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Annotations on a class of Cost-Benet Analysis

Carlos Grandet December 2011

1.

Introduction

We live in a world of scarce resources. This force us to always try to get the most out of the things we have or the activities we do. However, accomplishing this is not an easy task. You never take a course in school on decision-making and most people in college will probably go out without taking a class that will be give them a greater orientation in this topic. So, in the end, people are left with their very own intuition to decide what are the actions that will benet them the most. -It is rather natural - some people will say when asked on how is their internal decision proccess made. However, it does not mean, that is awless. Most people are unaware of the costs that an action implies or tend to overestimate the benets. In the end, this lack of analysis will probably turn against them. One or two individuals might not do any damage to the society, but now imagine a government simply doing an inappropiate evaluation of their projects. The current economical crisis has put in evidence the need of governments to wisely choose their policies and the terrible consequences of not doing so. These events pose an interesting challente to all people that wish to properly evaluate a project. In this summary, I will describe the most important things I learned to be able to analyze and evaluate dierent types of projects.

2.

Project Prole

When it came to the creation of a project prole I think that there are three concepts that really caught my attention. The rst is a simple one, but I had not stop to think about it. The rst question you have to ask is who are you doing the prole for. It is not the same thing to analyze a house mortgage from the bank perspective than from the household one. The bank will see the money borrowed as a cost and the interests received as a benet. On that basis, it will take a decision on wheter to give the mortgage or not. However, the household will have greater costs because they will have to put some additional money besides the loan one. On the benets, it is not as clear what are the benets because unless they are selling the house, it is hard to estimate how is anyone 1

beneting from buying a house for themselves. All we can presume, is that if the person buys the house, it is because their benets are greater than their costs. The problem can become more complex if we include the societys perspective. The existence of externalities on a house purchase also makes this point relevant. A tax on housing, for instance, could be a benet in terms of wealth redistribution; a subsidy on the purchase of this house, is a cost to them. In the end, the same project can have completely dierent approaches depending on which is your viewpoint. Will the household get the house? If so, will the society be aected or beneted? Which of the two benet is more important? All these questions arise from simply understanding that there dierent perspectives at which you can look at something. The second concept I learned was more of a practical way of doing a nancial analysis. I was thought in my other course to take the net present value of a project to zero. There was not a profound reasoning on the why, I guess is just the way they do it in books and the people do not stop to think in the consequences. However, I learned that a simpler analysis is to take all the ows to the period in which you start receiving benets (suppose it is time t). By doing this, you turn the Net Present Value a monotonically declining function of R (the rate of discount) that is easier to interpret. This is because, as R increases, the N P Vt will always decrease. On the contrary, when you take all the ows to the time t = 0 then the N P V0 will have a parabola-like behavior, which will make N P V0 to rst decrease and the start to increase as R increases. Graph 1. NPV on time t versus NPV on time 0

The third concept was on the use of the IRR. The common idea of always taking the project with the highest internal rate of return can have exceptions. This is because, you also have to consider the scale of the project. A prole can yield a high IRR but when it comes to real benets they might low, because the cost is equally low. This is an example:

Project A B

T=0 -1 -100

T=1 IRR 2 100 % 140 40 %

There were two other concepts I learned when creating a prole of a project. An ex-ante analysis of a project implies uncertainty in the ows estimation. For instance in the case of a cashow that depends on the price of a volatile commodity. The common statistical gures to deal with this are the mode, median and mean. A common mistake when dealing with this is to ignore the expected value and price outliers. A better approach is to try to incorporate the expected value by assuming a specic distribution function and running Montecarlo experiments. An easier approach is simply to include dierent scenearios based on fundamented price speculations about that specic market. Another interesting concept is how to deal with a change in the discount rate across the project implementation. Sometimes, the scarcity of funds might cause that the long-run interest rate be lower than the short-run one. In order to include this into your analysis all that is needed is to assume dierent interest rates across time. F2 F3 F1 + + (1 + R1 ) (1 + R1 )(1 + R2 ) (1 + R1 )(1 + R2 )(1 + R3 )

(1)

N P V0 =

3.

Ination, scale, timing and replacement

The issues covered in this section were all new to me. They gave me a broader perspective of the cost-benet analyisis I have learned which had always revolved around the ow discount and NPV value calculation but never went deeper than that or asked more interesting questions such as: How do you include price uncertainity? What is the right scale of a project? when should a project be postponed? In the end, the greatest benet I get from these concepts is the ability to create an analysis that models with more accuracy the real world.

3.1.

Scale of a project

The problem of the size that a project should have is a common one and the answer the bigger the better clearly does not apply in this case. The most important principle 3

when choosing the scale of a project is that each incremental change in its size should be treated as a project by itself. This means, that the decision of changing the scale of a project should be accompanied by an analysis of the present value of the marginal benets compared to the marginal costs. The goal when choosing scale is to have that one which has the biggest NPV. Therefore it become an analysis of choosing the project that maximizes it. You could see NPV as a function of the scale and therefore you will choose that point in which the incremental marginal NPV is zero. Graph 2. PV vs scale

An important observation of this graph is that it is comparing the NPV of dierent scale projects that have the same rate of return and period of time. To change the rate of return, you could do an analysis with the Internal Rate of Return (IRR). The basic idea is that each increment in the scale of the project has a unique IRR. If this idea holds, then the optimum scale will be the one at which the IRR for the incremental benets and costs equals the discount rate used to calculate the net present value of the project. This internal rate of return is called the marginal internal rate of return (MIRR).

