Midterm Flashcards

Question

Economic value

Answer 1

What is the “value” of a policy to some individual? A person derives utility from the consumption of goods: U = U(X1, X2, …, XN) Notation: subscripts are used to indicate which good we’re referring to; “Xj” is the quantity of good j (with j = 1, 2, …, N) Recall: a “good is anything that an individual values. It need not be material and there need not be a market for it. A policy changes the person’s consumption of the N goods by dX1, dX2, …, dXN If the individual consumed 25 units of good 7 (X7 = 25) before the policy, and consumes 28 units after the policy, then dX7 = 3 If the individual had X2 = 15 before and has X2 = 11 after, then dX2 = -4 (dXj is negative if Xj decreases; not an absolute value)

Answer 2

How much would you pay for a policy that benefits you, or pay to avoid a policy that hurts you?

Answer 3

How much would you accept in lieu of a policy that benefits you, or accept as compensation for a policy that hurts you?

Answer 4

These are conceptually similar, but… Willingness to pay is constrained by current income WTP and WTA have different reference points In practice, which measure is appropriate is dependent on the assignment of rights Zerbe (1998): “Whether an action that results in a positive change is felt as a loss restored or as a gain, is in large part a matter of established property rights.”

Answer 5

Two related concepts in determining economic value of policies are compensating variation (CV) & equivalent variation (EV)

Answer 6

Compensating variation (CV) is the amount you could pay and still be as well off after the change as you were before (what you would pay to compensate for the change) CV can be negative; this just means that you would “pay” a negative amount (i.e., receive money) CV>0 indicates a beneficial change; CV<0 indicates harm In the case of a beneficial policy (e.g., price decrease), CV is the amount you would be willing to give up in order to receive the benefit of the policy; i.e., “willingness to pay” In the case of a harmful policy (e.g., price increase), (the size of) CV is the amount you would require to tolerate the cost of the policy; i.e., “willingness to accept” Calculated by looking at original utility In a world where the policy is implemented, how much money must you pay (or receive) in order to restore your pre-policy level of utility? This shows how CV depends on “rights.” It factors in utility under the status quo, effectively presuming that that’s what you’re entitled to.

Answer 7

Equivalent variation (EV) is the amount you must receive to make you as well off without the policy as you would be with it (the monetary equivalent of the policy) EV can be negative; this just means that you would pay money instead of receiving money EV>0 indicates a beneficial change; EV<0 indicates harm In the case of a beneficial policy (e.g., price decrease), EV is the amount you would accept in place of the policy; i.e. “willingness to accept” In the case of a harmful policy (e.g., price increase), (the size of) EV is what you would pay to avoid the policy; i.e. “willingness to pay” Calculated by looking at new utility In a world where the policy is not implemented, how much money must you be given (or have taken away) so that you have the same utility that you would have if the policy was implemented? This shows how EV also depends on “rights.” It factors in utility under the new policy, effectively presuming that’s what you’re entitled to.

Answer 8

Consumers’ welfare changes can be measured (approximately) via changes in consumer surplus Suppliers’ welfare changes can similar be measured via changes in producer surplus Reminder: producer surplus is the area above the competitive supply (i.e., marginal cost) curve and beneath the price suppliers are paid

Answer 9

A policy should be enacted if the winners from a policy change could (in principle) fully compensate the losers and still be better off than before

Answer 10

A policy should be enacted if the losers could not bribe the potential winners not to enact the policy (and still be better off than if the policy had been enacted)

Answer 11

Must meet both of the criteria above

Answer 12

Potential Pareto rule Are there side payments among individuals such that the policy, if accompanied by these side payments, would create a Pareto improvement? Important note: there is no requirement that these side payments are actually made! This is essentially the Kaldor-Hicks criterion; does the policy make the “social pie” bigger? Straightforward to evaluate in practice: does the policy generate net benefits? In order for the Kaldor-Hicks criterion to give the correct decision, what must be true about the social welfare function? (What does use of KH imply?)

