Economic Questions (Calculation Based)

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TECON 480 – Class 3

July 31, 2019

Part 1 - Outlining the scope of the project:

planning report content

• No class this Friday (Aug 2)

• Assignment #1 due Sunday (Aug 4) at midnight

Announcements / Reminders

Last Class

• Discussed objective/framework of cost-benefit analysis

• Illustrated the 9 steps of a CBA via an example

Today’s Class

• More detail about the philosophical underpinnings of CBA

• How CBA can be used as part of the decision-making process

• Discussion of some limitations of using net benefits as

decision-making criterion 4

• Before discussing how to measure/monetize costs and benefits

(Steps 3-5), we must understand how we intend to use this

information

• Is it appropriate to evaluate all public policy alternatives in the

same way?

• What is the “correct” decision criteria? Does one (or more) exist?

• When can we use CBA and when can’t we use it?

� To think about these questions we need to understand the

conceptual foundations of CBA

Developing the CBA Model

• There are 12 students in the class

• Suppose that we are considering a new policy in the classroom

that could change the amount of money that each student has

• How do we view the following scenarios?

Philosophy of CBA

• Each student gains $100

Scenario 1

• Half of the students gain $100

• Half of the students are unaffected

Scenario 2

• 9 students gain $100

• 3 students lose $10

Scenario 3

• 9 students gain $100

• 3 students lose $200

Scenario 4

• 11 students gain $100

• 1 student loses $2000

Scenario 5

• CBA can be seen as a framework for measuring efficiency

• As long as efficiency is one of the objectives, CBA is relevant

and useful

• Very rare that efficiency is not a goal

• …however, it is also rare for it to be the only goal

• Often care about both efficiency and equity

Philosophy of CBA

• Efficiency: the size of the pie

• Equity: the distribution of the slices

Philosophy of CBA

• Pareto efficiency: An allocation of goods is Pareto efficient if no

alternative allocation can make at least one person better off

without making anyone else worse off

• In other words, any allocation that gives more to one and does

not penalize one another is “more efficient” than the initial

allocation

Pareto Efficiency

• Scenario: The allocation of $100 between 2 individuals

• Two possibilities:

1. If they agree on the allocation, they split the $100 as agreed

2. If they disagree on the allocation, they each receive $25

• The potential Pareto frontier is the line representing all the potential splits of the entire $100

• (25, 25) is the “status quo” point

� We must compare the different possibilities

Pareto Efficiency

Note the difference between “Pareto frontier” and “Potential Pareto frontier”

• Any point in the grey triangle is a “Pareto improvement” in

comparison with the status quo

• Any point in the grey triangle and on the Pareto frontier is a

Pareto efficient allocation

• Often have > 1 Pareto efficient allocation

� As is the case in this example

Pareto Efficiency

Net social benefits and Pareto efficiency are directly linked:

• If a policy has positive net benefits, then it is possible to find a

set of transfers that makes at least one person better off

without making anyone else worse off

• To determine the net social benefits, must evaluate the

opportunity cost of inputs and the willingness to pay for

outputs

� Evaluation of the resources required to implement a policy

Pareto Efficiency

Accounting profits ≠ net social benefits

Net Benefits and Pareto Efficiency

• Willingness to pay (WTP): WTP is the maximum amount that an individual or an organization is willing to pay (or to receive) to get something (product, policy, etc.)

• He/she/it would be indifferent between the status quo and the policy/product with this payment included

• The sum of the WTP is the appropriate measure of the net benefits resulting from a policy

• If this sum is > 0, a Pareto improvement over the status quo is possible using transfers

Willingness to Pay (WTP)

• Suppose that the cities of Tacoma and University Place are looking for

a new shared waste disposal site

• They would like to store their waste in a landfill in Puyallup

• Tacoma’s WTP is $500,000 and University Place’s WTP is $300,000

• Because the landfill is in Puyallup, Puyallup would like to receive a

payment of at least $700,000 (to compensate for disutility)

• Therefore, Puyallup’s WTP is -$700,000

• Question: Can this project be a Pareto improvement in comparison

with the status quo?