Graph 3. MIRR and IRR

These graph shows the relationship between the IRR and the MIRR. When the MIRR is greater than the IRR, then expansions of the project will cause the IRR to increase. On the contrary, when the MIRR is lower than the IRR, the overall IRR will decrease. The scale where the IRR=MIRR is always the scale at which the IRR is maximized. However, it is important to note that this is not the scale at which the net present value of the project is likely to be maximized. The optimum scale is where MIRR=IRR

3.2.

Ination

The issue of ination is usually ignore in a cost-benet analysis and my previous experience with it was not the exception. The reason for this omission is because the common way of controlling for ination, the Laspeyre Index1 does not consider the relative prices. This means for instance, that the benets of selling a good that increased its price over the years, or the costs of buying the same good. This is particularly important in some economies that depend on good with a high degree in volatility such as the oil in Mexico. A solution to this problem comes with the introduction of relative prices in your analysis. This is done through an index that divides the price of the relevant goods by a
1

The Laspeyre Index is dened as

one

Pi Q0 P0 Q0

where Pi Q0 is the Real GDP and P0 Q0 is the nominal

price index such as the CPI or the GDP deator.2 By doing this you can control for the inationary pressures on the nominal prices and at the same time ensure that the changes in real prices caused by the market interaction are reected. If we dene an economy with n goods, Pt as the price index in time t, Pi t as the price for the good i in time t and i the share of the good i in the economy then: (2) where n i = 1 i By applying (2) in (1), this can be converted to Pit =1 Pt Pt = n i Pit i

(3)

(4)

n i i

The estimation of this gure acquires a dierent diculty according to the moment in which the analysis wants to be made. If it is a ex-post analysis, then each of the variables is easy to compute because they had already been observed. However, an exante analysis of a project will require an estimation, the best way to do it is to directly estimate the equation Pit which are the relative prices. To estimate this ration we can use Pt the trends in the price of the relevant products. For instace, you can empirically observe that historically the price of a car tends to decrease with time while a computer tends to increase. In general, a decrease the trend in the price of a good is related to the intrinsic change in the productivity of a good or service. Therefore, the relative prices can adjust to that. The application of this concept in an analysis of a project will have the following structure: Pit Xit Pt Wjt Ljt Pt

(5)

Ft =

where Xit represents the outputs and Ljt the inputs.


The dierence between the two is that the CPI is a price index created from a consumersA basket basket and the GDP is created from a producersA
2

3.3.

Replacement

So far, the basic concept required to do any analysis is the margin. The extra benet of choosing a project or an increase on its scale should be compared to the extra costs. This approach can also be used for determining wheter an asset or good needs replacement. An example could be a familys acquisition of a new refrigerator. The possible choices to which the family faces are: 1. Choice A) Replace the old fridge. Buying a new fridge and selling the old one. However, the residual value is a sunk cost that should not be taken account to make an economic decision. 2. Choice B) Buy a new fridge. Buy a new fridge and keeping the old one 3. Choice C) Dont do nothing. Keep the old fridge The payos would look like: (6) (7) (8) P VA = PN + P V BN P VB = PN RV0 + P V BN +O P VC = RV0 + P V BO

Where RV0 is the residual value of the old fridge in time 0. The winning option must satisfy that P Vw > P Vi for every iw. In cases B and C, the present value of the residual value is subtracted because it is implicitly included in the present value of the net benets of the old fridge. As we already said, sunk costs are irrelevant. For example, lets suppose that option B is the winner, then:

(9) (10)

P VB P VA > 0P VO|N > RV0 P VB P VC > 0P VN |O > PN

When the marginal benet of the new asset is greater than its cost, then it is appropiate to replace the good. A more complex example will include the externalities of getting the refrigerator into the cost.

3.4.

Timing

The decision to postpone a project is also an important idea to consider in a project analysis because of the possible gains obtained from it. The basic idea to determine this is to is nd the time in which the present value of the benets not perceived by the postponing of the project is equal to the opportunity cost of the capital that could have been invest. A smaller benet lost than the capital gain in the money not spent means that the the project should be postponed. For example, a highway project could yield dierent results according to the trac ow today and the expected one. Graph 4 Benets of postponing

The analysis of timing requires that the period to which the Net Present Value is discounted be the same for all the scenarios. This is to guarantee that the NPV are comparable among each other. Therefore, this is a case in which the method of taking a NPV to the point in which it start receiving benets should not be used.

Graph 5.Maximizing of the NPV

The modelling of the timing problem is as follows: Suppose k is the initial investment or initial costs of a project, and N P Vt represents the net present value of constructing in period t. Then, Bt is the net benet of the project in the year t and N P Vt = t = 1T Bt k. The best timing is where N P Vtj > N P Vhj with th for every h. If initial costs depends on the time so that k varies in each year then the cost of postponing is expressed by kt kt+1 Bt+1 + rkt and appropiate time would be the one that gives the minimum value to that equation t. This method assumes the existence of increasing benets, however, when this is not the case, then you have to check if the NPV is greater than zero. If it is, the method mantains its properties.

