EMCA5103 Assignment PROJECT COST ANALYSIS AND APPRAISAL

8/3/2019 EMCA5103 Assignment PROJECT COST ANALYSIS AND APPRAISAL

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SEPTEMBER SEMESTER 2011

LECTURER;

SR. DR. ZULKIFLEE BIN ABDUL SAMAD

STUDENT;

NAME: MOHD. NORIZAM BIN MD. SALLEH

MATRIC NO.: CGS 00534317

I/C NO: 670703-01-6045 COURSE: MASTER PROJECT MANAGEMENT

ASSIGNMENT PROJECT COST ANALYSIS AND APPRAISAL EMCA5103


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Name: Mohd. Norizam Bin Md. SallehMatriculation No.: CGS 00534317Assignment: EMCA5103 (Project Cost Analysis and Appraisal)

Semester September 2011ii

Table of Contents

Question 1 ............................................................................................................................................... 1 Answer 1; ................................................................................................................................................. 1 1.1 Introduction .................................................................................................................................... 1 1.2 Misconception on CBA .................................................................................................................. 5

1.2.1 CBA is a mechanical substitute for common sense. ............................................................. 5 1.2.2 Unethical to use CBA for making public policy decisions. .................................................... 8 1.2.3 Regards the difference between a net improvement and a confirmed panacea. ............... 11

1.3 Conclusion ................................................................................................................................... 13 Question 2 ............................................................................................................................................. 17 Answer 2; ............................................................................................................................................... 17 2.1 Introduction .................................................................................................................................. 17 2.2 Three (3) Problems That Will Affect The Using of Demand Function to Measure Indirect Benefit.

..................................................................................................................................................... 18 2.2.1 The Shape of Demand Function (Elasticity) ........................................................................ 19 2.2.2 Shifts in the Demand Function ............................................................................................ 27 2.2.3 Market Effects...................................................................................................................... 32

2.3 Conclusion ................................................................................................................................... 37 Reference (continued) ........................................................................................................................... 40

List of Figures

Figure 1: The Cost Benefit Analysis Process .......................................................................................... 2 Figure 2: National Lead Poisoning Campaign Conducted in US. ........................................................... 7 Figure 3: Penang Bridge.......................................................................................................................... 9 Figure 4: Pedestrians Are Exposes to the Pollution Emitted by Vehicles ............................................. 10 Figure 5: Has Anti Drug Campaign achieved 100% its Goals? ............................................................. 12 Figure 6: Perfectly Elastic Demand Curve ............................................................................................ 20 Figure 7: Perfectly Inelastic Demand Curve .......................................................................................... 21 Figure 8: Benefit From a Subway. ......................................................................................................... 23 Figure 9: Shift in Demand ...................................................................................................................... 28 Figure 10: Income and Substitution Effects ........................................................................................... 30


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Semester September 20111

SEPTEMBER SEMESTER 2011

PROJECT COST ANALYSIS AND APRAISAL EMCA5103

ASSIGNMENT (50%)

Question 1

Cost-Benefit Analysis (CBA) is a method of evaluating the relative merits of

alternative public investment projects in order to achieve efficient allocation of

resources. It helps to identify, portray and assess the factors which need to be

considered in making rational economic choices. However, there are still

misconceptions about CBA. Critically discuss three common misconceptions about

CBA. Support your answers with appropriate illustrations and examples.

(50 marks)

Answer 1;

1.1 Introduction

There are a lot of misconceptions on Cost Benefit Analysis (CBA) and before we gofurther it is good for us to understand what CBA is all about. Some author calls it

CBA and some call it BCA (Benefit Cost Analysis). They are actually the same but in

this assignment term CBA will be used. An understanding on CBA shall give us the

answer how these misconceptions came about.

According to The Free Dictionary the definition of CBA in governmental planning

and budgeting is the attempt to measure the social benefits of a proposed project inmonetary terms and compare them with its costs. The procedure was first proposed

in 1844 by Arsene-Jules-Etienne-Juvenal Dupuit (180466). It was not seriously

applied until the 1936 U.S. Flood Control Act, which required that the benefits of

flood-control projects exceed their costs. A cost-benefit ratio is determined by

dividing the projected benefits of a program by the projected costs. A wide range of

variables, including non-quantitative ones such as quality of life, are often considered

because the value of the benefits may be indirect or projected far into the future.


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CBA was then further formalised by Alfred Marshall, Pigou and other twentieth-

century economists, where they have diligently argued and refined the fundamental

philosophy within the broader and rational analytical assemble of welfare economics.

Benefitcost analysis is one technique of analyzing proposed or previously endorsed

projects to determine whether doing them is in the public interest, or to choose

between two or more mutually exclusive projects. BCA assigns a monetary value to

each input into and each output resulting from a project. The values of the inputs and

outputs are then compared. In the most basic sense, if the value of the benefits is

greater than the value of the costs, the project is deemed worthwhile and should be

executed (Zerbe Jr and Bellas 2006).

Figure 1: The Cost Benefit Analysis Process

(Source: U.S. Army, 12 January 2010).

The Federal Navigation Act 1936 calls for cost benefit-analysis requirement. CBA

was later adopted as a federal policy in 1939 by the United States and gradually all

government departments are depending on CBA. It is then heavily used by the

government and big corporations even until today to make economic decision and

help appraise new projects. The last government instruction with regards to CBA was


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a subsequent presidential Executive Orders (12291: Reagan 1980 and 12866:

Clinton 1993) have stipulated government requirements for the analysis of costs and

benefits of regulatory proposals prior to their adoption. The key fundamental principle

of cost-benefit analysis is the evaluation of social benefits with corresponding costs.

It wills easier to the decision-makers if benefits exceed costs, as it means the project

can be proceed. In the other hand shall the costs exceed benefits, the decision

maker is at least need to inform of the net cost that people needs to accept shall the

project is proceeded.

In other words CBA is a framework or tool use to evaluate a project, pros (benefits)

and cons (costs). By execution, CBA is simply adding up all the expected gains(benefits) from the project and deduct all the losses, and then selecting the

alternative that might maximises the net benefits. To do so, very much the pros and

cons shall be quantified if possible, even when it is not. Economists claim that further

application of CBA could save billions of dollars annually. The BCA approach also

forms the core of a substantial portion of normative thinking about the law associated

with law and economics, usually under the rubric of wealth maximization. The

methodology is widely, and repetitively, criticised on foundational grounds. Thecriticisms concern moral and ethical limitations and, to a much lesser extent,

technical ones. A common view is thus that CBA is a flawed science that deprives

citizens of the opportunity to participate in democratic processes that bear on the

allocation of public resources.

Economists and other practitioners actually doing CBAs generally ignore these

criticisms. There are three reasons for this. One is that the critics fail to offer viablesubstitutes, except for rather sketchy references to political discussion. The critics do

not compare the results of CBA with those of alternate approaches, so they are

unable to answer the question of whether CBA is better than alternatives. Second,

they fail to address the issue of whether CBA is useful and, if it is, how it might be

improved. Defects found by the critics are generally uncontaminated by actual CBAs

so that it is unclear whether, as a matter of fact, these defects exist. Not surprisingly

then, practitioners find little to learn from the criticisms. Without determining relative

usefulness, how is it possible to argue persuasively against the use of CBA? Third,


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practitioners are divided, internally and externally, about what CBA is. Critics make

one set of assumptions about the nature of CBA and the practitioners another.

