National Academies Press: OpenBook

Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor Investments (2017)

Chapter: Appendix A - Rule of Half Principle, Consumer Surplus, Producer Surplus, Kaldor-Hicks Criterion, and Financial Versus Economic BCA

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Page 125
Suggested Citation:"Appendix A - Rule of Half Principle, Consumer Surplus, Producer Surplus, Kaldor-Hicks Criterion, and Financial Versus Economic BCA ." National Academies of Sciences, Engineering, and Medicine. 2017. Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor Investments. Washington, DC: The National Academies Press. doi: 10.17226/24680.
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Page 125
Page 126
Suggested Citation:"Appendix A - Rule of Half Principle, Consumer Surplus, Producer Surplus, Kaldor-Hicks Criterion, and Financial Versus Economic BCA ." National Academies of Sciences, Engineering, and Medicine. 2017. Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor Investments. Washington, DC: The National Academies Press. doi: 10.17226/24680.
×
Page 126
Page 127
Suggested Citation:"Appendix A - Rule of Half Principle, Consumer Surplus, Producer Surplus, Kaldor-Hicks Criterion, and Financial Versus Economic BCA ." National Academies of Sciences, Engineering, and Medicine. 2017. Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor Investments. Washington, DC: The National Academies Press. doi: 10.17226/24680.
×
Page 127
Page 128
Suggested Citation:"Appendix A - Rule of Half Principle, Consumer Surplus, Producer Surplus, Kaldor-Hicks Criterion, and Financial Versus Economic BCA ." National Academies of Sciences, Engineering, and Medicine. 2017. Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor Investments. Washington, DC: The National Academies Press. doi: 10.17226/24680.
×
Page 128

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125 A p p e n d i x A This appendix explains how to calculate consumer surplus and how the rule of half principle can be applied in determining benefits in multimodal contexts. It is simpler than the alternative— the logsum approach. A.1 Rule of Half A freight project improves capacity between locations i and j. The reduction in transport costs impact two groups of users: • Existing users—gain the benefit of the cost change (C0 - C1) each, or area C0AEC1. • New (induced or diverted) users—gain a benefit equal to the excess of their willingness to pay over their cost, or area ABE. The conventional user benefits (transportation economic efficiency benefits) are the sum of (i) and (ii) as given by the rule of half (1) (See Figure A1.): C C T C C T T or C C T T0 1 0 12 0 1 1 0 12 0 1 0 1( ) ( )( ) ( )( )− + − − − + The rule of half formula assumes the demand curve is linear between points A and B. There- fore, it is only an approximation to the true benefit: the larger the cost charge as can occur with large projects, the less accurate the approximation will be. Given the many sources of error in practical Benefit-Cost Analysis (BCA), the rule of a half is considered acceptable except in cases where cost changes may be considered “large” relative to base cost levels (> 25% change in direct user benefits based on prior research) (2). Consumer Surplus (Old users): Area C0-A-E-C1 represents benefits to old users (existing users). Consumer Surplus (New users/Induced Volume): Area A-B-E represents benefits to net new users with a potential short run demand function (T1 - T0). In the medium to long run, fac- tors like product market conditions, modal market share considerations, and firm logistical responses can influence the demand elasticity and consequently the new volumes. Figure A2 shows induced demand from such other factors. The advantage to this approach is that it is very simple to determine since it relies on observed and forecasted volumes. The disadvantage is that it is biased. Rule of Half Principle, Consumer Surplus, Producer Surplus, Kaldor- Hicks Criterion, and Financial Versus Economic BCA