4.

Distributional Weights

There are three fundamental characteristics that apply to welfare economics a) Benets being measured at each step by demand price (willingness to pay) b) Cost being measured at each step by supply price (willingness to supply) c) Aggregation of these two across individuals regardless of who is enjoying the benets or costs (adding up) 9

However, there are social concerns with the last point because of dierent values for dierent people of a certain good. If you ask anyone, who gets more utility from an incremental dollar?, they will favor the poor instead of the rich. This problem creates the idea that a dollar has a dierent value according to whom it goes. Graph 6. Marginal Utility of Income.

This situation has led to the existence of a distributional weight that measures benets and costs dierently according the the family or individual it aects; usually the poor ones. A great limitation, however, comes from the fact that people do not know what weight to assign and it is done in a rather hollistic manner. The results of this approach can cause a proyect to be approved despite having a negative value. Present Value of Benets Costs Net Present Value Unweighted 500 -1000 -500 Avg. Weight 1.5 .5 Weighted 750 -500 250

These creates a great eciency problem that increases as you weighted more the benets of the poor people. A better illustration of the eciency problem can be analyzed with dierent weights according to income. Suppose that the dollar of a rich family is worth .5, and for a poor family it is worth, 2. Therefore, taking 10

32 dollars from the rich family and giving 8 to the poor one will be appropiate because they will have the same value (32x.5)=16 and 8x2=16). This creates a lost of eciency of 75 % that is acceptable

The distributional weights approach also creates a dierent analysis for tax

5.

Basic needs versus Distributional Weights

There appears to be the confusion that basic needs and distributional weights are just two similar approaches to welfare distributional issues. Nevertheless, they are quite dierent. Distributional weights come from an individual framework in which the marginal utility of certain individuals has a greater value than others. Basic need externalities refers to the benet that people get from the improvement of the circumstances of others. In other words, they have a willingness to pay for the diseased to be heal, the hungry to be fed, etc. The idea of Basic Needs externalities is well illustrated when analyzing the in-kind and cash transfers. It has been demostrated that in terms of utility giving cash transfers is better than in-kind ones. However, most of the transfers given today are in-kind (food stamps, public education, a father paying for his children school rather than giving him the money to 11

use it) because the donors are better-o when they know that their money is going to be used for something. Basic need externalities therefore become a way in which the consumption of other people or the attainment of certain states enters into the utility function of donors. Therefore, this people are receiving a benet from the improvement of others, a positive externality. The analysis followed is the same as that of other externalities. Graph 7. Basic needs externalities approach

This approach, however, poses a great problem which is the fact of how to value the positive eect of an externality in the society. (The slope of the social demand curve in graph 3.

6.

Economic opportunity cost

Whenever you are evaluating a bussiness project you consider the inows and the outows throughout the years and then use an interest rate which is either the cost of borrowing the money or the alternative return to the investment that money could have in another project. Some technicalities set aside, the evaluation is fairly easy because the prole is clearly dened. Money coming in is a good thing and money going out is a bad. However when you are considering a public project, the 12

prole canAt be done so easily. Calculating the benet of a better-educated labor force or a healthier population is often dicult and inexact. To solve this issue the concept of economic opportunity cost (or shadow prices) is useful. A dierent approach to the three postulates of welfare economic can be: a) Competititive demand price measures the benet of each marginal unit to the demander b) Competitivie supply price (marginal cost) measures the opportunity cost of each marginal unit from the standpoint of the suppliers. c) To measure the eect of a project to society, you take the dierences between costs and benets. These ideas have made possible the analysis of the eciency costs of a tax, the problems of the monopoly and other contributions such as the Ramsey rule for optimal taxation. Altough they have met with criticism that they donAt control for multiple equilibria and the fact that they do not follow a similar result if the order of the policy is changed. Nevertheless, if you take them as only postulates instead of absolute truth then you can do interesting analysis One of the analysis that is supported by this ideas is that of the social opportunity costs in a market setting. The general concept is this: when a new demand for a good or service is generated, there are only two sources from which that demand can be satised - increase in total supply and the displacemente of other demanders. The welfare postulates indicate us that the increased supply should be evaluated at the supply price and the increased demand at the demand price In a market equilibrum without distorsions, both prices are the same and therefore marginal costs equal social costs. However, in the presence of distorsions such as a tax, these two prices are dieren and the social opportunity cost has to become a weighted average of them. In this context the following equations hold: If pd is the demand price, ps is the supply price and D is the distorsion we can say that: (11) pd = ps + D

and, because the social opportunity cost of one unit is a weighted average (12) (1) can be expressed as (13) (f 1 + f 2)ps f1 Di 13 f 1 pd + f 2 p s

However, because f1 is just the measure of displaced demand, it can be expressed as (14) ps + Di Xi

