NATIONAL ECONOMIC DEVELOPMENT PROCEDURES MANUAL -

October 1991 

OVERVIEW MANUAL FOR CONDUCTING 

NATIONAL ECONOMIC DEVELOPMENT ANALYSIS 

by 

The Greeley-Polhemus Group, Inc. 

West Chester, PA 

for 

U.S. Army Corps of Engineers 

Water Resources Support Center 

Institute for Water Resources 

Fort Belvoir, VA 22060-5586 

IWR Report 91-R-ll 
ii 
PREFACE 

This manual would not be complete without an acknowledgement of the Corps personnel 

responsible for its preparation and the process by which they guided its formation. 

From the outset, the content of this manual has been the invention of the Institute for 

Water Resources and the Field Review Group charged with its oversight. Dr. Mark Dunning, 

the technical monitor for this manual, identified a Field Review Group (FRG) consisting of ten 

Corps personnel. The Greeley Polhemus Group, Inc., the contractor for this manual, conducted 

interviews of the FRG members to ascertain the range of National Economic Development (NED) 

economic issues of concern to them. Each FRG member was asked to identify other Corps 

personnel knowledgeable in the area of NED economic issues. The contractor interviewed a 

dozen of these people. 

The results of the interviews were compiled to identify those issues that were both 

economic in nature, rather than formulation issues, for instance, and enjoyed some degree of 

consensus among the Corps personnel. The FRG members were provided with a draft manual 

outline and the contractor's suggestions for examples to be included in the manual. 

On November 7, 1990 the Institute for Water Resources convened a meeting between the 

FRG and the contractor. At that time, the FRO prepared a detailed outline for the draft manual 

that was used by the contractor to prepare the draft of the manual before you now. 

The draft manual was circulated to the FRO in January for initial comments. These 

comments were addressed by the contractor in a revised draft that was the subject of a second 

meeting of the FRG on March 13 and 14, 1991. At that meeting this manual was approved in the 

form in which it now appears. 

The contractor would like to acknowledge and thank, without implicating, the following 

members of the FRO. 

Dr. Mark Dunning CEWRSC-IWR 

Mr. Mike Arabatzis CENAD-PL-F 

Mr. Charles Armstrong CESWD-PL-P 

Mr. Ken Boire CENPD-PL-EC 

Mr. Roger Burke CESAM-PD-F 

Mr. Steven Cone CECW-PD 

Mr. William T. Hunt CECW-PD 

Mr. Russell Iwamura CEPOD-ED-PJ 

Mr. Larry Kilgo CELMVD-PD-E 

Mr. Harvey Kurzon CEWRC-WLRC 

Mr. Ron Roberts CEMRD-PD-E 

Mr. Dave Swenson CEPOD-ED-PJ 

Mr. Gary Wickboldt CENCD-PD-EC 

This manual was prepared as part of the NED Procedures Manual Work Unit, within The Planning 

Methodologies Research Program. Mr. Robert Daniel (CECW-PD) is the Program's Technical Monitor. 

iii 
iv 
Section 

PREFACE 

OVERVIEW MANUAL FOR CONDUCTING 

NATIONAL ECONOMIC DEVELOPMENT ANALYSIS 

Table of Contents 

............................................................... iii 

CHAPTER 1: INTR.ODUCTION.................................................. 1 

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 1 

Audience ....... , ............................................. , ... 1 

What this Manual is Not .............................................. 2 

Organization of the Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 2 

CHAPTER 2: GENERAL CONCEPTS mIDERL YING NED ANALYSIS ..................... 5 

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 5 

Scarcity--the Fundamental Economic Problem . . . . . . . . . . . . . . . . .. . . . . . . . . . . . .. 5 

Determining Benefits and Costs to the Nation ............................... 5 

Economic Decision Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 7 

Analytical Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 8 

Streams of Benefits and Costs .................................... 8 

Preview to Chapter 3 ................................................ 8 

CHAPTER 3: NED BENEFITS ................................................... 9 

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 9 

Overview of NED Benefit Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 9 

Willingness to Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 9 

Prices and the NED Principle ......................................... 11 

Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 12 

Consumer Surplus ................................................. 13 

Profit Maximization ................................................ 14 

Opportunity Cost .................................................. 15 

Supply Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 16 

v 
Section 

Table of Contents (Continued) 

Page 

Producer Surplus .................................................. 17 

Markets and Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 18 

Supply, Demand and Social Welfare. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 19 

Market Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 22 

Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 22 

Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 23 

Some NED Principle Assumptions .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 23 

Constant Prices (P&G Paragraph 1.4.10) . . . . . . . . . . . . . . . . . . . . . . . . . . .. 25 

Full Employment (P&G Paragraph 1.4.9) ........................... 25 

Risk Neutrality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 25 

Period of Analysis ........................................... 26 

Other Policy Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 26 

Interest Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 26 

Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 26 

What are Interest Rates Made Of? ................................ 27 

Choice ofInterest Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 28 

An Uncomfortable Impasse or Peaceful Coexistence? . . . . . . . . . . . . . . . . . .. 29 

Cost of the Most Likely Alternative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 29 

Project Benefits ................................................... 29 

Flood Control .............................................. 30 

Navigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 32 

Hydropower and Water Supply .................................. 32 

NED vs. RED .................................................... 35 

Preview to Chapter 4 ............................................... 36 

CHAPTER. 4: NED COSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 37 

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 37 

Economic Cost Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 38 

Relevant Cost .............................................. 38 

Opportunity Costs ...... '. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 38 

Explicit and Implicit Costs ..................................... 39 

Economic versus Financial Costs ................................. 39 

vi 
Section 

Table of Contents (Continued) 

Page 

Incremental and Sunk Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 40 

Total and Marginal Costs ...................................... 40 

NED Costs ...................................................... 41 

Financing the Project ............................................... 42 

Preview to Chapter 5 ............................................... 43 

CHAPTER 5: SELECmn TOPICS ............................................... 45 

Marginal Analysis ................................................. 45 

Maximizing Net NED Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 45 

Marginal Thinking ................................................. 45 

Relevant Costs and Benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 47 

With- and Without-Project Conditions ................................... 49 

Economic Rationality ......................................... 49 

With and Without in the Long Run ..................................... 49 

Value of Time Saved ............................................... 50 

Preview to Chapter 6 ............................................... 51 

CHAPTER 6: SELECmn APPLICATIONS OF NED PRINCIPLES ...... . . . . . . . . . . . . . . . . .. 53 

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 53 

Financial and Economic Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 53 

Non-NED Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 53 

Cost of Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 54 

When Economic Costs are Less than Financial Costs ................... 55 

Land and Fixed Assets in the With-Project Condition . . . . . . . . . . . . . . . . . . . . . . . .. 56 

The Basis for Land Values ..................................... 57 

Economic Rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 57 

Location, Rent, and Flood Plain Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 57 

The Flood Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 58 

Inundation Reduction Benefits ............................. 58 

Intensification Benefits .................................. 58 

Location Benefits ............................ . . . . . . . . .. 59 

Restoration of Land Market Values . . . . . . . . . . . . . . . . . . . . . . . . .. 59 

vii 
Table of Contents (Continued) 

Section Page 

Short Run vs. Long Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 58 

Supply and Demand in the Long Run ............................ " 60 

With and Without Condition .......................................... 64 

NED vs. RED .................................................... 66 

NED vs. GNP .................................................... 68 

GNP ..................................................... 68 

Related fucome Measures ...................................... 68 

GNP Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 69 

The Real Income-Real Ouptut Link ......................... 69 

NED Analysis is Here to Stay ................................ . . . . . . . .. 70 

INDEX ................. , ............................................ 71 

APPENDICES 

Appendix I: Suggestions for Further Reading ....................................... 75 

Appendix 2: NED Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 79 

LIST OF FIGURES 

Figure I: 

Figure 2: 

Figure 3: 

Figure 4: 

Figure 5: 

Figure 6: 

Figure 7: 

Figure 8: 

Figure 9: 

Figure 10: 

Figure U; 

Figure 12: 

Figure 13(a): 

Figure 13(b): 

fudividual Demand Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 12 

Consumer Surplus ............................................... 14 

Market Demand and Consumer Surplus ................................ 15 

Supply Curve .................................................. 17 

Producer Surplus and Opportunity Cost ................................ 18 

Market Supply and Demand ........................................ 18 

Maximum Net Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 19 

Overproduction ................................................. 21 

Underproduction ................................................ 21 

Underproduction of Flood Control .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 24 

Overproduction of Flood Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 24 

The Risk-Adjusted Nominal futerest Rate ....................... . . . . . . .. 28 

Flood Plain Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 31 

Flood Plain Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 31 

viii 
Table of Contents (Continued) 

LIST OF FIGURES (Continued) Page 

Figure l3(c): Flood Plain Benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 31 

Figure l4(a): Navigation Benefits .............................................. 33 

Figure l4(b): Navigation Benefits .............................................. 33 

Figure l4(c): 

Figure l5(a): 

Figure l5(b): 

Figure 16: 

Figure 17: 

Figure 18: 

Figure 19: 

Figure 20: 

Figure 21: 

Figure 22: 

Figure 23: 

Figure 24: 

Figure 25: 

Figure 26: 

Figure 27: 

Figure 28: 

LIST OF TABLES 

Table 1: 

Table 2: 

Table 3: 

Navigation Benefits .............................................. 33 

Water Supply Benefits ............................................ 34 

Water Supply Benefits ............................................ 34 

Cost Concepts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 37 

Economic and Financial Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 40 

Associated Costs Example. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 43 

Total Costs and Total Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 48 

Marginal Cost and Marginal Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 48 

Marginal Net Benefits ............................................ 48 

Secular and Cyclical Trends ........................................ 62 

Seasonal Trend and Random Influences ................................ 62 

Changes in Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 63 

Changes in Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 64 

Long Run Equilibrium Price ........................................ 65 

Short Run Equilibria Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 65 

Five Alternative Measures of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 69 

Initial Plan Formulation ........................................... 46 

Final Plan Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 46 

Labor Costs or Labor Benefits? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 56 

ix 
Chapter 1: INTRODUCTION 

"Contributions to national 

economic development (NED) are 

increases in the net value of the 

national output of goods and 

services, expressed in monetary 

units. Contributions to NED are 

the direct net benefits that accrue 

in the planning area and the rest of 

the nation. Contributions to NED 

include increases in the net value 

of those goods and services that 

are marketed, and also of those 

that may not be marketed." 

... Economic and Environmental 

Principles and Guidelines for 

Water and Related Land 

Resources Implementation 

Studies, p. 1, March 1983 

INTRODUCTION 

This manual provides an overview of the 

national economic development (NED) principle 

that is essential to determine whether the Federal 

government will construct any water resource 

project. The NED principle articulates a framework 

to assist in making this decision. Analysts working 

within this framework and decision makers who 

must understand it are the manual's intended 

audience. 

The NED principle is often misunderstood 

by analysts and a mystery to decision makers. 

Such misunderstanding and mystery can lead to 

problems in formulating projects. The manual 

seeks to unravel some of the mystery of the NED 

principle for laymen and to provide new and reignite 

old insights for Corps' economists and planners. By 

clarifying the NED principle, projects can be 

formulated and evaluated with greater consistency 

and better informed decisions can be made and 

understood by all interested parties. 

1 

Corps projects produce outputs. Project 

outputs have value because they satisfy people and 

contribute to their happiness. Inputs are required to 

produce Corps projects. Inputs have value because 

we have the opportunity to use them for other 

purposes. The challenge is deciding how to use 

these inputs to achieve socially valued outputs. 

The NED principle articulates a very 

specific perspective to be used in valuing project 

outputs, or benefits, and project inputs, or costs. 

The NED principle represents the current state of a 

continuously evolving Federal policy on water 

resource projects. The NED principle is not 

fundamentally an economic principle. It is 

fundamentally a normative economic policy, i.e., 

one that addresses what decision makers feel ought 

to be the Corps' economic priorities. As such, it is 

a matter of law, policy and interpretation rather than 

one of economic fact or theory, although it is a 

policy firmly rooted in economic theory. 

Benefit-cost analysis is undertaken to 

assure that the value of the outputs exceeds the 

value of the inputs. Benefit-cost analysis is not the 

NED principle. Benefit-cost analysis is an 

evaluation technique used to aid decision makers in 

determining the economic worth of a project. The 

NED principle provides the basis for identifying 

appropriate benefits and costs, from a Federal 

perspective, to include in the benefit-cost analysis. 

AUDIENCE 

This manual has been written for those who 

are involved in the development of water resource 

projects and who need to know how and why the 

NED principle can affect the scope and magnitude 

of such projects. It is intended for Corps and other 

professional planners as well as interested nonFederal parties. Though we hope it will provide an 

instructive introduction to the NED principle for new 

Corps economists and a useful refresher for 

experienced economists, this manual is not 

intended solely for economists. 
WHAT THIS MANUAL IS NOT 

Many of the topics introduced in this 

manual are the subjects of entire courses and texts 

in the field of economics. All readers should be 

aware that there is much more to the subject matter 

than is introduced here. This manual does not 

describe techniques for conducting NED analysis. 

