Index > Decision Analysis > 2021-01-28: Benefit-Cost Analysis

2021-01-28: Benefit-Cost Analysis

Goals:

• Setup a BCA calculation
• Understand limitations and issues with BCA
• Apply:
  • Sensitivity analysis
  • Breakeven analysis
  • Monte Carlo
  • Estimation

There are lots of ways to choose between two things:

• Consumer favor
• best engineering
• lowest risk
• cheapest
• simplest

Benefit-Cost Analysis is a method for evaluating each option by determining the option’s benefits and costs, then calculating the net benefit of each option. Then, the option with the highest net benefit is chosen.

In order to compare benefits and costs, they need to be measured in the same units. This could be money or utility.

Example: Hot Water Heater

I could keep my current hot water heater, or buy a new one.

• Keep Current:
  • No benefits
  • No costs
  • Net value of zero
• Upgrade:
  • Benefits: ~$5000
    • Energy efficiency savings
  • Costs: $4000
  • Net value: $1k

“More money, more better” - Prof.

Net Present Value

This will be covered more later.

The Net Present Value (NPV) is a measure of the current value of a future value. For example, $100 right now will be worth less in the future, thanks to inflation.

Example: Renting vs Buying a house

• Renting:
  • Benefits:
    • A place to live for some amount of years
  • Costs:
    • the cost of renting
    • Risk of rent increasing year-over-year
    • Potentially renters insurance
    • Risk of crabby neighbors: cheap, since we have high mobility
• Buying:
  • Benefits:
    • A place to live
    • A house!
    • Positive risk of the property value increasing
  • Costs:
    • The cost of buying the house
    • Interest rates for a mortgage
    • Repairs
    • Risk of damage
    • Risk of value decreasing overtime
    • House insurance
    • Property taxes
    • Risk of crabby neighbors: Higher impact, since it’s harder to move

Some of these attributes are easy to quantify, while some are very difficult. Prof. recommends conducting a quantitative analysis with the quantitative attributes, and a second qualitative analysis with the others.

“Contingent Valuation” or “Willingness to Pay”

These are the names for attempting to measure the value of a non-monetary thing - but this is still very hard.

Most people know the value of a phone charger - but willingness to pay to save an endangered animal varies wildly.

Conclusion

BCA is a very good tool - but its limitations must be understood.

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Index > Decision Analysis > 2021-01-28: Benefit-Cost Analysis