COST-BENEFIT ANALYSIS ECON CLASS

Reference - Boardman et al., Cost-benefit Analysis: Concepts and Practice. 4th Ed.

Exercise 1: Option Price Calculation (a) Dene option price. Explain why the option price of a policy might differ from the expected surplus generated by the policy. (b) Dene option value. Suppose that a public project is reducing the risk faced by farmers, but the expected income of each farmer does not depend on Whether the project is undertaken or not. Let farmer A be risk averse and farmer B be risk neutral. Compare their option values. Now consider the following project: Construction of a Dam. The only person affected by this project is a farmer, with utility U(I) Where $1 is his income. There are two possible contingencies: it rains a lot (Wet) or it does not rain a lot (Dry). With the Darn, his income is $180 if Wet and $120 if Dry. Without the Dam, his income is $100 if Wet and $80 if Dry. The probability of raining a lot is 50%. (c) What is the expected surplus of the farmer? (d) What is the variance of income with the dam and without it? (e) Assume U(I) : h1I. What is his expected utility in the case the Dam is not con- structed? What is his option price? Compare its option price to its expected surplus. (f) Assunle U(I) : I. What is his expected utility in the case the Dam is not constructed? What is his option price? Compare its option price to its expected surplus. (g) Calculate the option value for each case above. Compare them. How would you explain their difference? How does this case differ from the one in (b)