Townley Chapter 7

1. Townley Chapter 7 Problems in Project Evaluation

2. This lecture discusses some of the practical problems involved in a cost benefit analysis. • This highlights some of the potential pitfalls as well as the errors that should be avoided when conducting a cost benefit analysis

3. Inflation • Always treat discount rate that is used in evaluation projects as “real” • Social discount rate is net of inflation • Nominal interest rate has two components a real rate of return and an adjustment for price level changes • In cost benefit analysis all benefits and costs are measured in real (constant) dollars and net present values are computed using a real discount rate

4. Starting Dates, Planning Horizons and Scrap Values • Example 1 : consider a dam, which can be started in any of the next 3 years, it will have same economic life regardless of when it is built. • No change in value of project • Example 2: Suppose population changes and there is a change in aggregate willingness to pay out that could change net present value; e.g., suppose as the population ages there are more preferences for health care and benefits for seniors • Example 3: Suppose technological change reduces costs associated with a project then this could affect present value

5. Termination date of project is not usually an issue but can be sometimes (for example, on text p. 146, a private sector firm would operate/collect tolls on a bridge for 35 years, after which it transfers control to the Federal government who would operate it for the rest of its economic life; the project has an economic life of 100 years, but the private sector firm might use a planning horizon of 40 years (5 years to build + 35 years it operates ) if not aligning termination date with economic life of project scrap values – determined by its worth in its next-best alternative use. • For a steel bridge, can use girders as scrap metal

6. Depreciation and Interest Charges • In evaluating a project only concerned with resource costs, not with how it’s financed. • Interest payments and transfers between borrowers and lenders and shouldn’t be part of the calculation. • Depreciation allowances are the same sort of issue, used for tax purposes.

7. Spillovers and Secondary Effects • Easiest to illustrate these with an example. • Suppose a multipurpose dam is built which will provide flood protection, irrigation, recreational water use. Other potential impacts might include: • Enhancing productivity of nearby agricultural land and increases farm profits. • Increase in agricultural production would lead to increases in profits to firms that supply farmers. • Increased recreational facilities might expand tourist industry in a region. • Altered flow of water might cause more downstream dredging to be used more frequently than otherwise for navigation • Altered flow of water will be conducive to fish breeding • Increases in demand for construction workers will raise wages of other workers

8. Which Impacts should count? • Only 1, 4, and 5 should be counted in a cost-benefit calculation. The rationale for this is discussed below. • Only impacts which result in changes to physical production should be counted. • Impacts that result in redistribution of income should be ignored.

9. Impacts to Count • Benefits • Direct impacts • (1) is an increase in farm output that is directly attributable to enhanced water supplies; it is a change in physical output should count (changes in profits or value of land induced by this shouldn’t) • Positive Technological Spillovers • 5) increases the productivity of downstream fishing industry and is an improvement in the real output of the economy. • Costs • Negative Technological Spillovers • 4) Dredging the river is a real resource cost to the economy

10. Impacts to Count • All of the impacts on the previous slide are direct effects • Only direct effects should be counted in a cost benefit analysis

11. Impacts That Should Not Be Counted • Secondary impacts that are purely redistributive, or are accounted for somewhere else or are offset in the analysis should be excluded, i.e., (2), (3), (6)

12. Multiplier Effects • Multiplier effects should not be included in a cost benefit analysis • Why? • Multiplier effects are basically like secondary effects except they are not specifically identified. • A multiplier is applied to the aggregate project expenditure to capture aggregate secondary effects • Almost all of the effects captured by the multiplier will be redistributive and not involve real resource costs. • As above only costs/benefits should be included in an evaluation