Expenditure Evaluation:

Principles
Cost-Benefit Analysis
BITS Pilani
Pilani Campus
 Expenditure Evaluation: Principles

Learning outcome
Expenditure Evaluation:

Know- The concept of social cost-benefit analysis

Principles

Learn- Various decision rules for project evaluation, measurement of costs and
discounting technique.
 Cost-Benefit Analysis: Definition

• For a government making decisions about how much of a public good to

provide, however, these theoretical concepts must be translated into hard
numbers.
Expenditure Evaluation:

• To accomplish this translation, the government uses cost-benefit analysis to

compare the costs and benefits of public goods projects to decide if they
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should be undertaken.
• In principle, cost-benefit analyses are accounting exercises, a way of adding
up the benefits and costs of a project and then comparing them.
• Cost-benefit analysis: The comparison of costs and benefits of public goods
projects to decide if they should be undertaken.

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 Cost-Benefit Analysis: Definition

• Cost-benefit analysis represents a practical technique for

determining the relative merits of alternative government projects
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over time.
• Use of cost-benefit analysis can contribute to efficiency by making
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sure that new projects for which marginal social cost exceeds
marginal social benefit are not considered for approval.
• Cost-benefit analysis, if done well, provides essential information to
be used by government authorities and citizens in making choices
among alternative government projects.

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 A. Decision Rules

• The project evaluation is a complex question with regard to,

• The most efficient use of scarce resources.
• Determining the appropriate size of the budget.
Expenditure Evaluation:

• Further complications arise when projects are not divisible but in lumpy
form.
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• In taking a first look at these various situations, we assume that benefits

and costs are known.
 Divisible Projects- Budget Size Fixed

• We begin with a setting in which all projects are finely divisible, i.e., may be
increased or decreased by small amounts.
Divisible Projects- Budget Size Fixed
Expenditure Evaluation:

• Suppose that the budget director is to advise the legislature, how best to
allocate $1 billion, between two projects, X and Y.
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The objective of evaluation:

• To derive the greatest total benefit from the budget, i.e., to maximize
the sum of net benefits (∑NB) or
• The excess of total benefits over costs ∑(B - C).
With ∑ C given by the size of the budget, the task is simply to maximize ∑B
• The opportunity cost of spending a dollar on X is the loss of benefits due to
not spending it on Y.
 B. Divisible Projects cont..
• Total expenditures should therefore be
distributed between X and Y so that the benefit
derived from spending the last dollar on X will
equate that derived from spending the last dollar
on Y.
Expenditure Evaluation:

• Mx schedule = marginal benefit derived from

spending successive dollars on X
• MY schedules =the marginal benefit derived
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from Y.
• OA is spent on X &
• OB is spent on Y ,
• AC = BD, &
• OA + OB = total permissible outlays.
• By equating the benefits derived from the
marginal dollars on X and Y, we
maximize the sum of total benefits derived from
X (as measured by the area OFCA) and from Y
(as measured by the area OGDB).
 Budget Size Variable
• Determining the size of the
budget between private and
public use is crucial issue.
• In the fixed budget, the
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opportunity cost of pursuing one

public project consists of the
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benefit lost by not pursuing

another public project.
• But in the open budget the
opportunity cost of public
projects is the lost benefits from
private projects which are
forgone for public use.
 Budget Size Variable
• The task now is to maximize '(B - C), including
benefits and costs of both public and private
projects.
• Public projects are expanded, and private
projects are restricted until the benefit from the
Expenditure Evaluation:

last dollar spent in either sector is the same.

• Interpreting X as "the" public project and Y as
"the" private project, we find that the solution
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of Figure 9-1 again applies.

