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.