1 Investment criteria are the bêtes noires of the economist. Although we shall begin by examining the more familiar proposals in the following chapters in order to reveal the particular difficulties inherent in proposals to reduce a flow of values over some time span to a single figure, we may as well mention such difficulties briefly at the start.
First, the data are much harder to gather, or rather to predict, over future years than are currently available data. The unavoidable uncertainty of future benefits, disbenefits, and outlays, may be dealt with in various ways. Yet, they are all somewhat arbitrary inasmuch as none can be anchored in the subjective preferences of those affected by the project being evaluated. Therefore, the treatment used to cope with uncertainty cannot be assumed, strictly speaking, to accord with a potential Pareto criterion.
Second, even if it were the case that all the magnitudes for future benefits, disbenefits, and outlays, were absolutely certain, no investment criterion, no matter how sophisticated, can be sure of meeting a potential Pareto criterion.
What is invariably being suppressed in the popular treatment of such investment criteria as discounted present value, or internal rate of return, is the basic economic rationale involved: what economic meaning can be attached to the magnitude arising from the application of any of these investment criteria?
2 Let us first be quite clear about the nature of these benefits and costs. An investment in, say, a railroad requires an initial outlay of capital to be spread over the first one or two years. These expenditures are clearly costs. So also are the anticipated outlays at future periods of time, whether for repairs, maintenance or for adding equipment, though their magnitudes are usually smaller than the initial outlays. Benefits are understood in the most comprehensive sense to include all additions to social welfare that can, in Pigou’s words, ‘be brought into relation with the measuring rod of money’.
Benefits should therefore include not only expected receipts over time, as the services produced may not, in fact, be sold to the public but provided free, or sold at a price below their cost (underground rail travel could, for instance, be made free). Evenif the good produced is sold at a price that covers its cost, the revenue collected is almost always less than the full amounts people would be willing to
QUAH: “CHAP21” — 2007/1/25 — 14:02 — PAGE 122 — #4 pay rather thango without. For, as indicated earlier, anestimate of the full benefit to the buyers of the good is roughly equal to the area under the market demand curve.
Again, there are positive and negative spillover effects to be evaluated and added, algebraically, to the benefits of the direct recipients of the goods that are purposely produced by the project. For example, the very existence of the railroad is a form of insurance even to those who use other means of transport, a form of insurance for which they would presumably be willing to pay something. Such sums, the estimated value of indirect benefits, are to be added to the direct benefits. On the other hand, any compensatory sums called for by those people whose assets or whose welfare decline as a result of the noise or pollution, or any other disamenity associated with the railroad service, are to be subtracted from the benefits.
We remind ourselves in passing that if we correct the benefit calculation for all spillover effects inorder to come up with a net figure for social benefits, we cannot also invoke the concept of social costs – else we should be entering the same spillover effects twice, i.e. onthe cost side as well as onthe benefit side.
By convention, therefore, outlays will be calculated as the actual money disburse-ments – the sums spent on the project at any time during its life, all the incidental spillover effects onsociety that arise either inthe building or inthe operation of the project being added to, or subtracted from, the direct benefits at the time they appear.
3 A distinction is sometimes made between ‘capital costs’ and ‘operating costs’, the former being the sums needed to build the project, the plant machinery and the like, the latter being the sums to be disbursed at regular intervals in order to maintain the flow of products or services. Such sums or ‘operating costs’ can be met from what is sometimes called a revolving fund, which can take the form of a line of credit from a bank which may be drawn upon as needed in order to meet the wage bill, maintenance, repairs, and payments for materials. Indebtedness to the bank or other financial institution, however, may be eliminated altogether or else limited as a result of a stream of cash receipts from the sale of the goods being produced by the project.
In calculating the magnitude of these operating costs, only as a first approx-imationmay they be set to the actual disbursements to be made for repairs, maintenance, and materials. Ideally, however, we should have to calculate the opportunity costs of the resources used for these things by the project – that is, the social benefits that would have occurred if, instead, these resources were left in their current uses. In particular, it is not the wage bill that is to be included in the operating costs but the opportunity costs of the labour employed by the project (as defined and measured in Chapter 11).