Another way of looking at this is through an example with specic taxes. Assuming we have two taxes tc a capital income tax and tp a personal income tax, we will have three rates of return. p, the gros return to investment, i = p tc , the market rate of interest and r = i tp the after-tax return on investment received by savers. In this market for capital, the money raised fo a project will come from displaced investment, with an opportunity cost of p and from stimulated saving, with an opportunity cost of r. This means that the social opportunity cost of capital will come from the expression: (15) which can also be expressed (16) given that, (17) This is equal to (18) i + f1 tc f2 tp f1 + f2 = 1 f1 (i + tc ) + f2 (i tp ) f1 p + f2 r

That is, a market rate of interest adjusted for distorsions. A graphical analysis of the project shows the following: Graph 9 Economic Opportunity Cost

14

The analysis advantage is that it can be applied to the changes in more than one good in the demand and supply side. In the case of the market for foreign exchange, we will have Em as the market exchange rate for the dollar. Then, the demand price will be Em + Tj where Tj is the tax on exports j. The supply price will be Em + Sk where Sk is the subsidy on imports k. The end result is an expression for the social opportunity cost on foreign exchange: (19) j fj (Em + Tj ) + k fk (Em + Sk )

which can be converted with (8) to (20) Em + j fj Tj ) + k fk Sk

which is equal to the market rate adjusted by the distorsion. An example Assume we have the following tax composition:

Rate Adjusted Corporate Investment 14 % Non-corporate Investment 8% Housing Investment 6%

Property Tax Corporate Tax 2% 6% 2% 2% 2 % (home subsidy)

Market Rate 6% 6% 6%

A graphical representation: Graph 10. Opportunity Cost of Investment

15

In this case, the opportunity cost of capital is given by the following fc pc +fn pn +fh ph where the weights are given by fc = ,30, fn = ,10 and fh = ,35. Then, (21) ,3(,14) + ,1(,08) + ,35(,06) = 7,1 %

On the savings side, the interest rate is given by r = i(1 tp ) In here we can assume that the rich households have an interest of 50 %, the middle ones of 33 % and no tax for the poor ones. A graphical representation: Graph 11. Opportunity Cost of Saving

In the case of the same 6 % market interest rate, the interest rate for the rich is ,06(1 ,5) = ,03 and for the middle is ,06(1 ,33) = ,04, assuming a weight of 10 % for the rich, 10 % for the middle and 5 % for the poor, then (22) ,1(,03) + ,1(,04) + ,05(,06) = 1 %

This means that the opportunity cost comes from both the savings and the investment and is 7,1 % + 1 % = 8,1 The analysis of the open economy creates a dierent result, because it allow us to include the capital funds from abroad. Now, the economic social cost also includes the marginal cost of foreign funds (M Cf ) making the equation;: f1 p + f2 r + f3 M Cf 16

The marginal cost becomes the economic opportunity cost of social capital because of two reasons: a) The capital market for international funds is not perfect. This means that the country can draw funds from abroad but not at the same price. The supply curve is not innitely elastic but with an upward slope Graph 12. Capital International Market

b) The upward slope of any supply curve means that the marginal cost (of getting an extra unit as one moves along that supply curve) is higher than the supply price. Another way of analyzing it is by assuming that the country has monopsony power for the funds destined to that country therefore:

17

Graph 13. A monopsony case for the borrowing of funds

This can be further demostrated with the following equations (23) (24) (25) (pq) = pq + qp (pq)/dq = p + q(p/q) (pq)/dq = p(1 + 1/

Then, marginal cost = average cost (1 + 1 ) Since the supply is upward sloping then the marginal cost is greater than the average cost. An appropiate estimation of the economic cost of foreign funds needs to recognize that they have a behavior that is not as straightforward as the domestic. This is because the supply of foreign savings is more volatile than the domestic one. The estimation should therefore consider both equity and debt nancing and should be expressed in real terms. s

18

7.

Applications of economic opportunity cost in foreign exchange and labor markets

The same analysis can apply to other markets rather than the capital market. For instance, foreign exchange. Suppose Mexico has an import tari of 20 % and an exchange rate of 10 pesos per dollars. New demand for dollars will come from displaced imports and newly estimulated exports caused by the increase in the price of the foreign money. We have a project that buys $100 dollars from which $60 come from displaced imports and $40 from stimulated exports. Then, the project will pay 1000 pesos for the 100 dollars bought. However, these do not consider the lost of 120 pesos from import taris caused by the 60 dollars of displaced income (60 10 ,20). Therefore, the economic cost of the project is 1120 pesos and of a dollar is 11.20 pesos. This extra cost becomes an externality of the project. Similarly, any selling of foreign exchange will bring a benet of 11.20 pesos. In the end, a foreign exchange premium is created of 12 % Labor in cost-benet analysis has always been subject of errors derived from considering job creation as a benet. However, they fail to see that such as capital or material, labor is a cost to a project. The false idea of job creation is brought down by the fact that the project should not be measured against nothing but rather the second best alternative. It is therefore important to analyze labor just as the previous markets. In such case, an added demand for labor will displace the demand and stimulate the supply. In order to do a proper analysis of the economic cost of labor we must consider certain principles a) People have a dierent supply price according to where they work b) The opportunity cost is the supply price after taxes and deductions have been made. c) When answering the question of where jobs come, one should analyze an with and without project scenario to determine wheter the supply comes from other jobs or from newly stimulated entrants.

