Economic appraisal for decision making Flashcards
What are WTP and WTA?
One is willingness to pay (WTP), which reflects the maximum monetary amount that an individual would pay to obtain a good. The other is willingness to accept compensation (WTA), which reflects the minimum monetary amount required to relinquish the good.
WTP and WTA should not, according to past theory, diverge very much.
In practice they appear to diverge, often substantially, and with WTA > WTP. • Hence the choice of WTP or WTA may be of importance when conducting
analyses of costs and benefits (CBA).
WTP in the context of a potential improvement is clearly linked to rights to the
status quo. Similarly, if the context is one of losing the status quo, then WTA for that loss is the relevant measure.
By and large, environmental policy tends to deal with improvements rather than deliberate degradation of the environment, so there is a presumption that WTP is the right measure.
What are the two aggregation rules?
- aggregating benefits across different social groups summing up WTP, regardless of the circumstances of the beneficiaries or losers.
- or, weighting benefits and costs according to social groups accruing to
disadvantaged or low income groups, since marginal utilities of income will
vary, being higher for the low income group
What is the discounting issue of CBA?
Aggregating over time involves discounting. • Discounted future benefits and costs are known as Present Values.
↘ Current activities imposing large costs on future generations may appear
insignificant in a Cost-benefit Analysis. Similarly, for actions now that will benefit future generations.
The weakness of the conventional approach, which assumes that one positive
discount rate is applied for all time, is that it neither incorporates uncertainty
about the future nor attempts to resolve the ‘tyranny of discounting’ problem.
Possible solution is using declining rates, in consideration of:
- hyperbolically discounting preferred by people
- uncertainty increases in the future
- adopting reasonable ethical axioms
What are the different types of decision making analysis?
Cost-Benefit Analysis (CBA)
• It provides an overview of the advantages and disadvantages of an
action/project, or a set of alternatives, in terms of social welfare, presented as
cost and benefit items on a cost-benefit balance sheet. The items are expressed in monetary terms. The main question in a Cost Benefit Analysis is “Do the benefits outweigh the costs?”. The welfare effect is expressed by that balance.
Cost-Effectiveness Analysis (CEA)
• It allows the identification of the alternative option (action/project) which can
reach a given objective at the lowest cost (cost minimisation). It can also be used to determine which option, given a certain budget, can contribute most to the achievement of the objective (effect maximisation).
Multi-Criteria Analysis (MCA)
• MCA methods can be used to get large quantities of incommensurable
information into a manageable form for decision-making. For each alternative,
multiple criteria are used to assess its performances to each of the effects
considered. Weighting procedures determine how relevant is the contribution of each criterion on the overall ranking.
Basic concepts of CBA
Benefits are defined as increases in human wellbeing (utility)
costs are defined as reductions in human wellbeing.
- the preferences of individuals are to be taken as the source of value.
- preferences are measured by a willingness to pay (WTP) for a benefit and a
willingness to accept compensation (WTA compensation) for a cost. - it is assumed that individuals’ preferences can be aggregated so that social
benefit is simply the sum of all individuals’ benefits and same for costs. - if beneficiaries from a change can hypothetically compensate the losers from a change, and have some net gains left over, then the basic test that benefits exceed costs is met (Kaldor-Hicks compensation).
What are the uses and objectives of CBA?
CBA can be adopted mainly when:
- An assessment should determine if an investment/decision is worth and
sound; involving the comparison of the total expected cost of the proposal against its total expected benefits, to check whether the benefits outweigh the costs, and by how much. - An assessment should determine which project(s) is/are worth to be
implemented; …involving the comparison of the total expected cost of each option against their total expected benefits, to identify which one maximises the ratio between benefits and costs
Why should one use CBA?
- it provides a model of rationality
- It is clear in its requirement that any policy or project should be seen as one of a series of options
- It should make the decision-maker include in the list of alternative options variations in the scale
- properly executed CBA should show the costs and benefits accruing to different social groups of beneficiaries and losers
- It is explicit that time needs to be accounted for in a rigorous way• It is explicit that it is individuals’ preferences that count
- It seeks explicit preferences rather than implicit ones
What are the Basic rules in a practical CBA?
