Applied Welfare Economics: Cost-Benefit Analysis of Projects and Policies

439 Pages·2014·5.145 MB·English

by  Massimo Florio

Applied Welfare Economics
What is the effect of a new infrastructure on the well-being of a local community?
Is a tax reform desirable? Does the privatisation of a telecommunication provider
increase social welfare? To answer these questions, governments and their policy
advisors should have in mind an operative definition of social welfare, and cannot
rely on simple official statistics, such as GDP. The prices we observe are often
misleading as welfare signals, and costs and benefits for the society should be
based on ‘shadow prices’, revealing the social opportunity costs of goods and of
changes in the world. This book explains how to apply these welfare economics
ideas to the real world.
After a theoretical discussion of the concept of social welfare, a critical analy-
sis of the traditional doctrine of welfare economics as embodied in the two
fundamental theorems, and a presentation of social cost–benefit analysis, the
book introduces the reader to an applied framework. This includes the empirical
estimation of shadow prices of goods, the social cost of labour and capital, and
the assessment of risk. This book also includes the state of the art of international
experience with CBA, including ex-post evaluation of major projects, economic
rates of return in different sectors, and a case study on privatisation.
This book offers a unique and original blend of theory, empirics and experi-
ence. The theoretical discussion clarifies why shadow prices are not virtual
market equilibrium prices, as they arise as the solution of a planning problem,
often with governments and economic agents constrained in their information and
powers. The empirical chapters show how to compute proxies of the shadow
prices in simple ways. The experience chapters draw from first-hand research,
gained by the author and his collaborators over many years of advisory work for
the European Commission and other international and national institutions.
Massimo Florio is Professor of Public Economics and Jean Monnet Chair
‘ad personam’ of EU Industrial Policy at the University of Milan.
Routledge advanced texts in economics and finance
1. Financial Econometrics 13. Modern Public Economics
Peijie Wang (Second Edition)
Raghbendra Jha
2. Macroeconomics for Developing
Countries (Second edition) 14. Introduction to Estimating
Raghbendra Jha Economic Models
Atsushi Maki
3. Advanced Mathematical
Economics 15. Advanced Econometric Theory
Rakesh Vohra John Chipman
4. Advanced Econometric Theory 16. Behavioral Economics
John S. Chipman Edward Cartwright
5. Understanding Macroeconomic 17. Essentials of Advanced
Theory Macroeconomic Theory
John M. Barron, Bradley T. Ewing Ola Olsson
and Gerald J. Lynch
18. Behavioural Economics and
6. Regional Economics Finance
Roberta Capello Michelle Baddeley
7. Mathematical Finance 19. Applied Health Economics
Core theory, problems and statistical (Second Edition)
algorithms Andrew M. Jones, Nigel Rice,
Nikolai Dokuchaev Teresa Bago d’Uva and
Silvia Balia
8. Applied Health Economics
Andrew M. Jones, Nigel Rice, 20. Real Estate Economics
Teresa Bago d’Uva and Silvia Balia A point-to-point handbook
Nicholas G. Pirounakis
9. Information Economics
Urs Birchler and Monika Bütler 21. Finance in Asia
Institutions, regulation and policy
10. Financial Econometrics Qiao Liu, Paul Lejot and
(Second Edition) Douglas Arner
Peijie Wang
22. Applied Welfare Economics
11. Development Finance Cost–benefit analysis of projects and
Debates, dogmas and new directions policies
Stephen Spratt Massimo Florio
12. Culture and Economics
On values, economics and
international business
Eelke de Jong
Applied Welfare Economics
Cost–benefit analysis of projects
and policies
Massimo Florio
Routledge RTayolour &t Flreandcisg Geroup
LONDON AND NEW YORK
First published 2014
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa
business
© 2014 Massimo Florio
The right of Massimo Florio to be identified as author of this work has
been asserted by him in accordance with the Copyright, Designs and
Patent Act 1988.
All rights reserved. No part of this book may be reprinted or reproduced
or utilised in any form or by any electronic, mechanical, or other means,
now known or hereafter invented, including photocopying and recording,
or in any information storage or retrieval system, without permission in
writing from the publishers.
Trademark notice: Product or corporate names may be trademarks or
registered trademarks, and are used only for identification and explanation
without intent to infringe.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Florio, Massimo.
Applied welfare economics : cost-benefit analysis of projects and policies/
Massimo Florio.
pages cm
1. Welfare economics, 2. Cost effectiveness. I. Title.
HB846.F579 2014
330.12’6–dc23
2013030922.
ISBN: 978-0-415-85833-5 (hbk)
ISBN: 978-0-415-85831-1 (pbk)
ISBN: 978-1-315-81762-0 (ebk)
Typeset in Times New Roman
by Cenveo Publisher Services