Indeed even among the critics and the practitioners there is no uniformity of concept.

The issue of the validity of these criticisms is thus unresolved, and indeed

irresolvable within the existing framework, because there is no general agreement

about what CBA is, or what it might be.

The criticisms rest on a limited and narrow concept of CBA, but one that derives from

its historical origins. The critics see CBA as a sort of mechanical algorithm that falsely

claims to provide the answer to the question of what people want. Many see CBA as

missing important values such as integrity and equity, as rooted also in a narrowutilitarianism, and as using private values where public values are relevant. It is said

further that BCA does not make the necessary exclusions, such that it includes bad

values like envy and malice. Critics see CBA as an attempt to combine

incommensurables in a single metric so that the answer it provides is without

meaning. Others find that it loses legitimacy as it favours the preferences of the rich

and is defective or not deserving of our approbation, because it does not consider

issues of income distribution or fairness. In so far as it ignores transactions costs it isseen as flawed. A few critics see the Scitovsky (1941) reversal paradox as rendering

CBA useless. (The Scitovsky reversal paradox arises when analysis recommends a

move from position A to position B and, having arrived at position B, to then

recommend a move back to A).

The responsibility for the failure to provide a clear definition for CBA lies with

economists. As the inventors, users and, in general, the proponents of BCA,economists have responsibility for explaining the foundations of their methodology.

This they have failed to do. What, for example, is the relation of benefits and costs to

legal rights? Is bad utility to be counted? Are moral sentiments to be counted? Is the

benefitcost analysts role one of providing information to a decision-making process

or the answer to a public policy question? It is unnecessary to hold to the narrow

concept of CBA depicted by the critics. There is a more expansive version that is

fairly immune to these criticisms. Here we present two archetypal versions of CBA,

representing the narrow, older mainstream version (generally referred to as Kaldor


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Hicks, or KH) and a different, modified version that emerges from commentary and

practice of recent years. The latter version is called KaldorHicksMoral or KHM.

KHMis more clearly grounded in legal rights than is KH, more closely represents

preferences, is more realistic about the role for CBA and is more acceptable because

it obviates most of the foundational criticisms of CBA. In short, the use of KHM is

more likely than KH to come closer to satisfying a Pareto superior test in that its

broad use leads to gains for most members of society (Zerbe Jr and Bellas 2006).

1.2 Misconception on CBA

No doubt CBA is a powerful and very informative tool available that can assist

planners, engineers, and decision makers to measure project cost benefit for any

project but various critics had lead to misconceptions and later direct agencies to

shun or underutilise CBA. Among other are those misconceptions ten (10) that have

been introduced by Bruce Hokin. They are he common misconception is that Cost

Benefit Analysis is only applicable to those companies or government departments

that have a vast store of funds and have specialists to call on to pump out complex

recommendations, it is too complex for the layman to understand, it will take too long

to learn, easier ways give the same answers, its only for accountants and managers,

it takes too long to assemble all the data, its OK as a theory but it doesn't really work

in practice, it has only limited applicability, it is too costly to implement and finally

there are too few examples to learn from.

This assignment shall concentrate on three misconceptions about CBA as stated by

Edward Gramlich which are CBA is a mechanical substitute for common sense, it is

unethical to use CBA for making public policy decisions and regards the difference

between a net improvement and a panacea (Gramlich 1998).

1.2.1 CBA is a mechanical substitute for common sense.

CBA is an outline for organizing thoughts, or considerations. It is a norm to

encounter considerations that cannot easily quantified or gauged and where the


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results are quite imaginary. This uncertainty does not and should not be avoided or

hided by CBA. The best way to deal with uncertainty is to quantify what can be

quantified and to organise and categorise those unquantifiable factors and proceed

as far as possible. CBA is not established on market prices alone. Benefits to

society are appraised as an accumulation of individuals willingness to pay, where in

the other hand social costs reflect opportunities gave up.

As for example an individuals willingness to pay for electricity bill, may cost him/she

a couple of thousands RM a year, but the price actually paid for that electricity

consumed by him/she may be far lower (perhaps just a thousand RM per year). The

difference between the individuals willingness to pay and the price they actuallypaid is defined as the benefit generated from the consumption of the facility. Thus

benefit does not define solely on price but its net price is subjected to the

willingness of the customer to pay.

The net social benefit of making electricity available to the public and individuals is

the present value of the difference between the sum of the residents net willingness

to pay (their consumers surplus) and the sum of the opportunity costs of theresources used in supplying the electricity. Simply because a good or service is not

marketed and is not priced, does not mean that it does not create benefits to

people. As long the people keen to accept the non-marketed services or goods,

there will be a benefit enjoyed. Definitely CBA is not a mechanical substitute for

common sense as it is always considers in making CBA judgement. Off course to

quantify and measure such benefits, common sense shall be required.

Applying CBA will prevents consideration of important qualitative values such as

fairness and special concern for the welfare of children. If CBA is a mechanical

substitute for common sense it shall prevents consideration of important qualitative

values such as fairness and special concern for the welfare of children. It is well-

accepted among CBAs practitioners that, while many benefits and costs can be

quantified, other valid considerations cannot be. That is why CBA textbooks call for

intangible benefits and costs to be disclosed and considered.


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For example, suppose that a federal regulation or campaign would reduce the rate

of lead poisoning among children in poor urban communities. Assume further that

the quantified benefits and costs of this regulation/campaign are roughly equal. In

such a case, a tie-breaking, intangible consideration arguably favours the

regulation, namely the notion that the government owes a special duty to low-

income children who are less able than middle-class or wealthy adults to protect

their own interests. Certainly nothing in CBA prevents analysts and regulators from

giving weight to such intangible considerations (Graham 06/06/11).

Figure 2: National Lead Poisoning Campaign Conducted in US.

(Photo, Source: www.epa.gov).

Qualitative and quantitative analysis that normally use in CBA, factors out excellent

ideas but these benefits is difficult to determine because its often based on intuition

and does not offer immediate noticeable financial earnings. This however led the

room for CBA misconceptions. CBA, is extremely useful as it enables us to portray

an argument in terms of costs and benefits where securing a projects approval is

often very much subjected on these arguments. It is common where assumptions

by CBA are not verifiable, as it is difficult to measure the intangible benefits of a new

proposed project. One way to conquer this is by viewing what the cost would be


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shall the plan is implement as it shall gives ideas of the project worth including its

intangible benefits.

1.2.2 Unethical to use CBA for making public policy decisions.

The second major misconception, it is unethical to use CBA in making public policy

decisions. The reason to his is because public policy decisions always involved

important or substantial matters. For instant shall the government have intention to

built bridges, with the construction of these bridges construction workers might met

with accident get injured, permanent disable, and some might even lose their lives.

