Transcript
Chapter 4 – Economic Efficiency and Cost-Benefit Analysis
Key Ideas
Much of what economics does is implicitly cost-benefit analysis, with marginal benefits and marginal costs, but there are classes of projects or interventions that do not provide standard market tests. For these we need other types of analyses such as cost-benefit, cost-efficiency, or cost-utility analysis.
The chapter provides a direct link to the analysis of markets in Chapter 2. We show that economic efficiency is all about the right amount of quantity. This “right amount” would maximize the sum of the producers’ and the consumers’ surpluses. Monopoly, for example, is wasteful, not because it provides large profits to monopolists, but because it produces the “wrong” amount based on society’s consumer preferences and production technologies.
In conducting cost benefit analyses, one must enumerate all or the potential costs and all of the potential benefits. One cannot double count, such as adding jobs created (a cost to producers) to increased property values (a benefit to owners).
Cost-efficiency or cost-utility analysis is particularly important in health economics, often due in part to people’s (both the public and health professionals) reluctance to impart valuations to human life.
Teaching Tips
Some students may be uncomfortable with valuations of life, so one way to deal with it is to think about speed limits. Many Americans will remember the 55 mile per hour speed limits of the 1970s and that one of the rationales was that the speed limit saved lives. Although there was some debate about whether a 55 mile per hour speed limit would save lives, certainly there would be very few traffic fatalities if we had a nationwide 15 mile per hour speed limit. Why don’t we have it? What does this say about our valuation of life?
Computer spreadsheet programs can demonstrate the critical importance of the interest rate in discounting. It is easy to set up a two period model. Define the interest rate as a parameter. It is easy to show how present discounted values change depending on the interest rate. Students can see immediately how it changes, without having to make mistakes calculating it.
Chapter 4 – Economic Efficiency and Cost Benefit Analysis – Multiple Choice
The social optimum occurs when:
total benefits have been maximized.
total costs have been minimized.
total costs equal total benefits.
marginal costs equal marginal benefits.*
The social optimum:
minimizes total costs.
maximizes total benefits.
maximizes the sums of the consumers’ and producers’ surpluses.*
answers (a) and (b) are correct.
In the Figure above, the total benefits when quantity equals 50 are:
250
500
750*
1000
In the Figure above, the market benefit/cost ratio at quantity equal to 50 is:
1.0
1.5*
2.5
5.0
In the Figure above, at quantity equal to 50, the sum of the producers’ and the consumers’ surpluses is:
225
325
425
475*
In the Figure above, if 60 units of quantity is produced:
society is not at an optimal level of outputs because marginal costs exceed marginal benefits at that level.
society’s well-being is improved because marginal benefits are still positive.
one can draw a “loss triangle” involving the marginal benefit and marginal cost lines.
Answers (a) and (c) are correct.*
(Difficult) In the Figure above, at quantity equal to 60, the sum of the producers’ and the consumers’ surpluses is:
300
400
456*
475
In Figure 4-4 of the text, a city is currently abating pollution at level Q3. To increase welfare, decision makers should:
stay at level Q3.
reduce efforts to Q2.
increase efforts to Q1.*
strive to eliminate pollution by 100%.
In Figure 4-4 of the text, a city is currently abating pollution at level Q2. They are debating whether to abate pollution at level Q3 or level Q1. They should choose:
Level Q3 because it is less costly than Q1.
Level Q3 because marginal benefits exceed marginal costs.
Level Q1 because it is less costly than Q2.
Level Q1 because well-being is maximized when marginal benefits equals marginal costs.*
Consider a project with costs of $10 million per year for 10 years. Assuming that the costs are paid the last day of each year, the present discounted value of these costs, using a 5% discount rate is ___ million:
$100
$77.2*
$66.5
$44.3
Consider a project with costs of $10 million per year for 10 years. Assuming that the costs are paid the last day of each year, the present discounted value of these costs, using a 4% discount rate is ___ million:
$100
$81.1*
$77.2
$44.3
A project has costs of $10 million per year for 10 years. The benefits of $30 million per year occur in years 7, 8, 9, and 10. At a 5% discount rate, is this project socially desirable?. (Assume that costs and benefits accrue on the last day of each year).
The project is socially desirable; net benefits are $20 million.
The project is socially desirable; net benefits are $2.2 million.*
The project is socially undesirable; net benefits are –$0.7 million.
