ECON4540 Short Assignment 3 DUE: Thursday March 22, 2007
Benefit Cost Analysis
Cost-Benefit Analysis is a practical and potentially powerful analytical tool for helping public policy administrators make decisions. However, many aspects of this type of analysis are difficult and potentially subject to error. Hopefully being aware of some of these potential problems will help you improve your decision-making. With this in mind please briefly explain your responses to the following:
Part I (10 points each)
1. What is the major criticism of the Hicks-Kaldor criterion for acceptance of a project?
2. Why might you need to use a shadow price in benefit cost analysis? Give an example.
3. For the discount rate:
a) Why might you use the before tax rate of return on private investment projects?
b) Why might you use the after tax rate of return on private investments?
c) Why might you use a weighted average of these rates?
4. How do we estimate the value of a "statistical life"?
5. Enhancing the local park will benefit the 1,000 residents of a particular area by about $300 every year. Property values are expected to increase in that area by about $10,000,000. Based on this information alone what is the estimated benefit of the park enhancement? (Hint: Beware of double counting.)
6. The multiplier concept is a well-accepted principle based on Keynesian economics, so why is it also considered a common potential pitfall of benefit cost analysis? (Hint: What if we are already at full employment?)
Part II (40 points, 8 points for each part)
The city you work for is considering installing a pond with a fountain that will add beauty to the community and also reduce the probability of flood waters getting into local residences and businesses. The pond with fountain will cost $10 million to install and $10,000 a year for maintenance. Fortunately, with proper maintenance the pond and fountain are expected to last forever. For each of the 1,000 large businesses in the area the expected value of the flood reductions will be approximately $25 per year. About 100,000 residents will each benefit from the beauty and reduced likelihood of flooding by approximately $10 each per year. The interest rate is 10%.
A) What is the approximate present value of the project’s costs? What is the approximate present value of the project’s benefits? What is the approximate net present value of the project based on the data you have? Is the project admissible?
B) Suppose the maintenance cost estimates and benefit estimates were in current dollars and the interest rate of 10% was in nominal terms. Your analysis suggests expected inflation is 6%. How would your estimates of the approximate present value of the project’s costs, benefits, and net present value change?
C) If the pond and fountain would only last for three years even with the maintenance, what would be the approximate present value of the project’s costs?
D) There is another project that would provide a net benefit of $20 each to a different group of 200,000 people immediately, but is unlikely to be provided in the absence of government intervention. Unfortunately, due to insufficient budget and political will you can only do one of the projects. Comparing the project described in “A)” and this project, in the absence of any other information about the people involved, which project should be preferred and why?
E) What "distributional weight" would make you indifferent between the original project in part “A)” and this new project?