Chapter 3 - Cost-Benefit Analysis

27. The government has hired you to advise them on the merits of a project that is being proposed. The project is expected to generate benefits of 14 million dollars today, 5 million dollars in one year from today, and 1 million dollars in two years from today. (These are the only years of concern.) The project costs nothing today, but will cost 20 million dollars in two years. Assume the interest rate is 10%. If the benefit-cost ratio is greater than 1, the project should be allowed. What is your policy suggestion?

Answer: Answer: Benefit stream is 14M + 5M/1.11 + 1M/1.12 = 19371900.826. Cost stream is 20M/1.12 = 16528925.62. Therefore, B/C = 19371900.826/16528925.62 >1. Project should be funded.

28. If the interest rate is 5 percent, what is the present value of $5,000 five years from now?

Answer: Answer: PV = 5,000/(1.05)5 = 3,917.63

29. What is the interest rate that should be used to ensure a total balance of $3,000 two years from now if you have a starting balance of $2,000?

Answer: Answer: The rate should be 22.4744%.

30. Refer to the figure below. If the demand curve can be characterized by the equation Q = 10 - P, how much of an increase in consumer surplus will occur when the price of avocados falls from $2.89 to $1.35?

Answer: The original consumer surplus with 2.89 price is (1/2) * (7.11) * (7.11) = 25.28. The new consumer surplus with 1.35 price is (1/2) * (8.65) * (8.65) = 37.41. Consumer surplus increases by 37.41 - 25.28 = 12.13.

31. Suppose in a certain city the demand for low-cost housing can be characterized by the equation P = 500 - 2Q, where Q is housing measured in square feet. Further, suppose that supply is characterized by the equation: P = 25 + 3Q. (A) How much consumer surplus is there? (B) Suppose that a grant is given so that the supply of housing is increased. This increase changes the supply curve to P = 3Q. How much does consumer surplus change because of the grant?

Answer: (A) Setting supply equal to demand gives Q* = 95 and P* = 310. Therefore, consumer surplus is (1/2)(95)(190) = 9,025. (B) Setting the new supply curve equal to the original demand curve gives Q* = 100 with P* = 300. Now consumer surplus is (1/2)(100)(200) = 10,000.

32. Consider two projects. The first project pays benefits of $90 today and nothing else. The second project pays nothing today, nothing one year from now, but $100 two years from now. Which project would be preferred if the discount rate were 0%? What if the rate increased to 10%?

Answer: For a discount rate of 0%, the present value calculations would be $90 for project one and $100 for project two; therefore, project two is preferred. At a rate of 10%, the PV of project one is still $90. For project two, the PV is now 82.6; therefore, project one is preferred.

35. Why is it that projects that should not be undertaken are sometimes undertaken?

Answer: Sometimes the influence of special interests or other factors clouds the judgment of decision makers. Often the case arises where the analysis was a victim of faulty calculations of inputs or outputs. For example, there might be double counting or other problems.

34. Compare the following methods to evaluate a project: present value criterion, internal rate of return, and benefit-cost ratio. Which is preferred? Why?

Answer: The IRR method and the benefit-cost ratio are consistent with the present value criterion for evaluating project admissibility, but are not adequate for comparing admissible projects. The present value criterion is superior to the other two methods.

33. Some analysts have argued that cost-benefit analysis does not take into account issues involving equity and is nothing more than an efficiency test. Do you agree with this statement?

Answer: The use of cost analysis can be designed to handle issues of equity. Generally, these inputs need to be included in the model by making some assumptions about welfare gains and losses. A potential hazard of introducing distributional considerations is that political concerns may come to dominate the cost-benefit exercise.

13. Evaluating of costs and benefits is likely to require A) ad hoc assumptions. B) only observed prices. C) a PhD in economics. D) only economists as they possess all the technical expertise required.

Answer: A Evaluating of costs and benefits is likely to require ad hoc assumptions.

8. For certain intangibles that cannot be measured, it is best to A) exclude them from cost benefit analysis, and then calculate how large they must be to reverse the decision. B) guess. C) reevaluate using the Hicks-Kaldor criterion. D) leave it to the private sector to decide on value.

Answer: A For certain intangibles that cannot be measured, it is best to exclude them from cost benefit analysis, and then calculate how large they must be to reverse the decision.

12. Inflation favours A) borrowers. B) lenders. C) neither borrowers nor lenders. D) both borrowers and lenders.

Answer: A Inflation favours borrowers.

15. Internal rate of return analysis suggests that a project should be undertaken if A) IRR > discount rate. B) discount rate > inflation rate. C) MB > 0. D) NPV > 0.

Answer: A Internal rate of return analysis suggests that a project should be undertaken if IRR > discount rate.

9. The chain-reaction game A) counts secondary benefits without counting secondary loses. B) was cancelled on network TV. C) compounds a bad decision by making more bad decisions, causing unwanted projects to get funded. D) counts secondary costs without counting secondary benefits.

Answer: A The chain-reaction game counts secondary benefits without counting secondary loses.