126 Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor investments Supply, Sij0 Short run demand CCost, Ij New Users: (T1 –T0) and (T2- T0): Induced demand T Supply, Sij1 T Volume or Trips, ij 0 1 C0 C1 A B E T0 A: Base B: Build Longer term demand T2 Source: (2, adapted) Figure A2. Induced demand and consumer surplus. Supply, Sij0 Demand, Dij = f(Cij ,…) D CCost, Ij User benefit (=change in consumer surplus) in the do-something scenario compared with the do-minimum Supply, Sij1 T TVolume or Trips, ij 0 0 1 Benefit = CS C 0 C 1 A B E T A: Base B: Build Case: T1 > T0 and C0 < C1 Source: (2, adapted) Figure A1. Consumer surplus. Total welfare also includes producer surplus, which can arise in cases where tolls or fees are charged for usage/access which affect operator/producer revenues or when transport providers’ costs are lowered. Producer surplus is a measure of firms’ (it could be the asset producer itself) welfare and is the difference between the minimum price a producer would accept to provide a level/quantity of product and the price actually received. A reduction in maintenance costs is a good example of a producer surplus-related welfare benefit. These should be captured in BCA.

Rule of Half principle, Consumer Surplus, producer Surplus, Kaldor-Hicks Criterion, and Financial Versus economic BCA 127 A.2 Kaldor-Hicks Criterion The Kaldor and Hicks joint criterion suggest that a policy change is an improvement if the “winners” could fully compensate the “losers” and still be better off themselves. It is otherwise known as the Potential Pareto Improvement Criterion. The Kaldor-Hicks Cri- terion rules out policies with total benefits smaller than total costs (that is, policies with negative net benefits, where net benefits is equal to total benefits less total costs). When the Kaldor-Hicks Criterion is used to compare all feasible policy options, the best is that which maximizes net benefit. A.3 Financial BCA and Economic BCA A financial BCA is a type of financial analysis that aims to determine the financial viability of the proposed project from the viewpoint of the project sponsor. In the financial BCA, the unit of analysis is the project and not the entire economy, state, region, or some other geo- graphic entity. Therefore, a focus on the additional financial benefits and costs to the project, attributable to the project, is maintained. They are similar but yet very different. A financial BCA can also be conducted in constant or current dollars. An economic BCA is always in constant base year dollars. An economic BCA evaluates the project from a particular geographic perspective: national, statewide, regional economy. A financial BCA includes the following eight steps: • Determination of annual project revenues, which is closely related to traffic or freight volume forecasts. • Determination of project costs and sources of financing. • Calculate annual project net benefits and residual value. • Determination of the appropriate discount rate (i.e., weighted average cost of capital serving as proxy for the financial opportunity cost of capital). • Calculation of the average incremental financial cost. • Calculation of the financial net present value (FNPV) (compare to net present value [NPV] in economic BCA). • Calculate the financial internal rate of return (FRR) (compare to internal rate of return). • Conduct risk and sensitivity analysis. A template of a financial BCA looks like Table A1. A business case analysis (Figure A3) typi- cally includes both the economic BCA comprising public perspectives and financial analysis or financial BCA from the perspective of the private sector. Years 1 2 3 4 5 … 30 Total Revenues Sources 1,2, 3, $400,000 Residual Value -$5000 Total Cash Inflows Investment Costs Operating Costs Other Costs financial and other Total Cash Outflows FNPV FRR Table A1. Financial BCA sample (as separate from economic BCA).

128 Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor investments References 1. Button, K. J. Transport Economics, Edward Elgar, Cheltenham, Glos., 993. 2. World Bank. TRN-11. Noted on the Economic Evaluation of Transport Projects. World Bank. Washington DC. Figure A3. Business case analysis, BCA, economic impact analysis, and financial BCA. Business Case Analysis BCA Public perspectives EIA Local entity, Public sector perspectives Financial Analysis/Financial BCA Private Sector Perspectives

Next: Appendix B - Projects with Different Service Lives (EANB and CMPD) »
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TRB's National Cooperative Freight Research Program (NCFRP) Research Report 38: Guide for Conducting Benefit-Cost Analyses of Multimodal, Multijurisdictional Freight Corridor Investments explores how to conduct benefit-cost analyses (BCAs). A BCA is an analytical framework used to evaluate public investment decisions including transportation investments. BCA is defined as a collection of methods and rules for assessing the social costs and benefits of alternative public policies. It promotes efficiency by identifying the set of feasible projects that would yield the largest positive net benefits to society.

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