Again, if regular borrowings from banks are anticipated, a first approximation to the value of these outlays over the future would be set equal to the interest payments that have to be made in subsequent years. More accurately, however, we should calculate the annual opportunity costs (or net social benefits forgone) whenever the banks lend the required sums to the project managers.
QUAH: “CHAP21” — 2007/1/25 — 14:02 — PAGE 123 — #5 Introduction to investment criteria 123 Finally in this connection, it is important to bear in mind that, inasmuch as we are concerned with net social benefits, all taxes paid from the revenues of the project are not to be subtracted from the value of such benefits. The taxes that are paid from the revenues declared by the project are transferred to the government and have to be valued according to how the government disposes of them.
4 The social benefits, on their own, in each period is to be calculated as the sum of (i) the value of the project’s marketable goods (equal to the cash receipts from the sale of those goods plus their consumer surplus), (ii) the value of all unpriced benefits conferred on some segment of society, and (iii) the algebraic sum of all externalities, positive and negative, created in each period by the project.
By subtracting the opportunity costs of the factors employed in each period from the value of these social benefits in each period, we derive a stream of net social benefits over the relevant time span – some positive, some negative and possibly also some that are zero. And it is to this stream of net social benefits that we can apply our adopted investment criterion.
It is advisable, first, to set out these social benefit figures and their corresponding opportunity costs, period by period – more commonly year by year. For a four-year time span, we might set out our data as in the following example:
Social benefits 0 0 150 260 Opportunity Costs 100 130 135 0
The successive annual net social benefits are therefore –100, –130, 15 and 260.
Ingeneral, we cansummarize the stream of expected gross benefits less their costs as (b0− k0), (b1− k1), (b2− k2), . . . , (bn− kn), where b0and k0are the social benefits and opportunity costs, respectively, of the initial period, b1 and k1are the social benefits and opportunity costs of the first period, and so on, the subscript always referring to the period or year. If we now define the net, or excess, social benefit in any tthperiod or year, Bt as equal to (bt− kt) we canwrite the above as a stream of net social benefits: B0, B1, B2, . . . , Bn, where the Bs canbe negative, zero or positive. This is the stream to which an investment criterion is usually applied.
5 It may sometimes be proposed that the economist himself make available the results of his cost–benefit calculationinthe form of anactual stream of net social benefits, B0, B1, . . . , Bt, thus allowing the decision makers themselves to cast their eyes over the time-profiles of the various projects being mooted, in preference to, or in addition to, their being ranked by the economist on some investment criterion or other.
Yet, in the absence of guidance from the economist, political decision makers cannot be depended upon either to rank alternative projects in a consistent man-ner on any acceptable principle, simply by contemplating their time-profile, or
QUAH: “CHAP21” — 2007/1/25 — 14:02 — PAGE 124 — #6 to judge whether any single one is economically acceptable. There is, indeed, no more warrant for decision makers’ drawing conclusions about the acceptability or ranking of alternative projects from their study of the relevant time-profiles thanthere is for their imposing their political judgements onthe valuationof the economic data used in a cost–benefit calculation. If it is economic expertise they are requesting, they are implicitly accepting strictly economic methods of calculation.
And in a CBA based on the Pareto criterion, the economist necessarily has to compare alternative investment streams by reducing each to a single figure at a common point of time – the discounted present value (DPV) criterion being currently favoured. Certainly, if we have to use some one rule for the appraisal or ranking of investment streams, this favoured criterion is generally superior to the somewhat crude criteria commonly employed by business concerns.
There is, nonetheless, some pedagogic value in briefly describing the latter, as we do in the following chapter, if only to highlight their weaknesses and so pave the way for an understanding of the standard DPV methods and, later, for more sophisticated investment criteria.
Insum, the search for aninvestment criterioninvolves us ina search to discover an answer to the question: what single figure best summarizes the net social benefits of each of the investment streams under consideration? If we are able to find a satisfactory answer to that question, we shall have no difficulty in finding a solution to another common question: given funds that will enable us to finance one, two or more projects, which of these projects, if any, should we choose?
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