Cost-benefit analysis

Question 1

What is welfare economics?

Answer 1

Deals with normative issues. Does not describe how the economy works but assesses how well it works.

Question 2

What effect does tax have on the market?

Answer 2

. quantity sold reduces, so producer surplus is smaller
price consumer pays increasesconsumer surplus reduces
. creates a tax wedge causing a deadweight loss
.

Question 3

What is a deadweight loss?

Answer 3

A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.

Question 4

What is the basic appraisal of taxes?

Answer 4

. we need tax revenue (to pay for public goods like roads, lighting, police) we must raise revenue
. = there will always be some cost to the economy from these taxes.
. We choose the structure of taxes to minimise total deadweight loss

Question 5

What must be done by government when assessing all taxes in terms of balancing deadweight loss and tax revenue?

Answer 5

(Across all taxes). Equate the ratio (marginal deadweight loss)/(marginal tax revenue).

Question 6

What does the magnitude of deadweight loss depend on?

Answer 6

The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price.
e.g elasticities of supply and demand curves

Question 7

When is deadweight loss lowest? i.e where should the highest taxes be placed? what is the exception to this?

Answer 7

. Where both supply and demand are inelastic .

. exception is, goods with price inelastic demand are often necessities, so taxing them may hit the poor hardest.

Question 8

When is the incidence of tax borne by consumers?

Answer 8

When there is elastic supply and inelastic demand

Question 9

When is the incidence of tax borne by producers?

Answer 9

Inelastic supply and elastic demand

Question 10

What is an externality?

Answer 10

When one person’s acftions has direct costs or ebnefits to other peoples consumption or production e.g pollution, noise and smells

Question 11

Should externalities be taxed?

Answer 11

. Putting a tax on a good which has a negative externality can be a good thing.
. You charge the consumer the marginal cost they are imposing on other people.
. This raises revenue and discourages the bad behaviour.
[But the more it discourages bad behaviour, the less revenue it raises!

Question 12

What does an investment project usually involve?

Answer 12

An investment project (private or public), generally involves spending money up front (capital investment), to provide the capacity to earn an income (or provide a benefit) later on.

Question 13

What usually happens with cash flows in a private investment?

Answer 13

. - negative cash flow at the start i.e when project first financed
. then a positive cash flow once the investment makes money

Question 14

How do we compare present costs with future gains with an investment project?

Answer 14

. The cash flow is more heavily discounted over time with a discount formula created

Question 15

What is a discount formula?

Answer 15

We set this up using a spreadsheet, with t=time down the rows.
The second column is the discount factor (1+r)^t. Note the power term. This is because time discounting is compounded.
. present value for each period is CF/(1+r)^t
.NPV is the sum of all the present values for each year

Question 16

What is the total discounted cash flow called and what does it tell us?

Answer 16

Total DCF is called the NET PRESENT VALUE (NPV). IF NPV is positive, the investment is worth it.

Question 17

Why are interest costs on loans not usually included in DCF analysis?

Answer 17

They may appear in profit and loss statements. Not usually included in DCF analysis (because we are already discounting future profits, and charging interest as an extra expense would be double-counting).

Question 18

Should annual maintenance be included in DCF analysis?

Answer 18

Capital may need replacing or upgrading every few years, or decommissioning at the end of the investment. These costs should also be included.

Question 19

When you do a DCF analysis of a project, what do you discount and what do you not?

Answer 19

It is the cash flow that you discount, not the profit/loss statement.

Question 20

What is sensitivity analysis?

Answer 20

. when planning for the future, there are lots of things which are uncertain such as economic growth and technology
. Uncertainties are dealt with by developing a set of scenarios
. For each scenario we do a DCF analysis and work out a Net present value

Question 21

What is probabilistic analysis?

Answer 21

. For each scenario, s, we can attach a subjective probability, Ps, (like betting odds) of the scenario occurring.
. Across all scenarios, Ps sums to 1.
. Expected Net Present Value of project = Sum(across all scenarios, Ps x NPVs).

. So NPVe= NPV1 x P1 +NPV2 x P2
+NPV3 x P3………..

Question 22

What is different about a public sector appraisal?

Answer 22

. Public sector will do modified DCF appraisal

. The public appraisals will be modified, to take account of social factors.

Question 23

What positive social factors are examined in a public sector appraisal?

Answer 23

. Taxation. If the project is profitable, it will yield tax revenue. This is a public benefit.

. External benefits.
Regional gains. Maybe jobs gain.
Spillovers to other firms (for example, from research subsidies).
Environmental benefits.

Question 24

What negative social factors are examined in a public sector appraisal?

Answer 24

. Social costs.
. Externalities.  These are costs borne by people other than the company/body doing the investment.
Noise
Pollution
Bad smells
Congestion
Etc. etc.

Question 25

How can a company be forced to take into account externalities?

Answer 25

. individuals, groups/other companies can force a company to take account of externalities (by threatening to sue)
. the government may impose a pollution tax. = private firms will take account of the marginal cost of the pollutant in their own appraisals