Question

Suppose a billionaire takes an extra hour to arrive at work each day because he must drive slowly through a crowded slum. The billionaire proposes that the slum be demolished. The monetary gains of getting the billionaire to arrive at work faster are assessed at $10m. The monetary costs to the 1,000 residents of losing their homes is only $1m. So a cost-benefit analysis would recommend that the slum be demolished, even though the suffering it would inflict far outweighs the hedonic benefit to the billionaire.

● Make your own example of a situation where a cost-benefit analysis would make a recommendation that would reduce the general well-being. (150-400 words)

● What is “diminishing marginal utility of income”, and why is it relevant to the story you wrote?

● What is “equal marginal utility of consumption”? Is it a reasonable assumption? (Goodstein Chapter 2)

● Why do neoclassical economists (the majority of economists) not assess “well-being” when doing cost-benefit analyses? Why do they only use monetary costs and benefits? (150-400 words).

Answer 1

Solution to Question 1

Suppose there is a densely forested area in the outskirts of a city. Considering that the city does not have an airport, it does not attract many tourists. The government is hence considering construction of an airport in the outskirts due to unavailability of land within the city limits. Since the forest is not reserved area, there is no restriction on uprooting the trees and the cost of uprooting the trees come to $2mn whereas the tourist traffic would increase the income for the city by more than $10mn within 5 years. In this case, a cost benefit analysis will approve deforestation for the construction of the airport without considering the impact on the environment and the impact the airport will have on the people around the area.

Solution to Question 2

Diminishing marginal utility of income is a theory that additional units of income give lesser satisfaction than previous units. This concept is applicable here as the income to the city will have increased satisfaction on totality but the marginal increase will be less but the dissatisfaction to people around the forest and those dependent on the trees for their livelihood will be high.

Solution to Question 3

Equal marginal utility of consumption is a theory that states that consumers will spend their income in such a way that the marginal utility derived from all the goods is same. This is not practical as this law assumes that the tastes and preferences of consumers donot change and the price of substitutes and compliments also remains constant. It has various assumptions which are not realistic.

Solution to Question 4

Neo classical economists believe that supply and demand determine everything in the market. They consider only aspects that are measurable in numbers and ignore qualitative aspects of the economy. Hence the well being which is subjective is not considered by neo classical economists. This is why their cost benefit analysis compares only monetary costs and benefits.