Benefit-Cost Criterion. Summary of Second Exam Scores for Econ 2. Chapter 14: The Environment, Health, and Safety

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1 Summary of Second Exam Scores for Econ 2 A: B: C: D: F: below 50 Top score: 100 Average score: 77 Chapter 14: The Environment, Health, and Safety Roadmap 1. Maximizing Economic Value --Benefit-cost/cost-benefit criterion/principle 2. How economists look at safety issues --Statistical value of life 3. Health (Thursday: Melissa Famulari) 4. Environment 5. Crime Basic Economic Objective: Maximize Value Sources of disagreement: (1) What has value Economics takes an anthropocentric view (2) Who determines value Consumer sovereignty people decided for themselves what they want. Value is determined solely by the tradeoffs people are willing to make in their actions such as purchases and votes (3) How does one determine value? Relative scarcity and utility (diamonds and water paradox) (4) How does one compare different time periods? Economics looks at net present value (NPV) (5) Whose values count and how should they be weighted? Ideal: Social welfare function Usual criteria for determining social welfare function: Pareto improvement Potential Pareto improvement (Hicks-Kaldor) Voting Rawlsian None of these criteria explicitly consider who to aggregate over. Controversies exist over: geographical areas current versus potential users time periods (future generations) Two most commonly used criteria: Potential Pareto and voting. A potential Pareto criterion counts all dollars as equal. Voting criteria counts all people as equal and ignores the magnitude of losses or gains. [Voting decision based solely on whether consumer loses or gains from the project.] For a project where the government (rather than individual agents incurs the cost), the Potential Pareto Criteria as compares the number of agents (N) times mean WTP while the voting criteria can be seen as comparing N times median WTP. For many environmental amenities mean WTP is 2 to 3 times larger than median WTP. Benefit-Cost Criterion Compare benefits to costs Net benefits=benefits - cost Only do if benefits exceed cost Benefit-Cost ratio > 1 (B/C > 1) Requirement of many govern projects/programs Application of Potential Pareto improvement objective From Chapter 7 and 9, difference between benefits and cost is where MB = MC This is a much stronger criteria than benefit > ratio > 1 But note that at point MB = MC, benefit-cost ratio may be < 1 1

2 Benefit-Cost Terms/Comparisons Project Possibilities Assume Potential Pareto criteria NET BENEFITS = BENEFITS - COSTS BENEFIT-COST RATIO = BENEFITS / COST Ratios greater than 1 imply positive net benefits MAXIMUM NET BENEFITS is where the difference between total benefits and costs is largest Or equivalently marginal benefits = marginal cost Level of Good Level 1 Level 2 Level 3 Level 4 Benefits Costs Net Benefits General Benefit-Cost Formula Σ i Σ t [B it C it ]/[1+r] t where B it are the benefits to the ith agent in time period t C it are the costs to the i th agent in time period t r is the discount rate Sometimes know as a net present value calculation [NPV] Generic Benefit-Cost Issues Measuring all of the benefits Measuring all of the cost Putting them in a common metric (money) Choosing the appropriate discount rate Consumer cost of credit Private investment opportunity Government cost of borrowing Zero Measuring Benefits & Costs of Environmental, Health, and Safety Programs Market value of input or output Implicit value of input or output Similar to derived demand curve for labor Embodied as an attribute of a product Hedonic pricing (compensating wage differentials and housing price models) Household production function approach Surveys of willingness to pay Voting behavior Distributional Issues Economist tend to ignore who gains [those with a positive NPV] and who loses [those with a negative NPV] Usual argument is that as long as each project has a benefit-cost ratio > 1, then gains and losses on individual projects will balance out producing a net gain for all Political process is capable of trying to undo this balancing and in the extreme (but not unusual) case undertakes projects with overall benefitcost ratio < 1 to provide gains to supporters 2

3 Chapter 14: The Environment, Health, and Safety 2. The optimal amount of safety One view: human life is priceless Does this mean all expenditures that make us safer are a good idea? Should we build pedestrian walkways at every intersection? Should we keep ourselves in bubbles to reduce risk of infectious disease? Example: controlling cotton dust exposure in the textile industry Byssinosis ( brown lung disease ): mild wheezing to severe respiratory problems 3

4 Suppose that without worker protection, 1 in 12 textile workers would eventually develop brown lung disease Suppose that it would cost the firm $2,000 per worker each year to improve ventilation system to reduce this risk Optimality principle: If it s worth more than $2,000 per year to the worker to reduce the risk, improved ventilation is a good idea. If it s worth less than $2,000 per year to the worker to reduce the risk, improved ventilation is not a good idea. 1. Outcome when there are no government regulations over worker safety Let s say that nobody used to think there was any danger from working in a textile plant, and the wage paid textile workers used to be $25,000 per year. Suppose first that the cost of improved ventilation is $2,000 per year and the value to the worker of improved ventilation is $3,000 per year (so improved ventilation is a good idea) Then a new scientific study establishes the risk of brown lung disease. If firm makes no changes at all, some workers would quit. Workers used to see $25,000 as adequate compensation for the job Given the new scientific information and the value workers place on safety, workers would now need $28,000 to remain If firm makes no safety improvements, it would have to raise the wage to $28,000 to keep all its workers Alternatively, the firm could make the ventilation improvements at a cost of $2,000 per worker and keep the wage at $25,000 per worker. 4

