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CHAPTER 2: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT ANALYSIS Purpose: Introduction to Pareto efficiency (primary definition of allocative efficiency). CBA AS A METHOD FOR MEASURING EFFICIENCY CBA is a method for measuring allocative efficiency. Allocative efficiency: Resources are deployed in their highest valued use in terms of the goods and services they create. Pareto efficiency: An allocation of goods is Pareto efficient if no alternative allocation can make at least one person better off without making anyone else worse off. CBA can be used to provide information about the relative efficiency of alternative policies. Net Benefits and Pareto Efficiency The link between net benefits and Pareto efficiency is straightforward: if net benefits are positive, then it is possible to find a set of transfers that makes at least one person better off without making anyone else worse off. Willingness to Pay (WTP) is the payment that one would have to make or receive under the policy so one would be indifferent between the status quo and the policy with the payments. The algebraic sum of the WTP values is the appropriate measure of the net benefits of the impacts of a policy. If and only if the aggregate net benefits of the policy (as measured by WTP of affected individuals) are positive, then there exists a set of contributions and payments that make a Pareto improvement over the status quo. Opportunity Cost places a dollar value on inputs required to implement policies. The opportunity cost of an input is its value in its best alternative use. Using CBA for Decision Making If all impacts are valued using WTP and all inputs are valued using opportunity costs, then the sign of net benefits indicates if it is possible to increase Pareto efficiency. Using a decision rule to implement only Pareto efficient policies is impractical for the following reasons: The information burden of measuring benefits and costs for each individual. The administrative burden of actually making each required transfer. Compensation would induce people to overstate costs and understate benefits. Boardman, Greenberg, Vining, Weimer / Cost-Benefit Analysis, 3 rd Edition Instructor's Manual 2-1
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Potential Pareto Efficiency (i.e. Kaldor-Hicks criterion) Alternative decision rule: Adopt only policies that have positive net benefits. Reasons for adopting it: It is feasible. Society maximizes aggregate wealth. If different policies have different winners and losers, then, in aggregate, costs and benefits will average out over the entire population. It counters incentive to give too much weight to organized groups and too little weight to unorganized groups. It is possible to do redistribution wholesale rather than within each separate policy. Application of the Decision Rule in Practice
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This note was uploaded on 01/26/2011 for the course ECON 1111 taught by Professor Fertar during the Spring '10 term at Memorial University.

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