Consider the following scenario and data. Air quality in Megalopolis is poor and getting worse. Heavy traffic, industrial growth, and poor geography have combined to produce frequent health warnings in the city, particularly during the summer. Violations of the ground-level ozone standard are especially frequent. During 2015, for example, there were more than 148 days in which Megalopolis exceeded the EPAs National Air Quality Standard for ground-level ozone of 70 parts per billion (ppb). Of equal concern is that ozone measurements have been as much as twice the EPA standard on violation days. On the worst days, school children are not permitted to go outside for recess, and sick and elderly individuals are strongly advised to stay inside. A recent study of air pollution by the Office of Technology Assessment has suggested measures to reduce the emissions of volatile organic compounds (VOCs), which would alleviate some (but not all) of the ozone problem in Megalopolis. Two strategies for reducing VOCs have been identified. You have been asked to assess the relative merit of these strategies using Cost-Benefit Analysis (CBA). To simplify the analysis, the city has asked for a study of benefits and costs for the ten-year period 2015-2024.

The two VOC-reduction strategies are as follows:

Policy Option I : Application of known pollution control measures at industrial sites. Initial costs are low, but costs are expected to rise over time as opportunities to apply existing pollution control measures to new situations become more costly.

Policy Option II : Substantial investment in research and development to foster and extend technological breakthroughs in the elimination of VOCs in some products. Costs will be extremely high during the first two years but will then fall as improved technologies become more cheaply available.

The city has decided to choose either Option I or Option II. Your task is to compare the two strategies. Epidemiological studies have been conducted to determine the likely benefits of VOC reductions. These benefits fall into three categories and are listed in Table 1. The annual expected costs of these strategies are listed in Table 2.

Table 1. Annual benefits with a one-ton reduction in VOCs (million $ per year)

Category / Benefit/yr

Reduction in asthma attacks / 200

Reduction in days of restricted activity / 200

Reduction in severe coughing episodes / 100

Total annual benefits / 500

Table 2. Annual costs to achieve a one-ton reduction in VOCs (million $)

Year / Option I / Option II

2015 / 300 / 1500

2016 / 350 / 1500

2017 / 400 / 100

2018 / 450 / 100

2019 / 500 / 100

2020 550 100

2021 600 100

2022 650 100

2023 700 100

2024 750 100

Total 5250 3800

1. Using a discount rate of 2%, calculate the NPV of Option I. [Express your

answer as an integer.]

2. Using a discount rate of 2%, calculate the NPV of Option II. [Express your

answer as an integer.]

3. Based on the dynamic efficiency criterion, which strategy would you

recommend to city officials?

a. Option I

b. Option II

c. There is not enough information to make a recommendation.

4. Using a discount rate of 10%, calculate the NPV of Option I. [Express your

answer as an integer.]

5. Using a discount rate of 10%, calculate the NPV of Option II. [Express your

answer as an integer.]

6. With the higher discount rate, which strategy would you recommend to city

officials, based on the dynamic efficiency criterion?

a. Option 1

b. Option 2

c. There is not enough information to make a recommendation.