As we all knows, construction of bridges especially crossing a straits like Penang

Bridge may invite a lot of possibilities to accident to occur. Workers might fall into

the sea, get struck by the cranes, hit by falling object, electricity shock and etc. In

the other hand shall the same fund is spend on cancer research it might be able to

save lives. Than the saving or losing lives shall become one of important criteria of

the gain/losses benefit of a project. So what is our best choice?

Critics are declining to turn such weighty matters to CBA thus creating this

misconception. Although indeed CBA cannot be relied 100% to solve the problems

but perhaps CBA might still be beneficial in some way. For instance a result from a

study had found out that the bridge workers are getting higher compared to other

sector and they are already aware of the risks they might faced?

Even these workers themselves chose to work in the bridge construction line thatoffers them better wages? Is it possible to presume that risks are already included

into the project cost or in the contrarily the study may point out that the risks are not

included and the market cost of the project minimise the true social cost.


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Figure 3: Penang Bridge.

(Photo, Source: eman.edu.pk).

In proper way it is workable to estimate the true project cost to compare them with

the expected benefits and to provide in addition real data on expected loss of life in

the construction phase. Shall these information being properly compiled and wisely

used it can assist the making of decision whether or not to proceed with the bridgeproject. In the contrary shall the data were compiled but not properly used, it does

not mean that it is no need to compile them.

Somehow rather the society still needs to make the decision whether or not to build

the bridge. One thing for sure society can never avoid all possible risk or else it will

never have any bridge. Or we choose to spend the entire budget on the cancer

research programme but that may not give a 100% result too. Therefore it musthave some form of balance in terms of weighing this option and that is where CBA

is requires. In order for CBA not to be illogical, the connection between the currency

of the economic analysis and human well-being should be established (Gramlich

1998).


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Figure 4: Pedestrians Are Exposes to the Pollution Emitted by Vehicles

(Photo, Source: Graham 06/06/11).

For example, it is unethical to use CBA for making regulatory decisions about

medicine, public health, safety, and environmental protection. The concept that

safety is an absolute right, regardless what the costs like, it is indefensible on

either philosophical or practical grounds.

Philosophically, complete safety (zero risk) is a delusion because well-informed

societies choose, on a daily basis, to assume many risks in life in trade for a

diversity of benefits. For example, people habitually choose, to reduce travel time by

driving faster on four-lane highways compared to lower-speed, two-lane roads.

When risks are imposed on societies without their explicit consent (e.g. whenpedestrians must inhale pollution emitted by vehicles), the philosophical problem

becomes more difficult. But the solution is still not necessarily to mandate zero risk.

A more persuasive resolution would be to protect societies from imposed risks to

whatever extent the affected citizens themselves would prefer, assuming those

affected societies experienced both the benefits and costs of the regulation.

Philosophically, this is a standard of hypothetical informed consent, and it forms the

ethical foundation of CBA. To reject the informed preferences of societies in favour


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of absolute safety amounts to a type of authoritarianism an ill-considered rejection

of the ideals of personal freedom and consumer sovereignty at the foundation of

democratic capitalism. The practical problems with a zero-risk approach are even

more troublesome.

If regulators go so far in the pursuit of complete safety that they make families

poorer through higher prices for zero-risk products, they can impose more risk from

the induced poverty than from the regulated activity. For example, many regulations

in the energy sector have the practical effect of raising gasoline prices, which has its

own adverse consequence for low-income households, including on their health.

Practical considerations favour some form of benefit-cost determination over blindpursuit of zero risk (Graham 06/06/11).

1.2.3 Regards the difference between a net improvement and a confirmed

panacea.

The third misconception regards the difference between a net improvement and a

cure. Always government programs are over advertised, i.e. program X can cure

poverty, program Y can stop illiteracy. But when program X was implemented and

poverty still exists then the problem surfaced because the public will presume that

program X has failed when it has not.

As Franklin and Lincoln had said a policy measure is worth embracing if its benefits

exceed its costs and thereby makes a net improvement even if it doesnt solve

some deep problems and issues. But if they are larger than the alternatives choices,the program is worthy of consideration. Society can ill afford to reject worthwhile

programs because they do not meet a standard that is far too demanding (Gramlich

1998).


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Figure 5: Has Anti Drug Campaign achieved 100% its Goals?

(Photo, Source: www.adk.gov.my ).

Another good examples is the government under the Home Ministry Department,

Against Drugs National Agency are spend millions a year to fight the misused of

drugs. But do they manage to cure all the drug addicts or to stop the young

generation from temptation of drugs? Or whether the most important thing is theimprovement (benefits) is acceptable and matches the cost?

Therefore CBA can be used to assist the decision maker to determine whether or

not a public project is to be implemented although their implementation will not

solve 100% of the problems. For many years, there have been calls from some

sector for greater reliance on the use of economic analysis in the development and

evaluation of environmental regulations. Most economists would argue that

economic efficiency was measured as the difference between costs and benefits

were shall to be one of the key criteria for evaluating proposed regulations. As the

society has limited resources to spend on regulation, such analysis can help to

illuminate the trade-offs involved in making different kinds of social investments.

Therefore, it would appear immature for not to conduct such analyses, while they

can actually inform decisions how insufficient resources can be put to the greatest

social good.


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In theory, CBA should be able to help in answering such questions of how much

regulation is sufficient on certain law. Answer to this question is to regulate them

until the incremental benefits from regulation are counterbalance by the incremental

costs. Although its look straight forward, on the other hand in reality the problem is

much more difficult especially for large project because of natural problems in

measuring insignificant benefits and costs . Adding to it, concerning about fairness

and process may also be very crucial economic and non-economic factors.

Regulatory policies unavoidably involve winners and losers, even when combined

benefits exceed combined costs.

Since CBA was first introduced , decision makers have sent diverged indicationsconcerning it usage in policy appraisal. Even in United Sate, The Congress has

passed several ruling to protect health, safety, and the environment that effectively

prevent the consideration of benefits and costs in the development of certain

regulations, although other ruling are actually require the use of CBA. However on

the other hand, American Presidents namely from Carter, Reagan, Bush, Clinton,

and Bush Jr. are all had demanded for the processes for reviewing economic

implications of major health, environmental, and safety regulations to use CBA. Seemingly the Executive Branch, who are control the designing and implementing

of regulations, has comprehend the need of CBA compared to The Congress. Since

then CBA has become the yardstick of choice against a new regulatory proposals.

Thus the misconceptions that public policy decision makings using CBA cannot

provide the complete panacea for solving the problems are not applicable.

1.3 Conclusion

One such question is the comparison of the benefits and costs of proposed policies

plays a truly useful role in making public policy decision, even opposing, to the

development, assessment, and implementation of sound policy for the public, in term

of environmental, resource, and energy realms. With an exceptionally talented group

of thinkers such as scientists, lawyers, economists and etc. who are now in keyenvironmental and energy policy positions within the government, the Department of


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Safety and Health (DOSH), the Ministry of Energy and Communication, and the

Ministry of Finance, this question about the effectiveness of CBA is of particular

importance. It is purely weighing the costs over the benefits which any layman could

understand and figure out. The tough part is how to manage the unquantifiable non-

tangible values. That is the biggest challenge for CBA.

CBA had proven its potential important role in helping notify regulatory decision

making. Off course CBA should not be the solitary footing for such decision making.