Answer 13

In terms of social welfare function, using Kaldor-Hicks is equivalent to using weights that are all equal to 1: 𝑑𝑊=∑_𝑖▒(𝜕𝑊/(𝜕𝑈_𝑖 )∗(𝑑𝑈_𝑖)/𝑑𝑀∗∑_𝑗▒(𝑝_𝑗∗𝑑𝑋_𝑗 ) ) =∑_𝑖▒∑_𝑗▒〖𝑝_𝑗∗𝑑𝑋_𝑗 〗 This is exclusively an efficiency criterion It asks: has the size of the “social pie” increased? It does not care how the pie is divided (ignores equity)

Answer 14

There are instances when Kaldor-Hicks is appropriate even if society values both equity and efficiency Does society have a more effective alternative mechanism for attaining distributional changes? E.g., progressive income taxes and transfers If so, then analysis of an unrelated policy will be minimally affected by consideration of distributional issues As we will see later in the course, it is fairly straightforward to explicitly incorporate equity into our analytical framework even though it is based on Kaldor-Hicks The big challenge is obtaining information about how society values equity, not any methodological difficulty in incorporating this information into CBA per se

Answer 15

Kelman’s (1981) main arguments Cost-benefit analysis is based on utilitarianism, which is not the appropriate moral standard in all cases CBA requires the pricing of non-market goods, which distorts the true value of many important rights and duties There may be cases in which a decision whose costs outweigh its benefits is still the correct decision “It is not justifiable to devote major resources to the generation of data for cost-benefit calculations or to undertake efforts to ‘spread the gospel’ of cost-benefit analysis further” Discuss!

Answer 16

Present consumption: 𝐶0=𝑊0 –𝑆0 Future consumption: 𝐶1=𝑆0(1+𝑟) Solving the second equation for S0 and substituting into the first gives the multi-period budget constraint: 𝑊_0=𝐶_0+𝐶_1/(1+𝑟) This a standard budget constraint with 𝑃0 = 1 and 𝑃1 = 1/(1+𝑟) (can look at it as 𝑊_0=〖1∗𝐶〗_0+1/(1+𝑟)∗𝐶_1) Graphically, this is a line with a vertical (𝐶1) intercept of 𝑊0(1+𝑟), a horizontal (𝐶0) intercept of 𝑊0, and a slope of –(1+𝑟)

Answer 17

An individual’s marginal rate of substitution (MRS) is the magnitude of the slope of their indifference curve

Answer 18

The marginal rate of time preference (MRTP) is defined as MRTP = MRS – 1 (or MRS = 1 + MRTP) MRTP is the % increase in consumption that the individual requires in order to delay that consumption by 1 year