• Given perfect markets, the Marginal Benefit
from spending $1 in the private sector or BD
equals $1, and the same must hold on the
public side.
• Thus, public expenditures are extended until
the last dollar spent yields a dollar's worth of
benefits.
 Lumpy Projects cont..
Expenditure Evaluation:

Budget Size Fixed

Principles

Suppose Budget size= $700,000 to spend on alternative highway projects,

• We may choose among projects I to VII.
• The benefit valuation gives the total benefit for each project.
Lumpy Projects
Expenditure Evaluation:
Principles
 Lumpy Projects cont..
Let rank projects in line with their benefit-
cost ratio and move down the line until
inclusion of a further project would exceed
the budget constraint.
Rule 1: Rank projects in line with their
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benefit-cost ratio, keeping in view of

budget constraint.
•We choose projects IV, I, V, and III
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• Total cost is $630,000,

•benefits are 1,049,000,
•net benefits equal $419,000, and
•$70,000 of the available budget is
left.
 Lumpy Projects cont..
Rule 2: Take mix of projects
which yields the largest net benefit.
By trying various combinations,
we find that net benefits are
Expenditure Evaluation:

maximized by choosing IV, I, V,

and II.
Under Rule 2:
Principles

• Here total cost is $695,000,

• benefits are $1,120,000, and
• Net benefits equal $425,000.
• An amount of $50,000 remains
unspent.
 Lumpy Projects cont..
Rule 3: Minimize the amount
leftover, subject only to the
constraint that projects must have
a benefit-cost ratio in excess of 1.
Expenditure Evaluation:

• In this case, the choice is for I,

II, IV, and VI,
• with a cost of $700,000,
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• benefits of $1 ,030,000, & net

benefits of $313,000
• Nothing is left over.
 Lumpy Projects cont..
Comparing the merits of the three rules :
• We find it is evident that both 1 and 2 are superior to 3, since both buy more benefits at a
smaller cost.
• The choice between 1 and 2 is more difficult.
Expenditure Evaluation:

• Rule 1 is reasonable, because it calls for selection of projects which yield the highest return
per dollar of the constrained resource, the available budget
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• Rule 2 offends this principle by choosing project II over III.

• Yet by moving from rule 1 to rule 2, additional benefits of $71 ,000 are bought at an
additional cost of $65,000. Net benefits rise by $6,000, and
• Even though the marginal benefit-cost ratio is only 1.09, this may still be considered a
paying proposition.
• Rule 2 will clearly be preferred if we interpret the fixed budget are rigidly so as to consider
turned-back funds as worthless.
• Taking a broader view and allowing for a possible transfer to another budget, we note that
rule 2 will be superior only if other budgets cannot offer projects with a benefit-cost ratio
above 1.09.
 Summary
The appropriate decision rules for selection of projects differ, depending on
whether the budget is variable or fixed and whether the projects are divisible or not.
The following rules apply:
•Fixed budget, divisible projects: Distribute funds among projects so that
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marginal benefits are equal.

•Variable budget, divisible projects: Extend all projects until the marginal
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benefits equal 1, i.e., the net benefit becomes zero

•Fixed budget, lumpy projects: Choose the project mix that maximizes net
benefits, subject to qualifications noted above.
•Variable budget, lumpy projects: Choose all projects with positive net benefits.
In practice, the combination of lumpy projects and limited budgets is the most
typical setting, so that rule 3 should apply.
To establish the proper rank order, all possible projects should be considered and
compared. More likely than not, comparison will be more limited and projects will
be chosen simply because the B/C ratio is above 1.
 B. Fundamentals of Project Evaluation
Expenditure Evaluation:

The problem of project evaluation is linked closely

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to that of consumer surplus and the change therein.

 CONSUMER SURPLUS
and Market Equilibrium

A buyer’s maximum is called her willingness to pay, and it

Demand, Supply,

measures how much that buyer values the good.

 B. Fundamentals of Project Evaluation
• The problem of project evaluation is linked closely to
that of consumer surplus and the change therein.
Consumer Surplus
• Suppose that the demand curve for a given product,
Expenditure Evaluation:

say automobiles, is given by AB.

• The demand curve shows the maximum amounts
which consumers are willing to pay for successive
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automobiles.
• Thus, they would be willing to pay a price of P1 for
the first car, of P2 for the second, and so forth.
The utility of the first car would be measured by the
block OP1NQ 1 , &
• The second car by the block Q 1RVQ2 , and so forth.
• If the blocks are drawn sufficiently small and are
added up, they sum to the area under the demand
curve measuring the dollar value of the total utility or
benefit derived from various levels of consumption as
indicated by the consumer's willingness to pay.
 B. Fundamentals of Project Evaluation cont..
• Consumers will extend purchases to the point
where the marginal value of the
last unit equals marginal cost or the price which
they must pay.
• If the product were available at a zero price, they
Expenditure Evaluation:

would consume OB.