Example

• Opportunity Cost: the monetized value of inputs required to

implement the project

• The opportunity cost of an input is its value in its best

alternative use

� measures the value of what society must forgo to use the

input in order to implement the policy

Opportunity Cost

Accounting costs ≠ opportunity costs

What is your opportunity cost for the following resources:

1. The 3 hours you spend in TECON 480 class today.

2. A check for $1000 that your Grandma gives you for your

birthday.

3. The woodworking tools in your garage.

Opportunity Cost

• Assume now that Puyallup could use the landfill land for a

public park instead

• The expected benefits from the park to the Puyallup

community are valued at $50,000

• Question: Can this project still be a Pareto improvement in

comparison with the status quo?

• Question: What if the expected benefits from the park are

$150,000?

Example

• If all impacts are valued in term of WTP and all required inputs

in terms of opportunity costs:

� the sign of net benefits indicates whether there may be a

Pareto improvement

• Adopting this criterion as a decision rule is very appealing

� Nobody is worse off and at least one person is better off

Using CBA for Decision Making

• However, implementing only Pareto efficient policies is

unrealistic in practice for many reasons:

• Information burden of measuring every benefit and cost for each

individual

• Transaction cost of processing each required transfer

• Difficulty of operating a system of compensation that does not

distort work and investment incentives of households

• Compensation would incite people to exaggerate costs and

minimize benefits in order to receive more transfer payments

� Consequence: many viable policies would be forgone

Using CBA for Decision Making

• Since Pareto efficiency is often an unrealistic decision rule, there is an alternative decision rule

• Potential Pareto efficiency rule: adopt only policies that have positive net benefits (without requiring the actual transfer payments)

• Justification for adoption of this rule:

• Feasibility

• Society maximizes aggregate wealth

• Various policies should have different winners and losers; consequently, on average, everybody should be better off

• Helps balancing the weight of organized and unorganized groups in the beneficiaries of the policies

• Wholesale redistribution is possible, rather than doing redistribution for each separate policy

Potential Pareto Efficiency

• If all policies are independent:

decision maker should adopt all policies with positive net benefits

• When funds are limited:

adopt those with the largest net benefits

� maximize net benefits subject to the resource constraint

• If policies are dependent (policies complement/interfere with each

other):

decision maker should adopt the combination of policies that maximizes

net benefits

Decision Rule Application

• Alternative decision rule: use the Benefit-Cost Ratio

• Benefit-Cost Ratio (B/C) = (Total benefits) / (Total costs)

� Adopt the policy if B/C > 1

• Is this an appropriate rule?

• B/C ratio can sometimes be misleading when projects/policies are of different scales � can you think of an example?

• Maximization of net benefits should be the rule used

Decision Rule Application

• Effect of combining projects should also be taken into account

• Interactions between projects can affect the joint net benefits

� interferences and synergies are possible

• When projects are not mutually exclusive, the maximization of

the joint net benefits should be the rule

• Mutually exclusive projects: only feasible to select one project

from a given set of a projects

Decision Rule Application

• Suppose that the projects are mutually exclusive (apart from being able

to combine C and D as one option)

• Question: Which project would you choose, based on net benefits?

Example

• Suppose that the projects are still mutually exclusive

• Question: Now, assume that you are using the B/C Ratio. Which project would you choose?

� Are the results different using the two decision rules?

Example

• Suppose now that you can combine as many of the projects as you want, but you have a budget of $10 million

• Question: Which project(s) would you choose?

Example

Three major limitations arise from using WTP:

1. Theoretical limitation of WTP as basis for social order

2. Dependence of WTP on the distribution of wealth

3. Dependence of net benefits on assumptions about standing

Limitations of WTP

My 3-year Old’s Preferences

Stickers Daddy

My 3-year Old’s Preferences

StickersChocolate

My 3-year Old’s Preferences

ChocolateDaddy

• What is the issue here?

� Her preferences are not “transitive”

• In other words, they are inconsistent or illogical

• Given this information, how would you determine what makes

her “better off”?

