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How to do an economic impact study, properly
My request for requests drew this topic. I have two simple suggestions:
1. Use a multiplier of 1, not three or four. The so-called multiplied funds are just sloshing around from one sector to another. But if your economy is in deep Keynesian unemployment and the project is relatively large, use a multiplier of 1.3 to account for aggregate demand effects.
2. Compare your studied project to the best available alternatives. Have you been hired to assess the benefits of a new stadium? Perhaps you think the stadium would be better than the status quo. But also list the forty-three projects that would be better than a stadium.
I am not aware of any economic impact studies that follow such procedures. Too often such studies are political marketing rather than an attempt to discover truth. Here is my previous post on the topic.
Posted by Tyler Cowen on May 2, 2006 at 07:31 AM in Economics | Permalink
Comments
Tyler,
Which multiplier to use for a local economic impact study very much
depends on the nature of the project. Urban and regional economists
and geographers have a very useful concept, the export base multiplier.
This is relevant for the impact of a project whose output is strictly
(or overwhelmingly) exported. That multiplier will be much higher
than one that largely serves people in or near the community, people
who are largely already spending their money in the community.
A reasonable guess for a real export base multiplier is closer to 2.
For something that is going to mostly serve locals, like a sports
arena, it will be near 1, might even be below 1, depending on how it
is funded. It is well known that most sports arenas that are
subsidized by local taxes are net losers.
Posted by: Barkley Rosser at May 2, 2006 9:15:30 AM
I still say "1." I don't believe in local subsidies just to pull aggregate demand away from other communities.
Posted by: Tyler Cowen at May 2, 2006 9:32:01 AM
It seems to me that advocates of new sports stadiums never even acknowledge that there are any alternatives. In other words, the build-the-stadium decisions are basically non-economic decisions.
Posted by: Peter at May 2, 2006 9:40:53 AM
Tyler,
I would have to agree with Barkley. If you're actually doing a
local economic impact study, the nature of the project will
change the multiplier. The focus being on how a project impacts the local
economy.
But, if you're doing your own political marketing, then I can see why you
wouldn't care.
Posted by: Student at May 2, 2006 10:43:41 AM
Tyler,
What if the project's exports are outside the country as a whole?
Still want to call it 1? Or are you one of those folks who
believes that the consumption multiplier at the national level is 1?
Most rough estimates put it at about 2, maybe a bit less.
Posted by: Barkley Rosser at May 2, 2006 11:01:51 AM
There is absolutely no need to compare projects. Invest if the Net Present Value is positive (assuming no irreversibility etc). The idea of "cost effective" is actually a great sin. If the project has positive economic return you should do it. There is no need to consider other projects.
For example, if you think it's worth $100/year to save a human life you should use ARVs to fight HIV. The argument that prevention is cheaper is not admissable unless you believe there are credit constraints (which there are probably because donors don't understand that cost effectiveness is a silly concept).
Posted by: John at May 2, 2006 11:05:08 AM
John, comparing projects is how you identify the economic return. The two terms you want are "scarcity" and "opportunity costs." You can only build so many projects on one site. You only have so much available for treating diseases.
If the stadium site would provide more benefit as a petting zoo, the economic value of building the stadium is negative, because of the opportunity costs. You have to pick one. If we have $1,000,000 to treat AIDS, we need to decide whether ARVs or prevention will provide the greater impact. There are always credit constraints.
Are there many cases where you can assume no irreversibility and no credit constraints? That sounds like assuming that you have infinite land for development projects, all of which can be costless converted between uses, along with an infinite pool of donors who will support projects. Can I also assume an endless pool of employees who are motivated primarily by the value of their work, combined with zero transaction costs?
We do assume some of these things for simple academic examples, but the whole point of deciding which policy to enact is that you cannot enact all of them. Pick the low-hanging fruit first.
Posted by: Zubon at May 2, 2006 11:50:18 AM
Zubon,
Your point is valid about scarce land and the stadium example. Thus my argument is not correct for those types of projects. But generally speaking I think "cost effectiveness" is often misused. For many development projects the only opportunity cost is the other project that might not be funded. But the reason it might not be funded is because there are too few funds. It would be far better to do both. Yes if you have $1 million you should fund prevention, but instead of yelling at people who advocate ARVs you should really be yelling at the person who only gave you $1 million to spend. The fact is we should be funding both prevention and AVRs. Both are incredibly cheap. Somehow the "cost effectiveness" argument allows people to advocate not saving somebody's life for $100/year. Something is seriously wrong with that.
My simple point is that too much effort is wasted by smart economists trying to pick the best possible development project (and maligning the projects they don't view as the utter best). Instead, the fact that we have to think what is "cost effective" should be a rallying cry to realize that development is massively underfunded -- at least for simple things like AVRs where it is obvious we can save a life for $100 and where there would be no opportunity cost if we had adequate funding.
Posted by: John at May 2, 2006 12:30:56 PM
John, the "buy all the projects with positive NPV" only works if you are not capital constrained and if the projects don't compete with each other or create an excessive risk concentration. These constraints are highly revelant for regional economic impact studies, as a smallish city straining to fund one stadium probably shouldn't subsidize NFL, NBA, and MLB stadiums at the same time. Your development example is misleading, since almost everyone agrees that development deserves more capital, while few economists at least do not favor radical expansions of the funds US cities use to compete with each other.
p.s. what are AVR's or ARV's, and which abbrev is correct? anti-retro-virals?
