Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Ten

1. Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Ten

2. MEASUREMENT OF COSTS AND BENEFITS OF TRANSPORTATION INVESTMENTS

3. Economic Benefits of Transportation Projects 1) Improvement of existing mode - Example of a road 2) Introducing new modes of transportation - Example of a Buenos Aires-Colonia bridge

4. Cost Benefit Analysis of Transportation Projects -- Road Improvement Benefits -- • Cost Savings for Existing Traffic • - Savings in Vehicle Operation and Maintenance Costs • - Savings of Time • Cost Savings for Newly Generated Traffic

5. Cost Savings for Existing and New Traffic Di Cost per vehicle-mile for type i Cost Savings for Newly Generated Traffic E cit F c`it G D’i Vit V`it Traffic Volume of type i Cost Savings for Existing Traffic

6. Cost Savings from Road Improvements • Traffic Volume with Project: the number of vehicles by type that we expect each year to use the road over its life after improvement; • Traffic Volume without Project: the volume of vehicles by type that would travel on the road without the road improvement; • Vehicle Operating Costs Without the Project and With the Project: the costs incurred by road users in terms of: - consumption of gasoline and oil - the wear-and-tear on tires - the repair expenditures for vehicles

7. Traffic: With Road Improvement • Diverted Traffic: The traffic that diverted to the upgraded road from other routes as a result of the road improvement. • Generated Traffic: The traffic that will arise from people who now made the trip more frequently due to the reduction in the cost of using the road.

8. Savings of Time • “Normal” traffic: For passengers and trucks, the improved road allows their vehicles to travel at a higher speed as compared to the existing road, thus saving them time. Example: Occupants of a vehicle value time at $20 per hour, vehicle speed is 30 kph Time cost per km: 20/30= $ 0.66/km If vehicle speed is 50 kph Time cost per km is 20/50= $ 0.4/km Value of Time Savings: 0.66-0.4= $ 0.26 per vehicle - km • The value of savings is tied to the value placed on occupants’ time and therefore sensitive to the level of per capita income of the country. • For Diverted and Generated passenger traffic, the value of time savings is taken on average as half of the value of time savings for “normal” traffic.

9. Savings of Road Maintenance Expense • The annual savings in resources used for maintenance is the difference between the amount of resources spent on maintenance “without” road improvements minus the maintenance costs during the life of the road “with” the improvement. • Road improvements or new roads will affect the pattern of traffic on other roads that are complements or substitutes to the road being improved. • For complementary roads, the maintenance requirements are expected to rise as the volume of traffic accessing or exiting from the improved roads increases. The increase in maintenance costs on the complementary roads should be included as a cost associated with the road improvement project. • Substitute road maintenance expenses are expected to decrease due to the lower traffic levels. The cost savings are a benefit to the road improvement.

10. Accident Reduction • A road improvement can be important factor in the reduction of the number of accidents. • A road improvement may not automatically imply a substantial reduction in the rate and severity of accidents as there are other influencial aspects. Some of these factors are the geometric alignment of the road, the volume of traffic, effectiveness of law enforcement, vehicles mechanical conditions and drivers behavior. • Steps to assess the benefits of accidents reduction: • the rate of traffic accidents “with” and “without” the proposed improvements must be estimated. (Number of accidents per millionvehicle-kilometer) • the monetary value of accident reduction should be estimated which includes the savings in damages such as property and cargo damages. It is difficult to put a monetary value on injuries and fatalities.

11. Vt=Vit i Calculation of Cost Savings in Transportation Projects Step One: Estimate a projection over time of the traffic volume in the area for different types of traffic: where Vt is the expected volume of traffic in year t, V is traffic, i is a type of traffic, t is time.

12. Step Two: Calculate the Average Speed Sit=ƒ(Vt), where Sit is the average speed of the ithvehicle type. Step Three: Estimate cit which is the average cost per vehicle-mile at time t for vehicle type i on the unimproved road. cit includes vehicle operating costs, depreciation, maintenance and time cost. Step Four: Estimate c’it which is the average cost per vehicle-mile at time t for vehicle type i on the improved road.