The following eight principles suggested by Professor Robert N. Stavins might be

able to assist in carrying out a good and dependable CBA;

First, benefit-cost analysis can be useful for comparing the favorable and unfavorable

effects of policies, because it can help decision makers better understand the

implications of decisions by identifying and, where appropriate, quantifying the

favorable and unfavorable consequences of a proposed policy change. But, in some

cases, there is too much uncertainty to use benefit-cost analysis to conclude that the

benefits of a decision will exceed or fall short of its costs.

Second, decision makers should not be precluded from considering the economic

costs and benefits of different policies in the development of regulations. Removing

statutory prohibitions on the balancing of benefits and costs can help promote more

efficient and effective regulation.

Third, benefit-cost analysis should be required for all major regulatory decisions. The

scale of a benefit-cost analysis should depend on both the stakes involved and thelikelihood that the resulting information will affect the ultimate decision.

Fourth, although agencies should be required to conduct benefit-cost analyses for

major decisions, and to explain why they have selected actions for which reliable

evidence indicates that expected benefits are significantly less than expected costs,

those agencies should not be bound by strict benefit-cost tests. Factors other than

aggregate economic benefits and costs may be important.


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Fifth, benefits and costs of proposed policies should be quantified wherever

possible. But not all impacts can be quantified, let alone monetized. Therefore, care

should be taken to assure that quantitative factors do not dominate important

qualitative factors in decision making. If an agency wishes to introduce a margin of

safety into a decision, it should do so explicitly.

Sixth, the more external review that regulatory analyses receive, the better they are

likely to be. Retrospective assessments should be carried out periodically.

Seventh, a consistent set of economic assumptions should be used in calculating

benefits and costs. Key variables include the social discount rate, the value ofreducing risks of premature death and accidents, and the values associated with

other improvements in health.

Eighth, while benefit-cost analysis focuses primarily on the overall relationship

between benefits and costs, a good analysis will also identify important distributional

consequences for important subgroups of the population.

From these eight principles, it is determine that benefit-cost analysis can play an

important role in legislative and regulatory policy debates on protecting and

improving the natural environment, health, and safety. Although formal cost benefit

analysis should not be viewed as either necessary or sufficient for designing sensible

public policy, it can provide an exceptionally useful framework for consistently

organizing disparate information, and in this way, it can greatly improve the process

and hence the outcome of policy analysis. If properly done, CBA can be of great helpto agencies participating in the development of environmental regulations, and it can

likewise be useful in evaluating agency decision making and in shaping new laws

(Stavins 2009).

A lot more misconceptions on CBA might surface during its implementation, but a

deep understanding on CBA fully will certainly helps to how to use CBA in project

cost, analysis, making appraisal and in selecting decision process. The common

objections and misconception about CBA are actually simply myths because of lack


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of understanding and stigma and perhaps the proper usage will actually helps to

make better decision whether or not to proceed with it.

These criticisms on CBA are also having bite to the extent that KH neglects equity

and other moral values. However, they are effectively vitiated by a version of CBA

that rests on rights and is inclusive of values. In this version, moral sentiments,

including those of equity, fairness, and the income distribution are considered as well

as the role of legal rights in determining values. Over time, the use of CBA

approaching this more sophisticated version increasingly reflects ongoing work by

both academics and practitioners (Zerbe and Bellas 2006). Therefore the use of CBA

is highly recommended.


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Question 2

The benefits of a project could be inferred from the demand function for a good or

service produced directly by the project. Demand functions could also be used to

measure benefits for a project that indirectly makes some good or service cheaper

for example, a dam that supplies power more cheaply and lowers the cost of

consumer goods, a road that lowers transportation costs, and so forth. But, it can get

complicated to see exactly how to use demand functions in this way.

Critically discuss THREE problems associated with the above issue. Support your

answers with appropriate illustrations and examples.(50 marks)

Answer 2;

2.1 Introduction

Demand function is defined as a behavioural relationship between quantity

consumed and a person's maximum willingness to pay for incremental increases in

quantity. It is usually an inverse relationship where at higher (lower) prices, less

(more) quantity is consumed. Other factors which influence willingness-to-pay are

income, tastes and preferences, and price of substitutes (wiki.answer.com).

Indirect Costs and Benefits are more subtle monetary consequences related to a

particular policy option. They are often long-term costs and benefits that result from

pursuing a particular policy option. Indirect costs and benefits also can be partial

costs or benefits that are affected by a specific policy but not completely determined

by it. Like direct costs and benefits, indirect costs and benefits need to be expressed

in U.S. dollars. For example, the indirect cost of unsafe working conditions may be an

increase in insurance premiums resulting from more workers' compensation claims.

An indirect benefit of a department-wide physical fitness program may be a decrease

in sick days taken by staff (FESHE Course).


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A cost and benefit of a project are consist of direct, indirect and intangible

cost/benefit, in this report we shall concetrate mainly on the indirect benefits as

instructed. The example for indirect benefit are building a dam that supplies power

more cheaply and lowers the cost of consumer goods, a road that lowers

transportation costs, and so onwards.

It is true that the demand functions of some public goods/services shall reflect the

indirect benefits of a project as because of its existence it can either indirectly reduce

the price of some public goods/services because part of the cost are now reduced

because of the indirect benefit from the project and become opportunities to theentrepreneurs/people to sell their product at bigger quantity.

The demand of public good/services are very much influence by the increases on

prices, competition, some are seasonable, intervention by the government policy,

market users and etc.

2.2 Three (3) Problems That Will Affect The Using of Demand Function to

Measure Indirect Benefit.

Although it is straight forward to use demand function to measure the direct benefits,

it would not the same when it involve indirect benefits. There should be a clearly

established demand for the public good/services. Demand should be effective,

namely backed up by purchasing power and willingness to buy of the consumers.

Demand alone is not enough to ensure the success of any projects and it can get

complicated to see exactly how to use demand functions in this way.

Among other problems that might be faced when using demand function to measure

the indirect benefit are three (3) problems namely The Shape of Demand Function ,

Shifts in the Demand Function and Market Effects and were explaining (Gramlich

1998).


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2.2.1 The Shape of Demand Function (Elasticity)

The price elasticity of demand can be applied to a variety of problems in which one

wants to know the expected change in quantity demanded or revenue given acontemplated change in price.

An important aspect of a product's demand curve is how much the quantity

demanded changes when the price changes. The economic measure of this

response is the price elasticity of demand. Price elasticity of demand is calculated by

dividing the proportionate change in quantity demanded by the proportionate change

in price. Proportionate (or percentage) changes are used so that the elasticity is a

unit-less value and does not depend on the types of measures used (e.g. kilograms,

pounds, etc).

As an example, if a 2% increase in price resulted in a 1% decrease in quantity

demanded, the price elasticity of demand would be equal to approximately 0.5. It is

not exactly 0.5 because of the specific definition for elasticity uses the average of the

initial and final values when calculating percentage change. When the elasticity is

calculated over a certain arc or section of the demand curve, it is referred to as the

arc elasticity and is defined as the magnitude (absolute value) of the following;

Ed = (Q2 - Q1) (P2 + P1)

(Q2 + Q1) (P2 - P1)

Where;

Q1 = Initial quantity

Q2 = Final quantity

P1 = Initial price

P2 = Final price

Ed = Elastic Demand

The average values for quantity and price are used so that the elasticity will be the

same whether calculated going from lower price to higher price or from higher price


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to lower price. For example, going from $8 to $10 is a 25% increase in price, but

going from $10 to $8 is only a 20% decrease in price. This asymmetry is eliminated

by using the average price as the basis for the percentage change in both cases

(NetMBA.com).

