© Harry Campbell & Richard Brown School of Economics The University of Queensland BENEFIT-COST ANALYSIS BENEFIT-COST ANALYSIS Financial and Economic Financial and Economic Appraisal using Spreadsheets Appraisal using Spreadsheets Ch 13: Economic Impact Analysis What is the difference between Net Present Value and Economic Impact? Keynes gives the example of land, labour and capital used in two alternative ways: 1. To dig a hole in the ground; 2. To build a hospital. The two projects have the same economic impact, in terms of generating income for factors of production and inducing additional expenditures, but the hospital has a higher net present value than the hole in the ground. Figure 13.1 The Circular Flow of Income $ GOODS FACTORS $ GOVERNMENT HOUSEHOLDS FIRMS The Circular Flow of National Income The National Income Multiplier Consider three models which can be used to derive the national income multiplier: 1. A closed economy, no taxes; 2. A closed economy, with exogenous taxes; 3. An open economy, with endogenous taxes. Symbols: Y = national income; C = consumption expenditure; S = Savings; I = investment expenditure; T = tax revenues; G = government expenditure; X = value of exports; M = value of imports Model 1: Closed economy, no taxes Y = C + I + G C = A* + bY, where A* is autonomous consumption expenditure, and investment and government expenditure are exogenous. Substitute to get: Y = A* + bY + I* + G* where “ * ” indicates a variable which is exogenous to the model (i.e. is assumed to be constant). Solve to get: Y = (1/(1-b))(A* + I* +G*), where (1/(1-b) is the national income multiplier. Now dY = (1/(1-b) dG* Model 2: Closed economy, with exogenous taxes Y = C + I + G C = A + b(Y - T) Substitute: Y = A* + b(Y - T*) + I* + G* Solve: Y = (1/(1-b)(A* + I* + G* - bT*) Now: dY = (1/(1-b)(dG* - bdT*) Note that if extra government expenditure is financed by increasing tax revenues, dG* = dT*, dY = dG* i.e. the balanced budget multiplier is 1. Model 3: Open economy, with endogenous taxes Y = C + I + G + X - M Note that X is added because income is generated in production of exports, but the component of C+I+G that represents imports (M) is subtracted because no domestic income is generated by imports. C = A + b(Y - T) T = tY M = mY Substitute: Y = A* + b(Y - tY) + I* +G* + X* - mY Solve: Y = [1/(1-b(1-t)+m)](A* + I* + G* + X*) Using plausible values: t=0.3; m=0.25; b=0.9, the multiplier takes the value 1.45. The Employment Multiplier Suppose that average per worker income is $y. The number of ‘jobs’ in the economy is, therefore: L = kY, where k = 1/y. The extra number of jobs resulting from an increase in government expenditure is, therefore: dL = kdY , which, from Model 3, can be written as: dL = k[1/(1-b(1-t)+m)]dG* , where k[1/(1-b(1-t)+m)] is the employment multiplier. Some points to note: 1. The size of the multiplier is inversely related to the size of the ‘leakages’: (1-b), t, m. The smaller the region (extent of the referent group) the larger the leakage caused by imports, and the smaller the multiplier. 2. National income, Y, is expressed in nominal terms. We can think of Y being the product of the average price of goods and services, P, times the quantity produced, Q. Y = PQ An increase in Y could be caused by changes in P and/or Q: dY = dP.Q + P.dQ but only changes in Q generate changes in real income. In other words, some of the multiplier effect could represent inflation. 3. Any project involving the use of scarce factors of production will generate income and, hence, expenditures and a multiplier effect. In comparing the economic impact of projects, it is the relative multiplier effects that count, and these may not differ significantly. 4. Multiplier effects may be particularly associated with the construction phase of a project, and, in that case, will be of limited duration. 5. Multiplier effects can be considered a benefit of the project only in so far as they are ‘real’ (i.e. represent the value of extra output net of any additional opportunity costs), and would not have occurred in the absence of the project (i.e. would not have been generated by an alternative project). [...]...Inter-Industry Analysis Table 13.1: Inter-Industry Structure of a Small Closed Economy _ Sales Final Demand Gross Output 1 2 3 _ Purchases 1 100 400 300... industries: y = 0.9 x1 + 0.6 x2 + 0.4 x3 When this equation is added to the other three and the system solved for national income, y, the following result is obtained: y = 10(g1 + g2 + g3) Inter-industry Analysis and Employment Suppose that the level of input of factor of production i to industry j is given by: vij = bij xj Where bij is a coefficient and xj is gross output of industry j as before Supposing... change in the level of autonomous demand for any of the three goods can be traced back through this system of equations to calculate the effects on the levels of the factor inputs General Equilibrium Analysis A computable general equilibrium (CGE) model can be constructed to determine the equilibrium values of prices and quantities traded in the economy, and to calculate the changes in these values . Brown School of Economics The University of Queensland BENEFIT-COST ANALYSIS BENEFIT-COST ANALYSIS Financial and Economic Financial and Economic Appraisal. Spreadsheets Appraisal using Spreadsheets Ch 13: Economic Impact Analysis What is the difference between Net Present Value and Economic Impact? Keynes gives the example