Answer 19

``` If the costs and benefits of a policy occur at different points in time, their dollar values are not directly comparable: a dollar today is not equivalent to a dollar some time in the future Why is this the case? Inflation (or deflation) Opportunity cost (could invest $1 now, earn interest) Preference for current consumption Uncertainty/risk of investment (if talking about expected dollar values, not certain dollar values) ``` To address this issue, all costs and benefits must be expressed in comparable units The standard way to do this is to express all costs and benefits in terms of their present value (the amount that, if paid/received now, would be equivalent to the specified future amount) This conversion process is called “discounting”

Answer 20

An amount X available today, invested at an interest rate r, will translate into X(1+r) in one year

Answer 21

This amount is referred to as the future value (FV) of the investment in one year: 𝐹𝑉=𝑋(1+𝑟) Example: $1,000 invested today at an interest rate of 4% (or 0.04) will return $1,000 + $1,000(0.04) = $1,040 next year

Answer 22

The present value (PV) of a future amount can be found by rearranging this equation $FV received in one year is worth $PV now 𝐹𝑉=𝑃𝑉(1+𝑟) 𝑃𝑉=𝐹𝑉/(1+𝑟)

Answer 23

In practice, the value of r may be something other than the market interest rate; r is referred to as the discount rate

Answer 24

The present value of a project’s benefits minus the present value of its costs is called the net present value (NPV) of the project – because it is negative in this case, the city should not purchase the land ($5.25m next year is not more valuable than $5m now!)

Answer 25

(1+𝑟)𝑛 is referred to as the compound interest factor

Answer 26

An amount X available today, invested at an interest rate r, will translate into X(1+r) in one year 𝐹𝑉_1=𝑋(1+𝑟) If this amount is then invested for another year: 𝐹𝑉_2=𝑋(1+𝑟)(1+𝑟)=𝑋(1+𝑟)^2 After being reinvested annually for n years: 𝐹𝑉_𝑛=𝑋(1+𝑟)^𝑛

Answer 27

1/(1+𝑟)^𝑛 is called the discount factor

Answer 28

If a project generates benefits over multiple periods, the present value of the entire stream of benefits is just the sum of the PVs of each period’s benefits: PV(B)=𝐵_0/〖(1+𝑟)〗^0 +𝐵_1/〖(1+𝑟)〗^1 +…+𝐵_𝑛/〖(1+𝑟)〗^𝑛

Answer 29

In order to use NPV to inform a decision, need to make certain assumptions: Value(s) of discount rate(s) Can have different rates for different periods Capital is readily available if borrowing is required Not generally an issue in developed countries like U.S. Borrowing and lending have the same interest rate Not always strictly true, but very close in U.S. All relevant benefits and costs have been included

Answer 30

One caution about a common mistake when compiling your list of relevant costs and benefits to be included: watch out for irrelevant transfer payments! A transfer payment is simply a payment from one party to another; it does not actually involve the use of resources (just moves resources from one party to another), and thus does not constitute a net cost or net benefit to society The transfer payment represents a cost to the payer and an identically-sized benefit to the recipient; if both were included, they would cancel each other out when calculating NPV Example: in what sense is “job creation” a benefit? Important exception: if the two parties have different social weights, a transfer payment between them has equity implications and should thus be included We’ll return to this issue later in the course

Answer 31

Using NPV as a decision rule for a single project: If NPV > 0 (benefits exceed costs), the project increases real wealth and should be undertaken Assumes no capital constraints (so no additional opportunity cost from an even better project that the money could have been spent on)

Answer 32

Must identify all possible alternatives (including combinations of other alternatives, if relevant) The project with the highest NPV increases real wealth by the largest amount, and should be undertaken Note: If doing nothing (not undertaking any project) is an option, then no project should be chosen if all have NPV<0 If projects have different lifespans, NPVs cannot be compared directly, and must be adjusted; several methods for doing this (e.g., invest FV of the shorter project at best available rate until the end of the longer project’s lifespan)

Answer 33

- benefits - costs - time horizon - discount rate We have made no mention of whether benefits and costs are expressed in real or nominal terms – it does not matter as long as you use the appropriate discount rates (real if benefits and costs are in real terms, nominal if they are in nominal terms) Not only do real/nominal give the same conclusions about a project, they give the same NPV – in the base year (present), real and nominal are the same The usual convention for public sector analysis is to use real values, while the private sector conventionally uses nominal values

Answer 34