The project is socially undesirable; net benefits are –$20 million.
In the problem (12), with a 4% discount rate, the benefit-cost ratio is:
0.94
1.06*
1.18
2.17
In the diagram above, the total costs of 15,000 inoculations are $15,000. At this level of inoculations, the benefit-cost ratio is:
5.5*
5.0
3.0.
2.0.
(Difficult) In the diagram above, if we provided 7,500 inoculations, the benefit-cost ratio would be:
10.0
7.75*
5.25
2.50
(Difficult) In the diagram above, if we provided inoculations at 0 charge, the benefit-cost ratio would be:
5.5
5.0*
3.0
2.0
The Stern Report seeks to discount $6,000 billion of annual benefits occurring 100 years from now. If these are discounted at a rate of 4%, the present discounted value of the benefits will be approximately:
$828.2 billion
$455.7 billion
$118.8 billion*
There is not enough information provided.
The Stern Report seeks to discount $6,000 billion of annual benefits occurring 100 years from now. If these are discounted at a rate of 2%, the present discounted value of the benefits will be approximately:
$828.2 billion*
$455.7 billion
$118.8 billion
There is not enough information provided.
Comparing the “cost/cancer” saved of various screening programs is an example of _______ analysis:
cost-efficiency.*
cost-benefit.
economic efficiency.
all of the above.
In screening programs, the ________ the probability of an incorrect or “false” positive finding, the ________ effective the screening program is:
lower; less.
lower; more.
higher; less.
answers (b) and (c) are correct. *
Suppose that the equilibrium wage in industry A is $50,000. Industry B is riskier with workers having a 0.05 greater chance of dying on the job; the wage in industry B is $55,000. Assuming that the average remaining length of life is 25 years, with a discount rate of 5% the implied valuation of life is approximately:
$0.
$0.7 million.
$1.4 million.*
$2.1 million.
Suppose that the equilibrium wage in industry A is $50,000. Industry B is riskier with workers having a 0.05 greater chance of dying on the job; the wage in industry B is $60,000. Assuming that the average remaining length of life is 25 years, with a discount rate of 3% the implied valuation of life is approximately:
$0.
$0.7 million.
$2.1 million.
$3.5 million.*
Quality Adjusted Life Years (QALYs) evaluates interventions in ____ rather than _____.
dollars; years.
utility; dollars.
years; dollars.*
dollars; utility.
Compare two treatments. Treatment A provides an improvement of 0.1 QALYs at a cost of $2,000, whereas Treatment B provides an improvement of 0.2 QALYs at a cost of $5,000. Which treatment will planners prefer by cost-efficiency criteria?
treatment A because it is cheaper.
treatment B because it provides a greater improvement.
treatment A because it has a lower cost per QALY.*
treatment B because it has a lower cost per QALY.
QALYs place a higher value on ________ because rich and poor people are evaluated ______.
equity; similarly.*
efficiency; similarly.
efficiency; differently.
equity; differently.
Suppose, Sam has the opportunity for a treatment that will extend his life by one year with a probability of 0.9 by two years with a probability of 0.5, and three years with a probability of 0.3. Sam will die with certainty after three years. QALY weight q1 is 0.9 in year 1, q2 is 0.6 in year 2, and q3 is 0.2 in year 3. The discount rate is 0.05 per year. The total number of discounted QALYs from this treatment is
1.1*
1.3
1.7.
2.1.
Considering the parameters from problem 26, if the treatment costs are $2,000 in Year 1, $3,000 in Year 2, and $5,000 in Year 3, then the expected costs per QALY for the three year regimen would be approximately:
$5,000
$8,000*
$50,000
$80,000
In problem 26, the planners must decide between two years and three years of treatment for Sam. Given the third year of Sam’s treatment would cost $5,000, what is the incremental cost per QALY for the third year of treatment?
$5,000
$20,666
$52,833
$83,333*
Consider the diagram above. Project A is a $1 million dollar project; Project B is a $5 million dollar project; Project C is also a $5 million dollar project. Investment ____ is the most economically efficient estimate with net benefits of $ ____ million.
A; 1.
B; 0.6.
B; 3.0.*
Information is insufficient
If planners are seeking to maximize societal benefits, they will implement project(s) ___.
A only.
B only.
A and B only.*
A, B, and C.
