Cost-Benefit Analysis 2008
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Transcript of Cost-Benefit Analysis 2008
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Policy Analysis Tools:
Cost-Benefit
Analysis
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Cost-Benefit Analysis
A technique for systematically estimating theefficiencyimpacts of policies
Valuable in identifying and categorizing costsand benefits for rationaldecision making inthe public arena
Used with variable success in a broad rangeof public policy areas
Success of use depends on the degree towhich cost and benefits can be monetized
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It can answer logical, rational questions such
as:
Should governmentproduce a good/service?
e.g., public housing, parking garage
Should government intervene in the market?
Regulating airline safety, automobile safety
How much of the good/service should be produced?
Superfund cleanups, public transportation
Cost-Benefit Analysis
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Getting a handle on the
costs and benefits ofproposed policies
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Cost-Benefit Analysis
It is a technique that can be used
to evaluate government projects
and programs. It encompasses an
appraisal of a policy based on thecosts and benefits of the project,
measured in comparable units
within and across time.
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Limitations to
Cost-Benefit
Analysis
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Most policies involve budgetallocation costs.
Limitations to Cost-Benefit Analysis
However, many policy benefitsand costs are neithertangible
noreconomically visible.
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Measurement of costs
Direct outlays are easy to determined
Private cost
Burden on taxpayers, inequities
Social costs
Concentrated highly visible costs (housing,
welfare)
Widespread invisible (tax burden)
Opportunity costs (rarely considered)
Limitations to C-B Analysis in theSocial Policy Arena
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Criterion of efficiency Bottom line for decision making?
Issues of equity Who pays, who gains?
Externalities Unintended side effect (+ and -)
Offsetting behavior
Limitations to C-B Analysis in theSocial Policy Arena
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Advantages ofCost-Benefit
Analysis
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Advantages of CBA
Provides a decision making tool thatis based on objective standards
Allows for a quantitative comparisonbetween multiple solutions forpolicy problems
Can be used to monitor the
efficiencyof existing programs
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Some central C-B
concepts beforewe start
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Central C-B Concepts
Time Value of Money
Cost of life
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Cost-Benefit Concepts
Time Value of Money:
inflation discount rate
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Inflation
A dollar today is always morevaluable than a dollar next year
Consumer Price Index An index of prices used to measure the
change in the cost of basic goods andservices in comparison with a fixed base
period Measures inflation
Considerable variation across time
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Inflation
In a cost-benefit analysis decisionsmust be made in constant dollars
You cant add apples and oranges
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How do we deal with
inflation and the valueof money over time?
How do we addapples and oranges
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Discounting
Discounting takes care of two factorsthat make it difficult to add upmonies over time: The influence of inflation The earning power of money
Using a discount rate you extract
out the inflation+interest effectfrom future costs and benefits Future dollars are worth less today
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In addition, using a discountrate you are assuming thatmoney invested today can
grow at a compound rate,producing more money in thefuture
You need less money now toproduce a specified amount ofmoney in the future
Discounting
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Cost-Benefit Concepts
Discount Rate Formula
nr
nD)1(
$
Dn = Present Value
$ = Dollars in the future
r= Discount rate (Inflation+Interest)
n = Number of Years
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Discount Rate
Choice of a discount rate is speculativeand subject to much debate
What will future inflation rate be? What will investment yields be in the future?
Discount rate= Estimate (inflation rate + bond yield rate)
E.g., 2% + 6%=8% discount rate
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An example
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Assume that you will be given exactly $1,000from Grandma on your birthday for the next 3years. How much is this 3 year b-day presentworth to you TODAY? Assume an annual
interest/discount rate of 6%.
Present Value
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Assume that you will be given exactly $1,000from Grandma on your birthday for the next 3years. How much is this 3 year b-day presentworth to you TODAY? Assume an annual
interest/discount rate of 6%.
Today
$1,000Dn
Present Value
1 2 3
$1,000 $1,000+ +?
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Cost-BenefitAnalysis Overview
How is a cost-benefitsanalysis done?
