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Understanding Cost-Benefit Analysis: Valuing Present and Future Dollars in Project Evaluation

This chapter delves into the essentials of cost-benefit analysis (CBA), focusing on the processes of projecting future dollars into present value. It discusses the significance of discount rates, internal rates of return, and the benefit-cost ratio in evaluating both private sector and government projects. Key considerations include market inefficiencies, social discount rates, and the valuation of intangibles. The chapter provides insights into the practical application of CBA in policymaking, with examples such as the Clean Air Act and the Endangered Species Act, examining the implications of uncertain factors in economic decisions.

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Understanding Cost-Benefit Analysis: Valuing Present and Future Dollars in Project Evaluation

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  1. CHAPTER 8 COST-BENEFIT ANALYSIS

  2. Projecting Present Dollars into the Future R0 = $1000 R1 = $1000*(1+.01) = $1010 R2 = $1010*(1+.01) = $1020.10 R2 = $1000*(1+.01)2 = $1020.10 RT = R0*(1+r)T

  3. Projecting Future Dollars into the Present R0 = $1000 R1 = $1000*(1+.01) = $1010 R2 = $1010*(1+.01) = $1020.10 R2 = $1000*(1+.01)2 = $1020.10 RT = R0*(1+r)T Present Value R0 = RT/(1+r)T discount rate discount factor

  4. Present Value of a Stream of Money

  5. Inflation

  6. Private Sector Project Evaluation Admissible Preferable Present Value Criteria

  7. Internal Rate of Return

  8. Benefit-Cost Ratio Benefit-cost ratio = B/C

  9. Problems with the Benefit-cost Ratio

  10. Discount Rate for Government Projects • Returns in Private Sector • Social Discount Rate • Concern for Future Generations • Paternalism • Market Inefficiency • Government Discounting in Practice

  11. Price per pound of avocados Pounds of avocadosper year Valuing Public Benefits and Costs • Market Prices • Adjusted Market Prices • shadow price • Monopoly • Taxes • Unemployment • Consumer Surplus e b d Sa $2.89 c g Sa’ $1.35 Da A0 A1

  12. Inferences from Economic Behavior • The Value of Time • The Value of Life • Lost earnings • Probability of Death

  13. Valuing Intangibles • Subverting cost-benefit exercises • Reveal limits on intangibles • Cost-effectiveness analysis

  14. Games Cost-Benefit Analysts Play • The Chain-Reaction Game • The Labor Game • The Double-Counting Game

  15. Distributional Considerations • Hicks-Kaldor Criterion – a project should be undertaken if it has positive net present value, regardless of distributional consequences • Government costlessly corrects any undesirable distributional aspects • Weighted benefits

  16. Uncertainty Certainty Equivalent

  17. Are Reductions in Class Size Worth It? • Discount rate • Costs • Benefits • The Bottom Line and Evaluation

  18. Use (and Nonuse) by Government • Using Cost-Benefit Analysis • Not Using Cost-Benefit Analysis • Clean Air Act • Endangered Species Act • Food, Drug and Cosmetic Act

  19. Calculating the Certainty Equivalent Value Utility U U(E + y) U* U(E) Certainty Equivalent Expected income Income per year E E + y C I*

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