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Efficiency, Surplus and Doing Benefit-Cost Analysis

How can economics help determine the optimal size of a project or extent of a regulation?

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Motivating Group Project

2001 Actual Group Project (Advisors—Profs. McAusland and Kendall):

A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties

2001 Actual Group Project (Advisors—Profs. McAusland and Kendall):

A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties

2001 Actual Group Project (Advisors—Profs. McAusland and Kendall):

A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties

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A few other examples

What should be the CO concentration standard in tailpipe emissions?

What is the appropriate level of GHG emission reduction worldwide?

How large should the Channel Islands marine reserve be?

Can we measure loss to recreationists of the Forest Adventure Pass?

Add another lane to Hwy 101? Close Mission Canyon to cyclists? What habitat to buy to protect endangered

species (eg, Least Bell’s Vireo – bird)

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Generic Problem

Characterize an Environmental Policy or Action (or multiple policies or actions)

Estimate the Consequences of that policy or action

Estimate the pluses (benefits) and minuses (costs) of that policy or action

Reach conclusions

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CBA: main principle

Quantify all costs and benefits in a common measure (usually $)

Common metric need not be $ eg, health- health analysis, with health as metric

• Benefits directly measured in terms of lives saved• Costs indirect: costs increase deaths since

• Regs make people poorer• lower incomes lead to higher mortality ($13 million in extra

costs results in 1 statistical death)• Eg, Compare risks in lower and higher income countries

• Compare projects based on net effects on health.

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What others method to use?

Cost-effectiveness Analysis Weighted cost-benefit analysis Multigoal analysis

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Basic measure of value is willingness-to-pay

Demand curve is marginal willingness to pay

Quantity of water

MWTP First units very valuable

Last units less valuable

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Consumers Surplus (CS)

D(x)

x

$

q

p

CS(q)

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Calculating benefitsfrom MWTP

Demand, D(x), measures MB.Consumers Surplus is the total benefit

to consumers minus their cost.

q

pqdxxDqCS0

)()(

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Example – gross value of water from new dam (excluding costs)

Acre-feet of water

Price

Demand for water

New dam

. . .

. . . . . . .

. . . . .. .

. . . . . . .

Add’l Value

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What about nonmarket goods?

Air quality

Price

Suppose there were a market:

Demand for air quality

BUT, NO MARKET: price similar to MWTP

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Environmental goods

Demand for env goods just as real as demand for market goods – just harder to measure

Demand is a measure of intensity of preferences

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Costs are simpler

Some units are cheap to produce “Marginal” units are most expensive Costs consist of

Fixed costsMarginal costs

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Marginal costs plus fixed costs add up to total costs

Quantity

MC

First units cheapest

Last units pricey

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Producer Surplus (PS)

x

$

p

q

PS(q)

MC(x)

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How are costs calculated?

Supply, S(x), is same thing as MC.Producer Surplus is the total revenue

to producers minus their cost.

q

dxxSpqqPS0

)()(

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Put it together

Q

P

. . .

. . . . . . .

. . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . .

Total Surplus

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Where is CS+PS maximized?

Demand, D(x)

Supply, S(x)

q1 q*

p

x

$CS

PS

Tension: Too little producedAt too high price. CS low, PS high

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Suppose goods supplied in fixed amount

Land

Price Supply of land

Producer surplus (goes to land owners)

Consumer surplus

Demand for land

MarketPrice

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Example: Add a dam

Q Water

Price

Status quo water availability

XXXXXXXXXXXX ##################

PS: Before: # and X After:

CS: ??

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Example: Add a dam

Q Water

Price

Supply of water increases; price falls.What happens to PS? CS?

XXXXXXXXXXXX $$$$$##################

PS: Before: # and X After: X and $

CS: ??

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If captured all costs & benefits

Then we want to maximize CS + PS which would occur where Supply = Demand.

Challenge is to capture all costs and benefits to accurately measure MC & MB.

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Costs come in different flavors:Private, external and social

In principle, need to capture all costs and benefits.

Social costs may exceed private costs.

Difference is the “external cost” – the monetized cost of the externality.

$/gal

GallonsOf Gasoline

MPC

Q0

P0

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Social vs. Private Costs

In principle, need to capture all costs and benefits.

Social costs may exceed private costs.

Difference is the “external cost” – the monetized cost of the externality.

$/gal

GallonsOf Gasoline

MPCMEC

Q0

P0

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Social vs. Private Costs

In principle, need to capture all costs and benefits.

Social costs may exceed private costs.

Difference is the “external cost” – the monetized cost of the externality.

$/gal

GallonsOf Gasoline

MSC

MPCMEC

Q*

P*

Q0

P0

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First Theorem of Welfare Economics

In a competitive marketSurplus is maximized at a market equilibrium

ImplicationsCan rely on market if we are sure of

competitive market

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Implicit Assumptions: Distribution

Distributional consequences ignored Compensation Principle

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Implicit Assumptions: Income

Restaurant meals

Price

Y=$30,000 per year

Y=$50,000 per year

Demand and thus surplus depend on income distribution

Therefore: Change in income distribution will change results of CBATO USE CBA, MUST BELIEVE INCOME DISTRIBUTION IS OK

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Implicit Assumptions: Completeness

What happens with difficult to monetize benefits?Eg, clear view of Santa Cruz Islands

Difficult to monetize benes often omitted

Results in bias against env. benes

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Implicit Assumptions: Other

Moral and political dimensions omittedShould we do a cost-benefit analysis

on executing someone who has committed a crime?

Are there other issues when lives are at stake?

Are intergenerational issues adequately treated by CBA?

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Ten Steps to doing and using a CBA

1. Decide whose benefits and costs count 2. Select the portfolio of alternative projects3. Catalog potential physical impacts and determine how they are

measured4. Predict quantitative physical impacts over life of project5. Monetize all impacts6. Discount for time to find present values7. Sum: add up all benefits and costs8. Perform sensitivity analysis9. Choose alternative with largest social benefits10. Make policy recommendation, using CBA only as part of guidance