19

Graph 14. Opportunity Cost in Labor Market

One way of approaching the economic opportunity cost of labor is through the comparison of the same job in dierent places

Market Wage Incom Tax Sourcing Fractions

Chicago 50 5 (.8,.1,.1)

Alaska 200 50 (.4,.5,.1)

Hawaii 30 0% (.3,.1,.6)

This means that the economic opportunity cost of labor is dierent in each city and is given by the available income of a worker in a city, plus the loss in taxes that the displacement of other workers caused. Chicago (26) Alaska (27) Hawaii (28) 30 0 + (,3x5 + ,1x50) + ,6x0 = 36,5 20 200 50 + (,4x5 + ,5x50 + ,1x0) = 177 50 5 + (,8x5 + ,1.x50 + ,1x0 = 54

8.

Using the economic cost of capital as discount rate

In the public projects evaluation there is a debate of which is the appropiate discount rate that should be used. There is a division between the ones that one to use the social opportunity cost of capital mentioned before (w = f1 p + f2 r) and those who say that the marginal rate of time preference (r) should be the proper discount rate. The intuitively reasoning is that the second discount rate does not consider the distorsions existing in the market which also aect the marginal productivity of capital in the private sector (p). However, the reality is that a correct estimation using any of these methods will yield the same result: Assuming we have a project that requires 1000 dollars, has the values p = ,12, i = ,06 and r = ,04 and the weights of f1 = ,75 and f2 = ,25, then we will have the following ows

Period Stimulated Savings Replaced Investments Total

0 750 250 1000

1 90 10 100

2 90 10 100

3 90 10 100

4 ... 90 ... 10 ... 100 ...

In this case the discount rate is ,12(,75) + ,04(,25) = ,1 = 10 % which is also the minimum return rate for this project to have a cost equal to its benet. When you are doing, the second approach you will only consider the r = ,04 rate, however you will use a way for compensating for the distorsions. This method is called shadow price and it consists on a lower bound for economic success of a project. When you are using the second type of discount rate you will take the perpetuity of the annual payment for both the investment and the savings: 90 = 2250 ,04 10 = 250 ,04

(29)

(30)

Therefore, the present value is 2500, which causes the shadow price to be 2.5 because it represents how many times should the 1000 borrowed needs to multiply itself overtime to have costs equal to benets. Despite both procedures being able to control for distorsions, the rst method is preferred for three reasons: 21

a) The second method is harder to communicate because the shadow price appears to be randomly generated. On the other hand, w is easier to sell to the audience b) c) It is easy to consider dierent rates for r when using the rst method. This is because it can also be interpreted as j fj (Em + Tj ) + k fk (Em + Sk ). On the contrary, because the justication for r comes from intertemporal consumption decision, varying across dierent groups of consumers will mean that that the benets of a group should be measured at their own rate. This causes problems of evaluation because if you outweight the costs of a two dierent projects in two dierent neighborhoods against their benets, dierent results can be obtained depending on the discounting period even though both projects have the same benets. The group with the lower discount rate will have a bigger NPV than the the group with the higher one, but if you take the future value, the contrary will occur.

9.

Labor Market Issues

Graph 15. Dual Labor Market

In this graph we see the eect of a dual labor market, which is a common situation when there is a big enterprise that will be paying a higher salary than the one existing in the 22

market. As you can observe, this causes two dierent supply curves, the one of the people being hired by the enterprise and the workers left. Graph 15a Distribution of protected workers

The justication of this new supply curve of people left comes from the fact that the big enterprise does not distinguish between the dierent reserve price of the supply, so they choose anyone in the supply curve which has dierent wage ranges. Therefore, it causes people in every of the wage ranges to be left and the ones that had a higher supply price will not be willing to work in the regular market. Graph 15b The existence of quasi-voluntarily unemployed.

23

The labor market will distinguish between two people, the ones that got a job at the market wage Lf and the ones that are not wanting to work because they want the higher wage. The second type of people will be called quasi-voluntarily unemployed Vqu . In the end, this will cause two economic opportunity costs: The cost for the regular workforce (31) EOCLf = wf

The cost for the big enterprise workforce (32) Vqu wf + wp Lf wf + Lf + Vqu Lf + Vqu 2

A common problem experienced in employment policies is to try to reduce it by telling enterprises to produce more jobs or having a decree saying they should increase their workers by a certain percentage. However, this often ends up creating more unemployment because the increase in jobs displaces people that werent in the workforce. An increase in the job demand will increase the wage and bring more people to the city to work. In the end, this will cause an increase in the supply of labor that will move the total amount of people working but preserve the unemployment rate and the expected earnings. Initial Equilibrum With 100 jobs more Short Run Response Long Run Response Employed 800 900 900 Unemployed 200 100 225 Full Employment 1000 1000 1125 Expected Earnings 4 4.5 4

The application of the theory in actual projects helped me to connect the concepts and have a better understanding of them.

10.