13. (cit – c’it)*Vit i Step Five: Estimate the benefits of savings in cost of travel due to road improvement in year t: and the present value of these benefits at discount rate r: (1+r)-t *(cit – c’it)*Vit t i Step Six: Estimate M’ and M , which are the annual road maintenance costs with and without the road improvement. t t

14. Step Seven: Estimate the benefits of savings in road maintenance cost due to road improvement in year t, in some cases maintenance costs may rise (Mt – M’t) Step Eight: Estimate the present value of total benefits due to improvement (when volume of traffic remains constant after improvement): (1+r)-t* (cit – c’it)*Vit+ (1+r)-t*(Mt – M’t) t i t

15. Cost Savings with an Increase in Traffic Volume after Road Improvement Step Nine: There is an additional benefit in consumer surplus of generating new traffic volume due to road improvement. EFG = ½(1+r)-t*(cit – c’it)*(V’it -Vit) Di i t Cost per vehicle-mile for type i Gain in Consumer Surplus due to Improvement E cit F c`it G D`i Vit V`it Traffic Volume of type i

16. Total Cost Savings with an Increase in Traffic Volume after Road Improvement Step Ten: The total present value of benefits due to road improvement with a traffic volume increase: i t + ½(1+r)-t*(cit – c’it)*(V’it -Vit) (1+r)-t*(cit – c’it)*Vit + (1+r)-t*(Mt – M’t) i t t

17. Externalities Connected with Road Projects Dit*(X’it - X0it) i Need to take into account all external benefits and costs: Where: Dit is the excess of benefits over costs associated with a unit change in the level of activity, Xi at time t, X’itis that level in the presence of the project, X0it is that level in the absence of the project.

18. Externalities Involving Traffic on Other Roads • Externalities can be: • Excess of marginal social cost over marginal social benefit for traffic on roads; • Excess of marginal social benefit over marginal social cost for traffic on other modes such as railroads. • Congestion impacts, a very important and pervasive externality.

19. There is a negative relationship between volume of traffic (V) to speed of traffic (S). • S = a - b*V • If H is the value of the occupant’s time per vehicle hour, cost can be approximated by time per vehicle-mile, or H/S, which is also the marginal private time-cost as seen by the typical driver. The total time-cost of all users will be VH/S, and the marginal social time-cost:

20. Excess of marginal social cost, MSC, over marginal private cost, MPC, can be expressed as: • Where: MSC is the marginal social cost; MPC is the marginal private cost; S is actual speed; H is time value per vehicle-hour; a is the average speed at low traffic volumes. • Example: a= 80 kph, s= 50 kph, Thus, (80-50)/50 = 0.60 • MSC exceeds MPC by 60 percent.

21. Externalities (Congestion) in Case of Complementary Road S’ (social costs) External costs associated with traffic increase I Cost per vehicle-mile D’ F D C’(private costs) J C1 D’ E C0 C D V0 V1 Traffic Volume on Complementary Road D’D’ is an increase in traffic on the complementary road. EFIJ is the external costs.

22. Externalities in Case of Substitution Road S’ (social costs) External benefits associated with traffic decrease Cost per vehicle-mile D F C’ (private costs) D* G E C0 C1 H D C D* V* V0 Traffic Volume on Substitute Road D*D* is a decrease in traffic on the substitute (competitive) road. HGFE is the external benefits.

23. Calculation of Externalities for Complementary or Substitute Road Where: C0 is initial cost per vehicle-mile on the alternative road; f is a fraction of C represented by time-costs; V is the change in traffic volume; j is a type of alternative road; k is a volume interval on a road.

24. Cost Benefit Analysis of Transportation Projects -- Introduction of New Roads -- • Since there was no traffic to the area before the new road, the whole triangle DiC’itH represents the total present value of benefits to road construction in year t. Di Cost per vehicle-mile for type i H C’it D’i V`it Traffic Volume of type i

25. Introducing New Modes of Transportation “Buenos Aires Colonia Bridge Project” • The BAC Bridge will introduce a new mode of traffic to the Buenos Aires-Colonia area: transportation for passengers and cargo crossing the river. • - An alternative mode of crossing the river, a ferry • - A long route for cargo • Beneficiaries of the BAC bridge consist of passengers diverted from ferry, newly induced bridge river-crossing passengers, and cargo.