• The benefit would equal OAB, and with price
equal to zero, this entire area would measure their
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"consumer surplus."
• If the price were to equal OC, OD units would be
bought and total benefits would equal OAED.
• With cost equal to OCED, the consumer surplus
would be OAED minus OCED, or CAE.
• This surplus, to repeat, is the excess of what
consumers would be willing to pay for D units
over what they must pay to obtain them.
 Net Benefit of Projects
We can now apply the concept of consumer surplus to
measuring the benefit derived from a public project.
The demand for the services of the project is again given by
AB, and the project is introduced with a unit cost of OC.
Expenditure Evaluation:

Returning to the tabulation of benefits and costs in Table 9-1,

suppose that we have an indivisible project of size OF.
Total benefits as recorded in the table correspond to area
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OAHF, with AB reflecting the vertically added "demand curves"

of the consumers.
Total costs correspond to area OCKF, and
net benefits, equal to consumer surplus, correspond to CAHK.
Project choice in the fixed budget maximizes the sum of these
consumer surplus areas.
For divisible projects, provision should be carried to OD, the
point where marginal evaluation equals marginal cost, i.e., the
marginal gain in consumer surplus becomes zero and total
surplus, equal to CAE, is maximized.
Expenditure Evaluation:

C. Types of Benefits and Costs

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 C. Types of Benefits and Costs

• In identifying various types of benefits and costs, these major categories may be
distinguished:
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• Benefits and costs may be real or pecuniary

• Real benefits and costs may be:

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1)Direct or indirect
2)Tangible or intangible
3)Final or intermediate
4)Inside or outside
Expenditure Evaluation:
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 Real versus Pecuniary
Real benefits :
• Real benefits are the benefits derived by the final consumers of the public project.
• They reflect an addition to the community's welfare, to be balanced against the
real cost of resource withdrawal from other uses.
Expenditure Evaluation:

Pecuniary benefits:
• Pecuniary benefits arises because of changes in relative prices which occur as the
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economy adjusts itself to the provision of the public service and the pattern of
resource demand changes.
• A pecuniary externality occurs when the actions of an economic agent cause an
increase or decrease in market prices.
• As a result, gains or losses accrue to some individuals but are offset by losses or
gains which are experienced by others.
• They do not reflect net gains or costs to society as a whole
 Cost-Benefit Analysis: Definition

• Cost-benefit analysis: The comparison of costs and benefits of public goods projects
to decide if they should be undertaken.
• Cost-benefit analysis is widely used to evaluate potential public programs and projects.
Expenditure Evaluation:

• Cost-benefit analysis represents a practical technique for determining the relative

merits of alternative government projects over time.
Principles

• Use of cost-benefit analysis can contribute to efficiency by making sure that new
projects for which marginal social cost exceeds marginal social benefit are not
considered for approval.
• Cost-benefit analysis, if done well, provides essential information to be used by
government authorities and citizens in making choices among alternative government
projects.

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 Cost-Benefit Analysis: Definition
• Cost-effectiveness analysis is a technique for determining the minimum-cost
combination of government programs to achieve a given objective.
• The first step in implementing a cost-effectiveness analysis would be to choose an
objective that alternative government programs can achieve.
Expenditure Evaluation:

• For example, suppose we want to achieve the objective of reducing deaths from
disease or accidents by 5,000 per year on average over the next 10 years. We can
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choose from many programs, all of which help reduce deaths.

• We can use tax funds to provide more information about the risks of smoking,
drinking alcohol, or having a diet high in fat.
• We also could require that all buildings be equipped with smoke detectors and
provide them for free in low-income neighborhoods where the quality of housing is
so poor that the incidence of deaths as a result of residential fires is high.
 Measuring the Costs of Public Projects: The Example
Quantity Price/Value Total
Costs Asphalt 1 million bags
Labor 1 million hours
Maintenance $10 million/year
First-year cost:
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Total cost over time:

Benefits
Driving time saved 500,000 hours/year
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Lives saved 5 lives/year

First-year benefit:
Total benefit over time:
Benefit over time minus
cost over time:

• Suppose that you are working for your state government on health and human services issues, you are running the highway
department.
• Your state turnpike is in poor shape, with large potholes and crumbling shoulders that slow down traffic and pose an
accident risk.
• You have been charged by the governor with the task of considering whether the state should invest in repairing this road.
• What are the costs and benefits of the project? In the first year? Over time?
Expenditure Evaluation: Measuring Current Costs

Measuring Current Costs

Principles

The first goal of the cost-benefit analysis is to measure the cost of this public good.

