In order to conduct an economic CBA, you need to know:

1) cost of project inputs, and

2) the value of benefits

At first glance this may seem like a simple problem to solve:

1) total cost = number of input units x their purchase price, and

2) total benefits = units of output x their market selling price.

This approach is generally permissible for a private sector financial CBA, but not for a public sector economic CBA. The public sector economic CBA requires a broader definitions of costs and benefits that may differ in some instance from private financial CBA.

The costs of a project are related to the project inputs. Inputs are generally classified as: land, labor and capital.

The principle concept to keep in mind regarding input costs, is that, for CBA inputs must be priced at their social opportunity cost .

Does budgetary outlay ever equal social opportunity cost?

Boardman et al say, in most cases the answer is yes: budgetary outlay will equal opportunity cost (p. 67).

However, situations where divergence between budgetary outlay and opportunity cost can occur:

1) if the market for the input has inefficiencies

Boardman et al examine 3 situations:

1) There are no inefficiencies in the market for the input. They conclude:

3) There are inefficiencies (failures) in the input market.

Boardman et al explore 3 examples of inefficient market, but say there can be hundreds of real-world examples.

Summary conclusions regarding costing of inputs:

1) Be especially alert to situations where the input market may have inefficient markets.

2) Follow these two rules:

The valuation of project economic benefits requires some knowledge of welfare economics. The purpose of welfare economics is to measure changes (i.e., increase/decreases) in social welfare resulting from changes in economic conditions. Social welfare measures require an ability to measure changes in personal utility; i.e., changes in satisfaction that arise from changes in prices, and shifts in supply and demand schedules. In order to measure welfare impacts, we must look at:

1. Producers - the economic well-being of economic producers is measured by their net benefits (profits + fixed costs). This measure, the area under the price line and over the supply curve, has not been much disputed.

2. Consumers - measurement of the economic well-being of consumers, in contrast, has been fraught with academic controversy and difficulty. A brief history follows:

Hicks’ willingness-to-pay notion is formalized as compensating variation:

Explanation of compensating variation: Assume that an economic change (i.e., price change) does happen and it results in:

Thus, money has been the basis of the 2 measures of consumer utility because personal utility cannot be measured directly. We have no happiness meter. Thus, an observable alternative (i.e., money) was chosen.

Welfare economics has largely chosen as its correct measure of consumer preferences willingness-to-pay; in other words, Hicks’ compensating variation. Because it restores individuals to their 'pre-price-change' level of utility.

But still, consumers surplus, along with producers surplus, are frequently used in applied welfare economics. Thus, we will explore CS & PS.

[Read: in Boardman et al App. 3A,p. 94, for a graphical comparison of CV & CS.]

The aim of CBA & welfare economics is to measure the total impact of changes in price and demand resulting from government policy.

However, a measurement problem exists: an increase in Px will cause 2 types of economic losses:

The aim of welfare economics is to measure both effects.

Problem with consumers surplus: it measures only the substitution effect.

The area under a regular (i.e., Marshallian) D-curve measures the substitution effect.

In contrast, a Hicksian (conceptual) demand curve:

a) includes the substitution effect (i.e., direct change in Dx due to change in Px)

b) also, includes (i.e., compensates for) the income effect

Thus, the area under a Hicksian D-curve exactly measures compensating variation; i.e., the full amount that it would take to restore an individual to his/her original level of utility given a price change.

CV is larger than CS because it compensates for the income effect as well as the substitution effect.

Thus the area under the Hicksian D-curves (CV) seems to be the correct measure of economic welfare.

Problem with Hicksian D-curves: they cannot be statistically estimated because...we cannot adjust for the income effect of price changes and thus hold utility constant.

Many economists (e.g., Samuelson) once said CS was a meaningless measure. Then came Willig (1976) and his "Consumers Surplus Without Apology." He concluded: The Δ CS resulting from a price change, is usually such a small fraction of total Y, that the income effect is negligible (i.e., usually the value of CS is within 95% of the value of CV).

