Lecture 8

Evaluating Trade-Offs: Benefit–Cost Analysis and Other Decision-Making Metrics

Byeong-Hak Choe

bchoe@geneseo.edu

SUNY Geneseo

September 13, 2024

Benefit–Cost Analysis and Other Decision-Making Metrics

Normative Criteria for Decision Making for Environmental and Natural Resource Economics

• Positive Economics: Describing what is, what was and what will be.
• Normative Economics: Attempting to answer what ought to be.
  • Normative analysis might be used, for example, to evaluate the desirability of a proposed new pollution control regulation or a proposal to preserve an area currently scheduled for development.
• Benefits and costs in economics are measured from a human-centered perspective.
  • This anthropocentric approach does not ignore ecosystem effects, as humans value environmental preservation.

Normative Criteria for Decision Making

Evaluating Predefined Options: Benefit–Cost Analysis

• Let \(B\) be the benefits from a proposed action and \(C\) be the costs.

  • Our decision rule would then be:
    • If \(B > C\), support the action
    • Otherwise, oppose the action

• Total benefits are the value of total willingness to pay, which is the area under the market demand curve from the origin to the allocation of interest.

• Opportunity cost is the net benefit lost when specific environmental services are forgone in the conversion to the new use: the marginal opportunity cost curve.

• Total costs are measured by the area under the marginal opportunity cost curve.

Normative Criteria for Decision Making

Evaluating Predefined Options: Benefit–Cost Analysis

• Should the 4-mile stretch stretch of river be preserved?

Normative Criteria for Decision Making

Finding the Optimal Outcome

• The process of finding optimal outcomes in environmental and resource economics involves three steps:
  1. Identify the optimal outcome
  2. Compare actual outcomes to the optimal, and identify reasons for divergences
  • Which institutions would produce optimal outcomes?
  • What are the behavioral sources of the divergences?
  3. Design policy solutions based on the problem’s nature and causes
• This approach is applied to various environmental and natural resource issues.

Normative Criteria for Decision Making

Finding the Optimal Outcome: Examples

1. Depleted ocean fisheries:

• Define optimal stock or harvest rate
• Compare to actual levels
• Understand reasons for excessive exploitation
• Develop solutions based on this understanding

2. GHG emissions and climate change:

• Determine optimal warming threshold (1.5°C)
• Compare current emissions to optimal levels
• Identify behavioral sources of the problem
• Propose economic solutions

Normative Criteria for Decision Making

Relating Optimality to Efficiency

• Optimal policies maximize net benefits (benefits minus costs)

• Static efficiency is achieved when economic surplus is maximized

• Efficient outcomes are also optimal outcomes

Normative Criteria for Decision Making

Relating Optimality to Efficiency

• What is the optimal level of preservation?

Normative Criteria for Decision Making

Relating Optimality to Efficiency

• First Equimarginal Principle (the “Efficiency Equimarginal Principle”):
  • Net benefits are maximized when the marginal benefits from an allocation equal the marginal costs.
• Pareto optimality:
  • Allocations are said to be Pareto optimal if no other feasible allocation could benefit at least one person without harming some other person.
• Allocations that do not satisfy this definition are suboptimal.
• Efficient allocations are Pareto optimal.