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 Measuring Current Costs

How to measure costs?

Expenditure Evaluation:

• Cash flow accounting: An accounting method that calculates costs solely by

adding up what the government pays for inputs to a project and calculates benefits
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solely by adding up income or government revenues generated by the project.

• Opportunity cost: The social marginal cost of any resource is the value of that
resource in its next best use.
• Measuring opportunity costs faces several challenges.

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 Imperfect Markets

Economic costs are only those costs associated with diverting the resource from its
next best use.
Expenditure Evaluation:

• Rents: Payments to resource deliverers that exceed those necessary to employ

the resource.
• If labor is efficiently employed, then wages are a social cost.
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• If some workers are unemployed, then we value their time at the value of
leisure, not the wage.
• The value of their leisure is likely to be above the equilibrium wage for most
workers, but there are also some instances where it would be below the
equilibrium wages.

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 CHAPTER 8: COST-BENEFIT ANALYSIS

Imperfect Markets: Measuring the Cost of Labor

• Suppose that the minimum wage of construction workers is $20 per hour.
• The market wage is $10 per hour for all other workers.
• The opportunity cost of this project is the next best alternative for the
construction workers who join the project, which is the $10 they could
have earned elsewhere. The cost is:
•$10/hour × (1 million hours) = $10 million
• Of the $20 million actually paid, $10 million is transfer of rents from
government to workers and is not counted as a true economic cost of the
project.
Expenditure Evaluation: Measuring Future Costs

How to measure future benefits against current costs?

• Use presented discounted value, discounting at the social discount rate.
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• Present discounted value (PDV): A dollar next year is worth 1 + r times less
than a dollar now because the dollar could earn r% interest if invested.
• Social discount rate: The appropriate value of r to use in computing PDV for
social investments.

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 The Example: Filling in Costs
Quantity Price/Value Total
Costs Asphalt 1 million bags $100/bag $100 million
Labor 1 million hours $10/hour $10 million
Expenditure Evaluation:

Maintenance $10 million/year 7% discount rate $143 million

First-year cost: $110 million
Total cost over time: $253 million
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Benefits Driving time saved 500,000 hours/year

Lives saved 5 lives/year
First-year benefit:
Total benefit over time:
Benefit over time minus
cost over time:

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 Measuring the Benefits of Public Projects:

Measuring the Benefits of Public Projects

Valuing Driving Time Saved-The first benefit associated with this project is that both producers and
consumers will save travel time.
Using Market-Based Measures to Value Time: Wages
Expenditure Evaluation:

Using Revealed Preference to Value Time

Valuing Saved lives-Returning to our highway example, the other major benefit of improving the turnpike is that
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repairing the road will improve safety and save lives. Valuing human lives is the single most difficult issue in cost-
benefit analysis.
Using Wages to Value a life
Revealed Preference
Government-Revealed Preference

Discounting Future Benefits

Cost-Effectiveness Analysis

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 CHAPTER 8: COST-BENEFIT ANALYSIS

Measuring the Benefits of Public Projects:

Using Market-Based Measures to Value Time: Wages
• Suppose we can show that the time that individuals save from driving
faster is spent at work.
• Then we could value their time saved at their wage.
• This theoretical proposition runs into some problems in practice:
o Individuals can’t freely trade off leisure and hours of work; jobs may come with
hour restrictions.
o There may be nonmonetary aspects of the job.
 Valuing Driving Time Saved: Using Survey-Based
Measures to Value Time: Contingent Valuation
Contingent Valuation
The second approach to valuing a life uses contingent valuation. One way to do this is to ask
individuals what their lives are worth.
Expenditure Evaluation:

An alternative approach to measure benefits is contingent valuation.