My 3-year Old’s Preferences

• May be a theoretical limitation of WTP as basis for social order

• (May be) easy to rank the preferences of an individual

• But, it is difficult when we have to aggregate those rankings

• Example: Can you rank the projects X, Y and Z?

� Requires intensity of preferences

Limitations of WTP: Social Order

• Qualitative rankings are often inadequate for ranking outcomes

• Intensity of preferences allows us to quantify our preferences

• This is the role of WTP and the monetization of costs and

benefits

Intensity of Preferences

• In order to deal with this problem, we need to make two

assumptions on individual preferences:

1. The utility function of individuals must be such that the

individual demand curves can be aggregated into a market

demand curve

� Recall: construction and interpretation of market demand curve

2. All individuals must face the same prices

Limitations of WTP: Social Order

• The WTP of a person depends on his/her current level of

wealth

• Example: how much are you willing to pay to save an hour of

commuting time per week? How much would Jeff Bezos be

willing to pay for an additional hour of time?

� Net benefits identified by the CBA are affected by the level of

wealth implied in the project

Limitations of WTP: Wealth Distribution

• This is at the heart of the difference between the concepts of

maximum willingness to pay (WTP) and minimum willingness to

accept (WTA)

• What is your max WTP to obtain a better outcome?

• What is your min WTA to receive a worse outcome?

� Typically, WTP < WTA

WTP vs. WTA

The “Endowment Effect”:

https://www.youtube.com/watch?v=bvjoIAhaIxI

• Consequently, ranking of alternative policies could also be

affected

� Project mainly benefitting wealthier people would be more

likely to be highly ranked

• If the distribution of wealth in society would change with a

project, WTPs would also change

• This problem does not exist if you use Pareto efficiency instead of

potential Pareto efficiency

� Transfers correct this problem, since losers are compensated

Limitations of WTP: Wealth Distribution

• Net benefits depend on assumptions about standing

� Determines which WTP should be counted in the CBA

It is of practical importance in four contexts:

1. Jurisdictional definition of society (standing)

2. Jurisdictional membership

3. Exclusion of socially unacceptable preferences

4. Inclusion of the preferences of future generations

Limitations of WTP: Standing

Jurisdictional definition of society

• Standing is usually the national level

• Standing can influence the results of a CBA

• Especially when other levels of government or some citizens from other countries are affected by the project

• Example: A subsidy from the Federal government can be considered as a benefit at the municipal level or as a cost (or not considered) at the national level

• To overcome this problem, analyze the project at different levels

• As was done with the Coquihalla highway example

Limitations of WTP: Standing

Jurisdictional membership

• Who should be counted?

• If the standing is the nation: • Citizens must be counted

• What about undocumented residents, citizens abroad, legal non- citizens, etc. ?

• A possibility is to refer to legally defined rights • Who has the legal right to enjoy the impacts of the policy? Who can

vote?

• However, this way of thinking is not always morally acceptable • Analysts should sometimes challenge rights presumptions

• With CBA only the WTPs of people count • Animals/plants/etc. do not have standing

• However, when people are WTP to protect these things, that is taken into account

Limitations of WTP: Standing

Exclusion of socially unacceptable preferences

• In CBA, we only take into account the WTP of legal behavior,

even if some people can have a WTP for certain illegal behavior

• May also face difficulty in including certain WTP when dealing

with preferences from foreign cultures

Limitations of WTP: Standing

Preferences of future generations

• Many projects/policies have very long-term impacts

• Since they will be affected, future generations should be included in the CBA

• However, difficult to measure their WTPs

• Examples: Nuclear waste, restoration of wilderness area, climate policy

• However, this is not a big problem, because:

• We can use the WTP of people today as a proxy for the future generations

• Most people today care about future generations and already include them in their own WTP

Limitations of WTP: Standing

• Technical limitations may make it impossible to quantify and

monetize all relevant impacts as costs and benefits

• Goals other than efficiency are relevant to the policy

� It is possible to take into account these limitations with other

approaches

• We will address these issues as they arise

Limitations of CBA

• Any questions?

Assignment #1