To better understand the price elasticity of demand, it is worthwhile to consider

different ranges of values.

Elasticity > 1

In this case, the change in quantity demanded is proportionately larger than thechange in price. This means that an increase in price would result in a decrease in

revenue, and a decrease in price would result in an increase in revenue. In the

extreme case of near infinite elasticity, the demand curve would be nearly horizontal,

meaning than the quantity demanded is extremely sensitive to changes in price. The

case of infinite elasticity is described as being perfectly elastic and is illustrated

below:

Figure 6: Perfectly Elastic Demand Curve

From this demand curve it is easy to visualize how an extremely small change in

price would result in an infinitely large shift in quantity demanded.


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Elasticity < 1

In this case, the change in quantity demanded is proportionately smaller than the

change in price. An increase in price would result in an increase in revenue, and a

decrease in price would result in a decrease in revenue. In the extreme case of

elasticity near 0, the demand curve would be nearly vertical, and the quantity

demanded would be almost independent of price. The case of zero elasticity is

described as being perfectly inelastic.

Figure 7: Perfectly Inelastic Demand Curve

From this demand curve, it is easy to visualize how even a very large change in price

would have no impact on quantity demanded.

Elasticity = 1

This case is referred to as unitary elasticity. The change in quantity demanded is in

the same proportion as the change in price. A change in price in either direction

therefore would result in no change in revenue.

Applications of Price Elasticity of Demand

The price elasticity of demand can be applied to a variety of problems in which one

wants to know the expected change in quantity demanded or revenue given a

contemplated change in price.


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For example, a state automobile registration authority considers a price hike in

personalized "vanity" license plates. The current annual price is $35 per year, and the

registration office is considering increasing the price to $40 per year in an effort to

increase revenue. Suppose that the registration office knows that the price elasticity

of demand from $35 to $40 is 1.3. Because the elasticity is greater than one over the

price range of interest, we know that an increase in price actually would decrease the

revenue collected by the automobile registration authority, so the price hike would be

unwise (NetMBA.com).

Among other factors influencing the Price Elasticity of Demand are the follows;

Availability of substitutes: the greater the number of substitute products, thegreater the elasticity.

Degree of necessity or luxury: luxury products tend to have greater elasticity than

necessities. Some products that initially have a low degree of necessity are habit

forming and can become "necessities" to some consumers.

Proportion of income required by the item: products requiring a larger portion of

the consumer's income tend to have greater elasticity.

Time period considered: elasticity tends to be greater over the long run becauseconsumers have more time to adjust their behaviour to price changes.

Permanent or temporary price change: a one-day sale will result in a different

response than a permanent price decrease of the same magnitude.

Price points: decreasing the price from $2.00 to $1.99 may result in greater

increase in quantity demanded than decreasing it from $1.99 to $1.98

(NetMBA.com).

Government intervention e.g. giving/pulling incentives and subsidies tomanufacturer might affect the prices (increasing/decreasing).

Example; Using the natural monopoly framework, suppose that a city is considering

building a subway that will lower the cost of a subway ride to $.25. Presently buses

cover the same routes and charge a fare of $.50, of which $140 is the marginal cost

of a bus ride and $.10 is profit. Transportation planners feel they know two points on

the demand function. Presently at the $.50 fare there are100,000 riders a year, and itis estimated that if the fare were $.40, there would be 140,000 riders. Perhaps this


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last point could have come from an earlier experience when the bus company may

have been forced to charge a fare of $.40.

The planners also know that the annual fixed cost of the subway will be $20,000.

Assume further that the planners know that if they build the subway, they should

maximize net benefits by charging the fare where the marginal benefits of the last

subway ride equal the marginal cost, $.25. Since they do not know ridership at this

low fare, a first reasonable thing for them to do would be to project on the basis of the

two demand points they do have, as shown in Figure 8. The $.10 fare reduction

seems to have caused a 40 ,000 increase in ridership. Extending this slope as if the

demand function were linear, the number of riders is projected to be 200,000

(Gramlich 1998).

Figure 8: Benefit From a Subway.

(Source: Gramlich 1998).

If the demand function is linear, each $.10 reduction in the toll raises ridership 40,000. Theprojected number of riders at a fare of $.25 is 200,000, and the consumer surplus gain is theshaded area, (.25)(100,000) + (.5)(.25)(100,000) = $37,500.

If the demand function has a constant elasticity of 1.5, the cut in toll to $.25 raises the number ofriders to 300,000. The consumer surplus gain would be larger than in the linear case.


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The consumer surplus from this change is the shaded area, equal to $.25*(100,000 +

200,000)/2 = $37,500. This consumer surplus is the sum of the pure price change

effect at the old quantity ($.25*100,000 = $25,000) and the expansion triangle

(.5*$.25*100,000 = $12,500). Note that some of this surplus is a pure gain and some

represents a transfer to consumers from the bus company, which lost $.10*100,000 =

$10,000 of profits.

The natural monopolies left one question unanswered. The planners know that the

fare that maximizes the net benefits of the subway is that where marginal benefits

equal marginal cost. But they do not know whether it is sensible to build the subway

in the first place. That is why a benefit-cost analysis must be carried out. Theiranswer is given by comparing the net benefits with the annual fixed costs of the

subway. The accord is

Gain to consumers (riders) $37,500Loss to producers (bus company) $10,000Loss to taxpayers (fixed costs) $20,000Net social benefits $7,500

Note that the marginal costs can be ignored in this calculation, because the toll

already pays for these marginal costs. The only gain attributed to consumers was

that received over and above paying the marginal cost of the subway ride.

This way of doing the analysis focuses on the gains and losses of different groups -

consumers gain $37,500, producers lose $10,000, and tax-payers lose $20,000,

making for net social benefits of $7,500. That same number can also be gotten by

ignoring the gains and losses of different groups and simply focusing on real

resource changes. Using this reasoning, 110,000 rides are taken more cheaply, for a

saving equal to the marginal cost difference ($.15) times the number of rides taken

more cheaply (100,000), for a total of $15,000. In addition, the expansion triangle,

already evaluated at $12,500, gives the added benefit from the increase in number of

rides. The annual cost of building the subway is $20,000. The sum is the same

estimate of net benefits as before, $7,500. From an economic efficiency standpoint

alone, there is not much to choose in one method over the other: probably the most


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reasonable advice is to do the analysis both ways to make sure the answer is the

same. If it is not, something is wrong.

This latter calculation also illustrates the nature of a transfer. Consumers are betteroff by $37,500 overall, $27,500 of which represents real social gain but $10,000 of

which represents a transfer from the owners of the bus company. When calculating

the total gain of consumers, or any other group, the gross gain of $37,500 is

relevant; when calculating the net social gain, all transfers should be netted out.