Transportation: Highway Projects

The rst step is to analyze the prole of the project. Therefore, the appropiate question is why and for whom are we doing the project? An important concept is that a highway project is not usually the construction from scratch of a project but the improvement of a road. THe objective is to reduce the transaction costs of the people that were using a certain path or road. However, if the cost reduction is the only criterion use to evaluate the project, then all highway projects should be approved because they will decrease to some degree the costs of someone. The correct approach is to analyze if the improvement is justied. This is determined, for example, through the growth of trac; if this growth is high enough that the transaction costs of the users is higher than the cost of the project then it should be implemented. 24

Let Ci be the private cost that an individual pays in order to use the road (gasoline, tires, etc). Then, suppose that the improvement change the cost from C0 to C1 . The benet can be divided into the one of the the existing users, V0 (C0 C1 ), and that gained by the new induced trac, 1/2(V1 V0 )(C0 C1 ). However, asides from the costs an individual pays, there are also social costs. This is the time that people spend on a highway. As a bigger car volume in a highway is related to a lower speed, then trac congestion in a highway also means time loss by user. The save on time that the highway improvement will bring, should therefore be also measured in the benets. Let H be the value of the vehicle-hours. Let S be the speed. Then H/S is the value of a vehicle mile. This value means that as speed increases, a vehicle mile gets cheaper. Let T C represent the total time cost per mile. Let V be the volume. Then, we asume that speed is a function of volume with the following values: (33) S = a bV

we can also write the Total Cost function as (34) TC = V H S

if we take the derivative with respect to V we have the marginal cost: (35) a T C =H 2 dV S

The percentage speed decit can be dened as the percentage that the marginal social cost, M C is above marginal private cost AC. This is, (36) (M C AC) (a S) = AC S

The externalities derived from an incremental vehicle are shown in the following graph: Graph 16. Externalities from incremental vehicles

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To eliminate the externality, then we could introduce a toll fate that acts as a tax and equals the marginal private cost to the marginal social one. Graph 17. Internalizing the externality.

The problem is that DPC curve is changing because the demand for trac in the road will be dierent at dierent hours of the day. So it is hard to nd an optimal tow. However, with new technologies maybe in the future this will be a reality. A last issue to be solved is the assigning to a value of time. By doing this you can have a complete prole of the ows of a project. A method proposed by Thomas Lisco, took advantage of dierent alternatives faced by transportation consumers to estimate their opportunity cost, In the City of Chicago, there were two ways of getting to the downtown from a suburb area. Using the expressway and paying to do it or taking public transportation. There was a time save related to the rst option. The ideas was therefore to analyze the dierence in costs and time spents from using each alternative. Once you have the dierence, the probability of going by car be P C, is estimated using a regression of P C = + (timesaved) + (extracost) + (income) + u Once you have the coecients, the next step is to set the probability equal to 1/2 in order to get the indierent agents between both options. Once you do this you solve for the ratio Time Saved/Extra Cost to get the value of time through dierent income levels. An important lesson that I learned is that the biggest incentive to improve a route is strictly related to the ow of trac. If the increase i trac does not justies the costs, 26

then there should not be a road constructed. +

11.

Electricity

The evaluation of any electricity projects requires the use of the least alternative costprinciple. This principle states that one project should not be assigned benets greater than the least alternative cost one would have to incur by providing an equivalent benet stream in a dierent way. This principle is a use given to the opportunity costs, because it considers the alternative scenario as the benchmark to evaluate a project. If we donAt use this principle then you will have an incorrect project appraisal. For instance, if we assume that the demand for electricity rises faster than the overall generating capacity, we will conclude that it is extremely important to make the project altough there was en ever rising price of energy. Similarly, we can conclude that the project is terrible if the price of energy does not rise. In the presence of this price volatility, the comparison between the creation of a new plant and the retirement of another should be give a method to measure the prole of a project. To keep the analysis simple, an assumption for a system managed eciently will be made. This means that the objective is to use the most ecient plant rst and move on from there. As with other projects, the cost-benet prole analysis requires a forecast to be made on how the whole electricity system will operate in the absence of a project. From there, we will try to estimate the cost of the dierent alternatives to determine the best one. This is a brief resemblence of some of them:

11.1.

Homogeneous Thermal

This type of plants use the same thermo-energy, for example, fuel. The homogeneous thermal plan is the benchmark of the project. We measure the capacity of a plant in kilowatts (KW), which is the potential power of the plant. When the demand for energy pushes beyond the actual capacity, it is necessary to have additional thermal plants In this analysis of the project, the peak hour requires an special analysis because it represents an extra demand that we are not capable of supplying. Thia means an increase in the variable costs for energy, therefore, there should be a dierent price charged in the peak hours. In terms of the project, we will want to spend in extra capacity if the cost is satised. Example Suppose that costs are $800 per KW, the relevant discount rate is 10 %, and that the relevant depreciation rate () for this equipment is 5 % per year. Then in order to justify the addition of a new KW of capacity, the necessary benet is (0,1 + 0,05)($800) = $120 per year. This comes come from the sale of energy during the peak hours at a dierent 27

price. If the peak hours per year were 2000, then the relevant peak-time surcharge would be 6 cents ($120/2000) per kwh. Note that 4 cents would be the charge in o-peak hours and 10 cents during on-peak hours.

11.2.

