Week 8 - Cost-benefit analysis

Question 1

Pros and cons of CBA

Answer 1

Pros:
1. Flexible, consistent approach
- can be used for any project
2. Promotes transparency
3. Can be ex-ante CBA or ex-post CBA

Cons
1. 5 possible errors
- strategic, omission, measurement, forecasting, valuation
2. 5 main issues in forecasting as argued by Weitzman
- past data, effect of policies, temperatures, corresponding damages & monetising them, uncertainty in discounting
3. How to consider benefits to future generations if we think that their preferences may differ from ours
4. {time-consuming}

Question 2

Kaldor-Hicks principle

Answer 2

Go ahead with policy even if it makes some ppl worse off, provided that the overall benefits are greater than the costs, ie. enough benefits to COMPENSATE those that are worse off

• this criterion asks whether a policy creates a potential Pareto IMPROVEMENT after some compensation
• embedded in this is the UTILITARIAN approach

Question 3

Weitzman’s (2009) dismal theorem

Answer 3

if the probability of catastrophic damages is not zero, ignore the CBA approach
» our models almost ignore this

Question 4

Market values & how to estimate

What if markets exist and are imperfect?

Answer 4

Sources of benefits for which we can use market prices

Look at the market prices.
If markets exist and are imperfect, adjust market prices to consider shadow prices, eg. MSC marginal social cost

Question 5

Non-market values & how to estimate

Answer 5

Benefits people value but market prices do not reflect

Cannot use existing prices but we can set up SURVEYS to estimate ppl’s WILLINGNESS TO PAY (WTP) to avoid inaction

Question 6

Valuing indirect effects (spillovers) in CBA & the human capital approach

Answer 6

Differences in earnings/productivity are valued using the human capital approach, which assumes that an individual’s life has a value = to their production

eg. if a product improves the probability of recovering well from a stroke, indirect benefit = possibly worker returning to work sooner (higher earnings)

Question 7

Valuation for benefits (anything that increases human welfare) is based on willingness-to-pay,
what about for costs?

Answer 7

Based on opportunity costs (benefits foregone)

Question 8

What is the biggest issue in quantifying the consequences of a policy?

Answer 8

UNCERTAINTY.

Can arise from…
1. Scientific uncertainty
2. Humans are unpredictable, eg. changes in preferences

Question 9

Purpose of sensitivity/scenario/sensibility analysis

Answer 9

To account for the uncertainties the future holds.
So most govs, including UK, use diff. social discount rates to evaluate social projects

Question 10

6 steps to conduct a CBA

Answer 10

1. Figure out PORTFOLIO of policies and think about what happens in absence of policy (the status quo, baseline)
2. Quantify the impacts for the AFFECTED POPulation (market vs non-market values)
3. Predict the impacts/consequences over the life of the project {OPTIMISM BIAS}
4. Monetise all the impacts and discount them to obtain the NPV {shadow prices, non-market valuation}
5. Sensitivity analysis, eg. what happens if interest rates change {NPV rule, social discount rate}
6. Make a recommendation