This example is a very simple and only used to illustrate the basic ideas of benefit-

cost analysis. For a real CBA, a host of complexities arise. CBA begin by

examining demand and supply functions more carefully, and then go on to a

more careful examination of the market equilibration process.

In the above subway example we assumed that transportation planners knew

two points on the demand function but had to extrapolate down to find how

many riders there would be at a toll of $.25. They extrapolated along the

linear demand function shown in Figure 8. Considering the Shape of the

Demand Function there could obviously be many demand functions going

through the two points given, and the planners should really try many different

ones to see how sensitive the results are to the assumed form of the demand

function. Often demand functions can be estimated with more points than two

by a statistical technique known as regression analysis. In that event as well,

the analyst should fit regressions of several functional forms, to see how

sensitive the results are to the assumed mathematical form of the demand

function.

Full-blown analysis of all possibilities may takes long time to be carried out.

Here we only show how the calculations would look with another common

demand function. The linear function shown in Figure 8 assumes that the

slope of the demand function is constant along its range; the other popular

alternative is to assume that the elasticity, or percentage change in quantity

caused by a percentage change in price, is constant along the demand


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function. The dashed line in Figure 8 plots a constant elasticity demand

function. This constant elasticity (E) can be estimated by plugging in the

formula:

( 1 ) E = ( Q/Q) / ( P/P)

Where Q refers to riders, P to the fare, and A represents the change. One

could use either beginning or ending values for both Q and P, and the results

would change accordingly. Since the choice is arbitrary, a reasonable compromise is to use the averages of the given points, 120,000 and $.45 respectively, and compute

what is known as an arc elasticity:

(2) E = (40,000/120,000) / (.10/.45) = 1.5

This value is then plugged in to solve for Q, the change in number of riders x 2 fare

of $.25

(3) 1.5 = ( Q/(.5*(100,000 + 100,000 + Q))) / (.25/.375)

Adding the change Q = 200,000 to the initial level, of 100,000 yields the number of

riders at a toll of $.25 as 300,000, as shown in Figure 8.

It is apparent from the figure that the constant elasticity form means that as the price

falls and ridership increases; the percentage, and not the absolute, change in the

number of riders remains the same. This forms then yield a larger consumer surplusgain than does the linear form. To compute exactly how much larger, it is necessary

to use calculus: specifically, to find the area under the demand function between Q =

100,000 and Q = 300,000 by integration. The formula for this area A , analogous to

the expansion triangle referred to earlier, is

300


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It is an increase of $4,940 in both the expansion triangle and the net social benefits

of the project.

The problem of estimating consumer surplus gains when one is uncertain about

functional forms has not attracted much attention, because there is not much one

can say about it. It is obvious from Figure 8 that this could be an important problem:

here this change alone raised the net social benefits from our prototype subway

significantly. But at the same time the evaluator is often in the position of observing

either two points on a demand function, or only points in a narrow range, with no clue

as to whether to extrapolate on a linear basis, a constant elasticity basis, or some

other basis. Economic theory cannot helpthere really is no guidance as to whatdemand functions should look like over particular price and quantity ranges. The only

sensible suggestion is that the evaluator should do the calculations in a variety of

ways, comparing the results to see how sensitive they are to the assumptions, a

technique known as sensitivity analysis. This technique will be proposed over and

over in this book to deal with various difficulties. Sometimes it does not help much,

but sometimes it does. In this case, for example, we are uncertain about how great

net social benefits are, but both way they are positive and the subway looks like agood deal (Gramlich 1998).

2.2.2 Shifts in the Demand Function

Even if we know the shape of the demand function, there are also other variables

that might shift it. Its impact is known as income elasticity of demand . The income

elasticity of demand is the relative change in the quantity demanded of a good inresponse to a change in consumer income.

Income Elasticity of Demand = (% change in quantity demanded) / (% change in

income)

Normal goods have positive income elasticity of demand because with an increase in

income, the demand for these goods increases. Inferior goods have negative income

elasticity. For example, if the income of a consumer increases by 50% and his


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consumption of fast-food hamburgers decreases by 10%, then his income elasticity

of demand for fast-food hamburgers is - 10/50 = - 0.2.

To understand how the law of supply and demand functions when there is a shift in

demand, consider the case in which there is a shift in demand:

Figure 9: Shift in Demand

In this example, the positive shift in demand results in new supply-demand

equilibrium point that in higher in both quantity and price. For each possible shift in

the supply or demand curve, a similar graph can be constructed showing the effect

on equilibrium price and quantity.

Some other factors that could affect demand function are as follows;

Consumer income - An increase in consumer income implies an increase in the

ability of consumers to purchase more of all goods. Therefore, demand for most

goods increase when consumer income increases. But we can also think of

products, such as public transportation, whose demand may decrease with

increases in income reasons because everybody afford to posses their own

vehicles. This happens because consumers can afford more desirable

alternatives. Such goods are known as inferior goods.


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Prices of related goods - Changes in the prices of related goods lead to changes

in demand. Related goods can be of 2 kinds - substitutes and complements. A

decrease in the price of a substitute good can cause demand of the concerned

good to decrease. For example, tea is a substitute for coffee. A decrease in the

price of tea can cause demand for coffee to decrease. A decrease in the price of a

complement good can cause demand of the concerned good to increase. For

example, if the price of balls decreases, the demand for bats may increase since

bats and balls are complementary goods.

Consumer preferences - Consumers have preferences for particular brands of

goods. These preferences can be changed in favour of a product with the help of

advertising, sales promotions etc. This will increase the demand for the product.

Building brand recognition is very important for organizations and the increases

demand justifies the additional expenditure.

Population - An increase in the population of consumers will increase demand for

all products. The quality of the population will also affect the demand for particular

products. For example, as the baby boomer generation ages and the population of

elderly Americans grows, the demand for health care and related services in the

United States will increase. Seasonal factors - Seasonal factors also influence the demand for a product.

Consumers purchase great deal of certain products during certain times of the

year. For instance, the demand for umbrellas is higher during the monsoons and

perhaps number of people going to zoo are are increases during public and

schools holidays.

Expectations - If consumers' expectations about the price of a good in future

changes, then the demand for the good will also change. If consumers expectprices to rise in the near future, they may demand more of a good today. The

opposite is true if consumers expect prices to fall in the future. When there is a

change in price, demand changes along the demand curve. However, when the

other factors affecting demand changes, the demand curve shifts to the right or

left.


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Even if we know the shape of the demand function, we have to worry about variables

that might shift it. Referring to Figure 10, suppose the initial price of some good or

service is Po and our project induces it to fall to Pi . Consumers would move along

what is known as their ordinary demand function, yielding the consumer surplus of

area ( A + B ). That is all straightforward enough, but it turns out that this is not an

exact measure of the gain from the price change if there are income effects

(Gramlich 1998).