These techniques are described in the National 

Economic Development Procedures Manuals 

referenced in Appendix 1. The manual tries to 

present as much intuition on a topic as possible, 

with a minimal amount of theory and technical 

detail. Economists will frequently recognize this as 

a limitation of the manual. The principles and 

analyses in actual practice will rarely be as simple 

as they are made to appear in this manual. 

In some instances, economists will 

recognize that the manual does not provide 

complete descriptions of underlying assumptions or 

well-known exceptions to the principles and 

statements the manual makes. It is not the 

intention of this manual to teach economics. Nor is 

it intended to clarify the details of the Economic and 

Environmental Principles and Guidelines for Water 

and Related Land Resources Implementation 

Studies, March 1983 (P&G). Our goal is to foster 

intuition about relevant economic concepts, rather 

than to provide a rigorous explanation of them. The 

non-economist reader of this manual need not be 

concemed about receiving an inaccurate picture of 

the concepts presented. The principles are not 

wrong; their complexities have just not been 

completely developed in some cases. 

Perhaps most importantly, this is not a 

policy manual. There are many conflicts between 

economic theory and principles (i.e., positive 

economics) and the economic policies (i.e., 

normative economics) of the Corps of Engineers 

that have been developed over time as a result of 

legislation and other policy decisions. Where 

appropriate, these conflicts will be identified. This 

manual intends no advocacy positions on any of 

these conflicts. Economic theory is the domain of 

the economist. Economic policy, in the context of 

this manual, is the domain of the decision makers. 

Where economic theory has been compromised in 

favor of policy it is almost invariably done to make 

the task of economic analysis and evaluation more 

manageable within the conte?d of project study 

constraints. Though Corps policy and economic 

2 

theory may diverge at times the policies are 

generally formulated to approximate willingness to 

payor opportunity costs, since rational govemment 

decisions and policies may depend on the resulting 

estimates, even though they are imperfect. 

On a closely related note, it must be 

pointed out that this manual does not address any 

of the many plan formulation issues related to the 

NED principle. These issues are perhaps the most 

difficult facing Corps and non-Federal personnel 

alike. What constitutes "acceptability" of a plan is 

a question of great importance. Designation of the 

NED plan hinges on the answer. This manual will 

not address this or other questions that are the 

domain of policy makers and planners. 

In summary, the manual attempts to 

provide both a broader and deeper understanding 

of the NED principle. It does not provide an 

economically rigorous treatment of the issues. The 

manual strives for a sound intuitive understanding 

of the basic economic principles involved. 

ORGANIZATION OF THE MANUAL 

The Foreword provides a summary of the 

process by which this manual was developed. The 

manual consists of 6 chapters and 2 appendices 

organized into three basic parts. Chapters 2 

through 5 provide an overview of the economic 

concepts that underlie the NED principle and, 

hence, economic analysiS of Corps projects. 

Chapter 6 provides example applications of the 

prinCiples and concepts introduced earlier in the 

manual. The manual concludes with 2 appendices 

that provide suggestions for further reading, 

additional material on the history of the NED 

principle, and current guidance related to it. 

Chapter 2 deals with some general 

concepts and economic principles that are used to 

help improve decision making. The basic problem 

is that we can't do everything. Given this fact of 

life, economics provides some guidelines on how to 

look at choices and decisions to at least avoid 

waste, or what economists call "inefficiency". The 

principles of economic decision making criteria, one 

of which is the benefit-cost ratio, are introduced in 

this chapter. 
The economic nature of NED benefits is 

the subject of Chapter 3. This chapter provides an 

introduction to demand and supply theory and 

presents more economic concepts than any other 

chapter. It addresses the question, "What are we 

trying to measure under the NED principle?" and 

takes it from the general concepts to examples of 

specific project purposes. 

NED costs are the subject of Chapter 4. 

While a great deal of guidance has been written on 

the subject of project benefits, relatively little has 

been written about project costs. Costs are of 

paramount interest to non-Federal partners, and 

the taxonomy of costs is becoming more and more 

complex. Cost concepts introduced in Chapter 3 

are expanded here, and different perspectives in 

common usage are explained. 

Chapter 5 addresses a small, but 

significant, collection of other issues relevant to the 

Corps' NED principle. First among these is the 

value of marginal thinking. Stifle the snickers, we 

do not mean the value of just barely thinking, but 

the value of considering only those benefits and 

costs that are relevant to the decision problem, i.e., 

the marginal values. This discussion leads to 

consideration of the benefit maximizing requirement 

of the NED plan. 

Chapter 5 also addresses the with- and 

without-project conditions with emphasis on the 

requirement of assuming economic rationality and 

its meaning for the with and without analyses. 

Imposing this assumption of rationality on the with 

and without analyses precludes certain illogical 

results that could otherwise arise during plan 

formulation. 

Chapter 6 provides discussion of selected 

topics that were identified by a group of practicing 

Corps planners during the development of this 

manual. Appendix 1 contains suggestions for 

further reading on the topics contained in the 

manual as well as references to selected Corps' 

documents. Appendix 2 provides a brief historical 

summary of the evolution of the NED principle. 

3 
Chapter 2: GENERAL CONCEPTS 

UNDERLYING NED ANALYSIS 

INTRODUCTION 

Why do we need an NED objective to 

assist in formulating and evaluating water resource 

projects? Because of the fundamental economic 

problem--we can't do everything! This chapter 

explains some of the underlying economic concepts 

upon which NED analysis is based. 

SCARCITY--THE FUNDAMENTAL ECONOMIC 

PROBLEM 

The NED principle is a policy developed to 

guide Federal water resource planners in their 

choice of problem solutions. Choice is the 

fundamental business of economics. Economics is 

the science of making rational choices, based on a 

set of assumptions that have been remarkably 

successful in predicting behavior. 

Consider a single stretch of river. It can be 

preserved in its natural state with restricted access. 

Or, it can be moderately developed for recreational 

uses, such as hiking, fishing, hunting, and 

canoeing. Or, the banks could be cleared and 

developed for industrial, commercial, and residential 

usage. Yet another alternative would be to dam the 

lower end of the reach and flood the entire stretch 

of river to provide flood protection, hydropower, 

water supply and recreation to thousands of people. 

The reach can't be used for all these purposes, so 

the fundamental problem becomes how, and on 

what basis, to decide among these competing 

choices. 

Because all resource~ are sc~rce, we are 

forced to make choices when they are used. 

Choose more of one thing and you sll11ultaneously 

are choosing less of another. Thus, every choice 

costs us something. If we make the best choice 

from among the river reach alternatives, at a 

minimum it costs us the opportunity to do the next 

best thing with the reach, this is called opportunHy 

cost. . 

5 

The process of developing a plan for the 

use of a water resource is an exercise in dealing 

with the fundamental economic problem of scarcity. 

The fundamental problem of scarcity is not confined 

to such broad issues as what to do with a unique 

reach of river. The concrete and steel used in a 

flood wall could be used in many other ways as 

well. Using these resources in a flood wall means 

they will not be available for alternative use 

elsewhere in, for example, an office building. Thus, 

the flood wall costs the Nation an opportunity to do 

something else with the resources. In essence, the 

NED principle is intended to ensure that the 

benefits to the Nation of the use of these resources 

in a project exceed the costs of the project to the 

Nation. In other words, the NED principle ensures 

that concrete and steel will be used in a flood wall 

only if the benefit to the Nation of using it exceeds 

the cost of using it. Though non-economists might 

be inclined to argue that concrete and steel are not 

"scarce" in the common usage of the word, that is 

precisely the point. All resources are scarce, their 

prices are an indication of their relative scarcity. 

Thus, concrete and steel, though easy to obtain are 

indeed scarce. 

DETERMINING BENEFITS AND COSTS TO 

THE NATION 

Water resource projects produce outputs--

goods and services that have value. Producing 

water resource projects requires inputs--goods and 

services that have value. The basic question 

economic analysis tries to answer is, "Does the 

value of the project's outputs exceed the value of 

the inputs used to produce the project?" What 

could be simpler? 

Any experienced planner will attest that this 

is much easier said than done. Nonetheless, to 

answer the question "Is a project worth it?" requires 

understanding a few simple concepts. 
To understand the NED objective requires 

some understanding of a field of economics known 

as welfare economics. Welfare economics 

focuses on using resources optimally so as to 

achieve the maximum well-being for the individuals 

in society. 

Evaluating Corps projects is complicated by 

the fact that "welfare" is not an observable variable 

like bushels of wheat, kilowatts of energy, or 

pounds of fish. The economic welfare of an 

individual is formally given by his or her utility level. 

Utility is a term that is generally synonymous with 

happiness or satisfaction. Thus, project outputs 

have value because they make people happy or 

provide them with satisfaction. 

It is commonly accepted among economists 

that the only objective basis under which one can 

say that society is better off with a water resource 

project than without it, is when some people are 

made better off and no one is made worse off by 

the project. This adaptation of what has come to 

be known as the Pareto principle is not 

experienced in the Corps' realm of practice. Corps' 

project benefits are generally localized, while the 

Federal share of costs come from taxpayers across 

the country. Thus, though the residents of a 

protected flood plain are made better off, some 

taxpayers are made worse off because they receive 

no benefits from the project and must pay some of 

the costs. If even one person is made worse off, 

there are no objective grounds to support the 

project on the basis of increased utility because it is 

impossible to objectively compare the increased 

happiness of the protected beneficiaries with the 

decreased happiness of the taxpayers. 

If economic theory stopped here, there 

would be no such thing as economically justified 

public works projects. In an effort to extend the 

class of issues that can be addressed by welfare 

economics, the compensation principle was 

developed in 1939. Again adapting the principle to 

water resource development, it says a project 

should be undertaken if potential "with-project" 

gains are sufficiently large that everyone could be 

6 
made better off by some redistribution of goodf or 

income following implementation of the project . 

The significant difference is that the 

compensation principle recognizes the existence of 

"winners" and "losers". It goes on to allow that if 

the winners gain enough from the project that they 

could, hypothetically, reimburse the losers, then the 

project is worth undertaking whether there is a 

reimbursement or not. Society as a whole is better 

off, even if some of its members are worse off. 

For example, if a project costs 1 ,000,000 

people $1 each and 100,000 people realize $20 in 

benefits each, there are clearly winners (the 

100,000) and losers (the 1 ,000,000). However, the 

$2,000,000 in benefits could be redistributed in 

such a way that each of the 1 ,000,000 gets his $·1 

back so no one is made worse off and each of the 

100,000 could still have $10 each. This 

compensation principle provides the theoretical 

basis for undertaking water resource projects--

society can, hypothetically, be better off. 

ECONOMIC DECISION CRITERIA 

For any given water resource project, we 

would like to know if the "winners" could 

hypothetically compensate the "losers", i.e., does 

the value of the outputs exceed the value of the 

inputs? There are many decision criteria suitable 

for answering this question (see box). The Corps 

uses the benefit-cost ratio (BCR) as its decision 

criterion. It is only one of many such criteria. 

Benefit-cost analysis is used to determine 

if total benefits produced by the project exceed the 

total costs of the project. Benefits are measured 

as the willingness to pay for project outputs, and 

costs are the true opportunity costs of the project. 

I A more accurate statement of the compensation principle is that a 

project is preferred to no project only if the gainers can compensate 

the losers in implementing the project and the losers cannot bribe the 

gainers into pot implementing the project. The original principle 

developed by KaIdor and Hicks, and this refinement offered by 

Scitovsky, eliminates the possibility of the reversal paradox, wherein 

there are cases where a project is preferred to no project and no 

project is preferred to a project. This footnote provides the noneconomist reader with an example of the type of detail you do not 

get from this manual! 

7 
The Corps uses two decision criteria in its 

formulation process, the benefit-cost ratio and net 

benefits. All alternative projects must have a BCR 

equal to or greater than one to be considered for 

implementation. Under the NED principle, the best, or 

NED, plan is the one that maximizes net benefits. The 

Corps traditionally expresses all monetary values as 

equivalent annual values. The BCR is annual benefits 

divided by annual costs. Net benefits can be readily 

expressed as a Net Present Value (NPV) and vice 

versa. Other decision criteria are often reported to 

provide additional information. 

ANALYTICAL TECHNIQUES 

Apart from the decision criteria described 

above, there are a variety of tools and techniques for 

conducting economic analysis in general and NED 

analysis in particular. For example, while the benefitcost ratio is a decision criterion, benefit-cost analysis is 

an analytical technique. This manual does not address 

analytical techniques. The Corps is developing a series 

of Procedures Manuals to describe the techniques 

applicable for NED analysis. 

