Assignment 5

Part I (10 Points each)

1.       What is the major criticism of the Hicks-Kaldor criterion for acceptance of a project?


2.       We’ve discussed the fact that although government has the power to requisition people’s labor, making the on-budget costs negligible.  However, the true social costs are not 0.  For people who are employed a common practice is to use their wage rate as a proxy for the opportunity cost of their time.  For those that do not participate in the market for paid work we need to develop shadow prices. Assume a project will take a homemaker, who takes care of two children under 5 years old, away from home (such as to be sequestered for a jury) for 7 days.  How much do you think you should use as a shadow price for this person’s time in your benefit cost analysis?  You can get some idea of the value of many different paid jobs from the bureau of labor statistics  In particular if you assume your project is in California you might look at data such as BRIEFLY explain your choices and give the total estimated cost.  Key considerations are usually how many hours at what rate(s).


3.       How should you choose an appropriate discount rate for your analysis?


4.       You know most people when asked feel their lives have an infinitely high value. However, you still need to make decisions such as how wide to make the highway. Based on people’s behavior how do we estimate how much they value 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. How would you include this information in your benefit cost analysis? (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’re already at full employment?)


7.       Suppose a proposed project has some risk so it’s exact costs are unknown, but we expect there is a 50% chance it will cost $100 million and a 50% chance it will cost $500 million. In including this cost data in your analysis does it matter if the costs will fall on millions of people or just 100 middle class people?  Briefly explain. (Hint: Be sure to think about why certainty equivalence estimates are sometimes used.)


8.        A proposal for a sports stadium points out that sports teams, owners and fans will not be the only beneficiaries of the stadium. Area restaurants, gas stations, souvenir vendors will also benefit and they in turn will buy more from local suppliers of other goods and services, who will in turn buy more goods and services locally too. What is the "Chain-Reaction Game" critique of this type of argument?


Part II (20 points)

1. 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?