The Implications of Political Transaction Costs for Benefit Cost Analysis

 Kerry Krutilla

Associate Professor

School of Public and Environmental Affairs

Indiana University

Bloomington Indiana 47405

(krutilla@indiana.edu)

Presented at the Department of Public Administration and Policy

National Taipei University

March 23, 2010

 

Acknowledgment and Disclaimer

The model in this paper is an extension of one jointly developed with Chulho Jung and W. Kip Viscusi to assess rent-seeking behavior towards environmental policy proposals. I am indebted to them for the insight and original collaboration. All errors and omissions in this extension are the author’s exclusive responsibility.

Overview• Conventional standard for economic efficiency

NB= B-C > 0, or B/C > 1

(absolute comparison)

• Issue: benefits and costs fall on stakeholders• Informed stakeholders have an economic incentive

to seek or avoid these benefits and costs, if they have “standing” in the political process

• Political behavior of stakeholders itself imposes economic costs

Relevant Question For Ex Post Evaluation

Could the economic cost of the political activity over a project proposal exceed the net value of a project whose conventionally-measured net-benefits are positive (B-C > 0, or B/C >1)?

Let C1* = the economic costs incurred by the beneficiaries to politically support the project

Let C2* = the economic costs incurred by the “losers” to politically oppose the project

Is NB = B-C > (C1*+C2*)?

Example for Ex Post Evaluation Context

B-C > (C1*+C2*) => B > C + (C1*+C2*), OR

B/C > 1+ [(C1*+C2*)/C]

Suppose (C1*+C2*)/C =.5

In this case, society would be worse off for approving any project with a B/C ratio less than 1.5

• Will a project’s conventionally-measured expected net-benefits cover its projected political costs?

• Since political decision-making is uncertain, a potentially beneficial project might or might not be approved.

• If a project is not approved, the political cost of the project decision-making ends up as unrecovered economic cost.

Relevant Question For Ex Ante Evaluation

Modified Decision Criterion for Ex Ante Evaluation

Assuming “risk neutrality”:

π(B-C) > C1*+ C2*

π=probability of a project proposal passing in a political contest, 0 < π < 1

Or: B/C > 1 + (1/π) [(C1*+C2*)/C]

Example for Ex Ante Evaluation Context

Suppose Π=.5 and (C1*+C2*)/C =.5

For B/C > 1 + (1/π) [(C1*+C2*)]/C]

B/C must be greater than 2 for the expected value

of the project proposal to be positive

Research Question and Objective

Question: Are C1* and C2* likely to be large enough to affect conclusions about the project’s overall economic effects?

Objective: Develop a model explaining C1* and C2*, and compute an adjusted project decision criterion reflecting C1* and C2*

1. Develop a model of strategic interaction giving:

C1= f1[Πν(C1,C2)B,X] => C1=f3(C2,B,X)

C2=f2[Πν(C1,C2)C,X] => C2=f4(C1,C,X)

2. Solve for C1*=f5(B/C,X); C2*=f6(B/C,X)

3. Substitute solutions for C1* and C2* into:

B/C > 1+ [(C1*+C2*)/C] => B/C > 1 + f7(B/C,X) (ex post) B/C > 1+ (1/Π)[(C1*+C2*)/C] => B/C > 1+ f8(B/C,X) (ex ante)

4. Solve out for modified B/C ratios from right-hand side of (3)

Research Strategy

Qualification

• Above assumes a political contest, rather than a negotiated “political settlement”

• Assumption maintained in this paper

Public Choice Literature

• Rent-seeking literature on the economic cost of public decision-making

– Tullock, Gordon. (1993). Rent seeking. Brookfield: Edgar Elgar.

• Development economics literature

– Krueger, Anne O. (1990). Government failures in development. The Journal of Economics Perspectives, 4(3), 9-23.

– Varian, Hal R. (1989). Measuring the deadweight costs of dup and rent seeking activities. Economics and Politics, 1, 81-95.

– Stevens, Paul. (2003). Resource impact-Curse or blessing? A literature survey. Journal of Energy Literature, 9(1), 1-42.

Project Evaluation Literature• Political Feasibility Assessment

Kelvin, Alex. (2000). How stakeholders with various preferences converge on acceptable investment programs. Evaluation and Program Planning, 23, 105-113.