• Contingent valuation: Asking individuals to value an option that they are not now
choosing, that they do not have the opportunity to choose, or that is not yet available to
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them.
• This approach relies on answers to hypothetical questions.
• Straightforward, inexpensive to apply.
• Contingent valuation refers to the method of valuation used in cost-benefit analysis and
environmental accounting. It is conditional (contingent) on the construction of hypothetical
markets, reflected in expressions of the willingness to pay for potential environmental
benefits or for the avoidance of their loss.
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 APPLICATION: The Problems of Contingent Valuation

Critics point out that contingent valuations are very sensitive to the survey.
Expenditure Evaluation:

• Isolation of issues matters: Respondents who are asked only one question tend
to give higher answers to a specific question than respondents who are asked
multiple questions.
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• Order of issues matters: Asking about an issue first or second changes its
reported value.
• The “embedding effect” matters: Asking about different location sites or
variances in the scope of the project does not affect answers.

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 Valuing Driving Time Saved:
Expenditure Evaluation: Using Revealed Preference to Value Time

An alternative to contingent valuation is to use revealed preference.

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• Revealed preference: Letting the actions of individuals reveal their valuation.

• Market prices potentially reveal preference: If people are willing to pay P for
something, then it is worth at least P to them.

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 CHAPTER 8: COST-BENEFIT ANALYSIS

EVIDENCE: House Prices and Commuting Time

•How much do commuters value reductions in commuting time?
• Price differences between houses close and far from downtown
might reflect the value of commuting time.
• But treatments and controls may differ, leading to bias.
o Everett is only 4 miles from downtown Boston, while Lexington is 11 miles
away.
o Average home price in Everett: $353,000.
o Average home price in Lexington: $778,000.
 CHAPTER 8: COST-BENEFIT ANALYSIS

EVIDENCE: House Prices and Commuting Time:

Solving the Problem of Bias
• One solution is to control for house characteristics.
o Lot size, number of bedrooms, square footage.
o But some features are hard to observe, such as granite countertops.
• In order to provide a more convincing estimate of the value of time
savings, a quasi-experimental approach can be used.
• Deacon and Sonstelie (1985) looked at how much people save by
standing in line to buy price-controlled gasoline—about $22.70 per
hour in 2020 dollars.
• This is very close to the average hourly wage in US.
 Revealed Preference Approaches to Valuing Lives:
Compensating Differentials

• We can value life by estimating how much individuals are willing to pay
Expenditure Evaluation:

for something that reduces their odds of dying.

• The extra safety is called a compensating differential because it
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compensates workers for lower wages.

• Compensating differentials: Additional (or reduced) wage payments to
workers to compensate them for the negative (or positive) amenities of a
job, such as increased risk of mortality (or a nicer office).
• This approach suggests value of life of $9.6 million.

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 Valuing Driving Time Saved:
Using Revealed Preference to Value Time

Revealed Preference
As with valuing time savings, the method preferred by economists for valuing
Expenditure Evaluation:

life is to use revealed preferences.

For example, we can value life by estimating how much individuals are willing
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to pay for something that reduces their odds of dying.

Suppose that a passenger air bag could be added to a new car for $350, and there
is a 1 in 10,000 chance that it would save the life of the car passenger.
This implies that the value of lives to individuals who buy airbags is at least $3.5
million.
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 Valuing Driving Time Saved:
Using Revealed Preference to Value Time
Alternatively, we can value life by estimating how much individuals
must be paid to take risky jobs that raise their chance of dying.
Expenditure Evaluation:

Suppose that we compare two jobs, one of which has a 1% higher risk of
death each year (e.g., a coal miner versus a cashier in a retail store).
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Suppose further that the riskier job pays $30,000 more each year.
This $30,000 is called a compensating differential.

In this example, individuals must be compensated by $30,000 to take

this 1% increased risk of dying, so that their lives are valued at $3
million ($30,000/0.01).
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 Discounting Future Benefits

• In addition to finding the value of lives saved in each year, a cost-benefit

Expenditure Evaluation:

analysis must discount these future benefits.

• Choosing the proper discount rate is difficult.
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• Since many projects have benefits that last long into the future, the
discount rate matters enormously.
o Reducing global warming will bring benefits hundreds of years into the
future.

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 Cost-Effectiveness Analysis

Cost-effectiveness is an alternative to cost-benefit analysis.

Expenditure Evaluation:

• Cost-effectiveness analysis: For projects that have immeasurable benefits

or that are viewed as desirable regardless of the level of benefits, we can
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compute only their costs and choose the most cost-effective project.
• Finding the cost of a life saved—and choosing projects with the lowest
costs—avoids making judgments about the value of life saved.