The reason can be seen by decomposing the price reduction into its two

components, the substitution effect and the income effect. As the price falls,

consumers would buy more of the good even if their initial utility were not increased,because this good competes more favorably with other goods. This is known as the

substitution effect. But they also gain income and utility, because the price reduction

gives them more to spend on all goods, and they might consume more of this good

because of this income effect as well. Consumption increases on the ordinary

demand function because of both factors. But when measuring the utility gain to

consumers from the price reductionthe goal in a benefit-cost analysisthe income

effect must be excluded. To measure the true utility gain from the price fall, we needto hold utility constant and measure consumer surplus by comparison with that

baseline.

Figure 10: Income and Substitution Effects

(Source: Gramlich 1998).


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As the price falls from P 0 to P 1, consumers move along their Ordinary Demand Function from Q 0 to Q 1, Utility rises from U 0 toU 1, and if that rise in utility, or income, shifts demand, we candescribe demand functions at the initial utility level, U 0 , and the higher final utility level, U 1.

Area A is the gain in consumer welfare of this change measured at the new price level and old

utility level, called the compensating variation.Area [ A + B + C ) is the gain in consumer welfare of this change measured at the old price leveland new utility level, called the equivalent variation.

This can be done in either of two ways, both of which make economic sense:

The gain can be measured by finding the value of the price change at the initial

utility level and the new price level, area A in the figure. This area is called the

compensating variation, the sacrifice consumers would be willing to make to keep

utility unchanged evaluated at this new price level.

The gain can be measured by finding the value of the price change at the final utility

level and the initial price level, area (A + B + C) in the figure. This area is called the

equivalent variation, the sacrifice consumers would be willing to make to keep utility

at its final level evaluated at the old price level.

Compared to the ordinary demand function, both measures remove income effectsfrom the calculation. The reason for doing so is that as prices fall and real income

rises, the income effect gives the change in consumption and consumer surplus from

the derived change in income, indicating a form of double-counting. To measure the

utility gain exactly, an experimenter might ask the consumer to pay the exact

marginal valuation of the Q 0 unit into a fund so that utility is held constant at U 0 , the

exact marginal valuation of the next unit, again keeping initial utility constant, and so

forth until the experimenter has collected exactly area A into the fund. Area A thenmeasures exactly what the consumer would be willing to pay for the price change

and still be at the same initial utility level, or the exact measure of consumer gain

(Gramlich 1998).

It may seem strange that there are two different exact measures of consumer

change, but do not be alarmed. The reason is that there are two different utility

levels. Once the price has fallen and the consumer is atU 1

, the consumer is better off

and consumes more of the good. Measured at this higher utility level, the value of the


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price reduction will then be greater. This means that when the price falls, the

equivalent variation at the high utility level will exceed the compensating variation at

the low utility level, and vice versa when the price rises.

The evaluator should first, recognize that the whole problem comes about because of

income effects. If alterations in the price of some goods do not change consumer

incomes much, or if income changes do not affect consumption, consumer surplus

could be measured exactly from the ordinary demand curve. Beyond that, when the

problem does exist, as it will for goods that loom large in consumer budgets such as

housing, income effects can be removed by either procedure (Gramlich 1998).

2.2.3 Market Effects

Companies or organizations have to know who are their customers to their goods or

services and inquire how the whole market mechanism in order to measure benefits.

Project managers have to decide how much of output to sell and what price to charge

for each unit of the product/service. These are important in order to maximise the

production and maximizing profits. For example a developer who wants to built

expensive houses for niece market should understand the regulation and the

capacity of the buyers, suitability it location and etc. before they make up their

decision otherwise the project will fail because of no demand.

Profit = Price*Quantity - Costs.

For the quantity produced and the costs incurred during the production, the higherthe price is charged the more the profits will be. Nevertheless, the maximum limit of

any prices can be increased are very much depend on the market strength benefited

by the organisation. If a company or organisation is the sole manufacturer of a

good/service then they have a full control over the demand and can charge a higher

prices. In the other hand the presence of several manufactures that produces similar

products might restricts the company selling their product too expensive due to the

fear of losing customers. Shall there are several manufacturers selling a similar


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product then the market is to be competitive while monopoly is a market with only a

single producer of any product or service. Some examples of competitive market are

automobile and computer industries where monopoly markets are electricity producer

and water supply.

The following are some brief scenarios how the market effect will influences pricing

and output decisions;

Perfect competitions normally have these characteristics;

Many players - There are a large number of companies in the market. As the

result each organisation produces a very small portion of the industry output.However this means that a single organisation cannot affect the market prices.

Identical products - All the organisations in market produce and sell a similar

product. The consumers cannot tell the product different between produced by one

company and another.

Free entry and exit Anybody are free to enter the market and it also goes to

whom that are want to leave. Therefore new company might reduce price but

increase their supply in order to gain the market with less profit margins but inbigger volume. Producers who cannot sustain shall leave.

Perfect information - All companies are fully aware about the prices and costs of

their rival. Buyers have full information about prices and other relevant factors.

For some product no organisation can influence the market price by increasing their

supplies because of its relative small size in the market. Then the price is determined

by the forces of total demand and total supply. Each organization takes theequilibrium price as given. The only variable that is under the control of an

organization is its level of productivity. An organization decided on a higher output

level will maximise profits.

Monopoly is a market where there is only one player of particular product/service.

Being the sole supplier, the monopoly organisation has the power to control prices

and output to maximise its profit. Monopoly means the absence of competitionamong organizations.


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In order for monopoly to happen the following conditions should be present;

Single producer of the product/service.

There must be no close substitutes for the product so that there is no

competition.

Strong barriers to the entry of new organizations into the industry.

For simplicity assume away the previous issueslet say demand functions are

known to be linear and income effects are known to be absent. Even then, the exact

measure of project benefits depends on two characteristics of the consumer market,

whether costs are constant or increasing, and whether there are market

imperfections.

The various cases are illustrated in Figures 11 and 12. Figure 11 shows the situation

when there are no market imperfectionsthe demand function for the good

measures the value of the good, and the supply function measures the true marginal

social cost of producing the good.

Things are pretty straightforward if the marginal cost of supplying the good isconstant, as shown in the left panel of Figure 11. Our project makes something

cheaperenergy, transportation, or whatever; this lowers the supply function and

generates the familiar shaded trapezoid in project benefits.

Now say the supply function is sloped upward, because it costs more at the margin to

expand output. The project shifts the supply function falls S to S' , the market price

falls from P 0 to P 1, and output rises from Q 0 to Q 1 Gains and losses from this changeare as follows;


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Figure 11: Value of Output, No Distortions

(Source: Gramlich 1998)

A project lowers the cost of providing a good or service, shifting down the supply function.(a) If there are constant costs in the supplying industry, the supply function is shifted down and

the shaded trapezoid represents project benefits.(b) If costs are increasing, project benefits are given by the shaded area.

Consumers gain the consumer surplus trapezoid P 0 ABP 1.Producers had a surplus of P 0 AE before the change and get P 1BF after the change. Netting outthe common triangle P 1CE , producers gain trapezoid ECBF and lose trapezoid P 0 ACP 1 The sum of the gain to consumers and producers from the change is the shaded trapezoidEABF , approximately the same as for the constant cost case but very slightly smaller.

In Figure 12 market distortions was added. There could be lots of ways in which a

market is distorted, and here we show only one. Suppose the good in question

generates benefits to outsiders, called external benefits. These external benefits can

be added to consumer demand to yield the higher social demand function D' . The

difference between D' and D at any quantity represents the external benefits from the

good.

