Chapter 3 




Evaluating 

Trade-Offs: Benefit–Cost
Analysis and Other
Decision-Making Metrics
 Chapter 3 Evaluating Trade-Offs: Benefit–Cost
Analysis and Other Decision-Making Metrics

• Introduction
• Normative Criteria for Decision Making
• Applying the Concepts
• Divergence of Social and Private Discount Rates
• Cost-Effective Analysis
• Impact Analysis

2 © 2012 Pearson Education, Inc. All rights reserved.

 Introduction

• This chapter illustrates the use of several

decision-making metrics that can assist us in
evaluating options.
• Normative analysis can be useful in public policy
in several different situations.
– Desirability of a proposed new pollution control
regulation
– Proposal to preserve an area currently scheduled for
development
– Whether an already-implemented program has worked
out in practice

3 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Normative choices can arise in two different contexts:

– Choosing among predefined options
– Finding an optimal option among all possible choices

4 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Evaluating Predefined Options: Benefit–Cost Analysis

– Let B be the benefits from a proposed action and C be the
costs. Our decision rule would then be:
• If B > C, support the action
• Mathematically equivalent, if B/C > 1 (assuming B and C are
positive)
• Otherwise, oppose the action
• In economics, benefits and costs follow an
anthropocentric system of measurement.
– Only considers ecosystem services when they directly affect
humans

5 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Total benefits are the value of total willingness to pay,

which is the area under the market demand curve from
the origin to the allocation of interest.

• Opportunity cost is the net benefit lost when specific

environmental services are forgone in the conversion to
the new use.
– Costs of environmental services are expressed as opportunity
costs to reflect potentially incompatible alternative uses.

• Total costs is the sum of marginal opportunity costs,

which is the area under the marginal cost curve.
6 © 2012 Pearson Education, Inc. All rights reserved.
EXAMPLE 3.1

Have you
consumed palm
oil lately?

How does the

food you eat
contribute to
climate
change?
7 © 2012 Pearson Education, Inc. All rights reserved.
 Normative Criteria for Decision Making

• Finding an optimal option also requires contrasting

benefits and costs.
• This process sets up the framework for
addressing environmental problems via three key
steps:
– Identify optimal outcome
– Identify potential behavioral sources causing optimal
outcome to deviate from actual outcome
– Design appropriate policy solutions
– Important examples: fisheries, solid waste

8 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Consider the net benefits from preserving a

predefined stretch of river using Figure 3.1.
• Let’s suppose that we are considering preserving
a four-mile stretch of river and that the benefits
and costs of that action are reflected in Figure 3.1.
• Should that stretch be preserved?
• Is there an optimal stretch that should be
preserved?

9 © 2012 Pearson Education, Inc. All rights reserved.

 FIGURE 3.1 The Derivation of Net Benefits

10 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Relating Optimality to Efficiency

– An allocation of resources is said to satisfy the static

efficiency criterion if the economic surplus from the use
of those resources is maximized by that allocation.

11 © 2012 Pearson Education, Inc. All rights reserved.

 Relating Optimality to Efficiency

• Preserving 5 miles is (Pareto) optimal and

efficient.
– Pareto optimality:
• Allocations are said to be Pareto optimal if no other feasible
allocation could benefit at least one person without any
deleterious effects on some other person.
• One implication is the First (or Efficiency)
Equimarginal Principle
– First Equimarginal Principle (the “Efficiency
Equimarginal Principle”):
• Net benefits are maximized when the marginal benefits from an
allocation equal the marginal costs.

12 © 2012 Pearson Education, Inc. All rights reserved.

 Exercise

• MB = 314 – 3.2X
• MC = 50 + 3.4X
• Graph MB and MC and find optimal X.

13 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Choices must account for the fact that benefits

and costs occur at different points in time.
• Comparing Benefits and Costs Across Time
– Present Value of a one-time net benefit (Bn) received n years
from now is

Where r is the interest rate

14 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• The present value of a stream of net benefit {B0,…, Bn}

received over a period of n years is

Where r is the interest rate

15 © 2012 Pearson Education, Inc. All rights reserved.

 TABLE 3.1 Demonstrating Present Value
Calculations

16 © 2012 Pearson Education, Inc. All rights reserved.

 TABLE 3.2 Interpreting Present Value Calculations

If you put $29,205.92 in a savings account earning 6%

interest and wrote yourself checks, respectively, for $3,000,
$5,000, $6,000, $10,000, and $12,000 on the last day of
each of the next 5 years, your last payment would restore
your balance to $0.

17 © 2012 Pearson Education, Inc. All rights reserved.

 Normative Criteria for Decision Making

• Benefits and costs can occur at different points in

time.
• Finding an optimal allocation requires the use of
dynamic efficiency
– An allocation of resources across n time periods
satisfies the dynamic efficiency criterion if it maximizes
the present value of net benefits that could be received
from all the possible ways of allocating those resources
over the n periods.

