Chapter 5
Cost-Benefit Analysis and
Government Investments
1
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 that attempts to compare the program
proposals of all government agencies authorized to achieve
similar objectives.
The mission of a government agency is comparable to a
business firm’s product.
Cost-Effectiveness Analysis is a technique for determining
the minimum-cost combination of government programs to
achieve a given objective
2
Cost-Effectiveness Analysis:
In the Example of Saving Lives
Cost-Effectiveness Analysis requires
stating an objective (saving lives)
recognizing the alternative means of
meeting the objective (inoculations and
smoke detectors)
choosing the mix of alternatives that
meet the objective in the least cost
fashion
3
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 4
The Cost-Effective Mix
At the point of tangency, the slope of the isoquant is
equal to the slope of the isocost lines, and
MRTS PSD PI
The MRTS, the marginal rate of technical substitution
between smoke detectors and inoculations, depends on
the marginal productiveness of each program.
The cost-effective mix of the two programs depends both
on their productivity in terms of lives saved and the prices
of units of services provided by the programs themselves.
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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
6
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, but
which were not part of the intended
purpose of the project.
7
Evaluating Costs and Benefits in Dollar
Terms
Though some costs and benefits
are easily quantifiable, others like s
the value of a human life saved or
lost because of a project, are not
as easy to objectively count.
8
Discounting Future Net Benefits
Present Value
An interest-adjusted value of costs or
benefits that will occur in the future
PV of X dollars received in n years at an
interest rate r is:
PV = (X/(1+r)n)
9
Discounting Payment Streams
10
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
set equal to this social opportunity
cost of funds because of the
distortions in the market caused by
government taxation.
The rate must also account for the
taxation on investment returns.
12
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
13
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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Disaggregating Net Benefits
Disaggregating benefits according to
demographic, income, and other social
characteristics of those who will receive
benefits and bear the costs allows cost-
benefit analysis to take into account
distributional considerations.
15
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 using real dollars and real
interest rates.
16
Ranking Projects
Net Benefit Criterion: Rank according
to the highest net benefits
Benefit-Cost Ratio Criterion: Rank
according to the highest ratio
17
Figure 6.3 Cost-Benefit Analysis and Efficiency
Marginal Social Cost and Benefit
Net Social Gain
from Q1
MSC
A
B G
F
Net Social Loss
E from Q2
C D H J
MSB
Q1 Q2
0 Q1Q2 Q* Q3Q4
Miles of Highway per Year
18
Cost-Benefit Analysis in Practice
Physical Infrastructure Analysis
Transportation
Environmental Capital
Schools
Power and Communication Networks
19
Government Infrastructure Investment in
LDC’s
LDC’s have invested considerable sums in
agricultural infrastructure because the estimated
project rate of return approaches 17%.
Projects like the creation of large water reservoirs
typically displace locals and these costs
(externalities) must also be counted.
Projects have been shown to help the poor by
adding substantially to their ability to produce crops
for sale.
20
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
21
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
22
Value of a Human Life
A number of techniques have been used to
estimate the value of human life saved:
A common method is to value lives according to the
discounted present value of future earnings.
The benefits of saving a life could be measured in
terms of the willingness of individuals to pay for a
reduction in hazards or risks to which they are
exposed.
23
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: $4,660
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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 difficult to quantify
Distribution of benefits affects the
political decisions of which programs
are funded.
25
Sports Stadiums
Cost-benefit analysis often used by state and
local governments to justify subsidies to such
projects as sports stadiums and civic centers
Supporters of sports stadiums argue that
combined benefits of the community will
more than offset costs.
Prominent economists argue that the logic
used by supporters of sports stadiums
substantially overestimates benefits while
underestimating costs.
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