27. ANALYSIS OF THE PROJECT FROM ALTERNATIVE VIEWPOINTS

28. Key Factors Affecting the Project • A BOT Project: project life 30 years • Construction costs - about US$831 million in 1997 prices - construction begins in 1999 and last four years • Volumes of freight and passenger traffic • Competitive response by ferry operators • Bridge tolls • Project financing • the initial debt/equity ratio is 65/35 • the long-term debt is denominated in US dollars, and the interest rate is set at 7% real - loan payment starts at the first year of the bridge’s operation

29. The gross economic benefits of the diverted and induced passenger traffic is measured by the total willingness of the passenger to pay to cross the river using this new mode. If the toll level is tB, the quantity of trips demanded on the bridge should be equal to qB. At this quantity, the economic benefits of the diverted and induced traffic is equal to the consumer surplus, (CBIJ), plus the value of the tolls (OtBKqB), plus the value of any taxes or other distortions associated with vehicle operating and time costs incurred to use the bridge (NPKtB). Average Cost, $ BAC Bridge I V max GC D B J C B t VOC B R B + TC B D B P Taxes and Other N q Distortions on B K VOC and TC B B River Crossing O per Year

30. Economic benefits or costs could arise because of the reduction in activity of the alternative modes due to the quantity of traffic diverted to the bridge. With no bridge, the demand for the alternative mode (the ferries) is shown as . With the introduction of the bridge, demand for ferries decreases and the quantity of ferry users falls from q wob to q wb. In this case, if the ferry toll were set at tA, which is above the relevant marginal cost of the ferry, there would be a loss in ferry profits of GEFH. If there were taxes (or subsidies) associated with vehicle operating and time costs incurred when using the ferry, then the reduction in this activity would create a further economic loss (or gain). $ Mode Alternative A B C A VOC A + TC A GC D E F wob t MC A G H GC D wb Taxes and Other Distortions on VOC , TC , and MC L M A A A q River Crossing q O wb wob per Year

31. Cargo: International Traded Goods

32. Cargo: Regionally Traded Goods

33. Benefits from Cost Reduction in Cargo Transportation • When the goods are internationally traded, producers of the exporting country within the region would benefit from the savings in transportation or logistics cost between the two neighboring countries. • In the case of regionally traded goods, producers in the exporting country and consumers in the importing country will share the benefit from savings in transportation and logistics cost.

34. Case Study Conclusions • The project is financially viable as the real rate of return on equity is in excess of 16%. • ADSCR is larger than 1.9 for the option with financing that requires debt be repaid over 15 years. • After paying the foreign concessionaire for the investment, the project will make a substantial contribution to the economies of Argentina and Uruguay. • Producers in Brazil will also benefit for international traded goods due to increased shipments of these goods from Brazil to Argentina via the bridge. • The big winners are bridge passengers in Argentina and Uruguay. • Airline and ferry operators are losers because of diversion of travelers to the bridge.

35. Externalities Involving Railroad Traffic

36. Externalities Involving Railroad Traffic The problems involved in the relationships between road and rail transport can be complex, given the difficulty of isolating the relevant costs of rail transport. Measuring Marginal Cost for Railroads: - The marginal costs of carrying additional passengers or freight on trains that are in any event running are very low. - The marginal costs of running additional trains where the track and station facilities will in any event be kept in working condition are at an intermediate level. - The marginal costs of providing rail service on a stretch of track as against the alternative of abandoning that stretch are higher still.

37. Project of Road Improvement Road Railroad DR(C1) c0 DR(C0) c1 MC3 MC2 DROAD MC1 V0 V1 Consequences: 1) traffic is diverted from rail to road 2) the railroad no longer has to bear the marginal cost of carrying diverted traffic The net external effect will therefore almost certainly be negative, and will be measured by: - is the fare or freight rate for the type of rail traffic - is the marginal cost associated with carrying that traffic - is the change in the volume, induced by the road improvement - type of traffic on the railroad

38. Figure 1 Unit Cost of Travel on road • the private unit costs of travel on the road • before the improvement - after the improvement M P N • the demand curve for services of the road • on the assumption that the railroad is operating • and charging the fare level OF (from Figure 2) R • the demand curve for the services of the road • assuming the railroad has been abandoned • the initial levels of unit costs and traffic • volume on the road Volume of traffic on road Figure 2 • the equilibrium levels after the road has been improved but before railway abandoned • the equilibrium levels after the road • has been improved and the railroad abandoned Fare G J F -the demand curve for services of the railroad on the assumption that there is no improvement on the road - the demand curve for services of the railroad after improvement on the road O H I Traffic level on railroad

39. Unit Cost of Travel on road M P N R Volume of traffic on road - the measure of direct benefits M N - the benefit perceived by traffic that would have used the unimproved road in any event M R - represents the net benefit perceived by those who would not have used the road at unit cost of C1, but who would have it at unit cost of C2. MNR - represents cost incurred in the road by traffic because of the abandoned railroad. NPV2V’2