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 Putting It All Together
Quantity Price/Value Total
Costs Asphalt 1 million bags $100/bag $100 million
Labor 1 million hours $10/hour $10 million
Maintenance $10 million/year 7% discount rate $143 million
First-year cost: $110 million
Expenditure Evaluation:

Total cost over time (7% $253 million

discount rate):
Benefits
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Driving time saved 500,000 hours/year $22.70/hour $11.4 million

Lives saved 5 lives/year $9.6 million/life $48 million
First-year benefit: $59.4 million
Total benefit over time (7% $848.6 million
discount rate):
Benefit over time minus $595.6 million
cost over time:

Present discounted value of benefits is more than three times the cost of project.

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 Other Issues in Cost-Benefit Analysis

• Common Counting Mistakes

o Counting secondary benefits
Expenditure Evaluation:

o Counting labor as a benefit

o Double-counting benefits
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• Distributional Concerns
o Costs and benefits may not go to the same people.
• Uncertainty
o Costs and benefits are often highly uncertain.

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 EFFICIENCY AND EQUITY ONCE MORE

Only those projects should be selected in which present value of benefits exceeds the
present value of costs.
Expenditure Evaluation:
Principles

Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash outflows over a period of time.

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 EFFICIENCY AND EQUITY ONCE MORE

By contrast, the internal rate of return (IRR) is a calculation used to estimate the
profitability of potential investments.
Expenditure Evaluation:
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 Canons of Public expenditure
Prof. Shirras
Expenditure Policy: Social and Health

The canon or principles of public expenditure are the fundamental rules which
should govern the expenditure policy.

1-Canon of benefit-public expenditure should be that it results in the achievement of

maximum social advantage
Insurance

2-Canon of economy- Economy means protecting the interest of taxpayers not

merely in affecting economics in expenditure but in developing revenue.
3-Canon of sanction-proper procedure of formulating the policy of public
expenditure and avoidance of arbitrariness and influence of certain vested interests
in the matter of public expenditure.
4-Canon of surplus- government should avoid deficit.

Other canons include elasticity, productivity, distribution, neutrality, performance,

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Expenditure Policy: Social and Health Effects of public expenditure

Dalton’s viewpoint
Insurance

1-Effect of public expenditure on production

2-Effect of public expenditure on distribution
3-Effect of public expenditure on economic stability
4-Effect of public expenditure on economic growth

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Expenditure Policy: Social and Health Effects of public expenditure

Effect of public expenditure on production

Insurance

A-Ability to work, save and invest

B-Willingness of people to work, save and invest
C- Effect of the diversion of economic resources as
between different uses and localities

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E. Assigning Weights In Project
Selection

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 Assigning Weights In Project Selection cont..
Expenditure Evaluation:
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• Suppose, for instance, that $3 billion is to be spent on schools and to be

distributed between elementary and higher education.
• Also suppose that for each $1 billion spent, outlays on elementary education
contribute more to literacy than do outlays on secondary education,
• But their contribution to advancing technology is less than that of higher
education.
 Assigning Weights In Project Selection cont..
Using alternative expenditure allocations, we then have these options:

•When moving from pattern I toward pattern II : we find that 2 (1/2) technology, units are gained for each
literacy unit lost,.
•with a move from pattern II to III: the substitution ratio is 1(1/3) technology units for each literacy unit lost.
Expenditure Evaluation:

•movement from pattern III to IV: results in a gain of only 3/4 technology unit for each literacy unit given
up.
➢ If 1 literacy unit is valued at 2 (1/2) technology units or more, pattern I will be chosen;
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➢ if at between 1 (1/3) and 2 (1/2) technology units, pattern II will be chosen.