To convert a nominal value into a real value, it must be adjusted to account for price differences between that year and the base year Letting Pt denote the price level in year t (typically measured by the Consumer Price Index), a nominal amount (in year t dollars) can be expressed in real terms (in year 0 dollars) as follows: 〖𝑅𝑒𝑎𝑙〗_0$=〖𝑁𝑜𝑚𝑖𝑛𝑎𝑙〗_𝑡$∙𝑃_0/𝑃_𝑡 For analysis of future costs and benefits, price indexes not known yet: need to forecast future prices with estimates of future inflation (from Federal Reserve, OECD, etc.)

Answer 35

There are a number of reasons that the market interest rate may not be equal to the MRTP and to the marginal rate of return on investment Key examples include market failures and taxes If it is not the case that the MRTP is equal to the rate of return on investment, with both given by the market interest rate, then the appropriate social discount rate is no longer obvious

Answer 36

MTRP as social discount rate One possibility is to use the MRTP In the example: 8% This is the rate at which individuals are willing to trade future consumption for current consumption Argument for this approach: If a project yields a return higher than the MRTP, then the increase in future consumption makes the sacrifice of current consumption worthwhile Advocates of the MRTP approach tend to be in favor of more extensive government investment A lower discount rate gives future benefits more weight

Answer 37

Another option would be to use the marginal return to private investment In the example: 17% This is also called the opportunity cost rate (OCR) Argument for this approach: Public investment can displace private investment by using funds that would otherwise go to private investment If the rate of return on a project is less than the OCR, then this project is less valuable than the private investment that it displaced, and the project should not be undertaken Whether or not the return is greater than the MRTP is irrelevant, as the alternative use of these funds is not a project with a return equal to the MRTP Advocates of the OCR approach tend to be in favor of less government investment A higher discount rate gives future benefits less weight

Answer 38

Both of these approaches have some intuitive appeal; what should we actually do? To the extent that a project displaces consumption, it should be discounted at the MRTP The project comes at the expense of current consumption, and this is the rate at which individuals are willing to trade current for future consumption To the extent that a project displaces private investment, it should be discounted at the OCR This is the return that would have been earned on those funds otherwise, so it is the relevant opportunity cost

Answer 39

Social discount rate = 𝑎∗𝑂𝐶𝑅 + (1−𝑎)∗𝑀𝑅𝑇𝑃 Social discount rate obtained this way also called the WSOC (Weighted Social Opportunity Cost of capital) 𝑎 = fraction of funds displacing private investment (1 – 𝑎) = fraction of funds displacing consumption Conceptual motivation: if some funds should be discounted at the OCR, and some at the MRTP, then the discount rate for the project as a whole should be a weighted average of these two rates Example: Suppose that OCR = 17%, MRTP = 8%, and 60% of funding would come from displaced private investment Social discount rate = (0.6)(17%) + (0.4)(8%) = 13.4%

Answer 40

This is the marginal rate of return on private investment We might use the real (inflation-adjusted) before-tax rate of return on corporate bonds E.g., Moody’s AAA-rated corporate bonds have typically yielded about 4.5%

Answer 41

This is the rate at which individuals are willing to postpone current consumption for future consumption We might use the real (inflation-adjusted) after-tax rate of return on government bonds Generally around 1.5%

Answer 42

The shadow price of capital (SPC) is the present value of the consumption that results from $1 of private investment The SPC answers the question: how many dollars of consumption is each dollar of private investment “worth”? Kind of like last week: even we everything is measured in $’s, not all $’s are directly comparable. A general expression for the SPC: (no need to memorize!) SPC= ((𝑟+𝛿)(1−𝑓))/(𝑝−𝑟𝑓+𝛿(1−𝑓)) r: net return on capital after depreciation δ: depreciation rate f: fraction of returns re-invested p: marginal social rate of time preference (SRTP) If there is no re-investment and no depreciation, this simplifies to SPC = 𝑟/𝑝 (the marginal value of displaced private investment divided by the marginal value of displaced consumption) BGVW’s recommended baseline SPC is 1.33; ignoring re-investment and depreciation (as the Harberger method does) but otherwise using the same parameters would give SPC = 3!

Answer 43

The SPC method converts all benefits and costs into consumption equivalents This resolves our dilemma about which discount rate to use; since everything is now expressed in dollars of consumption, we should discount as if only consumption has been displaced (i.e., use MRTP as the discount rate) "NPV"=∑_(𝑡=0)^𝑛▒(〖𝐵_𝑡〗^∗−〖𝐶_𝑡〗^∗)/〖(1+𝑟)〗^𝑡

Answer 44