2. The rate at which future money must be discounted is known as the A) discount rate. B) rate of inflation. C) time rate. D) exposure rate.

Answer: A The rate at which future money must be discounted is known as the discount rate.

20. Refer to the figure below. If the supply curve returns to its initial level of Sa, the amount of consumer surplus will return to its original level. A) True B) False C) Uncertain

Answer: A True - If the supply curve returns to its initial level of Sa, the amount of consumer surplus will return to its original level.

26. In the private sector, if the net return is positive it should be undertaken regardless of who gains and loses. A) True B) False C) Uncertain

Answer: A True - in the private sector, if the net return is positive it should be undertaken regardless of who gains and loses.

24. The shadow price of goods traded in imperfect markets is the underlying social marginal cost. A) True B) False C) Uncertain

Answer: A True - the shadow price of goods traded in imperfect markets is the underlying social marginal cost.

23. The systematic study of the costs of the various alternatives should be done to find the cheapest way possible is sometimes called cost-effectiveness analysis. A) True B) False C) Uncertain

Answer: A True - the systematic study of the costs of the various alternatives should be done to find the cheapest way possible is sometimes called cost-effectiveness analysis.

21. Using the present value criterion is more reliable than using the internal rate of return and the benefit-cost ratio. A) True B) False C) Uncertain

Answer: A True - using the present value criterion is more reliable than using the internal rate of return and the benefit-cost ratio.

17. When the benefit-cost ratio of a project is greater than 1, the project should be considered. A) True B) False C) Uncertain

Answer: A True - when the benefit-cost ratio of a project is greater than 1, the project should be considered.

1. Cost-benefit analysis is A) impossible since benefits and costs are hard to evaluate. B) a set of practical procedures for guiding public expenditure decisions. C) used by only the private sector to determine whether certain projects should be undertaken. D) all of these answer options are correct.

Answer: B Cost-benefit analysis is a set of practical procedures for guiding public expenditure decisions.

25. Counting as benefits of the project the sum of the increase in land value and the present value of net income from farming it is an example of the chain-reaction game. A) True B) False C) Uncertain

Answer: B False - counting as benefits of the project the sum of the increase in land value and the present value of net income from farming it is NOT an example of the chain-reaction game.

16. Real dollar amounts are essentially the same as nominal dollar amounts. A) True B) False C) Uncertain

Answer: B False - real dollar amounts are NOT the same as nominal dollar amounts.

22. A social rate of discount measures the value society places on consumption that is sacrificed in the future. A) True B) False C) Uncertain

Answer: B False - social rate of discount DOES NOT measure the value society places on consumption that is sacrificed in the future.

18. The term "present value" refers to the future value of present day money. A) True B) False C) Uncertain

Answer: B False - the term "present value" refers to the PRESENT value of present day money.

19. When the benefits or costs of a project are risky, they must be avoided. A) True B) False C) Uncertain

Answer: B False - when the benefits or costs of a project are risky, they NEED NOT be avoided.

5. Risk is ________ a part of cost-benefit analysis. A) decided by others whether to be B) always C) never D) unable to be calculated as

Answer: B Risk is always a part of cost-benefit analysis.

7. The term "future value" A) includes the shadow prices of all goods used in a project. B) can be determined by inverting the formula for present value. C) is not used in modern public finance analysis. D) refers to the present value of future money.

Answer: B The term "future value" can be determined by inverting the formula for present value.

11. As long as net returns are positive, the gainers could compensate the losers and still enjoy a net increase in utility. This notion is called A) the Hicks-Kaldor criterion. B) a potential Pareto improvement. C) both of these answers are correct. D) neither of these answers is correct.

Answer: C As long as net returns are positive, the gainers could compensate the losers and still enjoy a net increase in utility. This notion is called either a potential Pareto improvement or the Hicks-Kaldor criterion.

4. The value that society places on consumption that is sacrificed in the present is called A) social marginal damages. B) social marginal costs. C) social rate of discount. D) social returns.

Answer: C The value that society places on consumption that is sacrificed in the present is called social rate of discount.

10. For a government to be efficient, a project should be funded A) as long as the marginal cost exceeds the marginal benefit. B) only when the marginal benefit exceeds the marginal cost. C) only when the marginal cost exceeds the marginal benefit. D) until the marginal benefit equals the marginal cost.

Answer: D For a government to be efficient, a project should be funded until the marginal benefit equals the marginal cost.

6. Money values indexed to a given period are known as A) inverse. B) random. C) nominal. D) real.

Answer: D Money values indexed to a given period are known as real.

3. The value of a human life A) can be estimated using probability of death. B) can be estimated by lost earnings. C) is an intangible that is hard to value. D) all of these answer options are correct.

Answer: D The value of a human life (i) can be estimated using probability of death, (ii) can be estimated by lost earnings, and (iii) is an intangible that is hard to value.

14. When wages are viewed as benefits instead of costs of a project, it is an example of the A) dating game. B) chain-reaction game. C) double-counting game. D) labour game.

Answer: D When wages are viewed as benefits instead of costs of a project, it is an example of the labour game.