40. Figure 1 Unit Cost of Travel on road SUMMARY M a) The present values of cost savings to the users of the road (represented by area ) P N M N R lessb)The present value of those private net costs associated with abandonment of the railroad (represented by FD4G) Volume of traffic on road less c) The present value of the excess of rail fares over the direct marginal costs of operation plus d) The present value of the savings stemming lower equipment, maintenance, station operation costs, and so forth, for the railroad pluse) The current market value in alternative uses of the properties to be abandoned Figure 2 Fare G J F MC O H I Traffic level on railroad

41. COSTS AND BENEFITS OF ELECTRICITY INVESTMENTS

42. Economic Valuation of Additional Electricity Supply • Willingness to pay for new connections • Willingness to pay for more reliable service • Resource cost savings from replacement of more expensive generation plants • Marginal cost pricing

43. $ S D 0 PMAX=P’ B C P0m F D0 0 Q’ Quantity Q0 Economic Value of Electricity For New Connections or For Reduction of with Rotating Power Shortages Shaded area = economic value of shortage power (Q’-Q0) = Power shortage, evenly rotated to all customers Assuming willingness to pay (WTP) of all customers are also evenly distributed from highest 0P’ to lowest P0m: Economic Value of Additional Power Supply = ((PMAX+ P0m)/2) * (Q’-Q0)

44. D S0 P’ B C Pt F D0 0 Q0 Quantity Q’ Economic Value of Electricity Computation Formula • P’ = Maximum willingness to pay per unit of shortage power • = 2 (capital costs of own generation/KWh) + Fuel Costs/KWh • Need one generation to produce electricity and the second generation to provide reliability

45. Estimated Cost of Power Failure • 1. Based on willingness to pay • - Based on customers survey • 2. Based on actual costs to users • 3. Based on linear relationship between GDP and electricity consumption of industrial/commercial users

46. Estimated Cost of Power Failure* • 1. Based on Willingness to Pay • - Based on customers survey (Contingent valuation) • Ontario Hydro Estimates of Outage Costs (1981 US$/kwh) • Duration Large Small Commercial Residential • Manufacturers Manufacturers • 1 min 58.76 83.25 1.96 0.17 • 20 min 8.81 13.56 1.66 0.15 • 1 hr 4.35 7.16 1.68 0.05 • 2 hr 3.75 7.35 2.52 0.03 • 4 hr 1.87 8.13 2.10 0.03 • 8 hr 1.80 6.42 1.89 0.02 • 16 hr 1.45 4.96 1.75 0.02 • Average** 2.15 6.38 1.98 0.12 • All groups average***: 1.96 • Average power price: 0.025 • Average WTP for power during outage = 78.4 times average power price. • Notes:* C.W. Gellings and J.H. Chamberlin, Demand-Side Management: Concepts and Methods, Liburn, Georgia, The Fairmont Press, Inc., 1988. • ** Based on system simulation model • *** Based on shares: 13.5/13.5/39.0/34.0 %.

47. Own-Generation Cost and Willingness to Pay in Mexico Own-generation cost of one generator +fuel ($/kWh) 0.18 - Capital cost ($/kWh): 0.05 - Fuel cost ($/kWh): 0.13 Maximum willingness to pay ($/kWh) 0.23 (two generators + one fuel cost) Average willingness to pay to Utility ($/kWh) 0.14 Average power retail price (gross of tax, $/kWh) 0.05

48. Estimated Cost of Power Failure(cont'd) • 2. Based on actual costs to users • San Diego (sudden outage of a few hours)* • (1981 US $/kwh) • Industrial Commercial • Direct User 2.79 2.40 • Employees of Direct User 0.21 0.09 • Indirect User 0.12 0.13 • Total 3.12 2.62 • Multiples of Av Tariff** 62.4 52.4 • Key West, Florida (rotating blackout for 26 days)* • % of Cost Multiples • Time of Price • Nonresidential Users 4.8 $2.30/kwh 46.0 • Electric Power Research Institute study EPRI EA-1215, 1981, Vol. 2. • Average price in 1981 is 0.05 $/kwh.

49. Estimated Cost of Power Failure (cont'd) 3. Based on linear relationship between GDP and electricity consumption of industrial/commercial users* Outage cost = 1.35 (1981$/kwh) Or: = 27 (multiples of the average power price) * M. L. Telson, “The Economics of Alternative Levels of Reliability for Electric Power Generation Systems”,Bell Journal of Economics, (Autumn 1975).

50. Summary: Average power outage cost ranges from 6 to 80 times of the average power price.