Cost-effectiveness analysis (CEA) is a common alternative to cost-benefit analysis Similar techniques; CEA is essentially CBA without a dollar value assigned to benefits Usually a different goal: provides information about relative efficiency of alternatives CEA can be used when: The goal (desired effect) is known The budget is fixed There are missing data or there are outcomes that we choose not to monetize Major example: health policy

Answer 45

𝐶𝑜𝑠𝑡/𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑛𝑒𝑠𝑠 Unlike in CBA, denominator is not monetized If we monetized the effectiveness (benefits), this would be the inverse of the Benefit-Cost Ratio (discussed when we introduced CBA) Use of CEA requires a one-dimensional measure of effectiveness (we can sometimes get around this; more later) E.g., lives saved, decrease in high school dropouts, tons of pollution abated

Answer 46

CEA was not especially helpful in either of those special cases, just reinforces what should be obvious: Choose alternative with lowest cost if equally effective, or largest effect if equally costly In practice, no particular reason to expect competing alternatives to have equal cost or effectiveness

Answer 47

When considering an addition to an existing alternative (or a policy that can be implemented to various degrees), we use an Incremental Cost-Effectiveness Ratio (ICER): 𝐼𝐶𝐸𝑅=∆𝐶𝑜𝑠𝑡/∆𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑛𝑒𝑠𝑠 The basic CE ratio can be thought of as a special case where the “existing alternative” is no policy (C=E=0) Especially important to consider if diminishing returns and/or increasing costs apply

Answer 48

Even more generally, programs may have: Benefits besides the effectiveness measure Specifically, some benefits that you are willing/able to monetize Effects that occur over time What does the CE ratio look like then? Denoting monetized benefits as Bt , net CE ratio is: (∑_(𝑡=0)^𝑛▒〖(𝐶_𝑡−𝐵_𝑡)/〖(1+𝑟)〗^𝑡 〗)/(∑_(𝑡=0)^𝑛▒〖𝐸_𝑡/〖(1+𝑟)〗^𝑡 〗)=(𝑃𝑉(𝑁𝑒𝑡 𝑐𝑜𝑠𝑡𝑠))/(𝑃𝑉(𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑛𝑒𝑠𝑠)) In other situations, we may not know the value of a key benefit Missing data E.g., an after-school tutoring program with unknown effect on student outcomes Unwillingness to assign a value to an important variable E.g., life or health status Note: “unwillingness” is not the same as “inability.” More on valuing health later in the course. What can the cost-effectiveness structure give us in these cases?

Answer 49

Is the policy a “good idea”? CE ratio alone can’t answer this; what additional info is needed? CEA is a “threshold” method It gives the minimum valuation of one unit of effectiveness required to make a policy worth enacting E.g., if the value of an additional high school graduate is greater than $35,000, then the policy is worthwhile Even if you’re unable or unwilling to monetize a benefit, the reality is that resources are scarce, and we need to decide among alternative uses of those resources Should the government enact a policy that has a CE ratio of $1 per additional graduate? How about a policy that costs $1 trillion per additional graduate?

Answer 50

What if “effectiveness” can’t be captured by a one-dimensional measure? Most commonly an issue in health policy, as medical interventions may affect both life expectancy (mortality) and quality of life (morbidity) Cost-utility analysis (CUA) can be thought of as a special case of CEA in which the “effectiveness” term is a utility index that incorporates multiple dimensions In health policy, outcomes are often measured in terms of quality-adjusted life-years (QALYs)

Answer 51

Measuring a policy’s outcome in terms of years of life saved does not account for effects on quality of life, which we want to incorporate Outcomes are converted into QALYs by multiplying years of life saved by a quality factor ranging from 0 (death) to 1 (perfect health) E.g., 1 year in hospital = 0.16 years in perfect health, 1 year with osteoporotic fractures = 0.78 years in perfect health So, 5 years with osteoporotic fractures = 3.9 QALYs (5 years)*(0.78 QALYs/year) = 3.9 QALYs

Answer 52

Not everyone has the same preferences; whose do we use? Medical experts Patients who have experienced similar health states General population Other? What are the pros and cons of each group?

Answer 53

-Health rating method Individuals are given a scale with death = 0 and perfect health = 1, then asked to specify the locations of intermediate health states (described in detail) on this scale -Time trade-off method Individuals asked to rank different combinations of length and quality of life; the tradeoffs that make individuals indifferent imply the relative quality factors -Standard gamble Individuals given a choice between (a) n years with a specified health state or (b) probability p of n years in perfect health and probability (1 – p) of immediate death; quality factor is the value of p that makes them indifferent

Answer 54

Same issues in CUA as in CEA (conceptually identical) Potential issues when comparing projects of different scale Useful for comparisons when budgets or goals are known Is the policy a “good idea”? Is cost per QALY < value per QALY? Vigdor (2000) literature review puts reasonable values between $140,000 and $345,000 (tentative, with qualifiers; e.g., potential variation by age and health status) Many medical interventions have much lower costs per QALY than this, but not always lower than alternatives UK’s National Institute for Health and Clinical Excellence uses “threshold range” of £20,000 to £30,000 (equivalent to roughly $29,000 to $43,500 as of 2016)

