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					AGEC/FNR 406                              LECTURE 9




      Corn growing at site of former rainforest
         Benefit-Cost Analysis
First of two related lectures:


 1. Overview of benefit-cost analysis

 2. Specific benefit-cost tools


 Remember to review the BCA packet!
    Static vs. dynamic efficiency

Static efficiency is defined as maximization
  of net benefits for a single time period.

 Many economic decisions that occur over
   time are a series of static decisions.

      Example: Shopping for Food
Choose groceries each week, consume them,
     then start over again next week.
   Static vs. dynamic efficiency
A dynamic decision is one in which current
  decisions have impacts on net benefits
           arising in the future.
      Many economic decisions with
 environmental implications are dynamic.
            Example: Forestry
  If you choose to harvest trees this year,
harvesting next year is no longer an option.
          Benefit-Cost Analysis
What is benefit-cost analysis?

BCA is an economic technique used to:
    1.Evaluate a project or investment over time
    2. Compare the merits of a set of projects

BCA is conducted by comparing economic benefits of
an activity with economic costs of an activity.
              Key Point
As a tool for economic analysis, BCA
seeks to examine potential actions with
the objective of increasing well being...

…seeking an activity or use that provides
greater benefit than cost, or the greatest
benefit among competing uses.
              Key Point
Decisions are typically not made on the
basis of BCA alone…

but BCA can be useful for providing
information on economic features of
projects or activities, and can therefore be
useful for informing the debate.
         BCA in a timeless world

  Dam construction

Costs:

Materials = $500,000
Labor =     $600,000

Total Cost = $1,100,000
            BCA in a timeless world
  Dam construction
Benefits:
Recreation =    $400,000
Flood control = $300,000
Electricity = $500,000
Total Benefit =$1,200,000
         BCA in a timeless world
 Dam construction
Total Benefit =$1,200,000
Total Cost = 1,100,000

Net Benefit =    100,000

 Benefit exceeds cost, so dam appears to be a good
 investment
         BCA as “Approach”
To know whether society should build the
dam, other information may be needed:

1. Are there non-economic impacts?

2. What is the opportunity cost of the dam?
         Time and Discounting
Often the benefits and costs of a project accrue
at different times. The technique used to deal
with this issue is discounting.
               Discounting
Discounting is a technique used to convert all
benefits and costs to a common point in time,
usually the present.

The value of a project, expressed in terms of
the present, is called the Present Value.
               Discounting
Discounting is based on the premise that a
dollar of benefit received today is worth more
than a dollar of benefit received in the future.

The bias arises because current resources can
be invested.

Discounting is the opposite of compounding.
               Discounting
The rate at which a current value is
compounded is called the interest rate.

The rate at which a future value is discounted
is called the discount rate.
       Computing a present value

            PV = Pt / (1 +         r) t


PV = present value
Pt = value at time t
r = interest (discount) rate
t = year in which Pt is realized
           BCA with discounting

Dam revisited
Total Benefits accrue
  when dam is finished
  (t = 1)
Total Costs accrue at
  start of construction
  (t = 0)

Discount rate = 10%       Should the dam be built?
         Dam construction revisited

Total Benefits accrue when dam is finished (t = 1), so
  Pt = $1,200,000 and PV of benefit is:
           $1,200,000 / (1+0.10)1 = $1,090,909

Total Costs accrue at start of construction (t = 0), so
  Pt = $1,100,000 and PV of benefit is:
           $1,100,000 / (1+0.10)0 = $1,100,000

PV(B) < PV(C)        The dam shouldn’t be built.
              Why the reversal?

Total Benefits accrue in the future (i.e. when dam is
finished). The process of discounting reduces the
value of those benefits because they occur in the
future.

Because the merit of a project can hinge on the
choice of discount rate, it can be a source of debate.

There is no simple rule for choosing a discount rate.
Often a “well known” interest rate is used.
                  Key Points

Whenever benefits and costs accrue at different
points in time, amounts should be converted to
present values for comparison.

BCA is a decision-support tool, not a decision-
making tool.

Discounting can be used regardless of the length of
time under consideration, but discounting has
implications for equity.

				
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posted:7/10/2011
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