➢ If 1 literacy unit is valued at 3/4 to 1 technology unit, pattern III would be chosen,
➢ if valued at less than 3/4 technology unit, pattern IV would be the chosen education program mix.
 Assigning Weights In Project Selection cont..
• In Figure 9-3, where the dotted lines i1,i2,i3 ,
etc., are the social indifference curves
pertaining to literacy and technology.
• The tradeoff between literacy and technology
units in production gives us a convex ''project
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transformation'' frontier as illustrated by points

I to IV in the figure.
• As shown, II is now the preferred pattern, since
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it places us on the highest possible social

indifference curve i4 .
• At this point the marginal rate of substitution
(MRS) of technology units for literacy units as
a matter of social valuation (the slope of
indifference curve i4 at the point of tangency
II) equals the marginal rate of transformation
(MRT) of the educational output (the slope of
the project transformation curve at the point of
tangency II).
 Sectoral Allocation of Police
• Another illustration is given by the problem of allocating police forces among
sections of a city.
• Suppose there is an uptown precinct X and a downtown precinct Y.
• Population size is the same in both but the crime rate is higher in Y.
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• Assume further that crime prevention is subject to increasing cost in both

districts.
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• The question is how a given police budget shall be allocated between X and
Y.
Among various targets, the following may be considered:
1. Equal number of crimes prevented in each sector
2. Equal protection, or equal number of crimes still committed in each sector
3. Maximum crime reduction for both sectors combined
4. Equality of the MRT between crime reduction in the two districts and the MRS
of utilities derived from crime reduction in the two districts
 Sectoral Allocation of Police cont…
Which of these goals is preferable on equity
and/or efficiency grounds?
The alternative solutions to the problem
are illustrated in below Figure.
• The crime level in sector X is measured on
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the vertical axis &

• The crime level in sector y is measured on
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the horizontal axis.

• AB is a transformation schedule showing
what combinations of remaining crime
levels can be obtained with a given budget.
• If the entire police force is used in X,
crime levels will be shown by B;
• If the entire police force is used in Y,
crime levels will be as shown by point A.
• If there is no protection for either, the
location is at C
 Introduction- Direct Democracy
Implementations of various targets
Target 1: Equal number of crimes prevented in
each sector
• The appropriate solution is at D, obtained by
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drawing a line through C at a 45° angle with the

axes and taking its intersection with the
transformation curve.
• Crime in X will fall by CM and in Y by CL,
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• At D point : CL = CM
•
Target 2: Equal protection, or equal number
of crimes still committed in each sector
• The solution is at E, obtained by drawing a 45°
line through the origin &
• Again taking its intersection with AB.
• Remaining crime will equal ON in X and OU in
Y with ON= OU.
 Introduction- Direct Democracy
Target. 3. Maximum crime reduction for both
sectors combined
• The marginal cost of crime prevention must be
equal in both sectors.
• The solution is at F where the slope of the
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transformational function equals -1, it being

tangent to the line JK where OK = OJ.
• Goals 1 to 3 cannot be ranked without involving
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some distributional judgment, which judgment is

made explicit in goal 4
 Introduction- Direct Democracy
Target. 4 . Equality of the MRT between crime
reduction in the two districts and the MRS of
utilities derived from crime reduction in the two
districts
• Goal.4 calls for a social welfare function which
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values crime prevention in X &

• Y as expressed by indifference curves i 1i 1 and
i2i2
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• The optimal solution is given at G

• At G point, AB is tangent to the highest possible
indifference curve.
• At point G the MRT of crime reduction in X into
crime reduction in Y equals MRS of the social
value assigned to crime reduction in Y for that in
X.
 Shadow Pricing of Market Items

Shadow pricing refers to the practice of assigning a monetary value to

something whose value can only be estimated because it is not something
regularly bought and sold in a marketplace.
Shadow pricing is often required when a financial analyst is doing a cost-
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benefit analysis to decide regarding a proposed investment.

Shadow pricing can refer to the assignment of a price to an intangible item
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for which there is no ready market from which to derive a price.

Shadow prices are most commonly used in cost-benefit analyses where
some elements of the analyses cannot be quantified by reference to a
market price or a cost.
Prices of goods, services, and resources that are proportional to true
opportunity costs for the economy, taking account of any externalities.
 Conclusion

• Turning the abstract notions of social costs and benefits into practical
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implications for public project choice is challenging.

• What at first seems to be a simple accounting exercise becomes quite
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complicated when resources cannot be valued in competitive markets.

• Economists have developed a set of tools that can take analysts a long
way toward a complete accounting of the costs and benefits of public
projects.

@ Grubder, J. Public Finance and Policy: Musgrave and

Musgrave-Public Finance: Theory and Policy
 Thank You

@ Grubder, J. Public Finance and Policy: Musgrave and

Musgrave-Public Finance: Theory and Policy