Economic assignment due in 10 hours!!

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TECON480S2019-Class4.pdf

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TECON 480 – Class 4

April 11, 2019

Part 1 - Outlining the scope of the project:

planning report content

Part 2 - Formulating the cost-benefit model

• Assignment #1 due April 23rd

• Instructions available on Canvas

Announcements / Reminders

Last Class

• Discussed the philosophical basis for cost-benefit analysis

• Provided justification for using net social benefits as a

decision-making criterion

Today’s Class

• Conclude discussion of some limitations of using net benefits

as decision-making criterion

• Begin a review (?) of microeconomic concepts that are the

foundation of CBA

� Necessary to properly classify and quantity the costs and

benefits used in Steps 3-5

• Overview of Assignment #1 4

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

Introduction to Microeconomics

• CBA is based primarily on microeconomic concepts

• i.e. TECON 200

• These notes are based on Chapter 3 in Boardman

� Measurement of costs and benefits

� Welfare economics

• For simplicity, we assume the presence of perfect competition

throughout this discussion 22

Demand Curves

• A demand curve indicates the quantity of a good that a

person is willing to purchase at various prices

• The market demand curve is the horizontal sum of all

“individual” demand curves in the market

Demand Curves

• The market inverse demand curve represents the price as a

function of the quantity

• Classic graph of demand used in microeconomics

• Prices on the vertical axis

• Quantities on the horizontal axis

• The price can be interpreted as the maximum price that

someone is willing to pay for an additional unit of the good

• The inverse demand curve slopes downward

• Each unit of the good is valued slightly less than the preceding

unit � diminishing marginal utility

Demand Curves

• The highest WTP in society for the first unit of good X is P1

• The highest WTP in society for the second unit of good X is P2

• etc…

• Each additional unit is valued at the value given by the height

of the inverse demand curve at the quantity of interest

� For a given quantity Z, the sum of these WTP values for units

(1, 2, …, Z) represents the WTP of society for these Z units of the

good 26

Demand Curves

• In CBA, benefits generally measured in terms of WTP

� P1 measures the marginal benefit of the first unit

� P2 measures the marginal benefit of the second unit, etc.

• If X* is the quantity consumed, the sum of all marginal

benefits for units (1, 2, …, X*) is the total benefits (B)

� The light and dark grey shaded areas (combined)

Consumer Surplus

• To consume X*, consumers must pay P* for each unit of the

good

• They spend P*X* in total

• price times quantity (the dark grey shaded area)

• The Consumer Surplus (CS) or the “net benefit” to consumers

equals the total benefits received minus the amount paid:

CS = B - P*X*

� CS is represented on the graph by the light grey shaded area

Consumer Surplus

• Changes in consumer surplus is a reasonable measure of the

benefits to consumers from a new project or a new policy

� Consumer surplus provides accurate approximations of WTP

that can be used for CBA

Consumer Surplus

• Assume that the initial price and quantity are P* and X* for

good X

• Then consider a policy that reduces the price of the good X

from P* to P1

� Consumers are better off

�Their consumer surplus has increased exactly by the light and

dark grey area on the next slide’s graph 30

Consumer Surplus

• Light grey shaded area = additional surplus of existing consumers

• Dark grey shaded area = total surplus of new consumers

What is the maximum amount that consumers would be willing to pay

to obtain the price decrease from P* to P1?

Assignment #1

• While you are welcome to discuss the assignment with

classmates and incorporate our classroom discussions, each

student must submit their own assignment

• Assignments are due by midnight on the date indicated (they

may be submitted via email or uploaded to Canvas)

• Late assignments will receive a 25 percentage point penalty

for each day it is submitted beyond the due date

Assignment #1

• In this assignment, we will begin our analysis of Pierce Transit’s

potential investment in bus rapid transit (BRT) along the Pacific

Avenue corridor

• See Slides 38-40 in the Class 4 notes for some background

information relating to this project

• This assignment covers Steps 1-3 of the cost-benefit analysis

framework 33

Assignment #1

• Please provide a separate heading/section for each of the three

steps

• These sections will subsequently be used as part of the final

report, after you incorporate the feedback that I provide and as

your thoughts develop throughout the course

• Note that there is no minimum/maximum length of the various

sections at this point 34

Assignment #1

Step 1: Specify the set of alternatives

• In this section, discuss the potential alternatives available to the

decision-maker and explain/justify which alternatives you will

choose to analyze. Be sure to specify the status quo (or the

counterfactual) that will be used.

Assignment #1

Step 2: Decide whose benefits and costs count (standing)

• In this section, discuss who the decision-maker is in your

analysis, the objective of the analysis that will be undertaken,

and whose benefits and costs should count in the analysis given

the context.

Assignment #1

Step 3: Identify the impact categories, catalogue them, and select measurement indicators

• In this section, discuss the potential impacts of the project and classify them as costs or benefits (or undetermined, if it is potentially the case that the impact could be either a cost or a benefit). For each impact, suggest the “physical” units that you would ideally use to measure these impacts; note that at this point, these impacts should just be identified qualitatively, and you do not have to discuss how you would quantify/monetize these impacts.

• As an example, suppose the project was an investment in a new recycling facility. You may think that one of the impacts would be a reduction in plastic waste in the landfill, that this would be a benefit to society, and that you would measure it by the number of tons of plastic “saved” from the landfill over the course of a year.

Our Project for the Class

• Video of Pacific Avenue BRT project

https://www.youtube.com/watch?v=6cQl76sf0Ek

• Background information on the project:

https://www.piercetransit.org/brt/

https://www.piercetransit.org/brt-virtual-open-house/ 38

Our Project for the Class

• In groups of 3-4, try to brainstorm the following:

I. 5+ potential benefits of the BRT project

II. 5+ potential costs of the BRT project