5 Cost per worker when the firm makes no safety investment = $28,000 Cost per worker when the firm does make safety investment = $27,000 A profit-maximizing firm would choose to make the safety investment Conclusion: when added safety investment makes economic sense, the firm s desire to maximize its profit would lead it to make the investment Suppose instead that the cost of improved ventilation is $2,000 per year and the value to the worker of improved ventilation is $1,000 per year (so improved ventilation is not a good idea) If firm makes no changes at all, some workers would quit. Workers used to see $25,000 as adequate compensation for the job Given the new scientific information and the value they place on safety, workers would now need $26,000 to remain If firm makes no safety improvements, it would have to raise the wage to $26,000 to keep all its workers Cost per worker when the firm makes no safety investment = $26,000 Cost per worker when the firm does make safety investment = $27,000 A profit-maximizing firm would choose not to make the safety investment Conclusion: when added safety investment does not make economic sense, the firm s desire to maximize its profit would not lead it to make the investment 1. Outcome when there are no government regulations over worker safety 2. Outcome when the government forces firm to improve ventilation system Suppose as in the last case that the cost is $2,000 per worker and value to worker is only $1,000 With no government regulation, wage would be $26,000 and firm s cost per worker would be $26,000 With government regulation, wage would be $25,000 and firm s cost per worker would be $27,000 5

6 Conclusion: the regulation will raise firm s costs (leading them to lay off workers) and lower the workers wages Both workers and firm will be worse off than they would have been with no regulation 3. Actual response to the new scientific evidence about brown lung disease: Firms resisted improving ventilation Firms forced to adopt higher standards by Occupational Safety and Health Administration (OSHA) Without these problems: Question: why would a government agency force a safety requirement on a firm? Divergence between information underlying government and firm s benefit-cost calculation Informational problems (workers uniformed) Workers not mobile/employer market power Liability problems (firm can go bankrupt) 1. Outcome when there are no government regulations over worker safety-- result is optimal level of workplace risk 2. Outcome when the government forces firm to improve ventilation system result is lower wages, less employment, higher costs Government s Problem In The Face of Market Failure Agency (OSHA) has a hard task assimilating all the scientific evidence, firm s costs, and worker s preferences Mobility/Risk Aversion Interaction Workers may have limited mobility (stuck in current job, perhaps due to health care issues) But, if firm would not lose any workers if it lowered the wage to $23,000, why was it paying them $25,000? One possible answer: if job is riskier, firm would have to raise wage by less than $1,000 because more risk-taking individuals than those currently employed would take the job 6

7 Fatality rates also differ greatly by type of job within industry. For example, fatality rates per 100,000 in mining: managerial: 4.35 clerical: 0.00 transportation and material moving: Kip Viscusi, Economic Inquiry, Jan 2004: Statistical summary of wage earned by individual as a function of risk of death on the job, education, race, gender, union membership, age, Conclusion from Viscusi s literature review: For each 1/100,000 increase in probability of a fatal work-related accident, wages increase 0.17% To persuade 100,000 people to accept such an increase in risk, would have to pay them collectively $5 million more $5 million = value of one statistical life Statistical Value of Life Used to Determine How Much Safety Range of $1 to $10 million dollars per statistical life typically used Examples Airliners Crime Drugs Environmental health risks Large energy facilities Large disasters (earthquakes, fire, floods, hurricanes) Roads Terrorism (?) Question should the same value of a statistical life be used for all types of risk? 7

8 Reducing Crime Increasing likelihood of detection Increasing likelihood of arrest Increasing likelihood of conviction Increasing penalties Time incarcerated Time supervised probation Monetary Benefits and cost Unintended consequences 8

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10 Equivalence Between Setting Quantity and Imposing a Tax In the absence of uncertainty, it is possible to achieve the same outcome by either imposing a quantity constraint on the externality or by setting a tax on it (Martin Weitzman, 1974, Review of Economic Studies) With uncertainty, the shape of the damage function and the profit function may lead one to prefer either a tax or quantity (marketable permit approach). Implication for programs that reduce risk Choosing an expenditure level for a program that reduces risks implicitly places a value on how much reducing that risk at the margin is worth. Example, a program that reduces a 1/10000 risk for 200,000 people that cost $30 million dollars places a value of $1.5 million dollars on saving a statistical life 10