Answer 55

Net Present Value can be represented by this formula: 𝑁𝑃𝑉=∑_𝑖▒〖∑_𝑗▒𝑃_𝑗 𝑑𝑋_𝑖𝑗 〗 Benefits and costs are the product of: dX: The real impact of the policy How much does the quantity of goods (or “bads”) change as the result of the policy? P: The valuation (price) of the impacted goods For each good, how much value do we place on each unit gained/lost? This week: predicting impacts Coming weeks: valuing impacts

Answer 56

Most policy analysis requires predicting the future E.g., if the government implements a school voucher system, what will happen? “Prediction is very difficult, especially about the future.” – Niels Bohr (1922 Nobel Prize winner in physics) In order to predict the future, social scientists usually study what happened in the past What past events can you look at? What difficulties are there when using the past to predict the future?

Answer 57

-Primary/direct goals of policy Changes in price and quantity of goods (bads) Remember that “goods” defined very broadly Who benefits and who loses from direct impacts? -Indirect effects Are the indirect effects good or bad? For whom? Example: Federal minimum wage increase Primary intended effects? Indirect?

Answer 58

In addition to thinking about whether a policy will be effective at inducing the desired behavior, it is important to consider that it might cause additional unintended results Example: Endangered Species Act of 1973 protects physical habitats of endangered species There is often a lag between the time a species is declared to be endangered and the time that its habitats are officially established (Dubner and Levitt, 2008) What might happen in this time? Americans with Disabilities Act: provides protection against discrimination for disabled workers (Dubner and Levitt, 2008) One Child Policy: China, 1978 (Ebenstein, 2010; Chen et al., 2013) Youth bicycle helmet laws (Carpenter and Stehr, 2011) Tax evasion and avoidance examples (Rosen and Gayer, 2013)

Answer 59

- Is the policy you’re evaluating an extension/replication of an existing policy? - Is the policy you’re evaluating similar to other policies that have been implemented in other locations, with different populations, etc.? - Can the policy be interpreted as a price change? If so, how has the relevant population reacted to price changes in the past?

Answer 60

Two general concerns if using evidence from a past policy to predict the outcomes of a proposed policy Internal validity Can the measured difference in outcomes can be properly attributed to the policy? External validity Can the measured difference in outcomes be generalized to new circumstances? Also critical to have an adequate causal theory Explains behavior regulated by the policy and the relationship between the policy and that behavior Guides empirical analysis (looking at the right inputs & outputs?) Alleviates worry about “false positives” “Inadequate causal theories lie behind many of the cases of implementation failure” – Mazmanian and Sabatier (1989)

Answer 61

Can the measured difference in outcomes be attributed to the policy? In other words, is there a causal relationship between the policy and outcomes (not just correlation)? Three conditions (Rosen and Gayer, 2013): 1. Policy and outcomes are correlated 2. Policy precedes outcomes 3. Other explanations for correlation must be eliminated

Answer 62

What would have happened in the absence of the policy? (this hypothetical outcome is called the counterfactual)

Answer 63

Compare two groups that do not systematically differ except that one is subject to a “treatment” and the other is not

Answer 64

Concerns about internal validity relate to the how well the observed data reflects the scientific experimental ideal, embodied by the randomized controlled trial (RCT) Ideal: Before and after observations for a treatment and control group; random assignment into treatment and control groups If done successfully, then any observed differences in outcomes can be attributed to the program/treatment/policy/intervention

Answer 65

All empirical analysis makes some assumptions about the counterfactual If you’re producing original research… Be explicit (with yourself and your audience) about your assumptions Critically assess the assumption What seems plausible? What is concerning? If you’re consuming others’ research… Identify the assumptions Critically assess the assumptions to gauge whether you want to use the research

Answer 66

Can the evidence be generalized to new circumstances? Some reasons to question external validity: Different populations Different socioeconomic environments Different time periods Different program scale Not an exhaustive list; requires critical thinking and knowledge of the current and past programs that may go beyond that which is visible in data

Answer 67

