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Public Economics Dr. Saue

Chapter 8: Cost-Benefit Analysis

Suppose you are working for the Colorado state government in the highway department.- cost-benefit analysis of road repairs

I. Measuring Current Costs

We need the social marginal cost.- equal to its opportunity cost

Cost of Asphalt:

1 bag asphalt costs $100- next best use = sell to someone else- competitive market

- opportunity cost = price

Cost of Labor:

In a perfectly competitive market, the opportunity cost is equal to the wage.

Suppose instead an imperfect market with some unemployment among construction workers. (due tominimum wage of $20)

Suppose the value of one hour of leisure is $10.

The opportunity cost of hiring an unemployed worker is $10. The opportunity cost of hiring anemployed worker is $20.

Suppose we hire 500,000 previously unemployed workers and 500,000 previously employed workers.The opportunity cost of the labor is:

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Even though the government is paying out $20,000,000 in cash, the opportunity cost is $15,000,000.

The cash cost of the labor cost has two parts:- opportunity cost- transfer of rents

Rents are payments to resource acquisition that exceed those necessary to employ the resource.In this case the rents are a transfer from the government to previously unemployed workers.

II. Measuring Future CostsUse the Present Discounted Value.

The PDV of a long-term stream of payments is:PDV = payment amount

interest rate

Use 7% as the interest rate.

III. Measuring Current Benefits

Valuing Driving Time Saved:

Various Approaches:

- wages (2009 average wage $19.29)- overstate if value of leisure < wage (cant work overtime)- understate if there are non-monetary aspects of the job

- Contingent Valuation (ask individuals to value an option that they are not currently doing)

- reveled preference (let individuals actions reveal their value)- gas station natural experiment

Lets use $19.00 as the value of an hour of time.

Valuing a life saved:

Various Approaches:

- wages- a worker under age 50 will spend 10-20% of all future hours working- value of life is 5-10 times future lifetime earnings

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- Contingent Valuation- $963,000 to $26,000,000

- revealed preference- see how much pay to reduce odds of dying- if airbag costs $350 and there is a 1 in 10,000 chance that it would save the lifethen the value of a life is at least $3.5 million

- look at compensating differentials- compare 2 jobs, one has 1% higher risk of death in a year and pays $30,000 more- value life at $3 million

Kip Viscusi of Harvard says: $8.7 million

- government revealed preference- look at existing government programs and see how much they spend to save lives

Lets use $8.7million as the value of a life.

IV. Discounting Future BenefitsVery tricky!

- choice of discount rate matters a lot- how to treat future generations benefits?

Lets use 7%.

Total Benefits =