Run on the Stream

This energy is caused by the water from a river that is sent to turbines to produce mechanical energy. To evaluate the benets of this project, we start assuming that the turbine capacity will be fully used. This is typical a graph used to evaluate a run of stream project Graph 18 Run of the stream

Example (Taking the same assumptions as the thermal energy). If the peak hours are 2000 a year then we are left with 6760 hours of o-peak use. Now we can calculate, for each KW of turbine capacity the revenue: 2000hrs@10cents = $200 6760hrs@4cents = $270,4 Then, the total installed capacity will generate a revenue of $470,4 per KW. Because of the variable ow of the stream, turbines will not be used at full capacity always. Let assume 28

it is an 80 % of capacity. The estimated benets would then be $376,32(= 0,8$470,4) per year per KW. In the other hand, the cost of the new capacity would be $300(= 200015 %) per year per KW. The project is accepted.

11.3.

Daily Reserve

A way to improve the water availability is the creation of a dam that will help accumulate water and control the river ow. This becomes ecient becomes often you will have the river ow running when there is not enough electricty demand and therefore it will be wasted. This will allow for the water release when electricity is needed. T he next graph shows the excess of water-capacity (green area). It that can be stored and used later at the value of 10 cents or 4 cents. The blue area represents the water that is valued at 4 cents because is used in peak hours. Graph 19. Daily reserve

As with prior analysis, the size of the dam will be chosen according to the peak time electricity demand. If the peak time surcharge multiplied by the peak time hours is bigger than the costs, then the project will be accepted. The principal cost of this project are related to their constraints, this are: a) The cost of the dam 29

b) If the amount of the turbine capacity is not increased, the benet of extra peak time energy would be limited to the amount by which the turbine capacity of the ROS project exceeds the stream ow.

11.4.

Pump Storage

The main idea of the pump storage is the re-utilization of the water that already has been used to generate energy. This project requires the construction of a second dam (lower reservoir) to capture water and then pump it back to upstream. The idea is to pump it back in low demand period so the same energy is used, therefore you will a greater water stream in a high peak period. A necessary condition for this project is the existence of cheap o peak energy so the cost of pumping the water is not high. A concern that this project might cause relates on the water rights of the river, because it will mean taking water from others downstream. The existence of this technology usually is combined with the nuclear energy. Both technologies work together to provide an ecient source of electricity. To understand how this mix works, it is necessary to understand the concept of a load curve. This curve represents the electrical energy demanded in the whole year from the most demanded hours to the least demanded hours. This means that often the built capacity will be unused because there is not enough demand. For the case of the nuclear energy, for instance, they are usually never shut down. So a load curve could show us how much energy from the nuclear can be used to pump the water. Graph 20. Pump storage

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In the previous graph, we can see that R is the energy available for pump and G is the energy generated once the water has been pumped up. If we assume that N* is the optimal nuclear capacity, then there must be a function R = f (G) that relates the optimal storage to fulll peak hours demand.

11.5.

Seasonal Storage

Seasonal hydro dams aim at allowing extra water to be shifted from one part of the year to another to supply a steady energy demand. Also, this works in the other way. This means that it could be used in rivers that have pretty steady stream ow, but the demand of energy is highly concentrated in some seasons

11.6.

Economics of Electricity: A more realistic approach

A energy decision-making in the real world usually has all of the previous technology installed at the same time which leads to the need of analyzing which ones are to be activated rst based on the energy demand and the costs. The order of use will depend on how expensive is the energy. In this case, ROS is the cheapest technology and therefore it should be used rst. The pumping technology is the most expensive one, therefore it should be used last. When it comes to seasonal storage plants and thermal plants, the problem can be expressed like this: Graph 21. Load curve

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To solve you could have the following procedure Example Strategy A: 300MW turbine HA 600MW TA StrategyB400M W TB 500MW turbine HB Dierence (B-A)Uses 200MW less in TUses 200MW more in H Assume that we already have the plants but we are wondering which plant must be bigger in order to attend the peak hours. Lets focus on the costs of these strategies. The saving of strategy A is 200MW in hydro but an extra 200MW in thermal. In other words, as we move from strategy A to B, we are reducing 200MW of homogeneous thermal capacity and adding 200MW of turbine capacity in our seasonal hydro dam. Intuitively it is cheaper to add 1MW of turbine capacity to an existing dam with a place already prepared for additional turbines than to add 1MW of homogeneous thermal capacity which entails building the whole plant plus its associated turbines. And second, the start-up and shutdown costs vary signicantly since in a hydro dam are practically zero. As a result we should think that strategy B is usually the winner in the stacking process. We say usually because it could happen than that there is no extra room for more a a turbines (if it is a old dam) in the dam, so the history is dierent.

12.

