Efficiency, Surplus and Doing Benefit-Cost Analysis

1. Efficiency, Surplus and Doing Benefit-Cost Analysis How can economics help determine the optimal size of a project or extent of a regulation?

2. Motivating Group Project 2001 Actual Group Project (Advisors—Profs. McAusland and Kendall): A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties 2001 Actual Group Project (Advisors—Profs. McAusland and Kendall): A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties 2001 Actual Group Project (Advisors—Profs. McAusland and Kendall): A Cost-Benefit Analysis of Public Law 99-625: Sea Otter-Shellfishery Conflicts in Santa Barbara and Ventura Counties

3. A few other examples • What should be the CO concentration standard in tailpipe emissions? • What is the appropriate level of GHG emission reduction worldwide? • How large should the Channel Islands marine reserve be? • Can we measure loss to recreationists of the Forest Adventure Pass? • Add another lane to Hwy 101? • Close Mission Canyon to cyclists? • What habitat to buy to protect endangered species (eg, Least Bell’s Vireo – bird)

4. Generic Problem • Characterize an Environmental Policy or Action (or multiple policies or actions) • Estimate the Consequences of that policy or action • Estimate the pluses (benefits) and minuses (costs) of that policy or action • Reach conclusions

5. CBA: main principle • Quantify all costs and benefits in a common measure (usually $) • Common metric need not be $ • eg, health- health analysis, with health as metric • Benefits directly measured in terms of lives saved • Costs indirect: costs increase deaths since • Regs make people poorer • lower incomes lead to higher mortality ($13 million in extra costs results in 1 statistical death) • Eg, Compare risks in lower and higher income countries • Compare projects based on net effects on health.

6. What others method to use? • Cost-effectiveness Analysis • Weighted cost-benefit analysis • Multigoal analysis

7. Basic measure of value is willingness-to-pay • Demand curve is marginal willingness to pay MWTP First units very valuable Last units less valuable Quantity of water

8. Consumers Surplus (CS) $ CS(q) p D(x) x q

9. Calculating benefitsfrom MWTP • Demand, D(x), measures MB. • Consumers Surplus is the total benefit to consumers minus their cost.

10. Example – gross value of water from new dam (excluding costs) Price New dam . . . . . . . . . . . . . . .. . . . . . . . . Demand for water Add’l Value Acre-feet of water

11. What about nonmarket goods? Suppose there were a market: Price Demand for air quality Air quality BUT, NO MARKET: price similar to MWTP

12. Environmental goods • Demand for env goods just as real as demand for market goods – just harder to measure • Demand is a measure of intensity of preferences

13. Costs are simpler • Some units are cheap to produce • “Marginal” units are most expensive • Costs consist of • Fixed costs • Marginal costs

14. Marginal costs plus fixed costs add up to total costs Last units pricey MC First units cheapest Quantity

15. Producer Surplus (PS) $ MC(x) PS(q) p x q

16. How are costs calculated? • Supply, S(x), is same thing as MC. • Producer Surplus is the total revenue to producers minus their cost.

17. Put it together P Total Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Q

18. Where is CS+PS maximized? $ Tension: Too little produced At too high price. CS low, PS high CS p Supply, S(x) PS Demand, D(x) x q1 q*

19. Suppose goods supplied in fixed amount Price Supply of land Consumer surplus Producer surplus (goes to land owners) Market Price Demand for land Land

20. Example: Add a dam Status quo water availability Price PS: Before: # and X After: CS: ?? ################## XXXXXXXXXXXX Q Water

21. Example: Add a dam Supply of water increases; price falls. What happens to PS? CS? Price PS: Before: # and X After: X and $ CS: ?? ################## XXXXXXXXXXXX $$$$$ Q Water

22. If captured all costs & benefits • Then we want to maximize CS + PS which would occur where Supply = Demand. • Challenge is to capture all costs and benefits to accurately measure MC & MB.

23. Costs come in different flavors:Private, external and social • In principle, need to capture all costs and benefits. • Social costs may exceed private costs. • Difference is the “external cost” – the monetized cost of the externality. $/gal MPC P0 Q0 Gallons Of Gasoline

24. Social vs. Private Costs • In principle, need to capture all costs and benefits. • Social costs may exceed private costs. • Difference is the “external cost” – the monetized cost of the externality. $/gal MPC P0 MEC Q0 Gallons Of Gasoline

25. Social vs. Private Costs • In principle, need to capture all costs and benefits. • Social costs may exceed private costs. • Difference is the “external cost” – the monetized cost of the externality. $/gal MSC P* MPC P0 MEC Q0 Q* Gallons Of Gasoline

26. First Theorem of Welfare Economics • In a competitive market • Surplus is maximized at a market equilibrium • Implications • Can rely on market if we are sure of competitive market

27. Implicit Assumptions: Distribution • Distributional consequences ignored • Compensation Principle

28. Implicit Assumptions: Income Price Y=$50,000 per year Y=$30,000 per year Restaurant meals Demand and thus surplus depend on income distribution Therefore: Change in income distribution will change results of CBA TO USE CBA, MUST BELIEVE INCOME DISTRIBUTION IS OK

29. Implicit Assumptions: Completeness • What happens with difficult to monetize benefits? • Eg, clear view of Santa Cruz Islands • Difficult to monetize benes often omitted • Results in bias against env. benes

30. Implicit Assumptions: Other • Moral and political dimensions omitted • Should we do a cost-benefit analysis on executing someone who has committed a crime? • Are there other issues when lives are at stake? • Are intergenerational issues adequately treated by CBA?

31. Ten Steps to doing and using a CBA • Decide whose benefits and costs count • Select the portfolio of alternative projects • Catalog potential physical impacts and determine how they are measured • Predict quantitative physical impacts over life of project • Monetize all impacts • Discount for time to find present values • Sum: add up all benefits and costs • Perform sensitivity analysis • Choose alternative with largest social benefits • Make policy recommendation, using CBA only as part of guidance