# cba4 - Engineering Risk Benefit Analysis 1.155 2.943 3.577...

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CBA 4. Including Uncertainty 1 Engineering Risk Benefit Analysis 1.155, 2.943, 3.577, 6.938, 10.816, 13.621, 16.862, 22.82, ESD.72 CBA 4. Including Uncertainty George E. Apostolakis Massachusetts Institute of Technology Spring 2007

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CBA 4. Including Uncertainty 2 Uncertainty Practically any CBA requires consideration of uncertainty. Most methodologies in use are ad hoc , due to the intrinsic difficulty of the generalized problem.
CBA 4. Including Uncertainty 3 Methods 1. Scenario analysis 2. Adjustments of interest rates 3. Decision Theory 4. Simplified probabilistic models

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CBA 4. Including Uncertainty 4 Scenario Analysis Preparation and analysis of scenarios: -- “Optimistic” or “most favorable estimate” -- “Most likely” or “best estimate” or “fair estimate” -- “Pessimistic” or “least favorable estimate” Interpretation is difficult without assignment of probabilities to scenarios. Benefit: Brings additional information into the process.
CBA 4. Including Uncertainty 5 Example A new machine is to be purchased for producing units in a new manner. Pessim. Fair Optim. Annual number of units: 900 1,000 1,100 Savings per unit: \$50 55 60 Operating costs: \$2,000 1,600 1,200 etc. PW: -\$49,000 22,000 120,000 What are we to do with such information?

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CBA 4. Including Uncertainty 6 Developing Scenarios For each element in the problem, e.g., interest rate and costs, define the three values. We really don’t know how conservative (pessimistic) the final answer is. People are bad processors of information. Point estimates tend to cluster around the median value. Possibility of displacement bias. Extremes greater than the 75 th or smaller than the 25 th percentile are difficult to imagine. Overconfidence.
CBA 4. Including Uncertainty 7 Forecasting Oil Prices D. Draper, “Assessment and propagation of model uncertainty,” Journal of the Royal Statist. Soc., B (1995) 45-97. In 1980, 43 economists and energy experts forecast the price of oil from 1981 to 2020 to aid in policy planning. They used 10 leading econometric models under each of 12 scenarios embodying a variety of assumptions about inputs, such as supply, demand, and growth rates.

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CBA 4. Including Uncertainty 8 The Plausible Scenario One scenario was termed as the “plausible median case.” It represented “the general trends to be expected.” The 10 models were applied to the plausible scenario. Results for 1986: ¾ Actual price: \$13 ¾ Range of predictions: \$27 to \$ 51.
CBA 4. Including Uncertainty 9 High Interest Rates Justify choice of alternatives using a high interest rate, e.g., 30%. Example Total annual income: \$55,000 Capital cost: \$80,000 Annual capital recovery with return: \$80,000 (A/P, 30%, 6yrs) = \$30,272 Annual operating cost \$28,600 Net annual profit: 55,000 – (30,272 + 28,600) = = -\$3,872

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CBA 4. Including Uncertainty 10 Example (cont’d) The high rate of 30% is intended to cover
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cba4 - Engineering Risk Benefit Analysis 1.155 2.943 3.577...

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