Irrigation Projects

When thinking on irrigation projects it is fundamental to consider that they are linked to the amount of water delivered. Once this is considered the next important step is to analyze the value of water delivered by the project. The main problem that arises with water in an irrigation project is that there is not a market system that leads to an equilibrum in which the marginal product is equal to the price that has to be paid. In the case of water in agriculture, the amount of water is given by water rights over it which are determined by the hectares of land. Aditionally, one can never know how much water you will get because it depends on the forces of nature for that year. Therefore, there is no way of paying a price for a marginal unit of water or for that matter knowing the marginal productivity of water based on what farmers pay for it. In order to value water, two methods can be used: a) Residual Value Method: The basic idea is to suppose the construction of an irrigation project that increases water availability in a farm and leave another farm without a project. Then, you estimate the value of a crop with or without 32

the project and also the cost of input other than land and water. You then obtain a residual value for each of the two proles, which is the dierence between the inow and the outow. By substracting one residue value from the other you get the dierence that can be attributed to water in the project, or the value of water. However, because this method is innacurate you can end up with a big standard deviation that keeps the value of water relatively unknown. b) A second approach uses the land prices as estimates of the current value of water rights. This is possible when water is such a scarce resource and the land is so abundant that the marginal productivity of it is close to 0. Therefore, the reason why the value of land can increase is because it entitles access to water. Therefore, people will be willing to buy land just because of the water. In order to do a correct evaluation for this project one should consider the real product that the land buyers are getting. Since the amount of water is determined by nature, then a buyer wouldnt buy a specic amount of water but an expected one. Therefore, it is necessary to create a distribution of the water quantity across a period of time and get an expected value of the water according to the the probability given to each quartile of water available that year. Graph 22. Distribution of water in a year

The next step is to calculte the prices of water which is given by Ql Pl = PI I 33

where l is land and I is an index created with the probability of water according to the distribution over the years. To evaluate the eect of constructing a dam, we use the fact that water availability will increase with the dam to create two dierent indexes. I 1 which is the no project one and I 2 which is the project one. These causes the benet of the dam to partially be B = PI (I 2 I 1 ). However, the benet is not only caused by the increase in the amount of water but also by the increase in the value of water from the damn when compared to the water from the river. Because water in the damn is more readily available it is worth more. Therefore, the total benet is T B = PI (I 2 I 1 ) + d(PI I) where d is the increase in the value of the water of the dam against the river water.

13.

Education

The relationship between education and future earning power has always been noted. More years of education will in average yield a greater wage. However, the interesting question is to determine what is the actual eect of an extra year to your increase in salary. This could allow the creation of a nancial prole that could weigh the benets received by education to the costs it has. The application of nancial tools such as NPV or IRR to the education eects is important for public policy to determine wheter or not should there be a greater eort on reducing drop-out rates in a country. A methodology to estimate the NPV and IRR was given by Harberger and Peon in their paper Estimating Private Returns to Education in Mexico. In it, they took the viewpoint from an individual demanding education to establish the prole of the project. The objective was to determine a rate of return of nishing the four levels of education in Mexico : primary, middle school, high school and college. The benets were given by the future earnings and the costs by the forgone earnings that studying implies. These prole creates somes bias problems caused by the existence of students that work and study at the same time or the existence of private school which require additional costs. Since these two eects have opposing signs and they account for a small fraction of the costs and benets and there the available data couldnAt allow them to incorporate this variables into the analysis, they were omitted. The Net Present Value of education is a function given by the discounted dierence between the wage of a worker with an educational level n and the wage of a worker with an educational level preceding n, n-1. N P Vn = T t=1 Wt,n Wt,n1 (1 + r)t

This analysis allows an estimation of the opportunity cost, forgone earnings. We know that Wt,n = 0 for the d number of years spent in schooling, therefore d Wt,n1 is the t=1 (1+r)t 34

opportunity cost of education at level n. By doing this present value, the study analyzes the decision of passing to the next education level for each individual based on the benets that going to that level will create minus the cost of doing it which is salary they will perceive with that education level if they were not studying. In order to estimate the value of Wt , the equation used was: In(w) =1 a ge +3 age2 +G +5 n gn + 5 n (agegn ) + i=1 i Oci + e n=2 n=2 where W is the wage income, G is a dummy for gender, g is a dummy that is equal to 1 when the worker belongs to the n level of education and O is a dummy for a specic type of occupation. The salary for each educational level could be estimated with the traditional earnings equation which is a function of experience and education. However, there are other variables that inuence the earnings prole such as the genre. The occupation is included because if the educational level is related to the occupation, then the estimators will be biased if they ommitted this variable. A traditional approach was to estimate wages a function of education and experience and consider the coecient of education as the rate of return, however, this is incorrect because it does not consider the costs associated with education, unlike the proposed methodology. This analysis was applied to estimate the returns on education in the 32 states of Mexico. Using a survey that inquired on the wages of workers from dierent industries they estimated the model using a state regression and a pooled regression They assumed an interest rate of 5 % because it is the average return that people get from banks and is close to the mortgag rate. Results show that there is an increasing rate of return as an individual pursues an additional level of education. The rate of return does not favor an specic gender as it varies in each educational level. Genre Masculine Femenine Primary 2.13 % 5.49 % Middle School 5.86 % 7.28 % High School College 11.26 % 14.27 % 10.36 % 14.39

The low rate of return that nishing primary school gives to students is interesting because it means that with the used discount rate it is better to be working than studying at that age. However, the conclusion should not be so eager to determine that because there is an increase in the earnings as people continue studying which end paying-o for that initial lost. Another interesting result is that the rates did not vary signicantly between all of Mexico states, this creates a strong case for suggesting an integrated labor market in the country. Finally, incorporating economic growth into the analysis does change the results and creates higher IRR and NPV, the conservative estimates of a 1 % and 2& for Mexico during the next years, makes this values trustworthy and important to model in the educational project prole. 35