Analysis of Benefit-Cost - Essay Example

Running Head: Benefit-Cost Analysis Name: Course: Institution: Lecturer: Date: An actual Pareto improvement in the market or economy is experienced when any changes or developments that occur makes one better off without making the other worse off. This is because the decision to let the change, event or development to affect a person is voluntary. In actual Pareto improvement transaction or policies made do not infringe a person’s decision but gives the person the free will. Pareto improvements contribute to betterment of the economy bit by bit until an economic equilibrium has been achieved where every individual is economically better off and further improvements in the economy leads to making individuals worse off. Pareto improvement is only possible in an ideal or perfect economy where there are unutilized resources and market failures do not exist. For instance introducing tax policies that make the rich pay more to help the poor does not promote Pareto efficiency, thus, in real economy where political powers dictate policies, achieving Pareto improvement is hard. For efficiency in the economy a competitive market, consumption and production efficiency are necessary. The diagram below illustrates Pareto improvements and how they contribute in creating efficiency in the economy. ii) a potential Pareto improvement Potential Pareto improvement refers to situation where if changes are effected in the economy one person is made better off to larger magnitude than the other is made worse off. Thus, the change will result to improvement of an individual’s status by far much and any individual that is hurt in the process will be hurt to a small extent. Thus, for potential a Pareto improvement there is no way that changes can be made in the market without any inefficiencies being created in the economy. Therefore, in potential Pareto improvements changes in the economy result to both winner and losers with the winners benefiting by far and the loss being very minimal so that it is neutralized by the loss. Thus, in potential Pareto improvement there is a cost-benefit analysis before introducing the policy to ensure that the benefits resulting from the policy are much more than the cost resulting from it (Arrow, & Lind, 2013). (iii) The Kaldor-Hicks criterion. This is contrast of Pareto improvement in attaining efficiency in the economy. In this state, changes in the economy result improvement of the economy through cost-benefit enhancement. This is because a change is a Kaldor-Hicks criterion if the change is able to make one better off without making the other worse off and if there are winners and losers from the change, then the winners are able to compensate the losers without altering the state that the change has put them to. The compensation of the losers in this case should not be influenced by the losers in a way to prevent the winner from accepting the change. This change involves a cost- benefit analysis so that when the change is implemented the outcome will result to efficiency in the economy. Unlike the actual Pareto improvement the changes do not create an ideal state in the economy and does not lead to inefficiency in production, consumption and does not hinder market competition which is an important market component that facilitates efficiency (Arrow, & Lind, 2013). b) 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 the others in this way According to Charness (2012), the Kaldor-Hicks criterion is the concept that can be used to come up with practical ways of cost benefit analysis because it is more realistic than the other concepts. This concept supports that as you make others better of you will to a small extent another individual worse, thus it is difficult to contribute in creating efficiency in the economy without affecting others. This concept is practical because it acknowledges the place of market failure and competition in the economy which hinder the ability to make one better off without hurting another. As such this concept is reliable since it brings in lace the importance of production, allocation and exploitation of resources. As such to enhance efficiency in the economy competition cannot be avoided. This results in increased efficiency in production and there is maximum utilization of resources available. This concept facilitate cost-benefit analysis since one has to calculate the cost of making one worse off in relation to the benefit of making the other better. It also reduces the chances of one group of people influencing the decision of the other since they fear they shall lose. Thus, in a political arena, political powers do not just impose decisions because they want to escape the cost of compensating the losers, thus it facilitate the elimination of corruption in the struggle to establish efficiency in the market. This concept unlike the others is practical since it does not uphold much idealism so that what is expected to result from the concept is impossible. The concept also determine the cot-benefit relationship by establishing risks resulting from any change introduced in the economy and how this risks can be mitigated for the benefit of the economy and to promote efficiency in the economy (Arrow, & Lind, 2013). The practicability of this concept and thus in a position to be used more than the others is because it aims at improving the cost-benefit relationships within an economy. Since the concept promotes compensation, then efficiency will be enhanced because those made worse off in the process of attaining equilibrium will be compensated while those who are made better off are brought to a better status than before The concept supports taking risks to establish efficiency because investor are ready to carry out a project of to implement a policy because there are people who will benefit from its outcomes and those who are made worse off will be compensated thus attaining the equilibrium in the long run. The concept does not only aim at creating efficiency but ensuring that the efficiency supports growth in the economy and is sustainable so that the status created for individuals will get better with each policy or decision (Dunn, 2012). 2a. i) net present value; Bierman Jr, & Smidt, (2012) supports that, net present value is the value of the difference between present cash inflow and present cash outflow. It is used to determine if investing in a particular project is worthwhile by analyzing the sensitivity and profitability expected from the project in future. The analysis is done by comparing the present value spent in the project and the future cash flow expected as returns. Since investments involves spending today with the expectation of earning returns in future, it is important that one considers the returns likely to occur by considering the rate of return, the amount invested and the time spent before one gets back the returns so that one can know the reliability of the project before investing in it. For instance if one invests $10,000 at an expected rate of return of 10% one will get $14,000 as the total return after a period of three years, thus the net present value will be $4000 which is positive making the investment viable. ii) Benefit-cost ratio. As discussed by Gitman, & Maxwell, (2011), benefit- cost analysis allows one to evaluate the profitability of projects so that one can determine its viability before investing in them. Cost-benefit ratio is a value that shows the ratio of benefits to costs in a project after they are appropriately discounted. This is done by getting the present value of benefits and dividing it with the present value of costs incurred in carrying out the project. Cost-benefit ratio facilitate decision making. The ratio enhances analysis of the relationship between benefits and cost before making an investment by considering the costs, benefits, rate of return and the amount of time the project will take for a project to be viable then the ratio should be above one. For instance for a project incurring $3.5 million as the costs and reaping benefits worth $8million the cost benefit ratio is 2.3:1. The project is viable since the ratio is more than one. b) Explain where and why the use of these is appropriate According to LeBel, (2011), net present value and cost benefit ratio are used in capital budgeting, which involves establishing the credibility of committing resources to a certain project. Capita budgeting is carried out by determining the amount of returns one will expect from a certain investment or project or financial decision that a company may make. These two are also used in determining the time that may be considered appropriate for a project to last since time influences the amount of returns. Since cost-benefit ratio enables a company to consider the present benefits and costs resulting from tan investment the company is able to make worthwhile decisions. These two capital budgeting techniques are used so as to establish the sensitivity of the projects adopted or investments that companies or individuals make. Since each technique provide a basis for terming a project as viable or not the techniques are used to enhance the company decisions since they are able to establish which investment is better over the other. The two techniques also provide a basis for comparison between projects so that the most appropriate is settled for. References Arrow, K, J, & Lind, R, C, (2013), uncertainty and the evaluation of public investment decisions, journal of natural resources policy research, (ahead-of-print), 1-16. Bierman Jr, H, & Smidt, S, (2012), the capital budgeting decision: economic analysis of investment projects, Routledge. Charness, G, Cobo-Reyes, R, Jiménez, N, Lacomba, J, A, & Lagos, F, (2012), the hidden advantage of delegation: Pareto improvements in a gift exchange game, the American Economic Review, 102(5), 2358-2379. Dunn, W, N, (2012), public policy analysis, Pearson. Gitman, L, J, & Maxwell, C, E, (2011), a Longitudinal comparison of capital budgeting techniques used by major US firms: 1986 versus 1976, Journal of Applied Business Research (JABR), 3(3), 41-50. LeBel, P, (2011), cost-effectiveness analysis, Montclair State University, New Jersey. Read More