What Is Benefit-Cost Analysis - Assignment Example

Question 1 What are the conceptually correct measures of benefits and costs in benefit-cost analysis? A) Describe them and explain why they are considered to be conceptually correct. Measures of benefits include things such as increased income, reduced illness, increased access to water, reduced cost of transportation, and so forth. Measures of costs include costs of all resources that are used such as equipment, personnel, and facilities that are utilised in the planning and implementation of an intervention. These measures are regarded to be conceptually correct because they can be calculated by comparing measurements before and after an intervention as projected in the benefit-cost analysis. b) Describe why it is often difficult to use these measures in practice. It is often difficult to use these measures in practice because of methodological problems. For instance, measuring health benefits of reduced emissions may not be possible if data on the situation that existed before an intervention is not available. Similarly, measuring the costs of emissions may be a complex process because of the diverse nature of parties that are affected by emissions. As well, valuation of future costs and benefits through discounting can be a tricky affair because of the uncertainties that surround future costs and benefits. More importantly, it is difficult to use the aforementioned measures because the values have to be converted into a monetary value in order to be used in benefit-cost analysis. Question 2 Why are future benefits and costs converted into present values in benefit-cost analysis? Answer this question by carefully explaining the economic basis for discounting the future. Future benefits and costs converted into present values in benefit-cost analysis in order to make it possible to calculate and analyse benefits and costs for a particular number of years into the future. Discounting future values in benefit-cost analysis is done because of two fundamental reasons. The first reason is time preference and the second reason is the social opportunity cost of capital. Time preference implies the degree to which people are keen on forgoing present consumption opportunities for consumption opportunities in the future. Time preference is measured based on the after-tax rate of interest on savings since this is the rate at which people are compensated for postponing consumption. The social opportunity cost of capital informs the decision maker about the rate at which the society can relocate resources across various points in time. A discount rate that is premised on social opportunity cost of capital means that opportunities that have been forgone are used to determine the significance of time, but the economic cost of public finances would continue to be reflected entirely by the shadow cost of public finances. Question 3 Benefit-cost analysis has been attacked from a variety of perspectives. Clearly state what you believe to be the most important of the conceptually valid criticisms of the use of benefit-cost analysis as a guide for public policy making and justify your choice. What I believe to be the most important of the conceptually valid criticisms of the use of benefit-cost analysis as a guide for public policy is the issue of equity. This is because the decision rules in benefit-cost analysis do not take into consideration how the costs and benefits are allocated across various segments of the society. There is a possibility that the allocation of benefits may be biased in such a way that some groups of consumers or some individual industrial sectors receive less than their fair share. As well, the distribution of costs may be done in such a way that some economic sectors bear an inequitable share of the cost burden. While either problem will be less troublesome if the same inequity happens on both the cost side and the benefit side, there is no guarantee that this will be the scenario. The limitations of using a purely money-based system and of a simplistic benefit-cost analysis based on the idea of allocating costs and benefits equitably is an indication that more factors, especially those that are based on value judgements, are needed for societal decision-making. Question 4 Consider Harberger’s approach to measuring the costs of an input for a project in a closed economy with no distortions. Describe the conceptual basis for measuring these costs when the total quantity of the input is partially met by displacing existing consumers of the input and partially supplied from new production of the input. Use a demand/supply model for this description. When the total quantity of the input is partially met by displacing existing consumers of the input and partially supplied from new production of the input, the situation creates a market distortion in the form of a monopoly. This affects the quantities of inputs that are demanded and supplied in the market, as shown by changes in Q (demand curve) and S (supply curve) in the graph. In the graph below, the grey area (triangle) is caused by the intersection of the supply and demand curves having been cut short, and given that the supplier and consumer surplus is cut short. The loss of such surplus is referred to as a deadweight loss. Question 5 You have been asked to undertake a benefit-cost analysis of a project that will construct a hydro-electric dam that will result in the flooding of a large area of old-growth forest in Tasmania. Describe the valuation techniques that might be employed to evaluate the environmental costs of the project going ahead and outline the advantages and disadvantages of the valuation