Hence, Consumers Surplus, rather than Compensating Variation, is frequently used without apology in CBA as a measure of consumer welfare.

This notion of the demand curve as a measure of willingness-to-pay is critical to the measurement of benefits for CBA.: Benefits are the sums of the maximum amounts people would be willing to pay in order to obtain outputs they view as desirable.

2. Measuring consumer gross and net benefits

How do we measure the benefit that an individual obtains from consumption?

But this person has to pay something to consume this good. Cost of consumption = P*cQ*a. What are the net benefits?

net benefits = the area bcP*; or the area over the price line and below the demand curve.

Important concept:

Consumer surplus is an important concept in CBA and welfare economics because changes in consumer surplus provide reasonably correct estimates of the impacts of the benefits of consumers from government policies.

Situation: Assume that the government institutes a policy (say a subsidy on consumption), that lowers the price of commodity x.

* P* falls to P1.

* consumption of x increases from x* to x1

Question: what happens to consumer welfare as measured by the change in consumers surplus?

Answer: consumer surplus increases by the amount equal to the area P*abP₁.

Computing the change in welfare:

a) as a trapezoid P1P*ab, or

b) as the difference in the area of the 2 triangles: cP1b - cP*a = P1P*ab

1. Supply curves

* axes, P & Q

* the supply curve represents the firm=s marginal variable cost of production

* the area under the supply curve is the calculus integral of MC, i.e., TVC.

2. Measuring producer costs and profits

* assume that a firm faces a price of P*

* they will sell quantity Q*

* their total revenue; TR = P* x Q*

* and, if TVC is the area under the supply curve abQ*

Important concept: Producers Surplus

3. An Example of Producer Welfare Impacts (Changes in Producers Surplus)

Situation: Assume for some reason that price of commodity increases:

* price P1 rises to P2.

* production of x increases from x1 to x2

Question: what happens to producer welfare as measured by the change in producers surplus?

Answer: producer surplus increases by the amount equal to the trapezoidal area P2P1ab.

Key: this sort of change in PS is taken to be the appropriate measure of the economic impacts of policy changes on producers.

Computing the change in welfare, 2 ways:

a) as a trapezoid P1P2ab

b) as the difference in the area of the 2 triangles: cP2b - cP1a = P1P2ab

Producers and consumers surplus are the generally accepted measures of economic welfare.

It is the changes in PS and CS that ideally we want to estimate as measures of economic benefits from public policies. Changes in PS and CS measure the full impact of policy changes.

However, producers surplus has been better accepted than CS as a measure of economic well-being. CS is used in practice as benefits measure, but not without challenge.

Despite the controversy, CS remains the welfare measure of choice. (Willig’s paper said no problem changes in income and hence utility due to price change are so small as not to be an issue.)

Question: why can’t we simply use PxQ rather than CS as a measure of welfare impacts?

Valuing Welfare Impacts: Shifts in Supply & Demand Curves

We are now ready to examine conceptually correct measures of increases or decreases in benefits resulting from through shifts in the S & D curves. These are examples of the sort of economic welfare changes that public policies cause.

Key point: Benefit changes come through shifts in the S & D curves which, in turn, changes the size of the welfare triangles.

Examples of impacts:

Question: what are the benefits to this angler of the project?

Answer: the increase in consumers surplus due to the shift in the WTP curve.

Question: what are the benefits to the rancher?

Answer: the increase in producers surplus due to a shift in his supply curve.

Welfare Impacts in Markets: A Project Potentially Affecting Both Consumers and Producers Market S & D curves - conceptually, are the horizontal summation of all individual S & D curves.

Example #3 - for graph see Loomis, p.134.

Question: what are the benefits to society (producers and consumers)?

Answer: The increase in CS + PS. Society as a whole benefits.

Distributional issues: Consumers gain, but producers fate is uncertain.

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