Class Challenge�

Pere Riera

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01

Define “cost” in the context of Cost-Benefit Analysis (CBA).

Define “cost” in the context of Cost-Benefit Analysis (CBA).

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• A decrease in welfare (disutility).

Define “benefit.”

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Define “benefit.”

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• An increase in welfare (utility).

What is considered a transfer, or monetary transfer, in this course?

What is considered a transfer, or monetary transfer, in this course?

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• A “transfer” is a monetary benefit (cost) being offset by a monetary cost (benefit) –e.g., wages, entrance fees, taxes…-, with a net zero impact on society as a whole.

What is the difference between CBA and “Social” CBA?

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What is the difference between CBA and “Social” CBA?

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• Both take into account all affected members of society, but some authors use the added "Social" term for those CBAs that specifically incorporate equity considerations.

In the historical background explanation of CBA, two 19^th Century economists are mentioned, a French and a British one. Mention both.

In the historical background explanation of CBA, two 19^th Century economists are mentioned, a French and a British one. Mention both.

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• Jules Dupuit (1804-1866)
• Alfred Marshall (1842-1924).

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• N.B. The exam will not include this type of questions.

There are three major types of cost-benefit analysis, depending on when they are conducted:

ex ante,

ex post,

and which is the third one?

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There are three major types of cost-benefit analysis, depending on when they are conducted:

ex ante,

ex post,

and which is the third one?

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• In medias res.

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• N.B. The exam will not include this type of questions.

What are the optimal (non-distorted) values or prices called, in CBA jargon?

What are the optimal (non-distorted) values or prices called, in CBA jargon?

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• Shadow prices.

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• N.B. The exam will not include this type of questions.

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Observed in a perfectly competitive market, wages have x value per hour, but in a highly regulated economy, y per hour.

Would x be the correct value to be used in a CBA exercise?

Why?

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Observed in a perfectly competitive market, wages have x value per hour, but in a highly regulated economy, y per hour. Would x be the correct value to be used in a CBA exercise? Why?

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• Yes. Because the CBA objective is to reflect the (dis)utility (x), not the actual monetary compensation for it (y).

If labor is considered a cost in a CBA, why are jobs generally considered desirable by society?

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If labor is considered a cost in a CBA, why are jobs generally considered desirable by society?

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• Privately, because it is expected that the wage will (over)compensate the disutility of working.
• Socially, because it is expected that the output of labor -its benefit- will (over)compensate the cost of working.

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Define Net Present Value (NPV).

Define Net Present Value (NPV).

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• The Net Present Value is the difference between the discounted benefits and the discounted costs.

Define Internal Rate of Return (IRR).

Define Internal Rate of Return (IRR).

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• The Internal Rate of Return is the value of the discount rate that makes the Net Present Value (NPV) equal to zero.
• By convention, the IRR is an annual rate.
• By convention, the NPV being equal to zero is assessed at the initial year as base period.

Define Benefit-Cost Ratio (B/C).

Define Benefit-Cost Ratio (B/C).

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• The Benefit-Cost Ratio is the ratio between the discounted benefits and the discounted costs.

Define Break-Even Point (BEP).

Define Break-Even Point (BEP).

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• The Break-Even Point is the period in which, if any, the accumulated discounted benefits offset the accumulated discounted costs.

Can there be more than one Break-Even Points?

Can there be more than one Break-Even Points?

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• Yes, every time the accumulated discounted benefits equal the accumulated discounted costs.
• However, in this course we consider only cases with one BEP, unless explicitly mentioned otherwise

When the flux of discounted benefits – costs changes signs from negative to positive, to negative, and positive again, etc., more than one IRR may exist.

If a CBA has n IRRs, how many NPV will it have?

When the flux of discounted benefits – costs changes signs from negative to positive, to negative, and positive again, etc., more than one IRR may exist.

If a CBA has n IRRs, how many NPV will it have?

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• Only one NPV.

Doubling all Benefits and all Costs, double the:

1. NPV,
2. IRR,
3. B/C,
4. BEP,
5. A combination of the above (which?), or
6. None of the above?

Why?

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Doubling all Benefits and all Costs, double the:

1. NPV,
2. IRR,
3. B/C,
4. BEP,
5. A combination of the above (which?), or
6. None of the above? Why?

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• (a) NPV. The relative indicators would not be altered –otherwise using different currencies would yield different results.