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Step 1:
IdentifyingRelevantImpacts
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Identifying Relevant Impacts
Identify all relevant impacts
Classify them as costs or benefits for various
groups
Choosing geographic boundaries
e.g., flood control, public libraries, etc.
Choosing relevant groups with preferencestanding
Whose costs and benefits will be measured in a
decision to improve security in a local prison?
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Step 2:
Monetizing
RelevantImpacts
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Monetizing Relevant Impacts
Valuing inputs:
Measurable costs (objective)
Opportunity costs (subjective)
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Monetizing Relevant Impacts
Valuing outcomes:
Benefits of policy/program (objective)
Willingness to pay (subjective)
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Step 3:
Discounting for
Time and Risk
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Discounting for Time and Risk
Discounted future benefits/costs
Taking account of risk
Capital depreciation
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Step 4:
Choosing AmongAlternative Policies
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Choosing Among AlternativePolicies
Cost benefit ratio
Benefits/Costs > 1 = implement policy
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Numerical
Example
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Cost-BenefitAnalysis
An Example
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Taxing alcohol to save lives
Highway fatalities caused by alcoholimpaired drivers
Problem of younger drivers Innocent lives lost
Injury and property damage
Cost of morbidity: health care,accidents at work, loss ofproductivity, etc.
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Identifying the Costs and BenefitsOver a Specified Period of Time
Time Period: 1 year
Benefits (1) Tax revenue
30% increase in tax Consumer drink less (-16.6% in demand)
ESTIMATE = Increase of $16,739 billion
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Identifying the Costs and BenefitsOver a Specified Period of Time
Benefit (2) Reduction in fatalities
1,650 fewer young driver fatalities
1,270 non-driver fatalities from young drivers
861 driver and non-driver fatalities from >21year old drivers
Assume each life is worth $1million
Benefit (3) Reduction in property damage
$0.65 billion/year
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Benefit (4) Health and productivitygains
Absenteeism and workplace accidents
$4.29billion in annual health savings
$6.61billion in productivity savings
Identifying the Costs and BenefitsOver a Specified Period of Time
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How to count lives saved
Three estimates:
Upper bound: consumers of alcohol are totallyuninformed about increased risks of alcohol
consumption = all drivers and victims fatalitiesregarded as benefits
Lower bound: consumers of alcohol are totallyinformed about increased risks of alcoholconsumption = only victim fatalities regarded
as benefits Best guess: between the two
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Another example
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School Bus SafetyEnhancement Program
Installation of seatbelts on schoolbusses to ensurechild safety whentraveling on the bus
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Identifying the Costsand Benefits Over a
Specified Period ofTime
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Time period Assume a 20 year decision period
Benefits
Assume the only benefits are childrens livessaved
No injuries are taken into account in thisexample
Assume each childs life is worth $1,000,000
today Assume that 350 childrens lives are lost on
school buses each year in the state directly as aresult of no seat belts
Identifying the Costs and Benefits Over aSpecified Period of Time
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Costs Assume it costs it cost $4,000mill to
install the seatbelts on all school buses in
the state Assume that it costs $10mill to maintain
these seatbelts in useable order in thefirst year
Assume that after 10 years many of theseatbelts have to be replaced at a cost of$200mill in 2017 (Capital depreciation)
Identifying the Costs and Benefits Over aSpecified Period of Time
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Time Value of Money
Assume that the cost of a childs lifeincreases at 3% per year (inflation)
Assume that the cost of maintainingseatbelts on school buses increases by 3%per year (inflation)
Assume that money invested today in a fund
can earn 3.7% interest per year aboveinflation and that inflation is running at anaverage of 3% per year (6.7% discountrate)
Identifying the Costs and Benefits Over aSpecified Period of Time
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Lets recap what we know so far
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Cost-benefit analysis
Provides a rational frameworkfordecision making in the public arena
Allows us to compare multiplesolutions to problemssimultaneously
Provides an objective criterion to
base the decision on (efficiency, orat least benefits > cost)
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But..the approach has limitations
Measurement of costs and benefits
Efficiency criterion not alwaysapplicable
Cannot take into account equityissues in cost distribution
Often cannot predict externalities
that can significantly impact theanalysis
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Despite limitations still a useful tool
Time value of money
Concept of inflation
Value of the Consumer Price Index Capital depreciation
Andof course the discount rate
Lets consider the discount rate onemore time before moving on
A discount rate is a single combined
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A discount rate is a single combinednumber that estimates two components:
What the inflation rate will be infuture years
Whatpercentage interest rateabove inflation money will earn sothat it grows in future years.