STREAMS OF BENEFITS AND COSTS 

The bulk of project costs are generally 

incurred during the construction period. Benefits, on 

the other hand, typically are realized as uneven flows 

of income or monetary benefits that accrue over a long 

period of time. Decision criteria must provide a means 

of comparing the values of these streams of money on 

an equal basis. 

We all recognize that a dollar today is worth 

more than a dollar five years from now or at any 

reasonable time in the future. To account for these 

differences in the time value of money, monetary 

values are "discounted", i.e., amounts of money 

realized in the future are expressed as equivalent 

amounts of money today. This topic is taken up again 

in Chapter 3 in the section on interest rates. 

PREVIEW TO CHAPTER 3 

This chapter has provided an introduction to 

the fundamental economic problem of scarcity which 

requires us to make choices. Decision criteria for 

8 

evaluating choices have been introduced. Chapter 3 

provides an introduction to the basic concepts needed 

to identify and evaluate project benefits, and to a lesser 

extent, project costs. 
Chapter 3: NED BENEFITS 

INTRODUCTION 

The P&G generally defines NED benefits as 

follows: 

"Beneficial effects in the NED 

account are increases in the 

economic value of the national 

output of goods and services from a 

plan; the value of output resulting 

from external economies caused by 

a plan; and the value associated with 

the use of otherwise unemployed or 

under-employed labor 

resources ... "Economic and 

Environmental Principles and 

Guidelines for Water and Related 

Land Resources Implementation 

Studies, p. 8, March 1983 

This chapter concentrates on economic concepts 

necessary to understand the nature of NED benefits. 

The first sections develop critical economic concepts 

and relationships. By the end of the chapter, these 

concepts will be used to illustrate several categories of 

benefits in the NED account. The chapter concludes 

with a discussion of the differences between benefits to 

the Nation and benefits to the local economy. 

OVERVIEW OF NED BENEFIT ESTIMATION 

Anticipating what follows, we want the reader 

to see that, at best, measurement of NED benefits is a 

difficult task. Project outputs have value because they 

make people happy. We can't measure happiness so 

we use a proxy; how much would a person be willing 

to pay for that change in happiness? This willingness 

to pay can be measured rather precisely as areas under 

demand and supply curves. Unfortunately, the 

necessary demand and supply curves are not always 

available. When they are not, alternative techniques 

are used to approximate the relevapt areas. At times, 

the tools for implementing these alternative techniques 

are less than perfect. 

9 

Thus, the economist has to measure what 

cannot be measured using concepts that cannot be 

observed. So he must resort to using less-than-perfect 

tools as proxy measures of approximate values of 

things that don't really exist! Not an easy task! It's 

understandable that so many people get so confused. 

WILLINGNESS TO PAY 

Willingness to pay can be measured in one of 

two ways, depending on how we compare the 

alternatives people are choosing between. One 

estimates the amount of money one would be willing 

to pay for a project, the other estimates the money one 

would have to receive to willingly forego a project and 

be as satisfied in each case. These two measures will 

be presented in the context of a simple flood control 

project with and without condition comparison. 

First, to see what a project is worth we could 

start with the with-project condition and move back 

to the without-project condition. How much money 

could we take away from a person who is protected by 

a flood control project that would leave her just as well 

off as she was before she was protected? 

Flood control increases her utility, i.e., it 

increases her happiness. Conceptually, it would be 

possible to take away some amount of income such 

that she would be just as happy with flood protection 

and less income as she was without flood control and 

with more income. This difference in income is one 

measure of her willingness to pay for flood control2. 

2 This measure of willingness-to-pay is called compensating 

variation. It is the amount of money which. when taken away from 

an individual after an economic change. leaves the person just as 

well off as before. In other words. her utility before the project is 

exactly the same as her utility after the project. once the income is 

taken away. 
For an increase in her utility, we are looking 

for the maximum amount she is willing to pay for the 

change. If the with-project condition decreased her 

utility for any reason, say she valued a pristine 

environment more than flood protection, we would be 

looking for the minimum amount the person would 

require as compensation for the change. 

The second approach to estimating a project's 

value begins with the without-project condition and 

proceeds to the with-project condition. How much 

money would we have to give to an individual who, if 

the flood control project is not built, is as well off as 

she would have been had the project been built? 

Again, flood control would increase her utility. 

By not providing flood control, she is deprived of 

utility and it would be possible to give her some 

amount of income that would leave her as well off as 

she would have been with the project This difference 

in income is an alternative measure of her willingness 

to pay3. 

For an increase in her utility, this income is 

the minimum compensation she would have to receive 

to forgo flood control. If the project decreased her 

utility, it is the negative of the maximum amount she 

would be willing to pay to avoid the project. 

3 This is the equivalent variation, the amount of money paid to an 

individual which, if the economic change does not happen, leaves her 

lIS well off as if the change had occurred. 

10 
These utility and willingness to pay 

concepts are equally applicable for ftrms as well. 

On the producer side of our economy, however, 

more well-known Quantities, such as profits, 

substitute for utility4. 

Economists generally measure these 

willingness to pay values as the areas under 

curves. For consumers, we measure areas, called 

consumer surplus, under demand curves and for 

flllIlS we measure areas, called producer surplus, 

over supply curves. Consumer surplus is deftned 

as the area below the demand curve and above the 

price line5. Producer surplus is deftned as the area 

above the supply curve and below the price line. 

Consumer and producer surplus are discussed in 

greater detail later in this chapter. 

PRICES AND THE NED PRINCIPLE 

All the techniques used to estimate NED 

beneftts and costs rely on the availability of prices 

or the ability to reasonably estimate prices if they 

are unavailable. If prices are so important to 

NED, and they are, we need to understand a little 

bit about them. 

4 Actually, profits serve this function only when fmns continue 

to operate in both scenarios, i.e., with and without the economic 

change. It would be technically more correct to say that quasirents are the quantities we should measure for firms. However, 

profits will do fine for our purposes here. 

S For individuals, the willingness to pay estimation matter is 

more complex. In order to avoid a protracted discussion of 

demand theory, we will simply suggest that an individual's 

welfare can be estimated by consumer surplus. In certain cases, 

this measure of an individual's willingness to pay can be 

seriously flawed. However, for a fairly wide range of 

circumstances, it is a reasonable estimate of an individual's 

willingness to pay for a change. 

Exact measures of compensating and equivalent 

variations can be found from areas under the Hicksian or 

utility-constant demand curve. Hicksian demand curves are 

generally unobservable. The demand curves that most people 

are familiar with are the Marshallian, a.k.a. ordinary or incomefixed demand curves. These curves are different from the 

Hicbian curves. To the extent they are reasonably close to one 

lIIlother, the area under an ordinary demand curve will provide 

a reasonable estimate of the true willingness to pay. 

11 
In the following sections, supply and demand 

curves are introduced separately. Then we look at how 

the forces of supply and demand combine to produce 

prices. Finally, we will consider how the equilibrium 

price determined by supply and demand represents a 

social optimum. 

DEMAND CURVE 

Demand is the maximum quantity of a good 

or service people are willing and able to purchase at 

various prices. The "Law of Demand" states that, all 

other things equal, if the price of a good goes up, the 

quantity purchased will go down, and vice versa. 

The demand curve is sometimes referred to as 

a willingness to pay curve because it measures how 

much people are willing to pay for each additional unit 

of the good or service. People buy additional amounts 

of a good until the last unit is worth exactly what it 

costs. 

Figure I shows a hypothetical consumer's 

demand curve for recreation days at a specific Corps 

project. If a $5 user fee is in effect, the consumer will 

purchase 10 recreation days. The 10th recreation day 

is worth exactly five dollars to the consumer. 

Each of the first nine recreation days is worth 

more than $5 to the consumer. She would have 

purchased them if the price were higher than $5. In 

fact, the figure shows that the consumer would still 

have purchased 8 of the 10 recreation days at a price 

of $6. Even though the price of each day is $5 she 

was willing to pay more than that for them. 

Willingness to pay should not be confused with price. 

The area under the demand curve is an 

approximation of the total benefit a person derives 

from being able to consume a certain amount of a 

good. It is the person's total willingness to pay for the 

good. In Figure 1 total willingness to pay is $100 

Figu,e 1 

Individual Demand Cu,ve 10 

>. 9 

(0 

0 

C 9 

0 

f-l 7 

(0 

(]) 

L 6 

U 

(]) 

0:: 5 

L 

(]) 

Q. " 

(f) 3 

L 

(0 

2 

0 

0 

0 

0 2 3 <I 5 6 7 9 9 10 11 12 13 1<1 15 16 17 19 19 20 

Numbe, of Rec,eation Days 

12 
(areas a+b+c), i.e., 20 days of recreation at this site 

is worth a maximum of $100 to our consumer6. 

How many days our consmner will actually buy 

depends on the price. 

For example, our consumer won't use the 

site at all if the fee is $10. She is willing-to-pay a 

maximum of $9.50 for the frrst recreation day 

because the utility she gets from this one day is 

worth $9.50 to her. Because the price is only $5, 

and the day is worth $9.50, she'll surely purchase it. 

The utility of the second day is worth $9 to her, and 

it costs only $5, so she'll clearly purchase it, and so 

it goes until the 10th recreation day, which is worth 

$5 and costs $5. Though she will purchase the 10th 

day, the 11th day is worth only $4.50 to her and it 

costs $5. She will not buy it. Her purchase rule is, 

like your own, if you are willing to pay an amount 

equal to or greater than the price, you buy. If you 

aren't, you pass. 

CONSUMER SURPLUS 

The willingness to pay interpretation of the 

demand curve allows us to measure how much better 

(worse) off a person is when the price decreases 

(increases). At a price of $9.50, our consmner buys 

one day of recreation use. To induce the purchase 

of a second day, the price must be reduced to $9. 

At a price of $9, she pays $9 for each of the two 

recreation days she buys even though she would 

have paid $9.50 for the frrst day. The area under 

the demand curve and above the price (area a in 

Figure 1) represents the surplus the consumer 

realizes from having the lower price. This consumer 

surplus is only an approximation of the value of the 

increased utility to our consumer, but it will do well 

for our purposes. The area under the demand curve 

to the left of a quantity of 10 is $757 (areas a+b in 

Figure 1). This represents the total benefit of 10 

recreation days to our consumer; hence, it also 

6 Total willingness to pay is the entire area under the demand 

curve. It is obtained by finding the area of the triangle, i.e., 

0.5(20)($10) = $100. 

7 The rectangle formed by a price of $5 and a quantity of 10 has 

an area of $50. The triangle above it has an area of $25, for a 

total willingness to pay of $75 for the 10 days of recreation. 

13 
represents her total willingness to pay for 10 days of 

recreation at this site. At a price of $5, she pays only 

$50 (area b in Figure 1) for 10 recreation days though 

she was willing to pay $75. She realizes a consumer 

surplus of $25, i.e., the difference between her total 

willingness to pay and what she actually pays or the 

area below the demand curve and above the price line. 

If we add all the individual demand curves to 

get the market demand curve, we can obtain a measure 

of consumer surplus for all consumers by taking the 

area under the demand curve and above the price line. 

Figure 2 shows the consumer surplus for our consumer. 

Consumer surplus for the entire market would be 

measured in the same way, but the quantities of 

recreation days would reflect the quantity demanded by 

all users of this site, as shown in Figure 3. 

Relating this to benefits is a simple matter. 

The area under the individual's demand curve ($75 in 

the Figure 2 example) is a measure of total benefits for 

the quantity of output (10 in the example). The cost of 

these benefits is the area below the demand curve and 

tbeprice line ($50). The consumer surplus of $25 is, 

analogously, the consumer's net benefits. 

PROFIT MAXIMIZATION 

Rational people are assumed to maximize their 

utility subject to their available budgets. When those 

rational people organize as fmns, we can be a bit more 

specific about how they maximize their utility. Firms 

are assumed to be profit maximizers. If profit is 

defined as total revenues erR) minus total costs (TC), 

it is impossible to maximize profits unless costs are 

minimized. If total revenues are fixed at any level, 

profit will not be as large as possible unless costs are 

as small as possible. Thus, profit maximization 

implies cost minimization. 

It is a simple matter to make the jump from 

profit maximization to net benefit maximization. Total 

revenues become total benefits (TB), total costs remain 

total costs. The Corps becomes the rational frrm and 

the difference between TB and TC are net benefits. 

In some instances actual benefits are not 

known and are not estimated. For example, municipal 

water supply benefits are generally assumed to exceed 

F i gur-e 2 

Consumer- Sur-plus 

>- 10 

ltI 

0 9 Consume~ Su~plus = $25 

c 

0 8 

+.l 

ltI 

OJ 

L 

U 

OJ 6 a: 

L Consume~ Cost $50 

OJ 5 

0. 

(J) 4 

L 

ltI 

0 

0 a 

o 

Number- of Recr-eation Days 

14 
Figur-e 3 

10 Mar-ket Demand and Consumer- Sur-plus 

>- B Consumer Surplus = $25,000 

CO 

0 8 

C 

0 7 

.f-J 

CO 

()) 6 

L 

U = $50,000 

()) 5 

0: 

L 4 ()) 

0.. 

