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In this module, let's tackle one of the most important tools in micro-economics,
Benefit-Cost Analysis, which is also referred to as cost benefit analysis.
Here's the underlying concept.
Suppose the government is contemplating building that flood control project,
we talked about in an earlier module.
The big question is whether the government should undertake that project,
but it's not quite that simple.
Government officials must also consider what
the proper size and scope of the project should be.
For example, should the project consist of a big dam or
a medium-sized dam or simply a system of smaller levees?
Here's the key concept.
To move forward with their decisions,
the government officials must be able to identify and
accurately measure both the benefits and costs of the project,
and then have some way to determine whether the benefits might
outweigh the costs and thereby justify construction of the project.
The key rule is simply this,
if the benefits from the project exceed its costs,
we should build the project.
However, if the costs exceed the benefits,
we should not build.
Here's a key point,
benefit-cost analysis can indicate
much more than just whether a public project is worth building.
It can also help government choose among the best competing alternatives.
To illustrate this key point,
let's work through this table.
Here we have a series of
increasingly ambitious and increasingly costly flood control projects.
In columns one and two,
the projects range from a small levee with the total annual cost of
$3,000 to a large reservoir with a total annual cost of $30,000.
In column four, we see the total annual benefit of each project,
while columns three and five provide the marginal costs and marginal benefits.
Note finally, that column 6 provides the net benefits of each plan.
So let's pause now to see if you can fill in the blank circles in columns
three, five and six.
Here's the completed table.
Note that in column six,
the net benefits are positive for all four plans.
So which one should we choose?
Take a few minutes to really nail the answer to this question now,
as we pause the presentation.
Well, which plan we
should choose will be determined by comparing
the additional or marginal cost and
the additional or marginal benefit associated with each plan.
Using this approach, plan C is clearly preferred.
It provides the largest total net benefits.
But note, that of the four alternatives,
it is certainly not the most expensive.
To put this another way,
bigger isn't always better when it comes to
government budgeting and that's one reason benefit-cost analysis is so useful.
With that brief introduction to benefit-cost analysis, let's move on.
In our next module,
to our next market failure,
that associated with the precedence of
negative or positive externalities in the marketplace.
Dr. Peter NavarroProfessor
