FUN!!! Cost-Benefit Analysis!

1 Nov

I promise that I’m not writing about cost-benefit analysis just to spite those of you who pressured me into this.  There are, of course much more interesting topics than cost-benefit analysis.  Such as: conflict resolution, environmental impacts of macro-development, the history of “development”…

But here’s the thing: after getting an unsatisfactory grade on my Economics for Development Policy midterm, I will regurgitate what I’m learning in the hopes of understanding it better.  In the hopes that I will get a satisfactory grade on my final exam.

Let’s get started!

The conundrum for economists is figuring out what fuels economic growth (economic growth = an increase in Gross National Product = an increase in the sum of of the value of finished goods and services produced by a society in a given year).  History has shown that in general, GDP growth benefits all members of society.  Sometimes some people benefit more than others, but in the long run everyone is better off.  So what makes GDP grow?  In a word, investment.

“Investment” can mean a number of things.  I would define it as an external input, which is vague enough to mean nothing.  Some examples of investment: building a road, providing technical training, implementing projects, funding a business, distributing bednets, etc, etc.

Investors will look at the overall economic environment when deciding whether or not to invest in a project (or business, etc).  But they also look at the potential cost and benefits of the project in question.  High risks?  High costs?  Low payoffs?  Then the investment probably won’t happen.  One way investors decide whether or not to invest is by using cost-benefit analysis.

This is getting a little long so I’ll cut to the beef.

Calculating costs and benefits normally follows four steps:

1. The investor will try to predict the net cash flow of an investment.  This is a measurement of the difference between revenue and what is spent on material inputs, wages, services, etc.

2. Predictions take into account short-term and long-term costs and benefits.  Cash in the future is less valuable than cash earned immediately.  This is not only because of inflation, but also because of the forgone interest that could be accrued by funds in the present.  This process is called discounting.  And it works like this: if asked to choose between $1000 today or $1000 next year will choose to take the money today, and then put it in a savings account, which might earn 2% interest a year.  After one year, the firm will have $1020.  Conversely, the $1000 that might have been taken a year from now should be valued today as $1000/.02 = $980.  This process should be viewed over the course of a few years – so by year 2, the new balance would be $1040.40, and the present value of the $1000 taken two years from now is only $1000/1.04 = $961.

The general way of expressing this is: PV = Vf/(1+i)t  (t should be superscript but I can’t figure out how to do it).  Where PV = present value, Vf = future value, i = discount rate, and t = time.

Since investments usually expend in the beginning, and don’t see profits until later, its useful to look at predicted costs and benefits over the span of a few years.  From there, firms might want a single number summary (maybe they’re lazy?).  By dividing each year’s net cash flow by the corresponding year’s discount rate, you can get the net present value (NPV).  This is calculated as:

NPV = ∑[(B – C)/(1+d)t], which is the sum of the costs and benefits in each year t, and d is the discount rate.  If an investor is looking at projects they might fund, they will choose the project that maximizes NPV, rank projects by NPV, and fund the one with the highest NPV.

ah, but there’s a 3.  This type of cost-benefit analysis was very popular 20 to 30 years ago.  However, simple NPV analysis is overly simplistic.  It gives a “false sense of precision”.  The very numbers that the analysis is based on – costs and benefits – are predictions. There is really no way of knowing what costs and benefits might be in the future.  What if fuel prices go up?  What if there’s a coup?  Wise investors will generate a range of NPVs, looking at best and worst case scenarios, and everything in between.

And there are more problems!  How do you quantify benefits of certain investments, such as education or clean water?  How do you quantify certain costs?  What about external costs that are not absorbed by the investor, such as environmental degradation?  This is why this method of cost-benefit analysis has fallen out of favor… to a degree.

So like most things that I’m learning in Policy for Development Economics, BC analysis can be useful to an extent, but probably shouldn’t be the sole basis for making investment decisions.  The field of economics, I think, would like to be very precise, but like all social sciences, there is a lot of guesstimating.

Perkins, Dwight H., Steven Radelet and David L. Lindauer.  “Economics of Development”. W.W. Norton & Company, Inc.  New York. 2006.

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