T4 Course

Cost-Benefit Analysis
Professor Francesca Medda

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The Economic Case For HS2

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/365065/S_A_1_Economic_case_0.pdf

HS2 will be one of the largest public infrastructure projects ever undertaken in the UK and
will have long-lasting implications for how people will travel and how businesses will trade.
It will add much-needed additional track capacity to the north-south routes of our railway
system, creating opportunities to improve the frequency and reliability of rail services for
towns and cities, both on and off the HS2 network. By connecting 8 of the 10 major cities of
the UK with a high-speed network and releasing significant amounts of capacity on the
conventional network, HS2 will open up a vast number of options for rail service patterns.

https://www.gov.uk/guidance/transport-analysis-guidance-webtag
The PLANET Framework Model (PFM), provides forecasts of demand, travel patterns, and
crowding levels, has been updated using more recent input assumptions, better evidence
and improved techniques.

Using the CBA standard approach, the point-estimate Benefit Cost Ratios of the whole
network (including Wider Economic Impacts) is estimated at 2.3.
More than 75% of the benefit cost ratios in the analysis are higher than 2, i.e. offering a
return of more than 2 for every 1 invested.
The cost of HS2 What measures will be taken to limit the cost of constructing HS2? Is
the funding envelope of 50 billion for the cost of construction an absolute limit or will
this increase with inflation? How much cheaper would a new railway built for a lower
maximum speed (for example, 320 kilometres per hour as in France) be? Who will pay
for HS2 How does the high level of taxpayer subsidy of HS2 fit with the Governments
commitment to reduce the level of subsidy of the UK rail network? Lack of consideration
of alternative rail investment Could incremental improvements to the existing rail
network deliver the required capacity improvements? Could the use of flexible pricing
policies, such as those used by low-cost airlines, assist with managing overcrowding on
the busiest trains? Effect on the UK economy Given that evidence from abroad suggests
that large cities benefit the most from improving connectivity, how will HS2 rebalance
Britains economy?
HOUSE OF LORDS Economic Affairs Committee 1st Report of Session 201415
http://www.publications.parliament.uk/pa/ld201415/ldselect/ldeconaf/134/134.pdf 4

Lets assume that we want to

evaluate a transport project. We
collect the benefits and the costs of
those affected by the transport
project. Our society consists of 5
individuals (we ignore problems
derived from distorted preferences)
Individual

Benefits ()

Costs ()

Net Benefits ()

-6

-1

-5
5

The column net benefits allows us to anticipate that the

project would be rejected in a referendum (Like in Manchester
or Edinburgh for the congestion change). Individuals A and D
would vote in favour, but individuals B, C and E would vote
against it.
Would it be a good decision to reject the construction of the
bridge project?
To answer this question, we have to check whether the
construction of the bridge is a social improvement.
Would it be possible to reach a Pareto improvement despite the
outcome of the ballot?
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In the case of Pareto improvement we need to verify that at least

one person is better off without making anyone else worse off.

If all the individuals are better off with the bridge than without it, then
clearly we should build the bridge. If all the individuals are worse off, then
we should certainly not implement the project. If some individuals are
better off and others worse off, whether we should adopt it or not depends
critically on how we weigh the gains and losses of different individuals.
Although this is the correct procedure, it is not a practical one. We need
therefore to examine the problem through another framework.
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Definition
Cost-Benefit analysis is an analysis
which quantifies in monetary
terms as many of the costs and
benefits of a proposal as is
feasible, including items for which
the market does not provide a
satisfactory measure of economic
value.
(Transport Analysis Guidance
DoT, 2011)
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STEPS OF CBA
The economic appraisal of investment projects must be flexible enough to
capture the specific characteristics of each projects. In general, in CBA we
carry out the following steps:
1.
2.
3.
4.
5.
6.
7.

