7 Making Hard Choices

Question 1

Cost-Benefit Analysis

Answer 1

systematic approach to evaluating the total costs and benefits of a project or policy, expressed in monetary terms, to determine its net benefit

Question 2

Net Present Value

Answer 2

The sum of discounted benefits minus costs over a project’s lifetime. A positive NPV indicates the project adds value.

NPV = (Sum of discounted benefits - discounted costs) - initial cost

Question 3

Social discount rate

Answer 3

society’s preference for present benefits over future ones, crucial for weighting long-term benefits like climate change mitigation

Question 4

Public procurement (and goals)

Answer 4

process by which governments acquire goods, services, or works from private firms. Effective procurement ensures value for money, transparency, and alignment with public goals

Question 5

Principal-Agent problem

Answer 5

when one party (principal) contracts another (agent) to perform tasks, but the agent’s goals or information differ

Eg. Misaligned incentives, or asymmetric/unverifiable information
Under perfectly aligned motives or perfectly observable outcomes you won’t need a contract

Question 6

Shadow price

Answer 6

An estimated value of goods or services that do not have a market price, such as environmental benefits or time saved from reduced commuting. Shadow prices are crucial in cost-benefit analyses to include non-market impacts

Question 7

Revealed preference

Answer 7

A method of estimating the value individuals place on goods or services by observing their actual behaviour in market transactions. For example, the value of clean air can be inferred from higher property prices in low-pollution areas

Question 8

Hedonic pricing

Answer 8

A valuation method that breaks down the price of a good into the value of its attributes. For instance, the price of a house reflects characteristics like location, size, and proximity to schools or parks

Question 9

Value of a statistical life (VSL)

Answer 9

A measure of the monetary value society places on reducing the risk of death. For example, VSL is used to assess the benefits of safety regulations or health interventions

Question 10

Social Time Preference

Answer 10

The rate at which society values present consumption over future consumption. It is a key determinant of the social discount rate in long-term project evaluations

Question 11

Cost-Effectiveness Analysis

Answer 11

evaluates the least costly way to achieve a
specific objective, such as reducing carbon emissions or improving health outcomes. Unlike CBA,
CEA focuses on efficiency rather than overall net benefits.

Question 12

Outsourcing

Answer 12

contracting external firms to deliver goods or services traditionally provided by the public sector. Outsourcing aims to leverage private sector efficiency but may pose risks such as reduced accountability or quality

Question 13

Sealed-Bid Auctions

Answer 13

A procurement method where bidders submit confidential bids, and the winner is chosen based on predefined criteria, such as lowest cost. This approach promotes competition and reduces collusion

Bertrand Competition - optimal strategy for the firm is to bid where p=MC. If more than one bidder, solves the PA problem

Question 14

Contestability of markets

Answer 14

Refers to the ease with which new competitors can enter a market and challenge incumbents. High contestability ensures efficiency and innovation by preventing monopolistic behaviour

Question 15

Public-Private Partnerships

Answer 15

PPPs combine public funding with private delivery, sharing risks and rewards. While they can improve efficiency and innovation, they often lead to higher financing costs and renegotiation challenges. For example, PPPs in infrastructure projects frequently face criticism for cost overruns and reduced service quality

Question 16

PPP premium

Answer 16

The additional cost of financing a project through Public-Private Partnerships (PPPs) compared to traditional public funding, often due to higher private sector borrowing costs or profit margins

Question 17

Payments by results

Answer 17

A procurement model where contractors are paid based on outcomes rather than inputs, transferring risk to the implementer and incentivizing efficiency

Question 18

How to use CBA

Answer 18

Governments use CBA to allocate resources effectively. For instance, comparing the NPV of subsidizing malaria bed nets versus draining swamps highlights the importance of measuring benefits (e.g., lives saved) and costs (e.g., environmental damage).
Challenges include valuing non-market impacts (e.g., health, biodiversity) and choosing appropriate discount rates, which heavily influence long-term project rankings.

Question 19

Annual benefit: $500,000. Discount rate: 5%

Answer 19

PV of benefits = $500,000 x [(1 - (1 + 0.05)^(-10)) / 0.05] = $3,861,000

Question 20

Challenges of CBA

Answer 20

1. valuing non-market impacts, such as environmental benefits or social cohesion, which lack clear monetary values
2. Choosing the discount rate
3. Uncertainty about future costs and
   benefits (have to choose both direct and EXTERNAL effects) eg. pollution, natural beauty, biodiversity
4. biased or inaccurate input data - eg. are wages a good way to measure the social cost? Only if there is a perfect market! Under market failure, wages =/ marginal social cost (or value)
5. Ethical limitations also arise when attempting to assign monetary value to intrinsic goods like human life or cultural heritage
6. Catastrophic events eg. climate change

Question 21

Principal-Agent Problem in Procurement (and solutions)

Answer 21

Misaligned incentives and asymmetric information can lead agents to prioritize their own interests, such as minimizing costs or maximizing profits, over the principal’s goals of quality, efficiency, and timeliness. For instance, a contractor might reduce expenditures on materials or labor to increase profit margins, potentially compromising the quality of infrastructure or services, especially if government oversight and monitoring are inadequate.