techniques you consider are applicable. A number of methods can be used to value and evaluate environmental costs. First is market valuation that uses existing market prices to estimate damages, in this case damages to the forest area that will be flooded. The advantage of market valuation is that if done well, it can give the exact cost of the damage that will be incurred. The disadvantage of this method is that it is difficult to accurately determine the value the cost of damage that will be incurred in relation to the forest area since a forest contains a wide range of natural resources such as animals and not just trees and land. Another method of valuation is the use of contingent valuation, which involves the use of estimates from consumers using survey techniques. The advantage of this method is that it captures the views of many people thus reflecting a more accurate value. On the other hand, the use of survey can be a costly and time-consuming exercise, meaning that it will require more time add more costs to the process of conducting the benefit-cost analysis. Question 6 “Benefit-cost analysis is a decision-making tool”, discuss this assertion from the perspective of a decision maker who is trying to achieve a variety of social goals. Benefit-cost analysis is a process by which business decisions are analysed by comparing the benefits of an investment and the costs that are related with the investment. In cases where benefit-cost analysis is applicable, the decision maker makes a decision as to whether the investment is viable or not based on the ratio of the benefits to costs relating to the project. It is however important to note that benefit-cost analysis does not make the decision, it only offers a basis upon which the decision maker can make an informed decision. Therefore, when trying to achieve a variety of social goals, the decision maker may have to reason beyond the results of the benefit-cost analysis. The decision maker must be able to interpret the main findings of benefit-cost analysis in a way that is user-friendly in relation to the desired social goals and the beneficiaries of the project. There is also need to determine if benefit-cost analysis is the best decision-making tool in the scenario at hand. For instance, there are situations in which costs or benefits are extremely difficult to determine. Question 7 (i) Arguments have been made for the use of a special low discount rate when evaluating future outcomes that have environmental benefits or costs that occur in the distant future. Discuss some of the possible consequences of the use of such a special low discount rate from a practical and ethical perspective. Using a special low discount rate for evaluating outcomes in the distant future has the advantage of averting time-consistency challenges. For instance, if one makes use of a lower discount rate for generations of the future, then the assessment of a rule that has long-term benefits and short-term costs would become more favourable just by waiting for one year to conduct the analysis. As well, using the same discount rate across generations is good from an ethical point of view. This is because if one anticipates future generations to be better off, then allocating the generations a lower discount rate would move resources from poor people in the present day to richer people in the future. (ii) Describe an alternative approach to discounting the distant future and briefly outline the theoretical justification for its use. The alternative approach is the prescriptive approach. The theoretical justification for its use is based on the point that although high interest rates are permissible, individuals who make long-term investments tend to select less risky investments, which are associated with much lower returns. Question 8 (i) Explain the following concepts and how are they applied? a) an actual Pareto improvement. An actual Pareto improvement is a situation in which at least one type of agent can be made better off while no other agent is made worse off. For instance, if someone buys an item from a store, there is a Pareto improvement because the buyer is made better off and the seller is also made better off. b) a potential Pareto improvement. A potential Pareto improvement requires that only those who win from a change of regime be able to compensate the losers, so that the losers would not be made worse off from the change. This is rarely applied in practice since the society rarely compensates losers. c) the Kaldor-Hicks criterion. The Kaldor-Hicks criterion states that an efficient policy option is one that creates the biggest net financial gains when compared with other policy options. Thus, the application of the Kaldor-Hicks criterion is based on comparing various policy options to determine the option that generates the biggest net financial benefits. (ii) Which of these concepts can be used to formulate a practical choice criterion in benefit-cost analysis and why may it be difficult to use one or more of these in this way Kaldor-Hicks criterion offers a more practical way of making a decision in benefit-cost analysis. This is because based on this criterion, a policy option that creates the largest possible rise in net social benefits relative to the former situation is regarded to be efficient. On the other hand, the Pareto criterion is nearly impossible to meet the actual requirements of policy analysis. Question 9 (i) Briefly define the difference between risk and uncertainty. Risk refers to the chance of loss or injury that has a measurable probability. On the other hand, uncertainty refers to the indefiniteness about the outcome of a given situation, meaning that