For example: if you accept a rate of return on your bank investmentthat is under the average inflation rate (< 2.4% apr in 2008) you willbe losing money in every subsequent year. If the rate is at inflation,youll be simply protecting your money, not making your money workfor you.
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So..
If inflation is running at 3.5% and youvemanaged to get a rate of return on yourinvested money from the bank of 6.3%you are beating inflation by 3% and your
money is working for you. The concept of a discount rate assumes
that the rate of return on invested moneythat isgreater than inflation on
average. How much greater depends on the value
of the discount rate you choose to use inyour cost-benefit analysis.
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Now..onto the next question
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Federal Aviation Administration(Flight TWA 800)
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TWA Flight 800 was a TWApassenger flight that disintegratedwhile flying from John F. Kennedy
International Airport (New York) toCharles de Gaulle InternationalAirport (Paris) in 1996, killing all
230 aboard. The incident has beenone of the most investigatedcrashes in aviation history.
http://en.wikipedia.org/wiki/Trans_World_Airlineshttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/New_York_Cityhttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/Parishttp://en.wikipedia.org/wiki/Parishttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/Charles_de_Gaulle_International_Airporthttp://en.wikipedia.org/wiki/New_York_Cityhttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/John_F._Kennedy_International_Airporthttp://en.wikipedia.org/wiki/Trans_World_Airlines -
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The aircraft was flying more than eightmiles off the coast ofEast Moriches, NewYork (on Long Island) when the plane'scenter wing fuel tank exploded. The aircraft
developed cracks around the nose as aconsequence of the explosion, and thefront part of the aircraft broke off(including the cockpit and first class
section). The left wing ruptured, and theleaking fuel from the left wing tank ignitedin the air, triggering a second explosion.
http://en.wikipedia.org/wiki/East_Moriches%2C_New_Yorkhttp://en.wikipedia.org/wiki/East_Moriches%2C_New_Yorkhttp://en.wikipedia.org/wiki/Long_Islandhttp://en.wikipedia.org/wiki/Long_Islandhttp://en.wikipedia.org/wiki/East_Moriches%2C_New_Yorkhttp://en.wikipedia.org/wiki/East_Moriches%2C_New_York -
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A four-year investigation by theU.S. National Transportation SafetyBoard, the only official investigation
to date, concluded that fumes insidethe center wing tank ignited,causing the explosion. The NTSB
concluded that the spark wascreated by faulty wire insulation andan electrical arc.
http://en.wikipedia.org/wiki/National_Transportation_Safety_Boardhttp://en.wikipedia.org/wiki/National_Transportation_Safety_Boardhttp://en.wikipedia.org/wiki/National_Transportation_Safety_Boardhttp://en.wikipedia.org/wiki/National_Transportation_Safety_Board -
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The NTSB contends that theexplosion could have beenprevented by use of a system to
smother flammable vapors insidefuel tanks, rather than the industrystandards of the time that focused
on eliminating ignition sources thatcould enter them from the outside.
The Cost of
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The Cost of
Saving a Life
C bl
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Can we reasonably
value a life?
And, are all lives lost ofequal value?
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An alternative method
LIFE YEARS SAVED
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LIFE YEARS SAVED
Avoiding a particular risk of deathtoday means that you are more likely
to live the statistically average lifespan.
The difference between this averagelife span and a premature death is the
number of life years saved.
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Consider the case of
mammograms.
If we gave every woman in the
U.S. an annual mammogram wewould detect some breastcancers in the early stages and
prevent some women from dyingprematurely
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Mammogram screening
But, since the number of women whose liveswould be saved is small, the cost per lifesaved would be high since wed be screeninglots of women who never get breast cancer.
