Now in its third edition, Cost-Benefit Analysis has been updated, offering readers the perfect introduction to project, programme and policy appraisal using basic tools of financial and economic analysis.
The key economic questions of any social cost-benefit analysis are: do the benefits of the project or policy exceed the costs, no matter how widely costs and benefits are spread, and irrespective of whether or not project impacts, such as environmental effects, are reflected in market prices? And which group or groups of individuals receive the benefits and which bear the costs? This book addresses these questions with an emphasis on putting the theory presented in the book into practice.
This third edition has several attractive features:
Readers are encouraged to develop their own skills by applying the tools and techniques of cost-benefit analysis to case studies and examples, including an analysis of a project which is developed throughout the book.
The book emphasizes the use of spreadsheets which are invaluable in providing a framework for the cost-benefit analysis.
A dedicated chapter provides guidance for writing up a report which summarises the analysis which has been undertaken.
New pedagogical features, including Technical Notes and Examples, have been added as an aid to readers throughout the text.
An appendix provides 14 additional case studies which can be developed in class or as assignment projects.
Additional material for instructors and students is provided through Support Material maintained by Routledge.
This updated edition is an ideal text for a course on cost-benefit analysis where the emphasis is on practical application of principles and equipping students to conduct appraisals. It is also a useful handbook for professionals looking for a logical framework in which to undertake their cost-benefit analysis work.
Introduction to cost-benefit analysis 1
Introduction 1
The Referent Group 6
The structure of the cost-benefit model 8
The use of spreadsheets in cost-benefit analysis 11
The rationale for public projects 14
The role of the analyst 16 Further reading 17
Exercises 17
Project appraisal: principles 19
Introduction 19
Project appraisal from an individual viewpoint 19
Investment opportunities in the economy as a whole 22
The algebra of NPV and IRR calculations 23
Annuities and perpetuities 30
The Rule of 72 34
Economic depreciation and the annual cost of capital 35
Treatment of inflation in project appraisal 36
Incorporating a risk factor in the discount rate 38 Further reading 39
Exercises 39
Project appraisal: decision-rules 40
Introduction 40
Discounted cash flow analysis in practice 40
vi Contents
Discounting and the time value of money 41
Using Annuity Tables 44
Using investment decision-making criteria 45
The Net Present Value (NPV) criterion 45
The Benefit-Cost Ratio decision-rule 47
The Internal Rate of Return (IRR) criterion 48
Problems with the IRR decision criterion 51
Problems with the NPV decision criterion 53
Using spreadsheets 59 Further reading 64 Exercises 64
Private cost-benefit analysis: financial appraisal 68
Introduction 68
Benefits and costs measured as cash flows 69
Identifying project inputs and outputs 69
Valuing inputs and outputs at market prices 70
Characteristics of cash flows 70
Inflation and relative prices 72
Incremental or relative cash flows 74
Capital costs and the treatment of depreciation 76
Interest charges, financing flows and cash flow on equity 78
Taxation and after-tax net cash flows 83
The discount rate 84
Summary of the relationship between the Market Analysis and the Private Analysis 85
Derivation of project private cash flows using spreadsheets 85 Appendix to Chapter 4: Case Study of International Cloth Products 91 Further reading 97
Exercises 97
Cost-benefit analysis and economic efficiency 99
Introduction 99
The competitive market 100
Shadow-pricing project inputs and outputs 103
Shadow-pricing marketed inputs 104
Materials 105
Labour 109
Capital 117
Land 118
Rules for shadow-pricing marketed inputs 118
Shadow-pricing marketed outputs 119
Rules for shadow-pricing marketed outputs 124
The efficiency pricing rules: summary 124
Contents vii
Corrective taxation: the modified efficiency pricing rules 125
How to determine which pricing rule to follow 126
Shadow-pricing public funds 128
Shadow-pricing foreign exchange 133
The discount rate 133
Worked examples 136
Efficiency analysis of the National Fruit Growers (NFG) Project 136
Cost-benefit analysis of the 55 mph speed limit 140
Appendix to Chapter 5: Economic Efficiency Analysis of the ICP Case Study 142 Further reading 145
Exercises 146
The distribution of project net benefits 149
Introduction 149
How to identify Referent Group net benefits in practice 150
Some examples of the classification of net benefits 154
Shadow-prices on project inputs 154
Shadow-prices on project outputs 160
Corrective taxation 161
Further examples 166
Lessons from the examples 168
Worked example: Referent Group Analysis of National Fruit Growers (NFG) Project 168
Appendix 1 to Chapter 6: Referent Group net benefits in the ICP Case Study 171
Appendix 2 to Chapter 6: Incorporating the public funds cost premium in the ICP Case Study 177
Further reading 179
Exercises 180
