations per Year        Figure 6.1 Cost-Effectiveness Analysis

                        20,000           B

                                                        Lives Saved = 5,000

                             0       10,000   20,000
                                    Smoke Detectors per Year              4
    The Cost-Effective Mix
   At the point of tangency, the slope of the isoquant is
    equal to the slope of the isocost lines, and

                MRTS  PSD PI
 The MRTS, the marginal rate of technical substitution
  between smoke detectors and inoculations, depends on
  the marginal productiveness of each program.

 The cost-effective mix of the two programs depends both
  on their productivity in terms of lives saved and the prices
  of units of services provided by the programs themselves.
Cost-Benefit Analysis
     Enumerate all costs and benefits of a
      proposed project
     Evaluate all costs and benefits in dollar
     Discount future net benefits

Enumerating Benefits and Costs
    Direct Costs and Direct Benefits are
     those attributable to the purpose of the
    Indirect Costs and Indirect Benefits are
     those attributable to the project, but
     which were not part of the intended
     purpose of the project.

Evaluating Costs and Benefits in Dollar
     Though some costs and benefits
      are easily quantifiable, others like s
      the value of a human life saved or
      lost because of a project, are not
      as easy to objectively count.

Discounting Future Net Benefits
     Present Value
         An interest-adjusted value of costs or
          benefits that will occur in the future
         PV of X dollars received in n years at an
          interest rate r is:

                     PV = (X/(1+r))

Discounting Payment Streams

    Illustrating the Effect of Interest
    Rate Changes on Present Value
   Project 1 yields $90 in net benefits
   Project 2 yields $100 two years from now.
   Results
       At 0% interest $100 two years from now is worth
        $100 so project 2 is better than project 1.
       At 5% interest $100 two years from now is worth
        $90.7 so project 2 is better than project 1.
       At 10% interest $100 two years from now is
        worth $82.6 so project 1 is better than project 2.
Choosing the Social Rate of Discount
     If the private sector interest rate is r,
      then the social rate of discount must be
      set equal to this social opportunity
      cost of funds because of the
      distortions in the market caused by
      government taxation.

     The rate must also account for the
      taxation on investment returns.
                     Figure 6.2 A Tax on Investment Income and the
                     Social Opportunity Cost of Capital
                   20 = rG
Return (Percent)


                                                        D = Gross Return

I = 10 = rN                             E’

                                                 D’ = Net Return After Taxes

                                Funds Invested and Saved per Year
Weighting Net Benefits

  It also matters who gets the
  benefits and who pays the costs.
  Benefits accruing to certain
  people may be viewed as more or
  less important than costs that
  accrue to others.

Disaggregating Net Benefits

 Disaggregating benefits according to
 demographic, income, and other social
 characteristics of those who will receive
 benefits and bear the costs allows cost-
 benefit analysis to take into account
 distributional considerations.

Treatment of Inflation

  If all dollar figures are nominal,
  then interest rates must be
  nominal and account for inflation.
  Alternatively, all accounting can be
  done using real dollars and real
  interest rates.

    Ranking Projects
        Net Benefit Criterion: Rank according
         to the highest net benefits

       Benefit-Cost Ratio Criterion: Rank
        according to the highest ratio

Figure 6.3 Cost-Benefit Analysis and Efficiency

      Marginal Social Cost and Benefit
                                             Net Social Gain
                                              from DQ1
                                                        B           G
                                                                        Net Social Loss
                                                            E           from DQ2

                                                C       D       H   J
                                             DQ1                        DQ2

                                         0       Q1Q2 Q* Q3Q4
                                             Miles of Highway per Year
Cost-Benefit Analysis in Practice
Physical Infrastructure Analysis

Environmental    Capital


Power   and Communication Networks
Government Infrastructure Investment in
   LDC’s have invested considerable sums in
    agricultural infrastructure because the estimated
    project rate of return approaches 17%.

   Projects like the creation of large water reservoirs
    typically displace locals and these costs
    (externalities) must also be counted.

   Projects have been shown to help the poor by
    adding substantially to their ability to produce crops
    for sale.

Cost-Benefit Analysis of a Hypothetical
          Irrigation Project
Costs                       1    2    3    4      5    6    …   N
Engineering and Planning    E
Building and Construction   F1   F2   F3   F4     F5
Maintenance                                            M6   …   MN
Loss in Agriculture         A1   A2   A3   A4     A5   A6   …   AN
Loss in Recreation          R1   R2   R3   R4     R5   R6   …   RN
Total Costs                 C1   C2   C3   C4     C5   C6   …   CN

Increased Agriculture                                  A6   …   AN
Increased Recreation                                   R6   …   RN
Total Benefits                                         B6   …   BN
Figure 6.4 The Benefits of Widening a Highway

 Average Cost per Trip

                         C                 B
                         C'          A


                          0            T       T'
                              Number of Trips per Year
Value of a Human Life
 A number of techniques have been used to
 estimate the value of human life saved:
     A common method is to value lives according to the
      discounted present value of future earnings.

     The benefits of saving a life could be measured in
      terms of the willingness of individuals to pay for a
      reduction in hazards or risks to which they are

Cost-Benefits Analysis of Job Corps
Costs per Participant
      Operating the Program ($8,380)
      Forgone Output of Participants ($1760)
Benefits Per Participant
      PV of Increased output ($8,080)
      PV of reduced crime ($5,840)
      Reductions in costs of other programs ($880)

Net PV of Benefits: $4,660

The Role of Cost-Benefit Analysis in
   Useful tool to policy makers attempting
    to quantify decision making

   Some social benefits difficult to quantify

   Distribution of benefits affects the
    political decisions of which programs
    are funded.
                  Sports Stadiums
   Cost-benefit analysis often used by state and
    local governments to justify subsidies to such
    projects as sports stadiums and civic centers

   Supporters of sports stadiums argue that
    combined benefits of the community will
    more than offset costs.

   Prominent economists argue that the logic
    used by supporters of sports stadiums
    substantially overestimates benefits while
    underestimating costs.


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