``` Often not feasible to run a random experiment; can we randomly assign treatment and control groups? Costs, ethics (though sometimes goals of being ethical and randomizing for experimental purposes align) Even with randomization, can still have threats to internal validity Selection bias (are voluntary participants different from general population?) Randomization failure (can only control for observed treatment-control differences; bias may result if unobservable characteristics not perfectly balanced) Attrition bias (participants drop out non-randomly) Hawthorne effects (people know they’re being studied, and behave differently; may respond to treatment/control status) For examples/discussion of these issues, see Krueger (1999) ```

Answer 68

``` In practice, researchers in the social sciences often rely upon natural experiments (or quasi-experiments), which attempt to utilize the “treatment-control” framework in the absence of actual random assignment to treatment and control groups Example: Angrist and Lavy (1999), quasi-experimental variation in class size In Israel, class size capped at 40 (“Maimonides’ Rule”): if cohort has 40 students, get one class of 40; if cohort has 41, get classes of 20 and 21 Assuming no other systematic differences between cohorts of 40 vs. 41, differences in outcomes are attributable to class size ```

Answer 69

Strict adaptation of experimental framework would entail comparing outcomes of individuals exposed to the treatment with outcomes of similar individuals not exposed to it Example: do states with death penalty have lower crime rates? Policy impact = T – C Is this a good idea? Does the control group provide a valid counterfactual? Would their outcomes be the same the absence of the policy?

Answer 70

Another possible approach would be to simply compare the outcomes of those exposed to a policy before and after the policy was implemented Example: what were rates of smoking-related illnesses in CA before and after bans on smoking in public places? In the “treatment-control” framework, this is essentially using the participants’ pre-treatment selves as the control group Policy impact = Tpost – Tpre Is this a good idea? What counterfactual is implicitly assumed by this approach? Does that seem plausible? In practice, it may be the best you can do (e.g., no reasonable control group); in this case, you should control for as many other relevant factors as possible, and clearly note the limitations

Answer 71

A better approach would use both pre- and post-treatment information on the treatment group and a control group A common way of doing this is known as difference-in-difference estimation This method estimates the impact of a policy by comparing the outcomes of a treatment group and a control group before and after the treatment is received Underlying assumption: in the absence of the policy, the difference between the outcomes of the two groups would not have changed (i.e., they would have followed a common trend) One way to start exploring whether this seems reasonable: have the outcomes for these two groups followed similar trends in the past? The change in outcomes of the control group is viewed as the counterfactual for the change in outcomes of the treatment group Difference-in-difference estimator: Policy impact = (Tpost – Tpre) – (Cpost– Cpre) T: treatment group outcome, C: control group outcome The DD estimate is the amount by which the change for the treatment group exceeded the change for the control group Another way of writing this equation: Policy impact = (Tpost – Cpost) – (Tpre – Cpre) This shows another way of thinking about the DD estimate: it’s the amount by which the difference between the treatment and control group changed

Answer 72

In some cases, there may be many previous policies similar to the one whose effects are being predicted If reliable evaluations have already been conducted for these policies, then their results can be used to estimate both the expected size of the new policy’s effects and the uncertainty associated with that estimate Good examples from Washington State Institute for Public Policy: Aos et al. (2007); Drake et al. (2009); Aos and Pennucci (2013) Key question: which existing evaluations are “reliable” and should be included in your meta-analysis? Most straightforward approach to combining a set of estimates would be to take a simple average However, this does not account for differences in the precision of the various estimates E.g., if one study’s estimate is 10 with a standard error of 2, and another study’s estimate is 14 with an SE of 4, does it seem reasonable to give them equal weight (i.e., use the simple average, 12)? Instead, common to take a weighted average, assigning a weight to each estimate that is equal to the inverse of its variance: 〖𝑊𝑒𝑖𝑔ℎ𝑡〗_𝑖=1/〖𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒〗_𝑖

Answer 73

Many policies can be thought of as price changes Many policies explicitly change prices Example: subsidies for hybrid and electric cars Even if there was no previous policy that subsidized electric cars, there may be general information on how demand responds to price changes Often true even if the policy doesn’t explicitly deal with prices Example: school district implementing universal public preschool Essentially a price decrease to 0; may be able to find information on how demand for preschool changes with price The price elasticity of demand is the percentage change in quantity demanded that results from a 1% increase in price: Ep = "%∆Q" /"%∆P" E.g., if a good has a price elasticity of –2, a 1% increase in price will lead to a 2% decrease in quantity demanded Therefore, if your policy is a subsidy that would decrease a good’s price by 3%, you would predict a 6% increase in quantity

Answer 74

Does society value redistribution? I.e., is αi the same for all 𝑖? (Should everyone’s costs and benefits “count” equally? Does each dollar have the same value to society no matter who pays/receives it?) Rationales for redistribution (unequal αi): Social welfare function other than additive utilitarian Diminishing marginal utility of income Desire for income distribution to be more equal “One person, one vote” principle Price changes have bigger EV/CV effects for people with more consumption (typically higher income); can be offset by placing higher weight on the gains/losses of those with lower income Transfer programs exist that improve equity at the cost of efficiency, implying that society does value redistribution However, big differences in preferences across individuals/political parties

Answer 75