18 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Pollution Control
– Benefits include, not limited to, reduced death rate,
lower incidences of chronic bronchitis and other
diseases, better visibility, improved agricultural
productivity and etc.
– Costs include
• 1) higher costs passed to consumers such as installing,
operating and maintaining pollution control equipment
• 2) administrative costs such as designing, implementing,
monitoring relevant policies

19 © 2012 Pearson Education, Inc. All rights reserved.

EXAMPLE
3.2

20 © 2012 Pearson Education, Inc. All rights reserved.

 TABLE 3.3 Summary Comparison of Benefits and Costs from
the Clean Air Act-1990–2020 (Estimates in Million 2006$)

21 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Issues in Benefit Estimation

– Performing benefit-cost analyses encounters decision
points requiring judgment
• Primary Versus Secondary Effects
– Considering both primary and secondary consequences while
implementing environmental projects
– Cleaning a lake increases recreational uses of the lake (primary),
which causes a ripple effect on services provided to the increased
number of users of the lake (secondary)
– Should be counted if it involves an increase in demand for
previously unused resources rather than a rearrangement of
productively employed resources

22 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Issues in Benefit Estimation (contd.)

– Accounting Stance
• Who benefits? The accounting stance refers to the geographic
scale at which the benefits are measured.
• Are benefits measured locally or nationally?
– Aggregation
• Estimates of benefits and costs must be aggregated in order to
derive total benefits and costs
• How many people and how these people benefit might impact
the aggregation
• Households living closer to a project might get higher per
household benefits than those living farther

23 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Issues in Benefit Estimation (contd.)

– With and Without Principle
• The “with and without” principle states that only those benefits
that would result from the project should be counted, ignoring
those that would have accrued anyway.

– Tangible Versus Intangible Benefits

• Tangible benefits can reasonably be assigned a monetary
value.
• Intangible benefits cannot be assigned a monetary value.

24 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Estimating costs is generally easier than estimating

benefits, but it is not easy, especially due to the fact that
benefit-cost analysis is forward-looking (i.e. what a
strategy will cost).
• There are two approaches to cost estimation
– The Survey Approach
• Involves asking polluters about their control costs
• Incentive for producers to overinflate estimates
– The Engineering Approach
• Using engineering information to estimate the technologies available and
the costs of purchasing and using those technologies.
• Estimates may not approximate cost of any particular firm
– The Combined Approach
• Combining both survey and engineering approaches
• Example: Policy designed to conserve energy by forcing people to carpool
• Opportunity cost (OC) is generally appropriate for this analysis (studies
show that OC of travel time does not exceed half the wage rate)

25 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Environmental policies are often based on imprecise

estimates
– Extrapolation from (exposure to) high doses to small doses and
from animal studies to humans
• The Treatment of Risk
– The effect of climate change on sea-level rise and species losses
is unequivocal, but the timing and extent of these problems are
uncertain
– Dealing with this uncertainty involves (a) identifying and quantifying
risks (positive) and (b) deciding how much risk is acceptable
(normative)
– In deciding among various potential policies, a dominant policy is
one which confers higher net benefits in every outcome.

26 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• The Treatment of Risk

– In the absence of dominant solutions, other options exist that rely
on probabilities.
– The expected present value of net benefits is the sum over the
possible outcomes of the present value of net benefits of that
outcome (i) weighted by its probability of occurrence. The policy (j)
selected should be the one with the highest expected present
value of net benefits.
– (3.1)

27 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Suppose we have 3 possible outcomes with PVNB

values of $4m, $1m, and $-10m, with
corresponding probabilities 0.85, 0.10, and 0.05.
Assuming risk neutrality should this policy be
pursued?

EPVNB = 0.85x4m + 0.1x1m + 0.05x-10m

= 3.4m + 100k - 500k
= $3m
Pursue but would you ignore the magnitude of the
value of the 3rd outcome?

28 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• The Treatment of Risk

– EPVNB approach is appropriate if society is risk-
neutral
– If you were given a choice between a guaranteed $50
or a 50% chance at winning $100, which would you
choose?
– Risk-neutral? Risk-averse? Risk-loving?
– The evaluation of irreversible decisions requires extra
caution.

29 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• Many agencies are required to consider the

distributional impacts of benefits and costs
– Economic impact analysis
• a broad characterization of who gains and who loses from a
given policy
– An equity analysis
• Impacts on disadvantaged groups or sub-populations

30 © 2012 Pearson Education, Inc. All rights reserved.

 Applying the Concepts

• The discount rate can be defined as the social opportunity

cost of capital and consists of two components:
– Riskless cost of capital
– Risk premium
• Choosing the Discount Rate
– The appropriate rate to use will depend on the nature and
expected lifetime of the project, who is doing the financing and the
level of risk
– Suppose a project has an immediate cost of $4m, but would yield
$5.5m in benefits in 5 years.
– Is this project a good idea if r = 0.05? r = 0.10?
– Economists typically use long-term government bond rates
(currently around 3%) plus a risk premium
– Required discount rate in 1970s was 10%, reduced in 1992 to 7%,
and currently ranges between 3% and 7%

31 © 2012 Pearson Education, Inc. All rights reserved.