- Establish the context (identify actors, constrains, etc.)
- Consider the issue of scale and boundaries
- Establish what the alternatives are, and the degree to which they are mutually exclusive
- Same costs: choose the one with the highest net benefits.
- Different costs: normalize alternatives by comparison with the one with highest cost
- Consider time, i.e. the costs and benefits of delay. • Rank the policies by the ratio of their benefits to costs.
- Consider risks and uncertainties
How to chose context in CBA?
The necessary condition for the adoption of a project is that discounted benefits should exceed discounted costs:
(gross) present value of benefits is greater than gross present value of costs
In practice further considerations are needed:
– Possible constraints on the objective function (e.g. sustainability)
– allowances for either distributional concerns or risk and uncertainty
What are the basic types of choice in CBA?
- Accept-reject
• set of independent projects and no constraints
↘ the decision-maker must decide which, if any, is worthwhile. That is, any project i for which benefits exceed costs should be accepted. - Ranking
• some input, such as capital, is limited
↘ all “acceptable” projects cannot be undertaken
↘ projects must be ranked or ordered in terms of the objective function –>
B /C ratios - Choosing between mutually exclusive projects
• projects provide different ways of achieving the same objective.
↘ the appropriate decision rule is to choose the project with the largest NPV (provided existing constraints are met)
↘ one case of mutual exclusion can be also represented by different allocation in time (typical for climate change issues)
How to calculate costs and benefits of climate change?
Decision should be based upon the integration of multi-disciplinary analyses, in particular impact and vulnerability assessments should be combined with economic analysis, i.e. the valuation of full costs of climate change (FC)
FC = CM + CA + RC
with:
– CM = Costs of mitigation
– CA = Costs of adaptation
– RC = Residual costs = CI – BM – BA
with:
– CI = Costs of inaction
– BM = Benefits from mitigation
– BA = Benefits from adaptation
Then: FC = CM + CA + CI – BM – BA
In case of no mitigation the cost of adaptation is:
FC = CA + CI – BA
Basics of CEA?
CEA typically seeks to find the best alternative activity, process, or intervention that:
– minimises resource use
– maximises desired outcomes
to achieve a desired result (objective).
↘ …e.g. when the objectives have been identified and the only remaining question is to find the least cost−option.
• often used as an alternative when CBA is not feasible or desirable.
• the cost effectiveness of an option is calculated by dividing its annualized costs by physical benefit measures, such as tons of emissions of a given pollutant.
• In the context of environmental policy, CEA is applicable in those cases where the decision on environmental objectives has already been made, based on ecological or biochemical grounds, or as a result of political
bargaining.
• In these cases, a CEA may help find the least−cost way of achieving the targets.
Ex-ante vs ex-post?
Like CBA, CEA can be used either to assess the expected impacts of alternative policy measures before they are implemented (ex−ante), or to assess the effectiveness of a policy measure that is already in place (ex−post). • Ex−ante assessment relies on assumptions and projections, ex-post requires
counterfactual comparisons, or checking compliance with the original objectives
What is CEA in practice?
- decision makers define the policy/project of interest
- analysts conduct a cost assessment and an effectiveness assessment for each alternative measure for implementing the measure/project
- analysts integrate assessments into a decisional analysis.
↘In general, CEA is most relevant when different policy
measures yield the same effectiveness, but at different
costs.
What are the steps of CEA?
- Identify the specific policy
- establish a baseline (to what extent the objective is already met; (distance to target)
- Identify the drivers of negative impacts (e.g. human activities) on the objective (in physical terms)
- decide which policy solutions can reasonably achieve the regulatory target (relative to a specified baseline situation)
- determine the total annualized costs for each policy measure (capital, personnel, start up, etc. costs) discounted to their present value by using an appropriate discount rate: “life cycle cost” of a policy alternative
- determine the appropriate measures of effectiveness
- infer on the cost−effectiveness of different options. An “overall” cost−effective analysis simply compares each policy intervention’s cost per unit of effectiveness (Cost Option A/Effectiveness of A).
