7 Making Hard Choices Flashcards
(35 cards)
Cost-Benefit Analysis
systematic approach to evaluating the total costs and benefits of a project or policy, expressed in monetary terms, to determine its net benefit
Net Present Value
The sum of discounted benefits minus costs over a project’s lifetime. A positive NPV indicates the project adds value.
NPV = (Sum of discounted benefits - discounted costs) - initial cost
Social discount rate
society’s preference for present benefits over future ones, crucial for weighting long-term benefits like climate change mitigation
Public procurement (and goals)
process by which governments acquire goods, services, or works from private firms. Effective procurement ensures value for money, transparency, and alignment with public goals
Principal-Agent problem
when one party (principal) contracts another (agent) to perform tasks, but the agent’s goals or information differ
Eg. Misaligned incentives, or asymmetric/unverifiable information
Under perfectly aligned motives or perfectly observable outcomes you won’t need a contract
Shadow price
An estimated value of goods or services that do not have a market price, such as environmental benefits or time saved from reduced commuting. Shadow prices are crucial in cost-benefit analyses to include non-market impacts
Revealed preference
A method of estimating the value individuals place on goods or services by observing their actual behaviour in market transactions. For example, the value of clean air can be inferred from higher property prices in low-pollution areas
Hedonic pricing
A valuation method that breaks down the price of a good into the value of its attributes. For instance, the price of a house reflects characteristics like location, size, and proximity to schools or parks
Value of a statistical life (VSL)
A measure of the monetary value society places on reducing the risk of death. For example, VSL is used to assess the benefits of safety regulations or health interventions
Social Time Preference
The rate at which society values present consumption over future consumption. It is a key determinant of the social discount rate in long-term project evaluations
Cost-Effectiveness Analysis
evaluates the least costly way to achieve a
specific objective, such as reducing carbon emissions or improving health outcomes. Unlike CBA,
CEA focuses on efficiency rather than overall net benefits.
Outsourcing
contracting external firms to deliver goods or services traditionally provided by the public sector. Outsourcing aims to leverage private sector efficiency but may pose risks such as reduced accountability or quality
Sealed-Bid Auctions
A procurement method where bidders submit confidential bids, and the winner is chosen based on predefined criteria, such as lowest cost. This approach promotes competition and reduces collusion
Bertrand Competition - optimal strategy for the firm is to bid where p=MC. If more than one bidder, solves the PA problem
Contestability of markets
Refers to the ease with which new competitors can enter a market and challenge incumbents. High contestability ensures efficiency and innovation by preventing monopolistic behaviour
Public-Private Partnerships
PPPs combine public funding with private delivery, sharing risks and rewards. While they can improve efficiency and innovation, they often lead to higher financing costs and renegotiation challenges. For example, PPPs in infrastructure projects frequently face criticism for cost overruns and reduced service quality
PPP premium
The additional cost of financing a project through Public-Private Partnerships (PPPs) compared to traditional public funding, often due to higher private sector borrowing costs or profit margins
Payments by results
A procurement model where contractors are paid based on outcomes rather than inputs, transferring risk to the implementer and incentivizing efficiency
How to use CBA
Governments use CBA to allocate resources effectively. For instance, comparing the NPV of subsidizing malaria bed nets versus draining swamps highlights the importance of measuring benefits (e.g., lives saved) and costs (e.g., environmental damage).
Challenges include valuing non-market impacts (e.g., health, biodiversity) and choosing appropriate discount rates, which heavily influence long-term project rankings.
Annual benefit: $500,000. Discount rate: 5%
PV of benefits = $500,000 x [(1 - (1 + 0.05)^(-10)) / 0.05] = $3,861,000
Challenges of CBA
- valuing non-market impacts, such as environmental benefits or social cohesion, which lack clear monetary values
- Choosing the discount rate
- Uncertainty about future costs and
benefits (have to choose both direct and EXTERNAL effects) eg. pollution, natural beauty, biodiversity - biased or inaccurate input data - eg. are wages a good way to measure the social cost? Only if there is a perfect market! Under market failure, wages =/ marginal social cost (or value)
- Ethical limitations also arise when attempting to assign monetary value to intrinsic goods like human life or cultural heritage
- Catastrophic events eg. climate change
Principal-Agent Problem in Procurement (and solutions)
Misaligned incentives and asymmetric information can lead agents to prioritize their own interests, such as minimizing costs or maximizing profits, over the principal’s goals of quality, efficiency, and timeliness. For instance, a contractor might reduce expenditures on materials or labor to increase profit margins, potentially compromising the quality of infrastructure or services, especially if government oversight and monitoring are inadequate.
Solution:
1. performance-based contracts - payments are tied to achieving specific, measurable outcomes.
2. Sealed-bid auctions enhance transparency and foster competition, reducing the likelihood of inflated costs or favoritism in contractor selection.
3. Outcome-based nancing, such as social impact bonds, transfers performance risk to private investors, who are repaid only if agreed-upon outcomes are achieved
Benefit cost ratio
BCR - one way of doing CBA (the other one is NPV method, which is preferred)
Net present value (benefits) / costs
Flaws or biases in valuation
- Strategic bias: misreporting to influence the outcome (or if not, hypothetical bias). Or political meddling - going against evidence, imposing unrealistic assumptions
- Information bias: respondents may have no info, or the wrong info (Pollack AER 1998), or be subject to behaviourial biases (e.g. bad with probability data)
- Framing bias: respondents affected by order/number of alternatives, and subject to an embedding effect
- Optimism bias: tendency to have overoptimistic assumptions about costs, benefits, risks, implementation time, etc. (In UK, each CBA in government needs to assess itself relative to this common bias)
How to calculate value of a life saved?
Milton Friedman - scarce resources have alternative uses! A revealed-preference approach: estimate the value of a statistical life (VSL) from wage differences - eg. coal miner vs cashier