Besides, in the absence of a mammogramwomen would most likely get an annualphysical breast exam, which might detect thecancer anyway.
So, we need to focus on the additional cost of
the mammogram policy and compare it to thenet additional benefit (additional life yearssaved) of adding the mammogram policy.
Remembering that policy benefits will differfor women of different ages.
Hill R dh Cli t did j t
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Hillary Rodham Clinton did justthat in 1993/94 in an attempt to
reform the U.S. health care system
She devised the Clinton health care planin which it was decided notto cover acost for a life year saved that exceeded$100,000.
Thats why the plan provided regular mammograms forwomen in their 50s ($108,401) but not for women in
their 40s ($186,635).
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But, even additional years of
life are not of equal value:
Need a measure that captures
quality of remaining life years
Quality Adjusted Life Years (QALY)
Concept of morbidity
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Lets consider an example
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Quality-adjusted Life Year (QALY)
Patient Option 1: No Surgery
10 remaining years of lifeQuality = .6
QALY = 6 years
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Quality-adjusted Life Year (QALY)
Patient Option 2: Surgery
15 remaining years of life
Quality = .8
QALY = 12 years
Where do those extra 6 years of life come from?
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Quality-adjusted Life Year (QALY)
Patient Option 2: Surgery
15 remaining years of life
Quality = .8
QALY = 12 years
longevity effect (5 X .8) = 4yrs
QOL effect = (10 X (.8 - .6)) = 2years
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Alternatives to Cost-
Benefit Analysis
..that assist policy makers
in their decision making
Alternatives to Cost-Benefit
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Alternatives to Cost-BenefitAnalysis
Cost-effectiveness analysis
Risk-Risk analysisHealth-Health analysis
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Cost-effectiveness analysis
Makes programs with identical types ofoutcomes comparable
Shows which program yields the greatest
outcome per dollar spent DOES NOT indicate whether a particular
policy has positive net benefits overall
Example: Effectiveness of medicationversus diet in preventing heart attackscompared to the costs of the twoprograms
Other examples of how cost-
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Other examples of how cost-effectiveness analysis is used:
Feb 2000 JAMA: Study concluded that annualretinal screening for individuals with Type 2 diabetesmay not be warranted on cost-effectiveness grounds(QALY=$150,000).
Vijan et al. 2000 JAMA: Compared with biannual
screening, annual retinotherapy screening for low-risk patients with diabetes cost more than $100,000for each QALY
NEJM 2000: Extending hospital stays beyond 4days for patients with uncomplicated myocardialinfractions was economically unattractive since itcost more than $105,000 per QALY
Annals of Internal Medicine 2000: Viagra is acost effective treatment for erectile dysfunction,producing an incremental QALY for the relatively lowcost of $11,000
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Risk-Risk Analysis
Policy analysts have long realized thatreducing one risk may unintentionally raiseanother risk
Risk-Risk analysis can be used to yield a countof desired/undesired outcomes in differentunits
Does not take account of the costs andbenefits of a policy
Example: treating drinking water withchlorine reduces the incidence of infectiousdiseases, but exposure to chlorine raises therisk of cancer
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Health-Health Analysis
An analyst who knows how thecosts of a program are distributedforecasts the number of adverse
health outcomes induced by theprogram
The analyst then compares a countof the fatalities averted by a
program versus a count of fatalitiesinduced by an alternative program
H l h H l h A l i
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E.g., Passenger-side airbags: For everyfive lives saved by passenger-side airbags,a life (usually a child) is lost. Thats a 5:1health-health ratio.
Program beneficiaries (adults) aredifferent from those who bear the cost(children), yielding DISTRIBUTIONALdifferences.
Disadvantage?
It confines the analysis to a tally of mortalitycosts.
Health-Health Analysis
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In summary
Comparing methods
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Methods comparing cost and benefits
Cost-benefit analysis
$benefits - $costs (sameunits)
Cost-effectiveness analysis
$costs compared to desirable(adverse) outcomes
Methods comparing cost and
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Risk-Risk analysis Measures only probabilities of
outcomes
Health-Health analysis Lives saved-lives lost
Measures only mortality risks
Methods comparing cost andbenefits
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