Cost benefit analysis

Kopied this, think it all is very important - Chapter three transport post of yesterday improved and longer :-)

Cost Benefit Analysis
Governments face difficult choices: do we build new roads or new rail track? Given limited resources how can government decide which projects to prioritise and build and which to reject?

Cost Benefit Analysis (CBA) offers a systematic framework for measuring and evaluating the likely impact of public sector project, takes into account both private and external costs and benefits over the entire life of the project.

Cost benefit analyses was used in the original M1 motorway, the third London airport, London's Victoria Line underground, and more recently Birmingham Northern Relief Road

CBA Worked Example: a project to build a toll bridge over a river:
CBA seeks to measure the value to society as a whole of the resources used by, and the benefits created by, an investment project such as a new toll bridge over a river over its expected life eg 25 years

Step 1: Economists identify all costs and benefits – both private and external:

Private Costs borne by the supplier eg construction costs, operating costs and maintenance costs

External Costs incurred by non users eg pollution, noise, loss of countryside,

Private benefits to consumers

- direct ie the amount consumers are prepared to pay eg the tolls paid as shown by the demand curve

- indirect ie consumer surplus – the difference between the toll and the maximum consumers are prepared to pay for a crossing

External benefits ie benefits to non users eg time savings for all travellers and fewer accidents

Step 2: Place a monetary value of costs and benefits

Height is measured in feet or metres. Economists measure benefits and costs using money as a unit of account. Economists estimate:

- Private costs eg Construction costs: £5,000, 000 to build the bridge; operating costs: say £200,000 a year; Maintenance costs: Repair and maintenance say £5,000 a year
- External Costs are more difficult to estimate. How do we value the effects of negative externalities such as congestion, accidents, noise, loss of countryside and air pollution?
- Private Benefits eg

1) Direct 1,000,000 journeys each paying £1 toll = £1,000,000 a year

2) Indirect consumer surplus eg £500,000

External Benefits eg time savings. What value do we place on work time saved or leisure time saved? Is the time saved worth the same to everyone? If 100,000 hours are saved and valued at £4 per hour, benefit = £400,000 Fewer accidents. Economists value human life using money! One life = £750,000. One limb = £80,000. If the bridge reduces accidents and saves on life a year, annual benefit is £750,000

Step 3: Estimate Future Costs and Benefits
The major costs of the project occur straight away eg £20m in Year 1
The benefits occur over the life of the project eg If the expected life of the bridge is 25 years consumers benefit by £1m a year now and for the next quarter of a century. However, how do we value now £1m of benefit in 25 years time? Economists use a technique called discounting to establish the present value of future benefits.

Present discounted value PDV is the value today of an expected stream of future net benefits ie costs – benefits for each year of the project discounted using the equation PDV = (B-C)/(1+r)n
The net present value of a future amount of money is the maximum amount you would be willing to pay today for the right to receive that amount of money in the future. Eg you may pay £100 today for the right to receive £1,000 in 10 years time.

Step 4: Is a Project worth Undertaking?

This involves establishing the present discounted value (PDV) of future costs and benefits
Present discounted value PDV is the value today of an expected stream of future net benefits ie costs – benefits for each year of the project discounted using the equation PDV = Σ(SB-SC)/(1+r)n where Σ is the sum of; SB is social benefits; SC is social costs; r the discount rate of interest used eg 5% and n the life of the project.
A project is worth undertaking if the stream of current & future benefits, exceed current & future costs ie PDV is positive.
If the government has to choose between competing prjects then the ones with the highest positive net present value should be undertaken.

The Limitations of CBA
A CBA is simply a money value estimating the value today of all the costs & benefits, both private and external, associated with a given investment project such as a new runway for Heathrow. The following qualifications need to be taken into account:

- Have all relevant costs and benefits been included? COBA ignores environmental impacts and so is not comprehensive

- Many external costs and benefits are hard to measure using money. What is the value in money terms of loss of a species of butterfly? For this reason, Dept of Transport Appraisal Summary Tables AST’s use qualitative indicators

- Is it better to use ex ante or ex post valuations? In the ex ante willingness to pay (WTP) method, £1 is assumed to be of equal value to different people. Equity issue: £1 means ‘more’ to a poor person than a rich one.

- What rate of discount is appropriate? Do current market interest rates reflect long-term social opportunity cost of borrowing?

- Uncertainty. How reliable are the forecasted costs and benefits? Is there a significant margin of error or risk in figures and projections used? Sensitivity analysis is used to try to take account of future uncertainty. This result in a rang of valuations depending on best and worst case scenarios

- CBA ignores the effect on income distribution of a project that creates ‘winners and losers’. CBA assumes the value of £1 is the same even where the rich gain at the expense of the poor from a proposed project.