(f) " L 

CO :2 

0 

0 

0 

0 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 

Thousands of Recr-eation Days 

the costs of water supply but they are rarely estimated. 

In such cases benefits, though unknown, are assumed 

to be fixed at some level that exceeds costs. To 

maximize net benefits in such cases, it is necessary to 

minimize the costs of providing that level of water 

supply. 

Environmental mitigation is often based on 

the assumption that the benefits of providing some 

fixed level of mitigation (TB) exceed the costs (TC) of 

doing so. Rational economic behavior requires the 

analysts to minimize the costs of providing these 

benefits. 

Thus, cost mmnntzmg behavior is an 

important subcategory of profit maximizing behavior 

used when the level of benefits is unknown but 

assumed to exceed costs. 

OPPORTUNITY COST 

Because we have scarcity, we have to make 

choices. Whenever we make a choice, it costs us 

15 

something. A choice to do one thing is a choice not to 

do another. Choosing to use a resource, say reservoir 

storage, for anyone purpose costs us the opportunity to 

use that storage for another purpose. Thus, if storage 

is allocated to flood control it cannot be allocated to 

water supply. If water supply is the next best 

alternative use of the storage, the cost of the flood 

control storage is the value of that storage as water 

supply. 

Price is routinely used as the measure of the 

cost of a good or service. While $50 per acre-foot 

may be the price of water, that may not be its cost 

The economic definition of cost is that which must be 

foregone to use the resource in a given way. The 

opportunity cost of any decision is the foregone value 

of the next best alternative not chosen. Fortunately, for 

most goods purchased in a competitive market, price is 

opportunity cost Unfortunately for water resource 

planners, there are many goods and services used and 

produced by water resource projects that are not 

produced in competitive markets, and for which price 

does not exiSt, or price does not equal opportunity cost 
Opportunity costs are taken up in more detail in 

Chapter 4. 

SUPPLY CURVE 

Supply is the quantity of a good or service a 

ftrm is willing and able to produce at different prices. 

A supply curve, as shown in Figure 4, shows the 

amount of output the ftrm will offer for sale at any 

given price. The industry supply curve for a 

competitive ftrm shows the opportunity cost to the 

economy of providing the last unit of output8. 

Figure 4 shows how the output choice of the 

ftrm, in this case a ftsherman, will respond to market 

price. Let's assume that if the price of ftsh is $3 per 

pound, he will produce 900 pounds per week. At any 

production beyond this amount, it costs him more than 

$3 per pound to catch the ftsh. This may be because 

900 pounds is the maximum he can catch alone. To 

increase the catch, he may have to add a laborer or buy 

new equipment. If the price rises to $4, the ftsherman 

ftnds that the higher price covers the higher cost (i.e., 

the extra wages or the cost of new equipment) of 

catching more ftsh, and at the new price he would be 

willing to provide 1,000 pounds of catch. 

The opportunity cost of the 1,0OOth pound of 

ftsh is $4. The ftsherman won't produce more because 

he would incur costs greater than the $4 per pound he 

receives. A rational ftsherman would not incur costs to 

catch ftsh that would exceed the value of the ftsh. 

Just as areas under the demand curve show 

total willingness to pay, areas under the supply curve 

show total opportunity costs of producing a 

8 There are complications if we want to be precise, but this 

eltplllllation is good enough for our purposes. 

16 
, . Figure 4 

Supply Curve 

.c 

(/) 

LL 

I!-

o 

"0 

C 

:l • o 

0.. 

L 

(JJ 

a. • (/) 

L 

lt1 

o o • 

... 

a 

- ... BOO '000 120a 1oU11 1BD1l '800 2DD11 

Pounds of Fish 

given level of oulput. The total cost of producing 900 

pounds of fish is $4509 (area b in Figure 4). 

To get the market supply curve, the procedure 

can be more complicated than simply adding the oulput 

that each fisherman would produce at each possible 

pricelO. Nonetheless, the intuition developed from 

thinking of market supply in this way best suits this 

manual's purposes. 

PRODUCER SURPLUS 

A "willingness to pay the costs of production" 

interpretation of the supply curve allows us to measure 

how much better (worse) off a producer is when the 

price increases (decreases). This measure is called 

producer surplus. Interpretation of the supply curve in 

a willingness to pay concept is just a little bit trickier 

than is the case for the demand curve. 

9 The area of the triangle in Figure 4 is given by 0.5(90()'600)($3) 

=$450. 

10 If th~re are many fmns and each increases its use of inputs. the 

prices of these inputs could increase. Thus. opportunity costs could 

be affe~ed by changes in prices as well as changes in quantities. 

rendering the simple addition of individual supply curves insufficient 

for deteftnining the market supply. 

17 

At a price of $4 per pound, our fisherman is 

willing to produce 1,000 pounds of fish. His total 

revenue is $4,000. The maximum amount the producer 

would be willing to pay (or, if you find it more 

intuitive, the maximum cost he would be willing to 

incur) to catch the 1,000 pounds of rt.sh is $4,000. 

Revenues, at the margin, would exactly cover his 

marginal costs, which include a fair return to him for 

his time and the use of his boat and equipment. 

It is evident from Figure 5 that the fisherman 

does not have to pay $4,000. The shaded rectangle 

represents the fisherman's total revenues, $4,000. The 

triangle beneath the supply curve, represents the 

producers total opportunity costs of $800 for catching 

these fish. The area above the supply curve and below 

the price line represents producer surplus of $3,20011. 

Relating this to benefits is a simple matter. 

The area under the price line, $4,000, is a measure of 

total income (or total revenue) for the quantity of 

output. The cost of this output, $800, is the area below 

the supply curve. What is left over, $3,200, is the 

I I The rectangle formed at a price of $4 and a quantity of 600 has 

an area of $2,400. The area of the triangle formed at a price of $4 for 

the quantity from 600 to 1000 is $800. for a total producer surplus 

of $3.200. 
10 

FIQure 5 

Producer Surplus and Cost 

.r= 

(/) 

u.. 

.... 

0 

"0 

c:: 

:=I Producer Surplus $3.200 

8-

ID 

a. 

(/) 

L 

......... . ............. . .......... . ............ . «l ............ . ......... .. . . ............ .. ............ . .............. " ............ . ............ ,' ............. . .............. ............ . 8 ........................... 

Pounds of Fish 

amount the producer would have been willing to pay, 

but did not have to. Hence, it is akin to net benefits or 

profit in this context 

MARKETS AND PRICES 

A competitive market equilibrium allocates 

resources efficiently. The intent of the NED principle 

is, likewise, to allocate resources efficiently. Thus, it's 

useful to consider market equilibrium. 

Consumerslbuyers and producers/sellers make 

plans independently of one another, plans 

fundamentally in conflict. One seeks the lowest price 

FIgure 6 

possible, the other the highest price possible. Consider 

the market for wheat. "If wheat costs $2 per bushel, 

I'll buy so much; if it's $l.75 I'll buy more," the 

consumer plans. This is the basis of the demand 

relationship above. "If wheat sells for $2, I'll produce 

so much; if it sells for $2.50, I'll produce even more," 

the producer plans. This is the basis of the supply 

relationship. These independent plans are coordinated 

and their actions influenced by the market. 

Figure 6 shows supply and demand for the 

wheat market. Each good is assumed to provide 

benefits only to the person who consumes it. Each 

seller is assumed to pay all the costs of producing the 

output. The intersection of supply and demand 

Market Supply and Demand 

Supply 

8lrplus 

B 

Bushels of Wheat (1.000s) 

18 
Figure 7 

4 Maximum Net Benefits 

3.5 

Q) 

..c 

Ul 

:::J 

[D 

2.5 

L 

Q) 

a. 2 

Ul 

L 

lI:! 1.5 

8 1 

0.5 

o 1 2 3 4 5 6 7 e 9 10 11 12 13 14 15 16 

Bushels of Wheat (1,000s) 

represents the market's equilibrium position. 

Equilibrium is essentially a state of balance between 

consumers and producers who have conflicting 

interests. 

When the price of wheat is above equilibrium, 

say at $3.00, consumers want only 4,000 bushels, while 

producers are willing to provide 12,000 bushels. The~e 

is a surplus of wheat at this price. Everyone who is 

willing to buy wheat at this price has done so, so the 

only way to sell the surplus wheat is to drop the price. 

Thus, if price is above the equilibrium there will be 

forces at work, the "force" of self-interest, that will 

drive prices lower. 

If the price of wheat is below equilibrium, say 

at $1.00, consumers want 12,000 bushels but producers 

provide only 4,000 bushels. Now, there is a shortage 

of wheat Consumers who want wheat and fear they 

won't get it will offer a higher price to assure they get 

some wheat, producers in search of profits will raise 

the price. Once again, self-interest assures that a price 

that is too low will rise. 

Only at the equilibrium price of $2.00 per 

bushel will there be no tendency for prices to change. 

The quantity of wheat produced at this price, 8,000 

bushels, will be exactly what people want to buy. 

Everyone who produces wheat at that price can sell it 

Everyone who wants wheat at that price can buy it 

No one has an incentive to lower or raise prices. 

19 

Prices are the result of a dynamic balance of 

the self-interests of buyers and sellers as they meet in 

the marketplace. 

SUPPLY, DEMAND AND SOCIAL WELFARE 

Social welfare is maximized at the equilibrium 

price. The demand curve represents the consumers' 

willingness to pay for additional output, and the supply 

curve represents the producers' opportunity cost of 

producing additional output. At equilibrium, society's 

opportunity cost and its willingness to pay are exactly 

equal. We will have neither too much nor too little 

produced. 

Consider the market for wheat again. Total 

benefits are shown as the area under the demand curve. 

Opportunity costs are shown as the area under the 

supply curve. The maximum possible difference 

between benefits and costs occurs at an output of 8,000 

bushels of wheat. The shaded areas of Figure 7 are the 

maximum net benefit possible in the wheat market 

Net benefits are defined as consumer surplus plus 

producer surplus at any level of output. 

Any increase in quantity beyond 8,000 bushels 

would reduce net benefits because the opportunity cost 

of producing the wheat, read from the supply curve at 

that quantity, exceeds consumers willingness to pay for 

it, read from the demand curve at that quantity. It 
would be possible to raise net benefits by dropping the 

last additional unit of wheat. For example, the 

opportunity cost of the 1O,OOOth bushel of wheat is 

$2.50, while consumers are only willing to pay $1.50 

for it. Net benefits are diminished by $1.00 for the 

1O,OOOth bushel produced. What may seem to be a 

peculiar insistence on stressing one more or one less 

unit of a good or resource will be made more clear in 

the section on Marginal Analysis in Chapter 5. Net 

benefits at an output of 10,000 bushels are $15,00012. 

At any quantity below the equilibrium, the 

benefits of an additional bushel would exceed the costs 

of producing it so it would be impossible for a quantity 

in this range of output to be optimal. 

Figures 8 and 9 show over- and 

underproduction of wheat. In Figure 8, net benefits 

would be reduced by the shaded triangle which 

represents an excess of costs over benefits. In Figure 

9, net benefits are shy of their maximum value by the 

shaded triangle. 

Underproduction makes consumers worse off 

than they could be because the benefits (willingness to 

pay) from each additional bushel of wheat would be 

great enough to allow them to pay the equilibrium 

price and still be better off than they are without the 

additional wheat. Producers are also worse off because 

they could produce the wheat at a cost less than the 

revenues they would receive for it at the equilibrium 

price. The sum of the consumers' and producers' loss 

is a loss to society. For example, at an output of 4,000 

bushels total net benefits are only $12,000. 

Overproduction would never be voluntarily 

arrived at. Buyers do not value the additional wheat: 

enough to even pay the equilibrium price. Producers 

must pay more than the equilibrium price to produce 

the additional wheat. If this quantity of wheat is 

produced there would be a lost opportunity to lIlake 

better use of the resources used in the extra production. 

This lost opportunity is an efficiency loss to society. 

12 The production of each of the 2,000 bushels of wheat beyoml tho 

equilibrium quantity incurs costs in excess of their value. The ne* 

loss for these 1.000 bushels is $1,000. Thus, net benefits for the fITS. 

8,000 bushels of $16,000 are reduced by Sf,OOO in producing the 

next 2,000 bushels. 

20 
I 

4;-

I " 

" I 

3.5 .J 

I 

I 

Q) I 

.c 3 I 

(f) I 

::::l I 

CD 2.5 ~ 

L 

Q) 

Q. 

(f) 

L 

I 

I 

2..! I 

I 

til 1.5-t 

1 ...! I 

I 

I 0.5 , 

" " 

Figul"e 8 

Ovel"pl"oductlon 

J " " 

J " 

" " " ,," Supply 

" " " " " " ..... ..... ..... ..... ..... 