uncertainty is an unknown whose probability of occurrence is not measureable or is indefinite. (ii) Describe and contrast the ways in which risk and uncertainty can be incorporated into benefit-cost analysis. Typically, benefit-cost analysis is conducted in a deterministic way. Nevertheless, the analyst is normally faced with a number of uncertainties and risks when assessing an investment project. The common approaches that are used to account for uncertainty and risk in benefit-cost analysis are sensitivity analysis, expected values of scenarios and risk analysis via Monte Carlo simulation. Sensitivity analysis is suitable for measuring risk while expected values of scenarios are appropriate for dealing with uncertainty. Simulation offers a practical solution for approximating overall risk. Question 10 Discuss the assertion that benefit-cost analysis is not compatible with the objectives of sustainable development. Benefit-cost analysis can be said to be not compatible with the objectives of sustainable development because of the flaws that are associated with the analysis. The flaws are measurement problems and equity concerns. These flaws make benefit-cost analysis fail to align with some of the goals of sustainable development. Sustainable development can be defined as development that meets the needs of the current generation without compromising the capacity of generations of the future to meet their needs. It is possible to evaluate the needs of the present generation using benefit-cost analysis, but when it comes to the needs of the future generations, using the same tool becomes problematic. This is specifically because tools such as benefit-cost analysis typically deal with time frames that do not exceed one generation. As well, measurement problems in benefit-cost analysis make it difficult to precisely measure aspects relating to the environment, while equity concerns imply that it is not possible to equitably distribute resources to the current and future generations by basing on benefit-cost analysis as a decision support tool. Question 11 When conducting benefit-cost analyses of projects in developing countries values can often be distorted since the national currency may be overvalued. Describe how adjustments can be made to observed valuations using the border price approach, paying particular attention to how non-tradable goods are valued using this methodology. Using the border price approach, the shadow price of tradable goods is the goods’ border price. If the goods are exported their FOB (free on board) is the shadow price, and if they are imported, the CIF (cost, insurance and freight) is their shadow price. Where demand and supply are not perfectly elastic, the border price is replaced by the marginal import cost or marginal export revenue as appropriate. For non-tradable goods, since such types of goods do not have a border price, their shadow price is determined by looking at marginal social benefit and marginal social cost. The marginal social cost of an item is the value in relation to shadow prices of the resources that are needed to produce an additional unit of the item. The marginal social benefit is the social value of an extra unit of the item. The shadow price of a non-tradable item is determined by the ratio in which the requirement for the item is met by an increase in production and a reduction in consumption by others. Question 12 a) Why is sensitivity analysis an essential part of any benefit-cost analysis? Discuss this statement with reference to the inherent uncertainties that any analysis involves. Sensitivity analysis is an essential part of any benefit-cost analysis (BCA) because it assesses how the outcome of BCA varies with changes in inputs, assumptions, or the way in which the analysis is conducted. The uncertainties that are involved in benefit-cost analysis include things such as making a choice between two designs of a bridge and determining how long a new road will last, among other examples. b) Explain how and why each of the following are used within a sensitivity test: (i) break-even values; Break-even values provide the value of inputs that offer a model output for which a risk manager is indifferent when given an option to choose between two or more risk management approaches. (ii) cross-over values; A cross-over point is a scenario in which combinations of values of variables where benefit-cost analysis is done show two alternatives to be of equal worth. If a cross-over point occurs, a recommended management option may no longer be appropriate. (iii) elasticities. Elasticities are used in determining the sensitivity of different variables to changes that occur in other variables. Question 13 (i) Explain the following concepts: a) net present value (NPV) NPV is the difference between the current value of cash inflows and the cost of a proposed investment. NPV is applied in capital budgeting to analyse the profitability of a proposed project or investment. b) benefit-cost ratio Benefit-cost ratio is measured as the ratio of present value of the benefits of a project to the present value of the project’s costs. (ii) Explain where and why the use of these is appropriate NPV is applied in capital budgeting to analyse the profitability of a proposed project or investment. The proposed investment must have a positive NPV to be attractive; i.e. the current value of cash involved has to equal or be larger than the investment cost. On the other hand, benefit-cost ratio offers a measure of how large the benefits of a project are relative to the project’s costs. If benefits divided by costs result in a value greater than 1, the project is considered worthwhile. Read More