Gruber4e ch08

Public Finance and Public Policy Jonathan
CopyrightGruber
2012 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 26
Cost-Benefit Analysis
8.1
8.2
8.3
8.4
Measuring the Costs of Public Projects

Measuring the Benefits of Public Projects
Putting It All Together
Conclusion
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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C H AP T E R 8 C O S T B E N E F I T AN ALY S I S
Cost Benefit analysis
This chapter covers cost-benefit analysis.

Cost-benefit analysis: The comparison of
costs and benefits of public goods projects
to decide if they should be undertaken.
Cost-benefit analysis is widely used to
evaluate potential public programs and
projects.
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8.1
Costs and Benefits of Highway Construction

Quantity
Costs
Asphalt
1 mill bags
Labor
Repairs
1 mill hours
$10 million
(yearly)
Benefi Time
ts
saved
Price/Va Total
lue
500k hours
(yearly)
Lives
5 lives
What are the costs and benefits of the
saved
(year)
project? In the first year? Over time?
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8.1
Measuring Current Costs
How to measure costs?

Cash-flow accounting: Accounting
method that calculates costs solely by
adding up what the government pays for
inputs to a project and calculates benefits
solely by adding up income or government
revenues generated by the project.
Opportunity cost: The social marginal cost
of any resource is the value of that resource
in its next best use.
Measuring opportunities costs faces several
challenges.
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8.1
Imperfect Markets
Economic costs are only those costs are

associated with diverting the resource from its
next best use.
Rents: Payments to resource deliverers
that exceed those necessary to employ the
resource.
If labor is efficiently employed, then wages
are a social cost.
If some workers are unemployed, then we
value their time at the value of leisure, not
the wage.
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8.1
Imperfect Markets: Measuring the Cost of Labor
Suppose that the wage of construction

workers is $20/hour.
But half the construction workers for the
project are unemployed and value their
leisure at $10/hour.
Then the true labor cost of the project is
$20/hour (500,000 hours) + $10/hour
(500,000 hours)
$15 million, not the $20 million accounting
price.
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8.1
Measuring Future Costs
How to measure future benefits against

current costs?
Use presented discounted value,
discounting at the social discount rate.
Present discounted value (PDV): A
dollar next year is worth 1 + r times less
than a dollar now because the dollar could
earn r % interest if invested.
Social discount rate: The appropriate
value of r to use in computing PDV for social
investments.
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8.1
Costs and Benefits of Highway Construction: Filling

in Costs
Costs
Quantity
Price/Val
ue
Total
Asphalt
1 mill bags
$100/bag
100
Labor
1 mill hours at 20,

at 10
15
Repairs
$10 million 7%
(yearly)
discount
rate
43
Benefi Time
ts
saved
Lives
saved
500k hours
(yearly)
5 lives
(year)
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8.2
Using Market-Based Measures to Value Time:

Wages
Suppose we can show that the time that
individuals save from driving faster is spent
at work.
Then we could value their time saved at
their wage.
This theoretical proposition runs into some
problems in practice:
o Individuals cant freely trade off leisure
and hours of work; jobs may come with
hours restrictions.
o There may be nonmonetary aspects of
the job.
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8.2
Using Survey-Based Measures to Value Time:

Contingent Valuation
An alternative approach to measure benefits
is contingent valuation.
Contingent valuation: Asking individuals
to value an option they are not now
choosing or do not have the opportunity to
choose.
This approach relies on answers to
hypothetical questions.
Straightforward, inexpensive to apply.
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8.2
APPLICATION: The Problems of Contingent

Valuation
Critics of contingent point out that contingent
valuations are very sensitive to the survey.
Isolation of issues: Different value for sum
of single issues or issues asked in
combination.
Order of issues matters: Asking about an
issue first or second changes its reported
value.
The embedding effect matters: Asking
about one, two, or three sites does not
affect answers.
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8.2
Using Revealed Preference to Value Time
An alternative to contingent valuation is to

use revealed preference.
Revealed preference: Letting the actions
of individuals reveal their valuation.
Market prices potentially reveal preference:
If people are willing to pay P for something,
then it is worth at least P to them.
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8.2
EVIDENCE: House Prices and Commuting Time
How much do commuters value reductions in

commuting time?
Price differences between houses close and
far from downtown might reflect the value
of commuting time.
But treatments and controls may differ,
leading to bias.
o Everett is only 4 miles from downtown
Boston, while Lexington is 11 miles
away.
o Average home price in Everett:
$345,000.
o Average
home
in Copyright
Lexington:
Public Finance and
Public Policy Jonathan
Gruberprice
Fourth Edition
2012 Worth Publishers
14 of 26
8.2
EVIDENCE: House Prices and Commuting Time:

Solving the Problem of Bias
One solution is to control for house
characteristics.
o Lot size, number of bedrooms, square
footage.
o But some features are hard to observe,
such as granite countertops.
In order to provide a more convincing
estimate of the value of time savings, a
quasi-experimental approach can be used.
Deacon and Sonstelie (1985) look at how
much people save by standing in line to buy
price-controlled gasolineabout $20/hour.
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8.2
Valuing Saved Lives
Saving lives is a central benefit of many

interventions.
Valuing human lives is the single most
difficult issue in cost-benefit analysis.
Many would say that human life is priceless.
By this argument, valuing life is a
reprehensible activity; there is no way to
put a value on such a precious commodity.
Every possible intervention has a chance of
saving lives. To decide which to finance
requires valuing lives.
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8.2
APPLICATION: Valuing Life: Car Recalls
Some General Motors pickup trucks produced

between 1973 and 1987 had a dangerous,
side-mounted gas tank.
1993: Consumer groups demanded GM
recall 5 trucks.
Recall would cost $1 billion and would save
at most 32 lives.
Using these estimates, the cost per life
saved by the recall would have been $1
billion/32 = $31.25 million.
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8.2
APPLICATION: Valuing Life
In October 1999, a commuter train crash at

Londons Paddington Station killed 31 people.
Outraged public for more investment in rail
safety.
Safety advocates proposed measures that
cost $39 billion and would save 13
lives/year for 3050 years.
At best: $20 million per life saved.
At worst: $300 million per life saved.
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8.2
Valuing Saved Lives
How to value saved lives?

Using Wages to Value a Life
o Lifes value is the present discounted
value of the lifetime stream of earnings.
Contingent Valuation
o Ask individuals what their lives are
worth.
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8.2
Revealed Preference Approaches to Valuing Lives:

Compensating Differentials
We can value life by estimating how much
individuals are willing to pay for something
that reduces their odds of dying.
The extra safety is called a compensating
differential because it compensates workers
for lower wages.
Compensating differentials: Additional
(or reduced) wage payments to workers to
compensate them for the negative (or
positive) amenities of a job, such as
increased risk of mortality (or a nicer
office).
This approach suggests value of life of $9.3
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8.2
Government Revealed Preference?

Regulation
Concerning
Year
Agen Cost per

cy
life
Childproof lighters
1993
CPSC
0.13
Food labeling
Reflective devices for
trucks
1993
1999
FDA
NHTS
A
0.5
1.2
Asbestos
1972
OSHA 7.2
Value of statistical
life
Benzene
Asbestos ban
Solid waste disposal
9.3
1987
1989
1991
OSHA 28.2
EPA
99.9
EPA
128.1
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8.2
Discounting Future Benefits
In addition to finding the value of lives

saved in each year, a cost-benefit analysis
must discount these future benefits.
Choosing the proper discount rate is
difficult.
Since many projects have benefits that last
long into the future, the discount rate
matters enormously.
o Reducing global warming will bring
benefits hundreds of years into the
future.
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8.2
Cost-Effectiveness Analysis
Cost effectiveness is an alternative to costbenefit analysis.

Cost-effectiveness analysis: For projects
that have immeasurable benefits, or are
viewed as desirable regardless of the level
of benefits, we can compute only their costs
and choose the most cost-effective project.
Finding the cost of a life savedand
choosing projects wit the lowest costs
avoids making judgments about the value
of life saved.
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8.1
Putting It All Together
Costs
Quantity
Price/Val
ue
Total
Asphalt
1 mill bags
$100/bag
$100
Labor
1 mill hours at $20,

at $10
15
Repairs
$10 million 7%
(yearly)
discount
rate
43
500k hours $19/hour

(yearly)
9.5
Benefi Time
ts
saved
Lives
saved
5 lives
(year)
$7
35
million/life
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8.3
Other Issues in Cost-Benefit Analysis
Common Counting Mistakes

o Counting secondary benefits.
o Counting labor as a benefit.
o Double-counting benefits.
Distributional Concerns
o Costs and benefits may not go to the
same people.
Uncertainty
o Costs and benefits are often highly
uncertain.
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8.4
Conclusion
Turning the abstract notions of social costs

and benefits into practical implications for
public project choice is challenging.
What at first seems to be a simple
accounting exercise becomes quite
complicated when resources cannot be
valued in competitive markets.
Economists have developed a set of tools
that can take analysts a long way toward a
complete accounting of the costs and
benefits of public projects.
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Public Finance and Public Policy Jonathan

Measuring the Costs of Public Projects

Cost Benefit analysis

This chapter covers cost-benefit analysis.

Costs and Benefits of Highway Construction

Measuring Current Costs

How to measure costs?

Economic costs are only those costs are

Imperfect Markets: Measuring the Cost of Labor

Suppose that the wage of construction

Measuring Future Costs

How to measure future benefits against

Costs and Benefits of Highway Construction: Filling

1 mill hours at 20,

Using Market-Based Measures to Value Time:

Using Survey-Based Measures to Value Time:

APPLICATION: The Problems of Contingent

Using Revealed Preference to Value Time

An alternative to contingent valuation is to

EVIDENCE: House Prices and Commuting Time

How much do commuters value reductions in

EVIDENCE: House Prices and Commuting Time:

Valuing Saved Lives

Saving lives is a central benefit of many

APPLICATION: Valuing Life: Car Recalls

Some General Motors pickup trucks produced

APPLICATION: Valuing Life

In October 1999, a commuter train crash at

Valuing Saved Lives

How to value saved lives?

Revealed Preference Approaches to Valuing Lives:

Government Revealed Preference?

Agen Cost per

Discounting Future Benefits

In addition to finding the value of lives

Cost effectiveness is an alternative to costbenefit analysis.

Putting It All Together

1 mill hours at $20,

500k hours $19/hour

Other Issues in Cost-Benefit Analysis

Common Counting Mistakes

Turning the abstract notions of social costs

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