" 

" J " 

..... 

" " " J " 

Social Cost of 

Overproduction 

$1,000 

" " J " " " " " " " J " ,," " J ..... " Demand " ..... " ..... J ..... 

I -","'" " I " ..... 

,,+ 

I ",/ I .......... 

Gf-,--r-,--r-,--r-'--r-'--r-'--r-'--r-'-~r---

3.5 

Q) 3 

.c 

(f) 

::::l 

CD 2.5 

L 

Q) 

Q. 2 

(f) 

L 1.5 til 

0 

0 

0.5 

o 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 

c 1 2 3 

Bushels of Wheat C1~OOOs) 

Figul"e 9 

Undel"pl"oduction 

SocIal Cost of 

Underproduction 

4 5 6 7 8 9 10 11 12 13 14 15 16 

Bushels of Wheat C1~OOOs) 

21 
It is impossible for society to improve over the market 

equilibrium output Thus, in estimating NED benefits 

and costs it is important that competitive market prices 

be used or very closely approximated, because without 

them society is not as well off as it could be and 

resources will be misallocated. The value of the 

increased wheat output from a water resource project 

would be obtained by comparing net benefits with the 

project to net benefits without the project 

MARKET FAILURE 

Situations that prevent efficient marketdetermined allocations of resources are called market 

failures. There are many reasons for market failure. 

Externalities and public goods, two of the best known 

examples, are briefly described below. 

Externalities 

Many economic activities provide incidental 

benefits to people for whom they were not intended. 

Other activities indiscriminately impose incidental costs 

on others. These effects are called externalities. When 

externalities are present, the private sector will 

underproduce or overproduce goods, resulting in an 

inefficient allocation of resources. The external 

economies referenced in the definition of NEO benefits 

at the beginning of this chapter are externalities. 

Externalities are defined as benefits or costs 

generated outside of any market transaction. Positive 

externalities make someone better off without that 

person being required to reimburse the party 

responsible for the positive effect. Flood control 

projects frequently generate positive externalities. 

Consider a large cannery in the flood plain 

that is the primary customer for a can factory several 

miles removed from the flood plain. Flood control 

protects the cannery and in so doing incidentally 

benefits the can factory as well. The can factory 

realizes a positive externality for which it does not 

l1ave to pay. 

Negative externalities make someone worse 

off without that person being compensated for the 

negative effect. Floodwalls and levees can produce 

higher flood stages or more frequent flooding at 

downstream locations. The residents of communities 

22 

affected by this induced flooding suffer a negative 

externality they are not compensated for. 

Corps policies bave been developed to deal 

with induced flooding. The very fact that policies were 

needed indicates the nature of externalities. 

Externalities do not take care of themselves. Tbere is 

no built-in incentive for the private sector to produce 

outputs that produce positive externalities. They bave 

no way to cbarge for them and bence have no incentive 

to produce them. In the private marketplace goods that 

produce positive externalities tend to be undervalued 

and, bence, are not produced in efficient quantities. 

On the other band, firms that produce goods 

that cause negative externalities do not have to pay 

those costs. Thus, they do not pay the full opportunity 

cost of their output. so it is undervalued and 

overproduced 13. 

Tbe NED principle requires that externalities 

be accounted for in order to assure efficient allocation 

of resources. Figure 10 shows bow failure to account 

for the positive externalities of a flood control 

project can result in underproduction of flood 

protection. Oemandl4, 01 in the figure, consists of 

benefits to flood plain occupants only. Maximizing net 

benefits to flood plain occupants only leads to an 

output of Ql wbicb falls short of the efficient output 

Q2' 02 includes the benefits of 01 plus positive 

externalities to beneficiaries like the can factory. 

I3 If the non-economist reader is confused by the fact that what is 

undervalued can be both. under- and overproduced, keep in mind that 

demand and supply are opposing forces in our economy. From the 

consumer's perspective, a price that is too low will have them 

demanding more than is optimal, while producers will not produce 

enough of what is priced too low. A fuller understanding of this 

apparent contradiction requires knowledge of factors that shift 

demand and supply curves, and that is beyond the scope of this 

manual. 

14 The demand curve can also be interpreted as a marginal benefit 

curve. At every point on the demand curve price is exactly equal to 

the marginal benefit (actually the marginal utility) of the last unit of 

output purchased. 
Figure 11 shows how failure to account for 

negative externalities can result in overproduction of 

flood protection. When only the direct costs of the 

project are considered (SI)' the level of flood 

protection is Ql' When the negative externality of 

induced flooding is included S2 becomes the true 

supply curve15 and the efficient output is Q2' 

Public Goods 

Another area in which the market fails to 

allocate resources efficiently is in the production of 

public goods. Public goods are best defmed by first 

considering private goods. Private goods have two 

important attributes. First, they are depletable, i.e., 

they are used up when they are consumed. Second, 

they are excludable, i.e., anyone who does not pay for 

the good can be excluded from enjoying it. 

Public goods do not have these attributes. 

Flood control is not depletable. Once a local flood 

protection project is built, anyone in the protected 

floodplain enjoys flood protection. Your consumption 

of flood control does not use it up and make i~ 

unavailable to me. We all consume the same level of 

protection. 

Neither are public goods excludable. Once 

flood control is provided for one person it becomes 

available to many more people whom it is difficult, if 

not impossible, to exclude from the benefits. 

Since nonpaying users cannot be excluded 

from enjoying a public good, private suppliers of such 

goods fmd it difficult or impossible to collect for 

providing the benefits of such services. This is 

becaqse of the "free rider" problem. How many people 

would voluntarily pay $5,000 for flood protection if 

they know that if their neighbors buy it they'll get it 

for free? Such goods cannot be provided by free 

enterprise because people will not pay for what they 

can get for free. 

IS Th 1 b . ed . al e SupplY curve can e Interpret as a margm cost curve. At 

every point on the supply curve price equals marginal cost. 

23 

A second, more subtle point about free goods 

is that if one person's consumption of the good does 

not use it up or deplete it, then the additional, or 

marginal, cost of one more person using the good is 

zero. With zero marginal cost, efficient resource 

allocation requires that anyone who wants the good or 

service be provided it at no cost (see Chapter 4 for a 

discussion of marginal cost). So, not only is it often 

impossible to collect for consumption of a public good, 

it is also undesirablel6. 

There is a legitimate role for government to 

provide public goods and to create conditions (e.g., 

taxes or local cooperation agreements) for cost 

recovery. The economists' challenge is identifying the 

optimal quantity of such goods in the absence of 

market prices. Benefit-cost analysis is a general 

technique for doing this. NED analysis is a more 

specific application of this technique. 

SOME NED PRINCIPLE ASSUMPI'IONS 

The answer to any economic question must 

begin with the phrase, "It depends". All economic 

analysis begins with a set of working assumptions and 

definitions upon which the analysis "depends". 

Without understanding the basic assumptions and 

definitions, there can be no clear understanding of what 

the results of an analysis represent. 

The NED objective and the guidance that 

support it establish a set of assumptions that have 

particular significance for the economic analysis of 

Corps projects. If one or more of these assumptions 

were changed, the implications for analysis of Corps 

projects could be significant. 

16 An efficient allocati6n of resources requires that the price of a 

good equal the marginal cost of producing it. If the price exceeds the 

marginal cost of producing a good then more should be produced. If 

price is less than the marginal cost of producing a good, less should 

be produced. Only when the price of a good equals the marginal cost 

of producing it do we have the efficient amount of the good. Thus, 

if the marginal cost of producing a good is zero, as it is with a public 

good, the price shonld be set equal to the marginal cost and the good 

should be provided free of charge. 
Q) 

u 

d: 

Q) 

U 

L 

0... 

Figure 10 

Underproduction of Flood Control 

Loss of Benefits Due to 

Q Q 

1 2 

Flood Protection 

s 

Figure 11 

Overproduction of Flood Control 

Reduced Net Benefits 

Q 2 Q 1 

Quantity of Flood Protection 

24 
CONSTANT PRICES (P&G PARAGRAPH 1.4.10) 

There are two basic types of price changes. 

First, general price level changes result in all prices 

rising by roughly the same amount. Planners are 

directed to use price levels prevailing during the 

planning period. Thus, general price levels of benefits 

and costs are effectively assumed to remain constant; 

this simplifies the economic analysis considerably. 

Non-Federal partners realize that construction costs do 

rise. While these increases are of critical importance 

in financing the project they are of no consequence in 

the NED. 

The second type of price change is a change 

in relative prices. Prices, as used in economics, are 

relative prices. Relative prices are assumed to remain 

constant 

If a candy bar costs $0.50 and a gallon of gas 

costs $1.00, the relative price of a gallon of gas is two 

candy bars. If the general price level rises 10 percent, 

candy costs $0.55 and gas $1.10 but the relative price 

is still 1 gallon of gas for two candy bars. However, 

if the price of gas rises to $2.00 because of decreased 

supply of oil due to conflict in the oil-producing pa:.1S 

of the world while candy prices are unchanged, then 

the relative price of gas is now four candy bars per 

gallon. To get a gallon of gas, one must give up more. 

The price of gas, relative to the price of other goods 

(candy bars) has increased drastically. 

If the relative prices of goods are allowed to 

change, this could significantly affect the values of 

project benefits and costs. Corps policy has allowed 

for projecting changes in the real price of petroleum 

products in the past. When projects affect the relative 

prices of goods, those price changes are to be 

accounted for. For example, a project that increases an 

agricultural crop output enough to lower its relative 

price should use the changed relative price. 

FULL EMPLOYMENT (P&G PARAGRAPH 1.4.9) 

All national forecasts are to assume a full 

employment economy. If all resources are fully 

employed, this means that all resources have alternative 

uses, i.e., all resources have opportunity costs. The 

significance of this assumption is that it provides the 

planner with a rationale for using market prices. 

25 

To an economist, "full employment" of labor 

resources does not mean the absence of unemployment 

It is generally recognized that there is some normal 

level of unemployment in our economy. Even when 

the economy is strong, with plentiful jobs, there are 

people who are unemployed because they are changing 

careers, moving to another part of the country, 

graduating from school, entering the work force for the 

ftrSt time, or reentering the workforce after some 

absence. Chapter 6 provides a discussion of 

unemployed labor resources. 

In recent years, mobility in the United States 

has resulted in a general consensus that a normal rate 

of unemployment is about six percent. Thus, the P&G 

assumption of full employment is that over the 

planning horizon the economy will generally have an 

unemployment rate of about six percent 

RISK NEUTRALITY 

One of the more esoteric assumptions imposed 

on Corps analyses concerns the public's attitudes 

toward risk. This has significance for Corps projects 

because of what risk attitudes imply about willingness 

to pay for project outputs. 

Let's consider this issue in the context of a 

flood control project. Each year a person lives in the 

flood plain he faces the possibility of zero damages if 

there is no flood, or some unknown amount of dollar 

damages if there is a flood. Suppose his expected 

annual damages are $1,000 per year and would be 

entirely eliminated by the project What would he be 

willing to pay to avoid those damages? The answer 

depends on his risk attitudes. 

A person who is risk averse prefers to avoid 

the risk of flooding. Hence, he would be willing to 

pay something in excess of $1,000 a year to avoid the 

possibility of flood damages in any given year. Flood 

control benefits would exceed the reduction in expected 

annual damages for this person. Risk averse behavior 

is very common and, in fact, it is the basis for this 

nation's vast insurance industry. If people weren't 

willing to pay premiums in excess of their expected 

losses, it would be impossible for the insurance 

industry to settle claims, pay expenses and tum a 

profit. 
A risk-seeking individual gets some pleasure 

from the risk itself. He enjoys the gamble, and the 

most he would pay for the $1,000 reduction in 

expected annual damages would be something less than 

$1,000. Thus, inundation reduction benefits for a 

risk-seeking individual would be less than $1,000. 

Risk neutral individuals would be willing to 

pay the expected value. Risk neutrality imposes the 

assumption that the maximum willingness to pay for an 

uncertain outcome is the expected value of that 

outcome. Flood control benefits are equal to the 

expected annual damage reductions. 

In general, the assumption of risk neutrality 

excludes the possibility that risk averse individuals 

would pay more than the expected value of any project 

output and that risk-seeking individuals would pay less 

than expected value because they enjoy the gamble. 

This assumption could understate benefits if people are 

risk averse and overstate them if they're risk-seekers. 

Corps analysts are to assume risk neutrality, enabling 

them to use expected annual damages as the measure 

of a beneficiary's willingness to pay for flood control 

PERIOD OF ANALYSIS 

Specifying an effective 100-year maximum on 

the period of analysis is a policy decision. It's most 

important implication for economic analysis is that it 

presumes a long-range outlook. Analysts and decision 

makers alike often have difficulty in maintaining a 

long-range outlook. It is all too tempting to overreact 

to short term fluctuations in trends and market 

conditions. This is an issue taken up in more detail in 

Chapter 6. 