Posted by: DK at May 2, 2006 12:50:18 PM
oops, i meant "few economists favor" more funds for US cities to compete with each other.
Posted by: DK at May 2, 2006 12:53:00 PM
Even if you had unlimited capital, real projects take time. Therefore the best possible project should always be started first.
Posted by: Noah Yetter at May 2, 2006 1:47:16 PM
You know, a lot of this sounds like issues
Charles Tiebout covered a long, long time
ago (40 years? in The Community Econmic
Base Study
How soon we forget...
Posted by: Donald A. Coffin at May 2, 2006 1:56:44 PM
I agree that the vast majority of economic impact analyses are really very poorly done. But I have two points I'd like to make:
1) I also "don't believe in local subsidies just to pull aggregate demand away from other communities." However, policy makers are hired to make decisions that will best influence thier city (or county, or state, or whatever). Residents of Colorado don't vote for the governor who has Kansas' best interest in mind. So while economists detest people who think about regional economics as cities and states "competing" for economic activity, this is still the framework for most policy makers' decisions.
2) With regards to measuring the opportunity cost of foregone public projects, I would argue that there are analyses that do a good job of addressing this issue. (Although again, most do a really poor job - these can be easily ignored). It's not necessarily a matter of analyzing the other 43 potential projects. But if the authors make an effort to quantify one or two and then explicity state that the NPV isn't the only thing policy makers should use to make decisions. (Frankly, I would imagine that policy makers already know what they do and don't want to spend money on, and the money's going to be spent anyway. Economic impact analyses are just the icing on the cake.)
Posted by: mystery at May 2, 2006 2:45:03 PM
"There is absolutely no need to compare projects. Invest if the Net Present Value is positive (assuming no irreversibility etc). The idea of "cost effective" is actually a great sin. If the project has positive economic return you should do it. There is no need to consider other projects."
John -
Not to continue arguing this point, but this logic is really quite flawed. I can think of a thousand public projects that would have a positive net present value that no one (I hope) would actually consider. For example, the government could pay me to dig holes all morning, then fill them back in in the afternoon. The NPV would be positive because of the Keynesian impacts, but nothing "real" about the region's economy has changed. Surely you don't think there's not a better use for this money?
Posted by: mystery at May 2, 2006 2:48:33 PM
Mystery, economic impact studies are also used for lobbying before the politicians and sometimes voters decide.
They are also used to lobby for federal dollars, which supports Tyler's point about not favoring local subsidies vs. other communities. The feds don't fund stadiums (yet), but, a lot of economic development projects involve federal money, too.
Posted by: DK at May 2, 2006 2:49:36 PM
DK -
I agree wholeheartedly, and those are the studies that are so poorly done. I despise these studies as much as the next guy.
My point is that there are intellectually honest impact studies being done.
Posted by: mystery at May 2, 2006 2:57:17 PM
Part of what matters here is who is paying for the study and who
is funding the project, presumably the same party.
While I disagree with the "fund all projects with net positive NPV"
approach (yes, there are priorities, limits on funding, timing issues,
and so forth), I also think that Tyler overdoes it on his "show 43
alternatives" approach. This is simply way overdoing it.
The problem is that there is a cost to doing any serious analysis
of the benefits and costs of any potential project. Doing so for 43
projects will get expensive fast.
There is an old conundrum hiding behind here that is one of the
reasons that we fundamentally live in a world of bounded rationality.
It is the infinite regress problem of how to decide how to decide how
to decide how to... (first spotted by Luce and Raiffa nearly a half a
century ago). So, presumably we should do a benefit cost study of how
many alternatives we should study. But then, we should do a B/C study
of how much time and expense we should spend on that study. And of course,
then we should do one on that study, and (so forth, ad infinitum). We
never know when it is optimal to stop, but we simply arbitrarily stop
at some point just because we know that eventually it will get out of
line (how many committees on committees do we need?).
So, certainly some recognition of reasonable alternatives should always
be done. But this should not be overdone, and 43 is clearly waaaaay too many.
Posted by: Barkley Rosser at May 2, 2006 3:12:08 PM
IMHO, ONE alternative is enough: what if we cut taxes instead of subsidizing this project?
That's really the heart of the question. If you like you can add 'spend it on education' or 'make a reserve against public employee retirement costs'.
Posted by: DK at May 2, 2006 5:16:45 PM
The "43 other projects" was simply hyperbole. The reality is that one only needs to compare the project in question to "the best" alternative use. Of course, identifying that best alternative is where the difficulties arise. That automatic assumption that the best alternative is the status quo is simply a straw man arguement, no more intellectually honest than comparing it to something like an open-air toxic waste dump or a nuclear test site. If one isn't willing or able to look for that best alternative use, then the "economic impact study" is nothing more than a PR piece and could more cost effectively be prepared by media interns rather than actual economists.
Posted by: Strophyx at May 2, 2006 6:27:05 PM
Actually, DK, raising taxes is pretty good but definitely not perfect. The higher the tax rate, the greater the marginal downside of tax increases.
Competition for large projects and people coming in (leading to overly subsidized stadiums and a total lack of local taxation on, say, an Boeing factory) is bad. Presumably the solution is to tax local areas for such ventures in the amount of the income they thereby deprive other areas of, thus removing any perverse incentives.
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Posted by: levan at Sep 7, 2006 4:12:29 AM
Can you help me to get a methodology to do an economic impact analisys? or do you now some web site where i can get it?
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