Objective of the Project and Examination of the Relevant Alternatives

(the problem to be solved)
Identification of Costs and Benefits (direct and indirect effects)
Measurement of Costs and Benefits (monetary measures and
willingness to pay)
Benefits and Costs Aggregation (in different periods of time and of
different individuals)
Interpretation of Results and Decision Criteria (Private vs Public)
Comparison of the Project with a Base Case (do nothing case)
Economic Return and Financial Feasibility (NPV vs financial analysis)

Several criteria are often used for project

evaluation
PRESENT VALUE
INTERNAL RATE OF RETURN
BENEFIT-COST RATIO

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PRESENT VALUE
Project evaluation usually requires comparing costs and benefits
from different time periods.
The method used is based on the concept that one pound today
is worth more than one pound tomorrow.
To evaluate projects we need to consider the returns (net profit)
in future years and calculate the Present Discounted Value
(Present Value).
T

PDV= RT/ (1+r)

Projecting present
money into the future
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r = rate of interest
T= number of years
(1+r)T = discount factor
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The present value of a future amount of money is the maximum

amount you would be willing to pay today for the right to receive the
money in the future.
PV = R0 + (R1 / (1+r))+ (R2 / (1+r)2) + (R3 / (1+r)3)+ + (RT / (1+r)T)

Nominal Amounts: returns are valued according to the level of prices

in the year the return occurs.
Real Amounts: returns measure in terms of the prices that exist in a
single year.
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The importance of computing present value is hard to overestimate.

Ignoring it can lead to serious errors. In particular, failure to discount
makes ventures that yield returns in the future appear more valuable than
they really are.
Pounds
Payable
R0
R1
R2
R3
.
RT

Years
0
1
2
3

Discount
Factor
1
(1+r)
(1+r)2
(1+r)3

(1+r)T

Present
Value
R0
R1/(1+r)
R2/(1+r)2
R3/(1+r)3
RT/(1+r)T

EXAMPLE: Consider a project that yields a return of 1 million 20 years from now.
If the interest rate is 5%, the present value is 376.889 = 1.000.000/(1.05)20
If the interest rate is 10%, the present value is 148.644 = 1.000.000/(1.10)20
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PRIVATE COST-BENEFIT ANALYSIS

Suppose we need to evaluate two mutually exclusive
transport projects:
X and Y
Cx and Cy costs,
X
Y
Years
(B-C)
(B-C)
Bx and By benefits
We consider
different Discount
Rates

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-1,000

-1,000

600

550

1,200
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The present value criteria for project evaluation are that:

1. A Project is admissible only if its present value is positive;
2. When two projects are mutually exclusive, the preferred
project is the one with the higher present value.
Year

Annual Net
Return
X

Annual Net
Return
Y

Discount factor
r=

PV
X

PV
Y

0
1
2
3

-1,000
600
0
550

-1,000
0
0
1,200

0
0.01
0.03
0.05
0.07

150
128
86
46
10

200
165
98
37
-21

The calculations show that the discount rate chosen is important.

For low value of r, project Y is preferred to project X. However, higher discount
rates weigh against project Y and for high r, the project is inadmissible.
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Several criteria other than present value are

often used for project evaluation
PRESENT VALUE
INTERNAL RATE OF RETURN
BENEFIT-COST RATIO

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Internal Rate of Return

If a project yields a stream of benefits (B) and costs (C) over period
T, the internal rate of return (g) is defined as the g that solves the
equation:
(B0 C0) + ((B1 C1) / (1+g)) + ((B2 C2) / (1+g) 2) + ((BT CT) /
(1+g)T) = 0
The internal rate of discount is the discount that would make the
present value of the project just equal to zero.
A project is admissible when the internal rate of return exceeds the
companys opportunity cost of funds, r.
Comparability criterion is that if two mutually exclusive projects are
both admissible. Choose the one with higher value of g.
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Internal Rate of Return

X
(C-B)

Y
(C-B)

PV
X

PV
Y

g
X

g
Y

100

1000

110

1,080

10%

8%

Neither project can be duplicated.