Solution:
1. performance-based contracts - payments are tied to achieving specific, measurable outcomes.
2. Sealed-bid auctions enhance transparency and foster competition, reducing the likelihood of inflated costs or favoritism in contractor selection.
3. Outcome-based nancing, such as social impact bonds, transfers performance risk to private investors, who are repaid only if agreed-upon outcomes are achieved

Question 22

Benefit cost ratio

Answer 22

BCR - one way of doing CBA (the other one is NPV method, which is preferred)
Net present value (benefits) / costs

Question 23

Flaws or biases in valuation

Answer 23

1. Strategic bias: misreporting to influence the outcome (or if not, hypothetical bias). Or political meddling - going against evidence, imposing unrealistic assumptions
2. Information bias: respondents may have no info, or the wrong info (Pollack AER 1998), or be subject to behaviourial biases (e.g. bad with probability data)
3. Framing bias: respondents affected by order/number of alternatives, and subject to an embedding effect
4. Optimism bias: tendency to have overoptimistic assumptions about costs, benefits, risks, implementation time, etc. (In UK, each CBA in government needs to assess itself relative to this common bias)

Question 24

How to calculate value of a life saved?

Answer 24

Milton Friedman - scarce resources have alternative uses! A revealed-preference approach: estimate the value of a statistical life (VSL) from wage differences - eg. coal miner vs cashier

Question 25

Strengths of CBA

Answer 25

1. Robustness: When the right value is unclear, I can try the CBA with several values and show which values change my choice.
2. Transparency: Anyone can look and see what choices I made, and what choices I rejected; and how we calculated them.
3. Dialogue: the CBA is the start of a conversation about policy, not the end-point. But it establishes analytical rigour early and sets the terms of engagement
4. Politicisation: Ministers can choose sub-optimal choices for political reasons, but a good CBA gives them few places to hide – and can make them think twice if public.

Question 26

Cost Effective Analysis (CEA)

Answer 26

CEA proposes a simpler decision rule: for projects with a clear common, desirable outcome, compute the costs, and choose the most cost-effective project.
* CEA is often used to rank projects to improve the quality and quantity of education and healthcare, avoiding trying to ‘value’ death or an education in monetary terms
* It could then use “extra years of life”, ”extra years of schooling, or “quality adjusted years of life (QUALY) or “learning adjusted years of schooling (LAYS)”

Question 27

Problems with CEA

Answer 27

1. a ranking, by itself, does not provide enough information to decide any of the projects should be executed
2. ranking along a unidimensional scale may not reflect full set of impacts (e.g. education is more than an extra year in school)
3. only compares projects with same outcome
4. challenges from CBA remain eg. costs to include, discount rate

Question 28

Disadvantages of public provision

Answer 28

Limited organisational incentive to maximise productivity:
(i) lack of competitive pressure
(ii) soft budget constraints
(iii) political goals

Restrictions on organisational ability to maximise
productivity:
(i) rigid employment rules (e.g., hard to fire or reward performance)
(ii) procurement restrictions (limited supplier pool)
(iii) budget restrictions (hard to invest for long term)

Question 29

When to privatise?

Answer 29

1. Efficiency and innovation are big concerns and expected to respond well to competitive pressure
2. Consumers are able to pay directly most of the cost of delivery (e.g., rules out non-excludable public goods), and
3. Quality and price can be regulated effectively where needed
   BUT equity concerns!

Question 30

Hold-up Problem

Answer 30

when a party makes an investment in a transaction, but risks losing some or all of the return on that investment due to future circumstances

It can occur when one party makes a relationship-specific investment, and then the other party refuses to perform unless the first party offers better terms. This can lead to underinvestment, as agents may not fully appropriate the return on their investment

eg. if the firm provides infrastructure to the government but is the only one who can fix it. Hence contract design is vital!

Question 31

How can governments get around PA problem?

Answer 31

Find vendors whose trust, morals and intrinsic motivation align. Or can create ‘moral actors’ through encouragement, recognition and judicious use of shaming (Bowles 2016)

Question 32

Payments by Results (PbR)

Answer 32

Government procures and pays for ‘outcomes’, and not ‘goods’ (outputs). E.g. it buys ‘malaria reduction’ rather than ‘bednets’.
1. Works for outcomes that can be well-defined and easily measured
2. requires a monetary value to be put on outcomes (eg. lives saved) the gov is willing to pay for

Question 33

Social impact bonds

Answer 33

allow providers to raise cash from private finance (working capital), with investors being paid once outcomes are actually obtained (including a ‘premium’ for the risk of failure to achieve outcomes required)

Question 34

Private finance initiative (PFI)

Answer 34

a long-term deal (e.g., 25 years) where the same firm builds and operates the infrastructure
eg. Government (G) and private firm (P) sign contract: P builds and owns the digital training centre, G rents it, employ trainers, and produces the digital skills.

Question 35

Pros and cons of PPP

Answer 35

Pros
1. Incentives to lower maintenance cost - internalised life cycle costs
2. Eases government’s credit constraints (lower upfront cost)

Cons
1. Higher financing cost
2. transaction cost
3. Renegotiation
4. Quality shaving - worse services (forgone benefit)