OTHER POLICY ASSUMPfIONS 

There are any number of additional 

assumptions imposed on the economic analysis of 

Corps projects by government and agency policy. 

Designation of low-priority outputs; direction to use 

rail rates rather than marginal costs; the assumption 

that there will be no transfers of tonnage from one port 

to another; guidance on freeboard, underkeel clearance, 

etc., all have important implications for economic 

analysis that are unrelated to economic theory. These 

and other policy decisions are often based on pragmatic 

26 

compromises between economic theory and time, 

budget and data constraints. 

For example, designation of low priority 

outputs helps allocate limited agency funds among the 

many projects under consideration, a pragmatic policy 

decision. The use of rail rates is predicated on 

additional requirements that the rates are "similar, 

competitive, and prevailing". Controls exist in the 

collection and analysis of rates that have the objective 

of screening rates that are not representative of long 

run variable costs. Though these and other policy 

decisions may cause project analysis and economic 

theory to diverge at times, these are pragmatic 

compromises rather than a wholesale abandonment of 

economic principles. 

INTEREST RATES 

TIME VALUE OF MONEY 

Project costs are incurred primarily at the time 

of construction. Benefits, on the other hand, accrue 

over a period of years in random amounts. Though 

both costs and benefits are measured in dollars, the 

dollars spent on construction today cannot be directly 

compared to the benefit dollars that will be realized 

years from now. 

One million dollars in costs today is not the 

same as $1 million in benefits 20 years from now. We 

could easily take $1 million today, put it in a bank 

where it earns 10 percent interest annually and in 20 

years we will have $6.7 million. If we had a choice 

between building a $1 million dollar project that yields 

a $1 million benefit in 20 years and saving the money 

at 10 percent, clearly saving is the best option. This is 

because of the time value of money. 

All other things equal, a rational person 

prefers $1 now to $1 in the future. Why? Because $1 

today can be saved and it will be worth more than $1 

in the future. On the other hand, if we want to have 

$1 a year from now, we need only $0.91 today, saved 

at 10 percent annual interest In one year's time, the 

$0.91 will grow to $1. 

The reason that people regard money today 

and money in the future as of different value is because 

money has an opportunity cost If the receipt of a sum 

of money, e.g. a monetary benefit, is delayed until 
some time in the future, the recipient suffers an 

opportunity cost--the interest the money could bave 

earned if it bad been received earlier and saved. If 

someone owes you $100 and the rate of interest is 10 

percent, and you can persuade them to pay you back a 

year earlier than originally planned, you come out $10 

ahead. Alternatively, if the payment is postponed one 

year, you lose the opportunity to earn $10. 

The process of equating a sum of money today 

with its equivalent amount of money in the future is 

called compounding. The more common practice of 

equating money values across time is to equate future 

sums of money with their equivalent today, through the 

process of discounting. 

The discount rate differs conceptually from 

an interest rate in that it is society's opportunity cost of 

current consumption. That is, it's the rate society 

would use to equate amounts of money at different 

points in time. 

WHAT ARE INTEREST RATES MADE OF? 

In a society of utility and profit-maximizing 

individuals, the only reason for lending money is to 

make money. If you have $1,000, you can choose to 

spend it or not If you spend it, you enjoy it now. If 

you save it, you enjoy it later. Presumably, you expect 

some reward for delaying your consumption. 

If you could lend your money to another 

person, you would expect that when you are paid back 

you can purchase more than you could at the time you 

lent the money. You would expect some real return on 

your money. For argument's sake, let's assume you 

want to be able to buy 3 percent more if you lend your 

money and delay consumption. 

Suppose, bowever, that prices go up 4 percent 

each year. If you lend money at 3 percent interest and 

prices go up 4 percent, you lose purcbasing power by 

lending money at a rate of interest less than the 

inflation rate. So, if you want to buy 3 percent more 

after adjusting for changes in the price level, the 

nominal rate of interest you cbarge will be 7 percent 

27 
Whenever you lend money there is some 

chance you will not be paid back. Any loan involves 

risk. If you lend money to the U.S. Government in 

the form of bonds, there is little risk of not being paid 

back. Lending money to your eccentric uncle who 

wants to buy a bar is a different story. Riskier projects 

generally must offer a higher rate of return, or risk 

premium, to induce lenders to part with their money. 

While this is neither an exhaustive nor 

sophisticated explanation 17 of the components of an 

interest rate, it will suffice for our purposes. Figure 12 

provides an example of the components of an interest 

ratel8. 

CHOICE OF INTEREST RATE 

What is the interest rate? Is it the rate you 

earn on your savings? The rate you pay for your car 

loan? For your mortgage? Is it the Federal Funds 

rate? There are literally thousands of interest rates in 

our society, and the choice of the rate at which project 

benefits and costs are evaluated has been a constant 

source of controversy with the Corps' program. 

Figure 12 

The basic economic problem is still one of 

allocating resources--this time, between the present and 

the future. Is it better to consume more now, or to 

invest now so we can consume in the future? Do we 

eat the grain of wheat or plant it? Society invests in 

water resource projects through the Corps' program so 

that future generations can consume. The rate of 

interest determines the size of the opportunity cost to 

society for realizing benefits at some future date rather 

than now. 

Low interest rates encourage society to invest 

more now, since the opportunity cost is low. For 

example, a typical flood control project evaluated with 

both a high and a low interest rate will yield a higher 

benefit-cost ratio and higher net benefits when 

evaluated at the low rate. High interest rates present a 

high opportunity cost to consuming now and make 

investment. less attractive. Society's incentives are 

much the same as those of the consumer who is 

considering the purchase of a new car. The consumer 

is more likely to invest when the interest on loans is 

low than when it is high. 

The Risk-AdJusted 

Nominal Interest Rate 

Real Rate o~ Return 

Expected Rate o~ In~latlon 

Risk Premium 

Interest Rate 

I i For example, we have not addressed liquidity preferences and 

premiums or the distorting effects of the corporate income tax. 

18 The figure and the discussion preceding it have been 

oversimplified. In fact, the actual interest rate would not be a simple 

summing of its component parts. The relationships among these parts 

can be considerably more complex. 

28 

3.0 

4.0 

+ 2.0 

9.0 

Economic theory suggests that the discount 

rate used by the Corps, i.e., the social rate of discount. 

should reflect the return that can be earned on 

resources employed in alternative private use. To 

avoid losses of well-being, resources should not be 

transferred from the private sector to the public sector 

if those resources can earn a higher return in the 

private sector. Setting the discount rate equal to the 

social opportunity cost of funds ensures an efficient 

allocation of resources across time. There are, of 

course, certain complications that prevent us from 
identifying and even agreeing on what the social 

opportunity cost of funds should be. 

Economists themselves are not of one mind 

when discussing the social opportunity cost of funds, 

hence no final resolution of this matter is forthcoming 

from economic theory. The issue has been resolved for 

the Corps through Section 80 of PL 93-251, which sets 

the interest rate based on the cost of government 

borrowing. 

AN UNCOMFORTABLE IMPASSE 

OR PEACEFUL COEXISTENCE? 

Though a policy decision has determined the 

discount rate to be used by the Corps, that decision 

satisfies few people. Proponents of a lower rate argue 

that Corps projects are evaluated assuming constant 

prices and the discount rate should not include an 

expected rate of inflation. Likewise, through riskpooling and risk-sharing arguments, they argue the risk 

premium should be zero or near zero. Thus, in the 

extreme, proponents of lower rates argue for something 

closer to the real rate of return. 

Proponents of a higher rate argue that private 

investments earn rates of return much greater than the 

7 to 9 percent range of returns that have been applied 

to Corps projects in recent years and even greater than 

the 10 percent return required by the Office of 

Management and Budget. They feel the appropriate 

rate is more like 14 percent or so. 

The current discount rate formula was 

prescribed by Section 80 of the Water Resources 

Development Act of 1974. This Act produced a rate 

that effectively represents a compromise between these 

two positions. 

COST OF THE MOST LIKELY ALTERNATIVE 

When demand curves are unavailable, benefits 

are sometimes taken as the cost of the most likely 

alternative project. If demand for an output, like 

bydropower or water supply, is so strong that the 

power !Jr water is going to be provided no matter what 

the cost, we assume the benefits of the power/water 

exceed the costs of providing it Society's decision to 

provide the power/water is considered prima facie 

evidence that the benefits exceed the costs, though we 

29 

do not have actual estimates of the benefits. For 

example, if the best project is a hydropower dam that 

will cost $1 billion and the second-best project is a 

coal-fired generator with the same capacity that costs 

$1.2 billion, given benefits are the $1.2 billion, net 

benefits are the difference in cost or $0.2 billion. 

The cost of the most likely alternative is 

subject to abuse in the absence of proof that the 

second-best alternative will actually be built if the best 

is not. It's always possible to fmd a more expensive 

way to build any project or solve any problem. At the 

other extreme, the net benefit may be made as small as 

you like by comparing the project with an alternative 

that differs only by a slight modification. 

The cost of the most likely alternative method 

inherently assumes some project is justified from the 

outset because the cost of the second best alternative, 

which will be undertaken, is always more than the best 

alternative cost The assumption that certain levels of 

goods like hydropower or water supply are essential, 

voids much of the value of economic analysis. We 

might all "need BMWs" if costs were not a factor, but. 

most of us buy cheaper transportation and use the 

savings for other purposes. Thus, the assumption that 

power or water will be provided at any cost may be far 

removed from the reality of providing that power or 

water. The cost of the most likely alternative approach 

should be used only as a last resort. 

PROJECT BENEFITS 

The value of a Corps project is the value of its 

outputs to all members of society. We measure the 

value of those outputs by summing everyone's 

willingness to pay for them. This is the benefit 

standard for all project purposes, and it's what 

economic analysis tries to measure. 

In the following paragraphs, benefit estimation 

for several of the Corps' project purposes are presented 

in terms of the concepts developed above. What 

follows is neither a complete nor a rigorous treatment 

of benefit estimation. Instead, it is an attempt to show 

that current Corps NED benefit estimation procedures 

are consistent with the theory and concepts presented 

above. 

There is frequently more than one type of 

benefit for a project purpose. There may be more than 
one way to think about the problem, as well. For 

example, flood control benefits can include inundation 

reduction, location, intensification, and restoration of 

land value. Both consumers and producers may be 

affected by flood control. In the following descriptions 

a single, simple example is presented for flood control, 

navigation, and hydropower/water supply. 

FLOOD CONTROL 

Consider a market for a hypothetical service 

called flood plain living as shown in Figure 13(a). 

Without-project condition consumer and producer 

surplus or net benefits 19, aka social welfare, are shown 

as the shaded area. The quantity of flood plain living 

depends on the price of living in the flood plain. To 

understand the nature of flood control benefits we need 

only think about the price of flood plain land a little 

creatively. The price of flood plain living includes all 

the costs of living on the flood plain. One of these 

costs, in addition to purchase price, includes flood < 

damages that will be incurred while living on this land. 

Flood damages can be thought of as a tax 

levied by nature against homeowners on a random 

basis. In our example, the annual price of living on 

flood plain land is $2,500. For simplicity, let this 

include the mortgage payment of $1,500 and expected 

annual damages of $1,000. A flood control project 

eliminates some flood damages. Continuing the 

analogy, flood control lowers the cost of nature's tax to 

homeowners, thus shifting the supply curve down, as 

shown in Figure 13(b), and reducing the price to 

$2,25020. Social welfare with the project is given by 

the shaded areas. SOciety would, theoretically, be 

willing to pay an amount of money equal to the 

increased consumer and producer surplus they realize 

19 In this example there is no producer surplus because the supply 

curve and price line coincide. This is done to keep the example 

simple. 

20 As the cost/price of Ii ving on the flood plain decreases there 

would be a simultaneous increase in the value of flood plain land. 

The annual cost decrease that results from flood control is a benefit 

that would be capitalized in an increase in land prices. Hence, 

changes in the market value of flood plain land is a theoretical 

alternative approach to measuring this benefit. Identical willingness 

to pay estimates can be obtained from different markets under certain 

circumstances. See, for example, Section 4.4 of the Just, Hueth, and 

Schmitz text referenced in Appendix 1. 

30 

from flood protection in order to obtain the flood 

control. These surpluses are the shaded areas 

representing project benefits shown in Figure 13(c). 

All that is needed to measure flood control 

benefits for these homeowners are these hypothetical 

curve;l. Unfortunately, they do not exist. In the 

absence of a demand curve, it seems reasonable to 

assume that homeowners would be willing to pay up to 

the amount of income they would save by this project. 

What the planner needs is simply an estimate 

of the shaded areas. It is not necessary to know what 

total willingness to pay is or the existing consumer 

surplus values. We are only interested in changes that 

take place as a result of the project. 

Expected annual damages (BAD) are 

computed by Corps' planners to approximate part of 

these areas. Let there be 100 houses in this 

community, each with existing EAD of $1,000. 

