Cost-Benefit Analysis - Assignment Example

Cost Benefit Analysis Name: Institution: Instructor: Course Code: Question 1: Consider the choice between three competing alternatives (A, B and C), with and without a budget constraint. When would we choose a benefit-cost ratio (BCR) and when would we choose the net present value (NPV) to compare these alternatives? In order to obtain either BCR or NPV, the present values of the benefits and costs of given projects are often measured over the life of the project. For NPV the present value of costs are subtracted from the present value of the benefits in order to arrive at the NPV, while for the BCR, the present value of all benefits is divided by the present value of all costs in order to arrive at BCR (Office of Best Practice Regulation, 2009; Gupta, 1990). This is as shown below Where there three projects A, B, and C, that are competing, then in making a decision on which one is to be chosen, whether there is a budget constraint or not, the project with the highest benefit will be most preferred. The accept rule for NPV is accept if NPV>0. In the case that of three competing projects A,B, and C, if C has a higher NPV than the other two, then C would be chosen. In the case of CBR, if project B has a higher CBR than the rest, it is the most viable to be chosen (Gupta, 1990). The NPV unlike the BCR measures the absolute size of the net benefits in present terms. The BCR measures benefits of a project relative to their costs since it divides up the present value by the present costs. It is this very essence that makes BCR a most suitable measure to use when working under budget constraints, while NPV most suitable one to use when there are no constraints to the budget of the project (Office of Best Practice Regulation, 2009). The relative size of a projects benefits and costs (BCR) are mainly dependant on how various impacts to the project are treated whether such an impact is a cost to be subtracted from the benefits or to be added to the costs. Unlike NPV, the classification of costs, whether they are negative benefits or initial outlay, makes no difference to the value of the NPV. This is unlike BCR where negative benefits rather than being considered as costs and added to the cost, are often viewed as negative benefits and subtracted from the benefits. The only cost in BCR is often the project initial outlay. This makes a great difference for BCR on how such negative benefits are treated. And this makes BCR more cost sensitive than NPV (Gupta, 1990). In addition, using NPV and CBR can give conflicting decisions when ranking the viability of projects. For instance, for project A, B and C, differences in ranking can be noted as shown below: Project Capital (discounted at 10%) Present value of benefits (discounted at 10%) NPV NPV ranking BCR BCR ranking A 1000 1800 800 3 1.8 1 B 1500 2500 1000 2 1.7 2 C 9500 12000 2500 1 1.3 3 Under NPV, project C would be chosen since it has higher NPV of 2500. On the contrary, BCR project A would be chosen since it has higher BCR of 1.8. In such situations, BCR would only be preferred where the budget is limited. This is because by allocating limited funds using BCR would a higher net benefit be attained than if NPV was used. In projects where there are no constraints, NPV would be most viable as it would enable the project with the highest benefit despite its cost be chosen (Office of Best Practice Regulation, 2009). Question 2: Consider Harberger’s approach to measuring the economic benefits of project outputs in a closed economy with no distortions. Describe the conceptual basis for measuring these benefits when the project output partially meets new demand and partially substitutes for (or displaces the) existing supply. Use a supply/demand curve model to help your explanation. Using Harberger’s Framework for measuring the projects economic benefits, the demand curve is used to measure the benefits of a project while the supply curve measures its costs. In essence while measuring economic benefits, the outputs in terms of their supply and demand prices and their elasticities are used. This economic benefit mainly depends on whether new demand has been produced by the output produced or it has substituted an existing supply source. In other instances it may partially substitute existing supply source while partially meeting new demand (Tham, 2002). In the case where the outputs of a project partially substitutes existing supply source and partially meets new demand, economic benefits can be derived if there are no market distortions such as taxes and subsidies (Tham, 2002). Considering the demand curve, D0 and supply curve, S0 for a given good, say for instance bread. Where there are no distortions such as taxes and subsidies, the market equilibrium is at point A where the supply and demand of the bread intersect, with P0 being the price consumers are willing to pay for Q0 quantity of good while it is also the price suppliers are willing to accept supply Q0 quantity of bread. With introduction of a new bakery project, quantity of bread supplied will increase shifting the supply curve outwards to S1, which will result to a drop in price of bread to P1. The new equilibrium moves to B (Tham, 2002). This project output resulting to a fall in price, increases the quantity demanded by customers due to lower prices from Q0 to Q1, thereby increasing the economic benefit and it also replaces existing out of the industry. The economic benefit in this case will rise by the given area Q0Q1BA which includes the increased benefit enjoyed by consumers Q0Q1BC added to consumer surplus CBA. The impact of the project will also replace some existing bread producers in the industry by cutting supply of bread from Q0 to Qe on the original supply curve (that is from point A to D), with the economic benefit in this impact being QeQ0AD. Therefore the total economic benefit is equal to QeQ1BAD, that is, amount actually paid by consumers (QeQ1BD) plus consumer surplus (P0P1BA) subtracts loss in producer surplus (P0P1DA). The total economic benefit of the project therefore can be attained by adding the weighted supply and demand of the output of the project. That is the weighted quantity of output that substitutes existing demand and the weighted output that meets new demand. This is shown in the calculations below (Tham, 2002): Weighted quantity of output that substitutes existing demand = average price of output * quantity of output that substitutes existing demand Weighted quantity of output that substitutes existing demand = [(P0+P1)/2] *(Q0-Qe) Weighted output that meets new demand = Average price of output * output that meets new demand Weighted output that meets new demand = = [(P0+P1)/2] *(Q1-Q0) The total economic benefit of the project = {[(P0+P1)/2] *(Q0-Qe)} + {[(P0+P1)/2] *(Q1-Q0)} References Gupta, G.S. (1990). Managerial Economics. New Delhi: Tata McGraw-Hill Publishing Company Limited Office of Best Practice Regulation (2009). Decision Rules in Regulatory Cost Benefit Analysis. Best Practice Regulation Guidance Note. Australian Government: Department of Finance and Deregulation. Retrieved May 1, 2012 from http://www.finance.gov.au/obpr/docs/Decision-Rules.pdf Tham, J. (2002). Framework for Economic Appraisal: a Simple Exposition of Harberger's Approach. SSRN. Retrieved May 1, 2012 from http://ssrn.com/abstract=313539 Read More