• Cost Minimizing Project Design

Fleming, E. (1998). Rent-seeking in rural development projects: Its potential causes and measures to reduce its costs. Journal of International Development 10: 277-299.

Thompson, Dale B. (1999). Beyond benefit-cost analysis: Institutional transaction costs and regulation of water quality. Natural resources Journal, 39, 517-541.

Influential Paper for Modeling Strategy

• Becker, Gary S. (1983). A theory of competition among pressure groups for political influence. Quarterly Journal of Economics, 98, 371-400.

Background for Model Set-Up

Financial transfers attenuate the incidence of project benefits/costs, altering the project’s net impact on various stakeholders

In particular, project financing affects the incidence of benefits and costs

Assumption 1: B-T > 0 Assumption 2: T+TP-C=0, or T+TP=C, or T-C= -TP Assumption 3: 0 < T < C, or -C < T-C = -TP < 0

Stakeholder Impacts

Beneficiary Input Suppliers

Tax Payers

Net

Benefit B BFinancial Transfer 1 (User Fee )

-T T 0

Financial Transfer 2(Tax Payer Finance)

TP -TP 0

Cost -C -CNet B -T > 0 T+TP-C=0 -TP B-C

Model

Model Solution

Model Solution – Cont’d

Aggregate Lobbying Costs

Aggregate Lobbing Costs as a Fraction of Total Project Costs

Figure 1Lobbying Cost as a Fraction of Project Cost

for Different B/C Ratios and Compensation Levels

1-d=0

1-d=.25

1-d=.5

1-d=.75

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

0 1 2 3 4 5 6 7 8 9

B/C Ratio

Rat

io o

f L

ob

byi

ng

Co

st t

o P

roje

ct C

ost

Figure 2Lobbying Cost as a Fraction of Project Cost for Varying Political Power and B/C Ratios

B/C=1

B/C=2

B/C=3

B/C=4

B/C=5

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

0 5 10 15 20 25 30

Relative Political Power

Rat

io o

f L

ob

byi

ng

Co

st t

o P

roje

ct C

ost

Implications for Project Evaluation

Ex Post Decision Criterion Continued

Figure 3Break-Even B/C Ratios for Different

Compensation Levels and Relative Political Power

a=.25

a=.5

a=.75

a=1

a=2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

0 0.2 0.4 0.6 0.8 1 1.2

Fraction of Project Cost Compensated throgh Transfer Payments(1-d=T/C)

Bre

ak-E

ven

Rat

ios

Figure 4Break-Even B/C Ratios as a Function of Relative

Political Power (No-Compensation Case)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

0 2 4 6 8 10 12

Relative Political Power

Bre

ak-E

ven

B/C

Rat

ios

Modeling Qualifications

Modeling attributes biasing the modified B/C decision criteria upwards

• Complete information/zero organizing costs

The two most approximate contexts: – large federal regulatory programs in health, safety,

environment– local issues with highly impacted and informed

stakeholders

• Some influence activities financial transfers• Consensual policy design possible • Assumption of risk neutrality

Modeling attributes biasing the modified B/C decision criteria downwards

• Loss aversion/feelings of entitlement increase resource costs of political activity

• Costs of political activity also falls on government “stakeholders”

• Project financing costs. Suppose “excess financing burden” is: C3/C

then B/C > 1+ [C1*+C2*]/C + C3/C (ex post)

Conceptual Issue

• If Stakeholders are uncompensated, always some political transaction costs

• Default CBA practice is to ignore them

• Standard CBA metric, Kaldor-Hicks criterion is justified by “the potential compensation test”

• Potential compensation test fails when modified B/C thresholds not met.

Figure 5Socially Optimal Level of Public Investment using Modified B/C

$ of public investment

SC

Y

Q2

MC

Q1

XMC

MB

Q31

MB

TC

Conclusions

Political costs of project proposals can be a significant fraction of a project’s total costs

These costs should be estimated and incorporated into ex ante and ex post project appraisal standards

“Rule of Thumb” for ex ante evaluation of controversial projects featuring mobilized and informed stakeholders:

=> only consider projects with B/C ratios of 2 or greater, or

=> include transfer schemes in the project design to compensate negatively-impacted stakeholders

More research needed to clarify the magnitude of political decision-making costs in different contexts

.

Next Research Steps

• More complete specification of the Ex Ante Evaluation Context

• Two Stage Game to examine incentives for political negotiation, and their implications for modified B/C ratios