Consumer and producer surplus in cost-benefit analysis 182
Introduction 182
Real versus pecuniary effects 183
Consumer surplus 184
Aggregating consumer surplus measures 185
The significance of income distribution 186
Producer surplus 186
Accounting for output price changes 186
Benefits of urban transport projects 187
Benefits of worker training 193
Producer benefits from an irrigation project 196
Accounting for input price changes 201
Price changes in other markets 203
Classification of consumer and producer surplus changes 204
viii Contents
Appendix 1 to Chapter 7: Allowing for an increase in the skilled wage in the ICP Case Study 206
Appendix 2 to Chapter 7: Compensating and equivalent variation 209 Further reading 215
Exercises 215
Non-market valuation 217
Introduction 217
Causes of market failure 217
Valuing environmental costs and benefits 219
Incorporating non-market values in cost-benefit analysis 223
Methods of non-market valuation 224
The production approach 225
The utility approach 230
Revealed and stated preference methods of applying the utility approach 233
Revealed preference methods 234
Stated preference methods 240
Benefit Transfer and Threshold Analysis 243
Alternative approaches to environmental valuation 244
Non-market valuation: the value of life 245
8.10 The Pandemic (NB page number required)
8.11 Climate Change (NB page number required)
Appendix to Chapter 8: The annual benefits of the Virginia Creeper Trail as measured by the Travel Cost Method 248
Further reading 251
Exercises 251
Uncertainty, information and risk 253
Introduction 253
The value of information 255
An abbreviated cost-benefit analysis 257
The option of delay 257
Calculating the value of information 260
The cost of risk 262
The theory of risk aversion 262
Dealing with project risk 265
Risk modelling 267
Use of discrete probability distributions 268
Joint probability distributions 269
Continuous probability distributions 270
Using risk analysis in decision-making 273
Modelling risk in spreadsheet applications using ExcelSim© 274
Modelling a "random walk" 279
Appendix 1 to Chapter 9: Incorporating risk analysis in the ICP Case Study 282
Contents ix
Appendix 2 to Chapter 9: Using the @Risk© (Palisade) Risk Modelling Program 285
Further reading 289
Exercises 290
Valuing traded and non-traded goods in cost-benefit analysis 292
Introduction 292
Traded and non-traded goods 292
Valuing traded and non-traded goods and services 293
Worked example: domestic and international price structures 294
Evaluation of an import-replacing project in real terms 294
Evaluation of an import-replacing project in money terms 295
Summary of the two approaches to valuation: border versus domestic prices 298
Equivalence of the two approaches 298
Determinants of the shadow exchange rate 302
Appendix to Chapter 10: Shadow-pricing foreign exchange in the ICP case study 305
Further reading 308
Exercises 308
Appraisal of the distribution of project benefits and costs 310
Introduction 310
Measuring the degree of inequality 311
Alternative measures of income distribution 313
Policies to change the income distribution 314
The use of income distribution weights in project appraisal: some illustrative examples 314
The derivation of distribution weights 316
Distributional weighting in practice 322
Worked example: Incorporating income distribution effects in the NFG Project 326
Inter-temporal distribution considerations 327 Further reading 331
Exercises 331
Economic impact analysis 334
Introduction 334
Multiplier analysis 334
The closed economy 334
The open economy 339
Crowding out 340
Cost-benefit analysis of fiscal stimulus 341
The employment multiplier 342
x Contents
Inter-industry analysis 342
Inter-industry analysis and the national income multiplier 345
Inter-industry analysis and employment 346
General equilibrium analysis 348
Case study: The impact of the ICP Project on the economy 349 Appendix to Chapter 12: The annual economic impact of the
Virginia Creeper Trail 350 Further reading 352
Exercises 352
Writing the cost-benefit analysis report 354
Introduction 354
Contents of the report 355
The Executive Summary 355
The Introduction 355
The Methodology 355
The Analysis 356
The Conclusion 356
Other issues 357
Appendix to Chapter 13: Report on International Cloth Products Ltd.: Spinning Mill Proposal 357
Appendix 1: Case study assignments 371
A1.1 South Australian Olive Oil Project 372 A1.2 Walnuts Tasmania Project 376
A1.3 A tuna cannery in Papua New Guinea 380
A1.4 Urban water supply in South-East Queensland 383
A1.5 The Scottish Highlands and Islands remote dental care program 388 A1.6 The Defarian Early Childhood Intervention Program (DECIP) 392 A1.7 A pulp mill for Tasmania? 399
A1.8 Qingcheng Water Project 403 A1.9 Highway Project 2012 409
A1.10 International Mining Corporation (IMC) Copper Mining Project 416
A1.11 Comparative Levelized Cost of Electricity: Renewables vs Coal
A1.12 Cost-Benefit Analysis of the Proposed Repeal of Water Saving Regulations
A1.13 Cost-Benefit Analysis of the Proposed Extension to the Mount Beno Walking Trail
A1.14 Cost-Benefit Analysis of a Proposed Drug Court Program in the State of Euphoria, Federal Republic of Oz
Appendix 2 Discount and Annuity Factors 424
Glossary 427
Index