Assume with-project damages are $750 per house, 

resulting in an inundation reduction benefit of $250 per 

house. If each homeowner would be willing to pay up 

to $250 for a $250 reduction in flood damages, then 

$250 per house times 100 houses or $25,000, provides 

a reasonable estimate of the rectangular portion of the 

increase in consumer surplus shown in Figure 13(c). 

That leaves the triangular portion of the 

change in consumer surplus to be explained. The 

decrease in effective price of living on flood plain land 

brings with it an increase in the quantity demanded 

The increase in consumer surplus that results can 

represent location or intensification benefits. In the 

case of location benefits, formerly undeveloped land 

is made developable. In the case of intensification 

benefits, developed land is used more intensively. For 

example, a family may be able to use their basement as 

livable space or a family may build an addition onto 

their home. 

21 It is a simple matter to demoustrate these benefits in terms of the 

supply and demand for flood plain land. In this case the supply curve 

remains the same but demand increases (i.e., shifts to the right) as a 

result of flood control. The changes in producer and consumer 

surplus are, conceptually, identical in magnitude. The difficulty with 

this approach is that it is not as easy to see the logic of using 

expected annual damage reductions as the proxy measure of project 

benefits. 
Q) 

u 

Q) 

u 

2.500 

100 

Figure 13(a) 

Flood Plain Bene~lts 

WithOut CcancUtlon 

_,y 

Quantity of Flood Plain Living 

Figure 13(b) 

Flood Plain Benefits 

WithOut Pr"OJect 

100 

WithOut CCtncIrtlon 

"'-"Ply 

With ConditIon 

8~1)' 

With Pr"OjKt Inc:rea.ae 

In f\Mt I!!Ierwf'lt8 

Quantity of Flood Plain Living 

Figure 13(c) 

Flood Plain 8ene~lts 

Change I n COnsumer 

100 

Change 1 n ConS;:Um&r 

Surplus Due 

Increased Q 

Quantity of Flood Plain Living 

31 
NAVIGATION 

Consider a navigation project that lowers the 

cost of transporting commodities by water. Deepening 

a coastal port or increasing capacity of a lock on the 

inland waterway could have this effect In both cases, 

the result is a decrease in unit costs. 

Assume the initial levels of consumer and 

producer surplus in the water transportation market 

shown in Figure 14(a). The result of the project could 

be to lower the costs of producing transportation 

services, thus shifting the supply curve to the right as 

shown in Figure 14(b). An increase in total consumer 

and producer surplus results. Figure 14(c) isolates the 

difference in the with- and without-project condition. 

These are the project benefits. Producers and 

consumers realize increased surplus for the original 

tonnage moved as well as a surplus increase for the 

new tonnage moved. 

If the supply and demand curves for 

transportation services are not available, the shaded 

area of Figure 14(c) can be approximated by estimating 

the difference in cost for each ton moved (roughly the 

vertical difference between the two curves) and the 

number of tons moved with and without the project. In 

the example, this is $1 for 1 million tons or $1 million, 

the area of the parallelogram. The surplus represented 

by the triangle results from increases in tonnage 

induced by the project For example, tonnage that 

could not move profitably at the price without the 

project, can now do so because of the decrease in costs 

of providing the transportation service. It should be 

noted, however, that although the P&G and Corps 

guidance allow consideration of project induced 

increases in traffic, such projections may be extremely 

difficult to support in actual planning studies. 

HYDROPOWER AND WATER SUPPLY 

In some cases, it is too costly or timeconsuming to estimate a demand curve for outputs, and 

the cost of the most likely alternative is used to 

estimate willingness to pay. This technique is 

frequently used for hydropower and water supply 

projects. 

For cqnvenience, assume the market for water 

in a project area is as shown in Figure 15(a). The 

supply curve shows the marginal cost of providing 

32 

varying quantities of water if the second-best 

alternative is buil~2. The price of water would be $2 

as shown. Construction of the best project lowers the 

price of water to $1. The area under the without 

condition supply curve is the cost of the second-best 

alternative. The area under the with condition supply 

curve is the cost of the best alternative. The shaded 

area represents the decrease in cost of supplying the 

water. This shaded area can also be interpreted as the 

increase in consumer surplus as shown in Figure 15(b). 

The change in willingness to pay is, thus, also given by 

the shaded area. 

Though the supply and demand curves may 

not be available, the change in consumer surplus can 

be approximated by the difference in cost between the 

alternatives. If the second-best alternative costs $1 

million more than the first-best alternative, it's 

reasonable to expect that consumers would be willing 

to pay as much as $1 million for the frrst best 

alternative. It would be irrational to pay more than this 

because the second-best choice would be cheaper than 

the frrst-best choice plus some amount of money in 

excess of $1 million. 

22 A horizontal supply auve implies a constant marginal cost of 

producing water. Such a curve is used to simplify the presentation. 
c: 

~ $2 

$1 

$2 

51 

Figure 14(a) 

Navigation Benefits 

1 Million 

Tonnage 

S 1 

Figure 14(b) 

NavIgation BenefIts 

Tonnage 

Figure 14(c) 

NavIgation Benefits 

Tonnage (MI I I Ions) 

33 

(WI Pr"Oject.) 

CWlO ProJecQ 
$2 

$2 

(I) 

U 

L 

0... 

$1 

Figure 15(a) 

Water Supply Benefits 

o 

1 Million 

Water 

Figure 15(b) 

Water Supply Benefits 

o 

Project Benefits 

1 

1 Mi Ilion 

Water 

34 

5 

(W/O Project) 

5 

(W/O PrOj ect) 

S 2 

(WI Proj ec:t) 
NEDVSRED 

Perhaps the most frustrating experience for 

any non-Federal partner is to hear that something she 

knows will be a benefit for her community is not 

counted by the Corps because it is RED, not NED. 

The local partner may see red, but she's not likely to 

see the distinction the Corps' planner is trying to make. 

Anything that increases the utility of an 

individual or firm is a benefit. The person's or firm's 

willingness to pay for that increase is the measure of 

the value of that benefit The distinction between RED 

and NED is a matter of perspective, not economics. 

RED stands for regional economic 

development. RED is never really defmed in any 

precise way by any of the Corps' past or current 

guidance. Perhaps the most informative statement on 

RED is the following one from the Principles and 

Standards of September 10, 1973 (see Appendix 2): 

" Through its effects--both 

beneficial and adverse--on a region's 

income, employment, population, 

economic base, environment, social 

development and other factors, a plan 

may exert a significant influence on 

the course and direction of regional 

development. The regional 

development account embraces 

several types of beneficial effects, 

such as (a) increased regional 

income; (b) increased regional 

employment; (c) population 

distribution; (d) diversification of the 

regional economic base; and (e) 

enhancement of environmental 

conditions of special regional 

concern." 

Benefit-cost analysis attempts to assess social 

benefits and social costs, i.e., benefit-cost analysis takes 

the public point-of-view. As stated at the outset of this 

chapter, benefits and costs depend on our defmition of 

society. The Federal objective in water resources 

planning is national economic development Under this 

objective, society consists of all U.S. residents. This is 

a matter of perspective and national policy, not 

economics. There is logical appeal to the notion that 

Federal dollars should be spent in the national interest 

35 

Corps' projects measure benefits and costs of 

all U.S. residents and only U.S. residents. If a Federal 

project induces a firm to leave one state to locate in the 

newly-protected floodplain of another state, the increase 

in regional income for the project area may well be a 

benefit to that area. Perhaps you think it should be 

included among project benefits. If, however, such 

effects are included as benefits, we must also include 

the loss of income in the state that loses the fnm as a 

project cost. This is necessary to be consistent with a 

perspective that values the benefits and costs of a 

project to all U.S. residents. In most cases, the project 

area's gain is another area's loss and the two effects 

represent a transfer of income that cancels out any net 

change23 

To the extent that a navigation project simply 

enables one port to lure traffic from another port is 

similarly a transfer. Corps guidance in navigation 

project evaluation is to include only net increases in 

traffic as project benefits. This is a policy consistent 

with the objective of national economic development 

It has long been recognized that foreign 

interests may benefit substantially from improvements 

to our Nation's coastal ports. These benefits are never 

quantified or considered in the decision process--not 

because they are not real economic benefits, but 

because from the national perspective, we are 

unconcerned about benefits in other countries. On the 

other hand, if a flood control project lured a foreign 

fnm to the project area, the increase in national output 

that results would clearly be a benefit to all U.S. 

residents. We would be unconcerned about the host 

nation's loss. 

23 Can increases in regional incomes be legitimately considered to 

be benefits? Sure, but losses of regional incomes mnst also be 

considered if we take a national perspective. As a practical matter, 

it is much simpler to simply ignore such transfers than it is to try to 

determine what net increases or decreases in willingness to pay for 

the firm's outputs might result from the transfer. However, there is 

no theoretical reason why the move of a firm from one state to 

another could not produce an NED benefit. As a practical matter it 

is quite difficult to estimate this benefit within the time and budget 

constraints of a typical study budget. As a practical matter such 

moves and related transfers are considered zero sum games. 
The above distinction between foreign and 

U.S. perspectives has its analogy when considering 

NED and RED perspectives. At the regional, state or 

local levels, the operational definition of society is 

different, because the perspective is different. There is 

nothing different about the economic principles we 

have considered. For value-based, i.e., normative 

reasons, local policy makers choose to take a 

perspective on benefits and costs that does not consider 

all U.S. residents. Instead they consider only the 

residents of their own "society". 

Thus, when a state is the non-Federal partner 

it would quite naturally be unconcerned about foreign 

interests, and interests in other parts of the nation. It 

would not be willing to contribute money to a project 

unless it were reasonably assured the benefits to its 

residents exceed the costs to the state. That people 

from another state will enjoy benefits from the 

construction of a reservoir is of little or no concern to 

a local partner who cannot charge for the benefits 

others receive. If a project induces a f11'lIl to move 

from one part of the state to another, there is no net 

gain for the state, and this will represent a benefit and 

equal cost that cancel each other. If a f11'lIl can be 

attracted from another state, however, that would 

represent a significant benefit in the eyes of the 

partner, though the Federal government sees it as a 

transfer. 

Likewise, if a city is the non-Federal partner, 

they could care less about benefits to anyone except 

their own residents. The city would, however, view 

attracting a f11'lIl from another part of the state as a 

benefit. From the state and national perspective, this 

is a simple transfer of benefits from one locale to 

another that generates a cost equal to the benefit. 

In a Federalist system, each level of 

government has certain areas of responsibility and 

concerns of particular importance to it. It is entirely 

appropriate that a local level of government be 

concerned only with the impacts on its residents and 

areas of concern. It need not be concerned with the 

effects of their projects on other governments or areas. 

However, it is entirely appropriate and consistent with 

the compensation principle mentioned in Chapter 2, 

that higher levels of government take a different 

perspective in guiding resource allocation decisions. 

Non-economists and economists alike can 

become befuddled in trying to determine what effects 

36 

constitute a transfer and what effects are net increases 

in outputs. There is no cure for this confusion. Life 

gets complicated sometimes. At such times, the best 

recourse is to return to the proper perspective and 

begin to think in terms of who is willing to pay for or 

to prevent the effect in question. 

PREVIEW TO CHAPTER 4 

This chapter has provided an introduction to 

NED benefit analysis using supply and demand 

relationships to develop the notions of consumer and 

producer surplus that are the basis for social welfare 

and NED benefits. In Chapter 4, the emphasis turns to 

consideration of NED costs. The chapter devotes 

considerable space to developing cost concepts that are 

helpful in understanding the NED cost concept and 

issues related to it. 
Chapter 4: NED COSTS 

INTRODUCTION 

Cost analysis plays a central role in water 

resource planning because virtually every management 

decision requires a consideration of costs. Study costs, 

design and formulation trade-offs, project costs, 

benefits and costs--in each case critical decisions 

depend on costs. In this chapter we examine a number 

of cost concepts. Costs are presented in three major 

sections. First, economic concepts of cost are 

presented followed by specific NED cost concepts. 

The chapter concludes with a brief discussion of 

project financing costs. 

Economists are interested in interest during 

construction. Design engineers are interested in the 

costs of concrete and steel, not in interest during 

construction. Local partners care about their share of 

costs and their debt service on these costs and litde 

else. Every player in the planning process cares about 

costs. Frequently the costs they care about are of little 

or no interest to other players. The apropos cost 

concepts depend on the context of the decision process. 

Figure 16 is a stylized illustration of both the 

independence and interdependence of the economic, 

NED and financial cost concepts addressed in this 

chapter. 

Each conceptual context has jargon uniquely 

its own. These are represented by the areas a, b, and c. 

For example, economics is concerned with marginal 

costs; NED with associated costs; and, finance with 

fully-funded costs. Nonetheless, there is considerable 

cross-over in concept, if not always in jargon. For 

example, the costs of a pump station are relevant for 

all three conceptual contexts as indicated by the 

commonality of area g in Figure 16. 