Contents
List of figures x
List of tables xi
List of boxes xiii
Preface xv
Acknowledgements xix
Abbreviations xxi
Main notation xxiv
PART I
Theory 1
1 On social welfare 3
Overview 3
1.1 The concept of social welfare 4
1.2 The welfare assumptions behind GDP and NNP 9
1.3 Individual and social welfare 13
1.4 Determinants of individual welfare: goods 17
1.5 Determinants of social welfare: individual utilities 18
1.6 Sen’s critique of individualistic SWF 25
1.7 Paternalism and not (only) individualistic Social
Welfare Functions 27
1.8 Happiness economics 30
1.9 ‘Positive’ analysis 32
1.10 Further reading 35
1.11 Summary of Chapter 1 36
2 The two fundamental theorems re-examined 39
Overview 39
2.1 Theorems versus intuitions 40
2.2 The Arrow-Debreu economy 43
vi Contents
2.3 The axiomatic structure 45
2.4 Consumers, producers and government:
objectives and constraints 47
2.5 The Walrasian equilibrium 51
2.6 The two theorems without ideology 53
2.7 The informative structure: Stiglitz’s critique 56
2.8 Critical analysis of the second theorem 58
2.9 The government rediscovered in second-best economies 62
2.10 Further reading 65
2.11 Summary of Chapter 2 67
Appendix 2.1: Policies based on the Second Theorem:
Lump-sum transfers 69
3 Shadow prices and the social planner 73
Overview 73
3.1 Introductory remarks 74
3.2 A model for project and policy evaluation 77
3.3 A second-best economy in the DS frame 82
3.4 Policy reforms and shadow prices 85
3.5 Multi-government setting 89
3.6 Why use shadow prices? 94
3.7 Further reading 95
3.8 Summary of Chapter 3 96
Appendix 3.1: Some results from Drèze and Stern (1987) 97
PART II
Empirics 101
4 The social cost of goods 103
Overview 103
4.1 Observed prices and financial analysis 105
4.2 Accounting prices and economic analysis 108
4.3 Empirical approaches for guessing accounting prices 115
4.4 The border price rule for tradable goods 117
4.5 The Standard Conversion Factor 120
4.6 The long-run marginal cost 121
4.7 Willingness-to-pay 123
4.8 Further reading 137
4.9 Summary of Chapter 4 139
Contents vii
Appendix 4.1: Financial analysis 140
Appendix 4.2: An example of financial and economic analysis 144
5 The social cost of labour 152
Overview 152
5.1 Earlier literature on the social opportunity cost of labour 153
5.2 A conceptual model for the social cost of labour 158
5.3 The shadow wage rate and labour market conditions 160
5.4 Empirical estimation of shadow prices for EU regions 166
5.5 Further reading 169
5.6 Summary of Chapter 5 170
6 The social cost of capital 173
Overview 173
6.1 Rationale for discounting 173
6.2 Estimating the social discount rate 175
6.3 The social discount rate as a function of time 181
6.4 Empirical estimates of the social discount rate 185
6.5 The opportunity cost of public funds 192
6.6 Further reading 194
6.7 Summary of Chapter 6 195
7 Welfare weights and distributional impacts 199
Overview 199
7.1 Why are equity considerations needed in CBA? 200
7.2 Deriving welfare weights 202
7.3 Estimation of distributional weights 204
7.4 The distributional characteristic of goods 207
7.5 Group and regional welfare weights 210
7.6 Basic needs and social affordability 213
7.7 Further reading 217
7.8 Summary of Chapter 7 219
8 Risk assessment 222
Overview 222
8.1 Rationale of the risk assessment 223
8.2 Definitions and concepts 224
8.3 Historical background: the World Bank model 226
8.4 Sensitivity analysis 227
8.5 Probability analysis 233
viii Contents
8.6 Risk analysis 239
8.7 Further reading 244
8.8 Summary of Chapter 8 246
Appendix 8.1: Distributions of probabilities 248
Appendix 8.2: Monte Carlo method 253
Appendix 8.3: Generating correlated random numbers 257
PART III
Practice 263
9 International evaluation practices 265
Overview 265
9.1 National traditions and operative guidelines 265
9.2 Evaluation practice in the EC regional policy 276
9.3 Multilateral development banks 279
9.4 Further reading 286
9.5 Summary of Chapter 9 288
10 Project returns observed 291
Overview 291
10.1 Conceptual framework of the analysis 292
10.2 Empirical methodology 297
10.3 Comparisons between financial and economic
rates of return 302
10.4 Comparison between ex-ante and ex-post economic
rates of return 306
10.5 Inter-sector comparisons 308
10.6 Conclusions 313
10.7 Further reading 315
10.8 Summary of Chapter 10 315
11 Ex-post project evaluation: ten case studies 318
Overview 318
11.1 Timing and scope of CBA 319
11.2 Performing ex-post CBA 320
11.3 International practice of ex-post CBA 338
11.4 CBA and the decision-making process 341
11.5 CBA and incentives 343
11.6 Further reading 344
11.7 Summary of Chapter 11 344
Contents ix
12 Ex-post policy evaluation: a case study 349
Overview 349
12.1 Theoretical framework and earlier research 350
12.2 Methodology 354
12.3 Results of the ex-post scenario analysis 357
12.4 Conclusions 363
12.5 Further reading 365
12.6 Summary of Chapter 12 365
Appendix 12.1: Time-series behaviour of BT costs and revenues 367
Appendix 12.2: Building up the projections of revenues and costs 372
Bibliography 375
Index 403