Chapter 6
Cost-Benefit Analysis and
Government Investments
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Economic Analysis for the Budget
Process:
Achieving the Least-Cost Means of Accomplishing an
Authorized Objective
A Program is a combination of government
activities producing a distinguishable output.
Program Budgeting is the system of managing
government expenditures attempting to compare
the program proposals of all government agencies
authorized to achieve similar objectives.
Cost-Effectiveness Analysis is a technique for
determining the minimum-cost combination of
government programs to achieve a given objective
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Inoculations per Year Figure 6.1 Cost-Effectiveness Analysis
20,000 B
A
10,000
Lives Saved = 5,000
0 10,000 20,000
Smoke Detectors per Year
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Cost-Benefit Analysis
Enumerate all costs and benefits of a
proposed project
Evaluate all costs and benefits in dollar
terms
Discount future net benefits
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Enumerating Benefits and
Costs
Direct Costs and Direct Benefits are
those attributable to the purpose of the
project.
Indirect Costs and Indirect Benefits are
those attributable to the project that
were not part of the intended purpose of
the project.
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Evaluating Costs and Benefits
in Dollar Terms
Though some costs and
benefits are easily
quantifiable others, such as
the value of a human life
saved or lost because of a
project, are not as easy.
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Discounting Future Net
Benefits
Present Value
It is an interest-adjusted value of costs or
benefits that will occur in the future
The PV of X dollars received in n years at
an interest rate r is
PV = (X/(1+r))
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Discounting Payment
Streams
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Illustrating the Effect of
Interest Rate Changes on
Present Value
Project 1 yields $90 in net benefits
immediately.
Project 2 yields $100 two years from now.
Results
At 0% interest $100 two years from now is worth
$100 so project 2 is better than project 1.
At 5% interest $100 two years from now is worth
$90.7 so project 2 is better than project 1.
At 10% interest $100 two years from now is worth
$82.6 so project 1 is better than project 2.
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Choosing the Social Rate of
Discount
If the private sector interest rate is r then the
social rate of discount must be at least that
because of the distortions in the market
caused by government taxation.
The rate must also account for the taxation on
investment returns.
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Figure 6.2 A Tax on Investment Income and the
Social Opportunity Cost of Capital
S
20 = rG
Return (Percent)
E
16
D = Gross Return
I = 10 = rN E’
D’ = Net Return After Taxes
Funds Invested and Saved per Year
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Weighting Net Benefits
It also matters who gets the
benefits and who pays the
costs. Benefits accruing to
certain people may be
viewed as more or less
important than costs that
accrue to others.
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Treatment of Inflation
If all dollar figures are
nominal then interest rates
must be nominal and
account for inflation.
Alternatively, all accounting
can be done with real dollars
and real interest rates.
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Ranking Projects
Net Benefit Criterion: Rank according to
the highest net benefits
Benefit-Cost Ratio Criterion: Rank
according to the highest ratio
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Figure 6.3 Cost-Benefit Analysis and Efficiency
Marginal Social Cost and Benefit
Net Social Gain
from DQ1
MSC
A
B G
F
Net Social Loss
E from DQ2
C D H J
MSB
DQ1 DQ2
0 Q1Q2 Q* Q3Q4
Miles of Highway per Year
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Cost-Benefit Analysis in
Practice
Infrastructure Analysis
Roads
Bridges
Dams
Levies
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Government Infrastructure
Investment in LDC’s
LDC’s have invested considerable sums in
agricultural infrastructure because of a 17%
estimated project rate of return.
Projects (such as the creation of large water
reservoirs) typically displace locals and these
costs must also be accounted for.
Projects have been shown to help the poor by
adding substantially to their ability to produce
crops for sale.
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Cost-Benefit Analysis of a
Hypothetical Irrigation Project
Year
Costs 1 2 3 4 5 6 … N
Engineering and Planning E
Building and Construction F1 F2 F3 F4 F5
Maintenance M6 … MN
Loss in Agriculture A1 A2 A3 A4 A5 A6 … AN
Loss in Recreation R1 R2 R3 R4 R5 R6 … RN
Total Costs C1 C2 C3 C4 C5 C6 … CN
Benefits
Increased Agriculture A6 … AN
Increased Recreation R6 … RN
Total Benefits B6 … BN
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Figure 6.4 The Benefits of Widening a Highway
Average Cost per Trip
C B
D
C' A
DT
0 T T'
Number of Trips per Year
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Cost-Benefits Analysis of
Job Corps Program
Costs per Participant
Operating the Program ($8,380)
Forgone Output of Participants ($1760)
Benefits Per Participant
PV of Increased output ($8,080)
PV of reduced crime ($5,840)
Reductions in costs of other programs ($880)
Net PV of Benefits ($4,460)
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The Role of Cost-Benefit
Analysis in Budgeting
Useful tool to policy makers attempting
to quantify decision making.
Some social benefits are difficult to
quantify.
The distribution of benefits plays a role
in the political output of which programs
are funded.
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