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A Benefit-Cost Ratio of 2 implies an Internal Rate of Return (IRR) of:

1. Twice the value of the discount rate used in the estimation of the Benefit-Cost Ratio,
2. More than twice,
3. Less than twice,
4. Either of the above, or
5. None of the above? Why?

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A Benefit-Cost Ratio of 2 implies an Internal Rate of Return (IRR) of:

1. Twice the value of the discount rate used in the estimation of the Benefit-Cost Ratio,
2. More than twice,
3. Less than twice,
4. Either of the above, or
5. None of the above? Why?

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• (d) Either. Because the B/C depends on the discount rate r, whereas the IRR does not.

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The Hicks-Kaldor Criterion is also know as the ________ Pareto Criterion.

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The Hicks-Kaldor Criterion is also know as the ________ Pareto Criterion.

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• Potential Pareto Criterion.

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Assume two mutually exclusive projects undergo a CBA, with positive and equivalent results (same NPV), one in Andorra with access to low interest loans, and the other in the Fiji Islands, with high interest loan rates. Applying the CBA logic, would you recommend

1. the Andorra project;

(b) the Fiji Islands project;

(c) both;

(d) either;

(d) none. Why?

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Assume two mutually exclusive projects undergo a CBA, with positive and equivalent results (same NPV), one in Andorra with access to low interest loans, and the other in the Fiji Islands, with high interest loan rates. Applying the CBA logic, would you recommend

1. the Andorra project;

(b) the Fiji Islands project;

(c) both;

(d) either;

(d) none. Why?

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• (d),either one, due to the same positive CBA result, being mutually exclusive, and the irrelevance of financing.

Assume the two mutually exclusive projects differ only in Andorra not having Workers Unions, and the Fiji Islands having an extra labor cost due to their Unions. Without the Unions’ effect, the NPV would be the same. Applying the CBA logic, would you recommend, and why?:

1. the Andorra project;

(b) the Fiji Islands project;

(c) both;

(d) either;

(e) none.

Assume the two mutually exclusive projects differ only in Andorra not having Workers Unions, and the Fiji Islands having an extra labor cost due to their Unions. Without the Unions’ effect, the NPV would be the same. Applying the CBA logic, would you recommend, and why?:

1. the Andorra project;

(b) the Fiji Islands project;

(c) both;

(d) either;

(e) none.

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• (d), either one, due to the same positive CBA result, being mutually exclusive, and the irrelevance of labor market imperfections (only the shadow price is relevant).

A regional government prepares a program to invest in new infrastructure, with the explicit objective to dynamize the economy. Should a standard CBA of the new infrastructure include those indirect effects?

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A regional government prepares a program to invest in new infrastructure, with the explicit objective to dynamize the economy. Should a standard CBA of the new infrastructure include those indirect effects?

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• No. If the change to evaluate is the new infrastructure, the aim of the government is irrelevant. To include it, it ought to be part of the change definition, and all the main costs and benefits related to it ought to be accounted for.

A regional government prepares a program to invest in a local infrastructure, co-financed by the central government. Should a CBA of the new infrastructure include the funds from outside the region?

A regional government prepares a program to invest in a local infrastructure, co-financed by the central government. Should a CBA of the new infrastructure include the funds from outside the region?

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• Financial aspects are excluded from CBA. Only the main welfare costs and benefits should be included, regardless of financing

What is the difference between the Kaldor criterion and the Hicks criterion?

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What is the difference between the Kaldor criterion and the Hicks criterion?

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• According to Kaldor, a change is socially preferable if the winners could compensate the losers, and still make someone be better-off.
• According to Hicks, a change is socially preferable if the losers could not bribe the winners to give up the change, and still make someone be better-off.

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A very detailed and expensive report for a new university campus is presented to the Department for Education. Based on it, they commission a CBA for the final decision.

Should the cost of the report be included in the CBA? Why?

A very detailed and expensive report for a new university campus is presented to the Department for Education. Based on it, they commission a CBA for the final decision. Should the cost of the report be included in the CBA? Why?

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• No, because it is a sunk cost

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As a follow-up from the last question, should the cost of performing the CBA be included in the CBA? Why?

As a follow-up from the last question, should the cost of performing a necessary geological survey be included in the CBA? Why?

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• If undertaken prior to the decision, no, because it is a sunk cost at the moment the Department of Education will make their decision. Otherwise yes.

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