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Distinguish between the private and public sector approaches to project evaluation using Cost Benefit Analysis (CBA).
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PUBLIC ECONOMICS NOTESCost-Benefit Analysis
Learning Outcomes:
• Distinguish between the private and public sector approaches to project
evaluation
• Explain the net present value approach to project evaluation, and compare it with
the internal rate of return and the benefit-cost ratio
• Show why, under ideal conditions, public sector projects should strive to
maximize consumer (and producer) surplus
• Explain the meaning of shadow prices, and comment on some of the difficulties
involved in quantifying benefits and costs
• Discuss the importance of the social discount rate in determining the net present
value of a public project
• Indicate how risk factors can be taken into account in project evaluation
Definitional issues:
• Cost-benefit analysis (CBA): An analytical tool used to evaluate the relative
merits of public projects financed by the state
• Difference between cost-benefit analysis and evaluation techniques used in the
private sector:
• Private-sector projects: Aim to maximize the difference between private benefits
and private costs (monetary profits)
• Public projects: Aim to maximize the difference between total social benefits and
total social costs (achieve a level of output where marginal social benefit equals
marginal social cost)
• Project valuation in the public sector is based on a different set of criteria from
those used in the private sector
Evaluation techniques: Net present value:
• Future value (F) of a present investment (P) after n years:
• F = P(1 + i)n
, • Net present value of future income:
• P = F/(1 + i)n
•
• i is the discount rate
• Net present value (NPV): The difference between the discounted benefits and
costs of a project:
• The importance of NPV calculations of the discount rate and the cut-off date
Evaluation techniques: Internal rate of return:
• Internal rate of return (IRR) for a given project over a given period:
• This method does not allow for comparisons between two or more projects of
different sizes.
Evaluation techniques: Benefit-cost ratio:
• The benefit-cost (B–C) ratio involves discounting the future streams of expected
benefits and costs for a given project
• Ratio: Present value of benefits divided by the corresponding costs
• B–C ratio > 1: The project is admissible
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