In both panels of the Figure, market output rises from Q 0 to Q 1. All the external

benefits up to Q 0 are not at issuethey were realized before the change and they

still are. But new external benefits equal to the shaded parallelogram ABCE are

realized on the expanded output, and these new benefits must be counted in to get


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the social benefits from the project. That gives the shaded areas shown, the sum of

benefits inside the market and new benefits outside the market.

Figure 12: Value of Output, Distortions

(Source: Gramlich 1998)

A project lowers the cost of providing a good or service in the presence of some market externality.a) If there are constant costs the trapezoid P 0 ECP 1 gives the gain to consumers of the good or

service and the parallelogram ABCE the external benefits of the change in output. The netgain is the shaded area.

b) If costs are increasing, project benefits are the sum of the net gains in the market and theexternal benefits, the shaded area.


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2.3 Conclusion

Definitely there will be indirect benefit that resulting because of the existent of a new

project. The increase/decrease prices of some public good or services will be someof them. Although the demand function can be used to measure or calculate the

indirect cost/benefit but there are three (3) problem that need to be cater namely The

Shape of Demand Function , Shifts in the Demand Function and Market Effects and

were explaining (Gramlich 1998).

The Shape of Demand Function is crucial to demand curve because the quantity

demanded changes when the price changes. This elasticity behaviour are very much

affected by the availability of substitutes: the greater the number of substitute

products, the greater the elasticity, degree of necessity or luxury: luxury products

tend to have greater elasticity than necessities, proportion of income required by the

item: products requiring a larger portion of the consumer's income tend to have

greater elasticity, time period considered: elasticity tends to be greater over the long

run because consumers have more time to adjust their behaviour to price changes,

permanent or temporary price change: a one-day sale will result in a different

response than a permanent price decrease of the same magnitude, price points:

decreasing the price from $2.00 to $1.99 may result in greater increase in quantity

demanded than decreasing it from $1.99 to $1.98, Government intervention e.g.

giving/pulling incentives and subsidies to manufacturer might affect the prices

(increasing/decreasing) and others.

On top of that, the demand curve that requires iteration or regression analysis

(solution using calculus) should be used compared to linear demand line solved

using extrapolation statistical method. The analysis should be carried out regression

that fit several functional forms in order to see how sensitive the result are to the

assumed mathematical form of the demand function.

The problems associated with Shifts in the Demand Function are other variables

that might shift the demand function e.g. the consumer income that are also known

as income elasticity of demand. An increase in consumer income implies an increase


40/42



in the ability of consumers to purchase more of all goods or services. Therefore,

demand for most goods increase when consumer income increases but for inferior

products, such as public transportation and cheap meal the demand may decrease

with the increases in income. This happens because consumers can afford more

desirable alternatives.

Some of the prices of related goods lead to changes in demand, related goods can

be of 2 kind; substitutes or complements, consumer preferences ; consumers have

preferences for particular brands of goods, an increase in the population of

consumers; will increase demand for all products, the quality of the population; will

also affect the demand for particular products, seasonal factors; also influence thedemand for a product, if consumers' expectations about the price of a good in future

changes; then the demand for the good will also change and if consumers expect

prices to rise in the near future; they may demand more of a good today.

The problems associated with Market Effects are that the companies or organizations

have to know who are their customers to their goods or services and inquire how the

whole market mechanism in order to measure benefits. These are important in orderunderstand the market in order to maximise the production and maximizing profits.

Therefore the company or organisation must know whether their businesses are

either perfect competitions or monopoly. This will very much contribute to the

productions, profit and market force.

If all these associated problems are solved then only the indirect benefits calculated

using the demand function are accurate enough and can used in the CBA.


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Reference

1) (ed), Cat Sharpe. (1998). How to conduct a cost-benefit analysis . [Books24x7 version]Available from http://common.books24x7.com/toc.aspx?bookid=6588 .

2) Armstrong, Michael. (2006). Handbook of management techniques, revised third edition . [Books24x7 version] Availablefrom http://common.books24x7.com/toc.aspx?bookid=18795 .

3) Boardman, A.E., Greenberg, D.H., Vining, A.R. and Weimer, D.L. (2006). Cost Benefit Analysis: Concepts and Practice . Englewood Cliffs, NJ: Prentice Hall.

4) Brent, R. J. (2006), Applied cost-benefit analysis , Edward Elgar Publishing Limited,Cheltenham, UK.

5) Bruce Hokin, Cost Benefit Analysis - 10 Most Common Myths Debunked, Article Snatch, LLCExtracted on 06/09/2011 from website; http://www.articlesnatch.com/Article/Cost-Benefit-Analysis---10-Most-Common-Myths-Debunked/144209 .

6) Buchanan, James M. (1999). The Demand and Supply of Public Goods . Library of Economicsand Liberty. Retrieved December 6, 2011 from the World Wide Web:http://www.econlib.org/library/Buchanan/buchCv5c10.html .

7) Burgess, David F. and Zerbe, Richard O. (2011) "Calculating the Social Opportunity CostDiscount Rate," Journal of Benefit-Cost Analysis : Vol. 2: Iss. 3, Article 8. DOI: 10.2202/2152-2812.1106. Available at: http://www.bepress.com/jbca/vol2/iss3/8 .

8) CBA Step 2: Identify Assumptions, Costs, and Benefits. FESHE Course: AnalyticalApproaches to Public Fire Protection. Extracted on 06/09/2011 from website;http://etudesproject.org/nonfpdata/cog/FS362/DOC0082.htm .

9) Defination for Cost Benefit Analysis. The Free Dictionary, Extracted on 15/11/2011 fromwebsite; http://encyclopedia2.thefreedictionary.com/cost-benefit+analysis .

10) Defination for Demand Function. wiki. nswer.com Retrieved from http://wiki.answers.com/Q/What_is_demand_function .

11) Economic Analysis Primer Benefit-Cost Analysis. United States Department of Transportation- Federal Highway Administration Extracted on 15/11/2011 from website;https://www.fhwa.dot.gov/infrastructure/asstmgmt/primer05.cfm .

12) Graham, John, D., (06/06/11), The Myths of Benefit Cost Analysis, University of Pennsylvania

Law School 3400 Chestnut Street Philadelphia, PA 19104Extracted on 15/11/2011 fromwebsite; http://www.law.upenn.edu/blogs/regblog/2011/06/the-myths-of-benefit-cost-analysis.html .

13) Gramlich, E. M. (1998). A guide to benefit-cost analysis (2nd ed.). Long Grove. WavelandPress, Inc.

14) G reenlees, J. S., & Mc Clelland, R. B. (2008). Addressing misconceptions about the consumerprice index. Monthly Labor Review, 131 (8), 3-19. Retrieved from http://search.proquest.com/docview/235706699?accountid=48462 .

15) Husdal, J. (2007) Cost-Benefit Analysis an essay about valuation problems. Unpublished working paper. Molde University College, Molde, Norway. Extracted from;

http://www.husdal.com/2007/01/05/cost-benefit-analysis-an-essay-about-valuation-problems/


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