 EXAMPLE
3.4

32 © 2012 Pearson Education, Inc. All rights reserved.

 EXAMPLE 3.4
(cont.)

33 © 2012 Pearson Education, Inc. All rights reserved.

 Divergence of Social and Private
Discount Rates

• Social and private discount rates often differ due to

differences in risk premium and time preferences.
– Risk premium
• It is the amount required to compensate capital owners for
potential differences between expected and actual returns.
• Risk imposed by potential government takeover would result in a
high-risk premium for firms (and low risk premium for society).
– Time preference
• Relative valuation placed on outcome occurring at an early date
compared to a later date
• It affects both private and social discount rates, as well as across
countries.

34 © 2012 Pearson Education, Inc. All rights reserved.

 Divergence of Social and Private

Discount Rates

• A Critical Appraisal
– Concerns exist on the reliability of benefit/cost analysis.
– Variation between ex ante and ex post estimates is
possible
– This does not imply that benefit-cost analysis is fatally
flawed. Rather, it highlights the importance of
calculating accurate values and incorporating all
potential benefits and costs.

35 © 2012 Pearson Education, Inc. All rights reserved.

 Cost-Effectiveness Analysis

• In the absence of means to quantify benefits and costs,

one can resort to expert opinion (e.g. public health,
ecology) or to cost-effectiveness analysis.
– An optimization procedure that helps find the lowest-cost means of
accomplishing an objective.
– Does not necessarily yield efficient allocation because the
predetermined objective may not be efficient.
– All efficient policies are cost-effective but not all cost-effective
policies are efficient.
• Cost-effectiveness has an important implication:
– Second Equimarginal Principle (the Cost-Effectiveness
Equimarginal Principle):
• The least-cost means of achieving an environmental target will have been
achieved when the marginal costs of all possible means of achievement
are equal.

36 © 2012 Pearson Education, Inc. All rights reserved.

 Cost-Effectiveness Analysis

• Suppose we have an allocation of control

responsibility where marginal control costs are
much higher for one set of techniques than for
another.
• This is not cost effective since we could reduce
emissions at a lower cost.
• The allocation must be the one that minimizes
costs.

37 © 2012 Pearson Education, Inc. All rights reserved.

 Cost-Effectiveness Analysis (Exercise)

• Assume that q1, q2, and q3 are the amounts of

Asian carp to be removed such that they add up to
10.
1. Suppose that MC1=10q1, MC2=5q2, and
MC3=2.5q3 , how much of each method would lead
to a cost-effective removal?
2. Why isn’t an exclusive use of method 3 cost
effective?
3. Answer 1 assuming MC1=$10, MC2=$5, and
MC3=$2.5
38 © 2012 Pearson Education, Inc. All rights reserved.
 Cost-Effectiveness Analysis (Exercise)

• MC1=10q1, MC2=5q2, and MC3=2.5q3

1. MC1=MC2=MC3 and q1+q2+q3=10

• 10q1=5q2 and 5q2=2.5q3
• 2q1=q2 ➔ 10q1=2.5q3 or 4q1=q3
• After substitution into first additive equation, we get
q1+2q1+4q1=10 ➔ q1=10/7
• This means that q2=20/7 and q3=40/7
39 © 2012 Pearson Education, Inc. All rights reserved.
 Cost-Effectiveness Analysis (Exercise)

• MC1=10q1, MC2=5q2, and MC3=2.5q3

2. Assuming no fixed costs, using only method 3

would yield, TC3=100x$1.25=$125 vs.
TC1+TC2+TC3=5x(10/7)2+2.5x(20/7)2+1.25x(40/7)2
=$71.43

40 © 2012 Pearson Education, Inc. All rights reserved.

 Cost-Effectiveness Analysis (Exercise)

• MC1=$10, MC2=$5, and MC3=$2.5

3. Only method 3 would be used for which TC3=$25
vs. TC1=$100 and TC2=$50

• Equating MC values would be nonsensical.

41 © 2012 Pearson Education, Inc. All rights reserved.

 Impact Analysis

• In the absence of information needed to perform

benefit-cost and cost-effectiveness analyses, we can
resort to impact analysis, which attempts to quantify
the consequences of various actions.
• Impact analysis does not necessarily attempt to
optimize. It places a large amount of relatively
undigested information at the disposal of the
policymaker.
• Until recently, there has been a tendency to rely on
environmental impact statements that are virtually
impossible to comprehend in their entirety
– Today, environmental consequences are quantified
whenever possible to avoid hidden value judgments.

42 © 2012 Pearson Education, Inc. All rights reserved.

 End of Chapter

43 © 2012 Pearson Education, Inc. All rights reserved.