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Lecture 2

Lecture 2. Cost - Benefit Analysis. Intertemporal welfare economics. An allocation of resources is efficient, if it is impossible to make one individual better off without making the other individual worth off.

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Lecture 2

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  1. Lecture 2 Cost - Benefit Analysis

  2. Intertemporal welfare economics An allocation of resources is efficient, if it is impossible to make one individual better off without making the other individual worth off. Consider two individuals (A, B), two time periods (0,1) with utility function U and who want to maximise consumption C

  3. Intertemporal welfare economics Allocation question: how is total consumption divided between two individuals in each period? Assuming a single efficiently produced commodity that can be either consumed or added to the stock of capital for future production. Efficiency requires: 1. Equality of A and B’s consumption discount rate; 2. Equality of rates of return to investment across firms; 3. Equality of the consumption discount rate with the rate of return to investment.

  4. An allocation is intertemporally efficient if the marginal rates of utility substitution are the same for A and B: Consumption discount rate: => rA = rB = r C1B (b) UB (a) C1A UA • • UB UA COA COB Figure 11.1 Equality of consumption discount rates (Perman et al.: page 353)

  5. C1 C1max C1b C1a • C1 A CO C0b C0a C0 Figure 11.2 Shifting consumption over time (Perman et al.: page 354)

  6. An allocation is intertemporally efficient if the marginal rates of returns to investment are the same for all firms: C11 C12 • C01a C02b C02a C01b C01 C02 Figure 11.3 Equality of rates of return (Perman et al.: page 355)

  7. An allocation is intertemporally efficient if the marginal rates of returns to investment equals the consumption rate of discount: = r. b C1 • a • C1* • c CO C0* Figure 11.4 Equality of rate of return and discount rate (Perman et al.: page 355)

  8. C1 C1max U • C1* U C0 C0* C0max Figure 11.5 Intertemporal optimum for an individual (Perman et al.: page 357)

  9. C1 R U A a • C1* b • • C1 B U S C0 C0* C0 Figure 11.6 Present value maximisation (Perman et al.: page 357)

  10. C1 U R A a • C1* • b U • C1 B S C0 C0* C0 Figure 11.6 (2) Present value maximisation

  11. Intertemporal welfare economics For any given set of data, resource endowment, production function, preferences and the like => several intertemporally efficient allocations. => Choosing among the set of intertemporally efficient allocations requires a social welfare function.

  12. Cost - Benefit Analysis Project appraisal: private: social: utility based consumption based a) b)

  13. Environmental Cost - Benefit Analysis Project appraisal: social: (Krutilla - Fisher model)

  14. Environmental Cost - Benefit Analysis Objections to ECBA: individuals may be inadequately informed individuals may be insufficiently deliberative in assessing consequences of alternatives individuals lack self-knowledge individuals’ preferences may not reflect their true interests due to preference shaping from socialisation processes

  15. Environmental Cost - Benefit Analysis Alternatives to ECBA: impact assessment cost-effectiveness analysis multi-criteria analysis deliberative polling citizens’ juries

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