Assume that we can borrow and lend freely at a 6% rate of interest.
On the basis of internal rate of return, X is clearly preferred to Y.
However, on project X we make only 4 of profit (10 - 6 in
interest costs) and on project Y we make 20 of profit (80 - 60
in interest costs).
When projects differ in size, the internal rate of return can give
poor guidance!
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Benefit-Cost Ratio
A project yields a stream of benefits and costs such as we can
evaluate the present value for each stream:
PVB = B0 + (B1 / (1+r))+ (B2 / (1+r)2) + (B3 / (1+r)3)+ + (BT / (1+r)T)
PVC = C0 + (C1 / (1+r))+ (C2 / (1+r)2) + (C3 / (1+r)3)+ + (CT / (1+r)T)

The benefit-cost ratio is defined as B/C

Admissibility requires that a projects benefit-cost ratio exceed 1,
(B/C > 1), implying that B-C > 0, which is just the present value
criterion for admissibility.
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Benefit-Cost Ratio
As a basis for comparing admissible projects, however,
the benefit-cost ratio is virtually useless.
Road
B

Road
C

Road
(B/C)

Rail
B

Rail
C

Rail
(B/C)

Road
damage
crop

250

100

2.5

200

100

40

If the 40 million is viewed as a reduction in the roads benefits, its

B/C becomes 2.1; if the 40 million is viewed as an increase in
costs, its B/C is 1.79.

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CBA:
Private vs Public
The discount rate chosen by private companies should reflect the rate
of returns available on alternative investments. Although in practice
to identify the rate may be difficult, from a conceptual point of view
the companys opportunity cost of funds gives the correct value of r
There is less consensus on the
conceptually appropriate discount rate
for government projects

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Social Cost-Benefit Analysis

The social discount rate measures the valuation society places on
consumption that is sacrificed in the present.
In the social cost and benefit analysis we take into account a
wider range of impacts, not just profits.
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/2
20541/green_book_complete.pdf
The discount rate is used to convert all costs and benefits to present values, so that
they can be compared. The recommended discount rate is 3.5%. Calculating the
present value of the differences between the streams of costs and benefits provides
the net present value (NPV) of an option. The NPV is the primary criterion for
deciding whether government action can be justified.
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Social Discount Rate

The social discount rate may be lower than the market rate of
return for several reasons:
1) Concern for Future Generations: it is the duty of the public
sector to care about the welfare, not only of the current
generation of citizens, but of future generations as well.
2) Paternalism: people may not be farsighted enough to weigh
adequately benefits in the future (defective telescopic faculty).
3) Market Inefficiency: by applying a discount rate lower than the
markets, the government can correct the inefficiencies.
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Common Errors in CBA

1. The Chain-Reaction
Game
2. The Labour Game
3. The DoubleCounting Game
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EXAMPLES
A study includes the cost of constructing a sound wall in the initial project costs, while also
counting the disbenefit of noise from the project without a sound wall. This is a mistake of
double-counting. Only the disbenefit of noise with the sound wall should be counted, since the
rest of the noise impact is eliminated by the sound wall.
A study of a proposed toll decrease on a publicly owned highway counts the benefit of lower
vehicle operating costs from reduced toll, even though the costs of toll collection itself remain
unchanged. This is a mistake since for government projects tolls and taxes are just transfers
between different members of society (as are fares paid to public transit operators). Tolls, fares,
and (to a lesser extent) taxes are financial tools used to transfer some or all of a project's cost to
its direct beneficiaries and away from society as a whole. While they may be useful for
identifying winners and losers, they do not correspond to net impacts on society as a whole.
A study of a proposed downtown transit improvement includes as a benefit the downtown
parking fees avoided by former auto users. This may be a mistake since parking fees may also
just be transfer payments. On the other hand, if reduced demand for downtown parking actually
frees up land or structures for other uses, the value of those released resources would properly
count as a benefit. (To the extent that parking fees reflect the value of the resources thus freed
up, parking fees could indeed be a reasonable surrogate measure of that benefit.)
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STUDY CHAPTER 11: COST-BENEFIT ANALYSIS

ECONOMICS OF THE PUBLIC SECTOR,
THIRD EDITION
JOSEPH. E. STIGLITZ

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Thank you very much

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