If NPV is all about efficiency, can we incorporate equity into our CBA without using a completely different method? Yes! Instead of the basic version of NPV that we have been using, we use distributionally-weighted NPV Before we compare our costs and benefits, we weight them according to the relative values that society assigns to changes in the well-being of those paying/receiving them For example, if benefits to one person are considered to be twice as valuable as benefits to another person, we could incorporate this into our analysis by doubling the value of the benefits received by first person (e.g., if they gain $100, we treat this as equivalent to a gain of $200 for the other person)

Answer 76

Internal weighting is a threshold technique analogous to the internal rate of return (IRR) Remember that IRR answers the question: what is the discount rate that makes the policy just break even? I.e., at what threshold does the policy switch from + to – NPV? If the true discount rate is greater, then the policy has negative NPV; if the true discount rate is lower, then the policy has positive NPV Internal weights answer the question: what is the weighting scheme that makes the policy just break even from a social welfare perspective? Only meaningful in cases where there’s a trade-off between efficiency and equity The internal weight for a disadvantaged group (relative to an advantaged group) is calculated as the size of the effect on the advantaged group divided by the size of the effect on the disadvantaged group Suppose that a policy generates benefits of $5 million for a disadvantaged group (e.g., poor), and costs of $7 million for an advantaged group (e.g., rich) The unweighted social NPV is: $5 million – $7 million = –$2 million What is the internal weight on the disadvantaged group? internal weight=|𝑒𝑓𝑓𝑒𝑐𝑡 𝑜𝑛 𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒𝑑|/|𝑒𝑓𝑓𝑒𝑐𝑡 𝑜𝑛 𝑑𝑖𝑠𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒𝑑| =($7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛)/($5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛)=1.4

Answer 77

Is the policy a “good idea”? Just like the internal rate of return (IRR) in CBA, internal weights do not provide a direct answer to this question However, internal weights (and even the intermediate step of providing a simple breakdown of costs and benefits for different groups) provide decision-makers with valuable information Internal weights explicitly demonstrate the trade-off between efficiency and equity If the “true” distributional weights are determined to be higher or lower than the internal weights, then this indicates whether or not the policy is worth enacting

Answer 78

No consensus on what the social weights should be “Opportunity cost” argument provides an upper bound If a program increases equality but reduces efficiency, it should be rejected if an alternative transfer program could be used with lower loss in efficiency If a program decreases equality but increases efficiency, it should be accepted if an alternative transfer program could compensate the losers without a net reduction in efficiency Note similarity to Kaldor-Hicks How much do transfers cost per dollar provided to beneficiaries? Gramlich (1990): $1.50-$2.00

Answer 79

False. A Pareto superior outcome leaves at least one person better off, and no one worse off. Therefore, the first statement regarding the Kaldor-Hicks Criterion is in fact true. Since Kaldor- Hicks places equal weight on all individuals, then those individuals who are better off increase the equally-weighted social welfare function. However, the second statement regarding social welfare is false. So long as no individual has a negative weight in the social welfare function (a negative weight implies that that person’s well-being negatively affects social welfare), then even an unequally-weighted social welfare function must increase if some individuals are better off and no one is worse off.

Answer 80

False. The equation for measuring changes in social welfare is 𝑑𝑊 = Σ 𝜕𝑊 𝜕𝑈𝑖 𝑁 𝑖=1 ⋅ 𝑑𝑈𝑖 which shows that both the social weight ( 𝜕𝑊 𝜕𝑈𝑖 ) and the change in individual utility (𝑑𝑈𝑖) are equally important. For instance, if person A has double the social welfare weight of person B but half the change in utility, then person A and person B will each change social welfare by the same amount.

Answer 81

Compensating variation measures the amount of income an individual must be compensated (positive or negative) to be as well off after an intervention as he or she was before the intervention. Equivalent variation on the other hand measures the amount of income an individual must be given/have taken away to be as well off as he or she would have been had an intervention taken place. They differ to the extent that compensating variation assumes that individuals are entitled to the initial utility (i.e. utility under the status quo) while equivalent variation assumes that individuals are entitled to the post-intervention utility. Both compensating and equivalent variation are measured as the area under the Hicksian (compensated) demand curve, but note that compensating variation uses the Hicksian curve that corresponds to initial utility while equivalent variation uses the Hicksian curve that corresponds to post-intervention utility.

Answer 82

Change in CS falls somewhere between CV and EV and is a good approximation of CV and EV when those two are close together. CV and EV are close together when a policy has relatively small effects, if it affects goods with small income elasticities, or if it affects goods that represent relatively small shares of income.

Answer 83

False. Discounting of future benefits and costs is required regardless of inflation. For instance, discounting is required even when inflation is zero. Discounting accounts for the opportunity cost of cash flows in the future relative to today, as well as intertemporal preferences for consumption sooner rather than later. In contrast, netting out of inflation accounts for changes in the purchasing power of a dollar due to price changes – even after accounting for that, the issues related to opportunity cost and intertemporal preference remain.

Answer 84

False. Standard discounting, with constant discount rates, leads the benefits and costs to future generations to be almost entirely ignored even if those benefits and costs are very, very large. Furthermore, it is harder to imagine that current generations can compensate (or be compensated by) future generations. In a sense then, standard discounting seems to place too little importance on future generations, and time-declining discount rates rectify that issue.