Whatever their nature, all costs involve a 

sacrifice of some kind. If you must give up something 

in order to get something else, you incur a cost What 

you give up may not always be measured in money. 

It may not even be tangible. In the following sections 

three conceptual contexts are offered and though each 

Figure 16 

Cost Concepts 

A I I Cost Concepts 

37 
has its own jargon and role in the analysis none of 

them can stand alone. 

ECONOMIC COST CONCEPTS 

RELEVANT COST 

Cost can be defmed any number of ways. 

Costs are incredibly complex, with all kinds of 

accoWlting, economic, fmancial, engineering and legal 

implications. There frequently is controversy over the 

nature of costs, how they are defmed, and what costs 

are relevant for decision making. Most of the 

controversy evaporates once it is realized that different 

decision problems require different cost information 

and that the necessary cost information varies from 

situation-to-situation. 

In everyday usage, cost generally refers to the 

price paid for an item. For non-Federal partners 

fulfilling fmancial and legal reporting requirements, the 

actual dollar amount spent on labor, materials, etc., 

may be relevant. For many purposes actual historical 

dollar outlays are sufficient. For planning and resource 

management decisions, however, historical costs may 

not be relevant Current and projected future costs are 

usually more important. 

For example, consider a foresighted nODFederal partner who earlier stockpiled "rip-rap quality" 

rock at the cost of $50,000 for hauling the rock away 

during excavation for a highway. If that rock, now 

needed for project construction, would cost $1.5 

million to acquire today, what cost should be assigned 

to the rock for the project? The partner would have to 

pay $1.5 million to replace the rip-rap it has, or he can 

sell the rip-rap for $1.5 million if he elects not to use 

it on the project. Therefore, $1.5 million is the 

relevant cost of the rip-rap, even though $50,000 may 

be the cost of the rip-rap for fmancial reporting 

purposes. 

Relevant cost is somewhat subjectively defmed 

as any cost that will make a difference in a given 

decision process. The notion of a sacrifice or an 

alternative use for resources is crucial to the 

understanding of relevant costs. The Federal 

government has indicated that for purposes of 

evaluating the economic feasibility of water resource 

projects, NED costs are the relevant costs. 

38 

OPPORTUNITY COSTS 

The term "opportunity costs", first introduced 

in the Chapter 3 discussion of supply curves, expresses 

the idea that relevant costs of a resource are determined 

by its value in the best alternative use. Opportunity 

cost is the cost of forgoing certain opportWlities or 

alternatives in favor of pursuing others. Wben marl.cets 

are competitive, opportunity costs of resources equal 

their marl.cet prices. 

When the Corps uses reinforcing steel to build 

a project. it bids against alternative users of the steel. 

The cost of that "rebar" is determined by its value in 

alternative uses. The Corps must pay a price at least 

equal to the value of this steel in use for other 

construction projects, automobiles, airplanes, ships, 

cookware, etc. If the steel manufacturer can get better 

value by using the steel in another way, she will do so. 

The P&G defme NED costs as opportWlity 

costs of resource use. Economists look at costs 

differently than do most people, especially accountants. 

Concerned primarily with the efficient allocation of 

resources, economists defme costs as opportunity costs. 

A couple of examples will help illustrate how 

economists and others see costs differently. 

Say you pay $35 for a ticket to a sold-out 

concert. On the way in to the concert. you are offered 

$100 for your ticket by a rabid fan. "How much did 

the concert cost?" a friend asks the next day. "Thirtyfive dollars," you respond, remembering what you paid 

for the ticket "Wrong!" says the economist. When 

you were offered $100 for your ticket. you had the 

opportunity to take $100 or see the concert You chose 

the concert and it cost you the opportunity to make 

$10024. Though you did not have to write a check for 

$100 to see the concert. the concert cost you $100 as 

surely as if you had. 

24 You made $100 only to the extent that the original purchase price 

is regarded as a sunk cost and no longer relevant to the decision to 

sell to the person bidding for your ticket. Perhaps a more intuitive, 

though less satisfying theoretically, explanation is that going to the 

concert cost you $35 for the ticket and a $65 profit for a total cost 

of $100. 
Let's consider another example. Say you 

make $40,000 per year in your current occupation but 

always wanted to work for yourself. You quit your 

job, open a donut franchise and have sales of $300,000. 

After you pay rent, franchise fees, your employees, and 

various other bills, you have $35,000 left over. Your 

accountant says you made $35,000 profit Your 

economist says you lost $5,000 last year. The 

difference lies in how costs are defined--the relevant 

costs. The accountant sees anything you pay to another 

as a cost of doing business. Thus, after these costs are 

paid, whatever is left over is your profit 

The economist recognizes your time as -a 

resource that could be used in many ways. Presumably 

you choose to use it in the best way, as entrepreneur of 

a franchise. You forego the opportunity to make 

$40,000 in your prior occupation. This $40,000 is the 

opportunity cost of your time and a cost of doing 

business. You end up with lost income of $5,000 

because of your choice. The facts of the case art~ 

invariable; it is a matter of how one looks at the faC'iS. 

What have at times been referred to as 

"disbenefits" or "negative benefits" are generally 

nothing more than opportunity costs. The loss of 

recreation benefits from a reallocation study is a cost 

to society. This impact should be included among 

project costs rather than as a reduction in project 

lJenefits. 

EXPLICIT AND IMPLICIT COSTS 

Opportunity costs involve comparisons with 

foregone opportunities. Foregone opportunities can 

frequently involve costs that never show up in an 

accountant's records. Thus we make a distinction 

between explicit, or out-of-pocket, costs and implicit, 

or noncash, costs. 

When someone reaches into his pocket for 

cash or writes a check, it is very easy to recognize 

these explicit expenses as costs. Implicit costs do not 

involve cash and are often overlooked in decision 

analysis. Since cash payments are not made for 

implicit costs, the opportunity cost concept must be 

used to measure them. 

An example will help to illustrate the nature of 

iulplicit costs. If I borrow $75,000 at 10 percent to 

build a ring levee around my home, I have an explicit 

39 

interest cost of, for simplicity, say, $7,500 per year. If 

my neighbor builds the same ring levee, and pays cash 

for it, does that mean that the cost of the levee is 

greater for me than for my neighbor? For decision 

purposes, the answer is no. Though I have higher 

explicit costs, the true costs, implicit plus explicit, are 

the same for both of us. If my neighbor was earning 

10 percent interest on his money, or could have earned 

10 percent interest by lending it to me, then she has an 

implicit cost of $7,500 per year. The levee costs each 

of us $7,500 per year. I write a check for $7,500 each 

year, my neighbor forgoes the opportunity to earn 

$7,500 each year. 

More familiar implicit cost examples for many 

Corps planners are interest during construction and the 

value of land in a project. There is no actual 

expenditure of funds to cover interest during 

construction. Land necessary for the project and 

owned by the non-Federal partner will not entail any 

explicit cost for acquisition. There is an implicit cost 

for using the land, however. The land once committed 

to the project can no longer be used in any alternative 

fashion. The implicit cost of the land depends on its 

opportunity cost, i.e., its value in its next best use. If 

the land is developable, its implicit cost could be great. 

If the land is open space, its implicit cost might be the 

value of the recreation output it no longer will produce. 

In other cases the implicit cost will be minimal. 

ECONOMIC VERSUS FINANCIAL COSTS 

The distinction between economic and 

financial costs is primarily, though not entirely, based 

on the distinction between explicit and implicit costs. 

Economic costs are all explicit and implicit 

opportunity costs. Financial or accounting costs are 

generally considered to be explicit costs or actual 

expenses. 

It is possible that any of the three possibilities 

in Figure 17 will exist for a given project. Economic 

costs may equal, exceed, or be less than fmancial costs. 

The most common case is that economic costs will 

exceed fmancial costs. It is possible, however, that 

financial costs will exceed economic costs, i.e., explicit 

costs exceed explicit plus implicit opportunity costs. 

Economic and fmancial costs are considered again in 

Chapter 6. 
F gure -17 

Econom c and Finane al Costs 

Economic Costs 

Economic Costs 

Economic Costs 

Labor that would have been otherwise 

unemployed may have a fmancial cost that exceeds it<; 

econoVtic cost. In a competitive market, the wage of 

labor ·represents the opportunity cost of that labor. 

When people would have been unemployed without the 

project, the wage overstates the opp+nity cost of 

their time. Opportunity cost is not *ro, because 

people presmnably do something with ¥ir time that 

has value to them; but it is not the full wage either. 

The Corps' current policies on uneHfployed ~r 

underemployed labor resources, formerly called 

redevelopment benefits, is based on this divergence4tl 

=~ru (markct prices) and ~omic (~~ 

INCREMENTAL AND SUNK COSTS 

Incremental costs are another essential 

dimension to the concept of relevant costs. When a 

decision has to be made in which costs are a factor, 

only those costs that will change as a result of the 

decision need to be considered. Incremental costs are 

costs that vary with the decision, and they are the only 

relevant costs of the decision. 

Incremental costs are similar to marginal costs 

in that they vary with the decision. The major 

difference is that marginal costs are normally 

associated with an arbitrarily small or unitary change 

in output while incremental costs are conSiderably 

broader. It embraces any change in the total cost of 

producing output. Marginal costs are a subset of 

incremental costs. 

40 

F nanc al Costs 

F nanc al Costs 

F nanc al Costs 

Incremeutal costs may relate to changes in 

costs that arise from any aspect of the decision 

problem. For example, the cost of iucluding a river 

reach in a flood control project entails a large discrete 

jmnp in costs that is more properly an incremental 

change in costs rather than a marginal change. 

Incremental costs include all costs affected by a 

decision. Future as well as current costs must be 

considered and opportunity costs must not be ignored. 

Inherent in this definition of incremental costs 

is the fact that any cost that is not affected by the 

decision is irrelevant to that decision. Costs that do not 

vary across alternatives are labeled sunk costs. Sunk 

costs play no role in determining the optimal course of 

action. Corps' budgetary analyses frequently require 

an analysis of the remaining benefits and remaining 

costs of a project. In these exercises costs already 

incurred, or sunk costs, are ignored. 

TOTAL AND MARGINAL COSTS 

For any level of output, total costs (TC) are 

defined as the smn of fIXed costs (FC) plus variable 

costs (VC). Total costs, then, are a function of output 

and the prices of the inputs used to produce it. Fixed 

costs are the costs of production that do not vary with 

the quantity of output produced. Variable costs do 

vary with the amount of output produced. Both fIXed 

and variable costs depend on input prices. 
Fixed and variable costs are relevant concepts 

for certain benefit categories. For example, if a flood 

makes it impossible to use a building for a month, 

society loses the use of capital resources including the 

building. The value of the building capital is 

approximated by the fixed cost of the building, whether 

they are explicit or implicit. If flood protection would 

eliminate this damage, the value of the prevention of 

this lost resource is the monthly fixed costs in a 

competitive marke~5. 

A second example is increased fish catch as a 

project benefit It must be borne in mind that the 

benefit of the catch is the income net of variable costs 

incurred in catching that fish. In this example fixed 

costs are irrelevant; they would not change whether the 

additional fish are caught or not. 

Perhaps the most important economic cost 

concept is that of marginal cost. Marginal cost is the 

change in total cost that results from producing one 

more unit of output. Since fixed costs don't change 

with the level of output, marginal costs are the change 

in variable costs incurred to produce one more unit of 

output. Marginal cost is a significant concept in 

resource allocation decisions and it is taken up again in 

Chapter 6's discussion of marginal analysis. 

NED COSTS 

The relevant costs for project evaluation have 

been determined by policy to be NED costs. NED 

costs are defined as follows: 

"Resources required or displaced to 

achieve project purposes by project 

installation and/or operation, 

maintenance, and replacement 

activities represent a NED cost and 

should be evaluated as such. 

Resources required or displaced to 

minimize adverse impacts andlor 

mitigate fish and wildlife habitat 

25 Once again it is important to understand that economic costs 

mean opportunity costs, i.e., explicit plus implicit costs. For example, 

if a company owned its building, its explicit fixed cost might be 

Illodest, perhaps limited to insurance and taxes. But, if its building 

could be reuJed for $5,000 per month, then implicit fixed costs must 

include the amount of the rent foregone by the company. Thus, fixed 

costs should include all costs, explicit and implicit. 

41 

losses are also NED costs. Costs for 

features not required for project 

purposes, avoiding adverse effects, 

andlor mitigating fish and wildlife 

habitat losses are not project-related 

NED costs and should not be 

evaluated." ... Economic and 

Environmental Principles and 

Guidelines for Water and Related 

Land Resources Implementation 

Studies, p. 97, March 1983 

The definition is not so much based on economic 

theory as it is on the perspective of the decision 

makers. The last sentence in the above excerpt says 

that some opportunity costs connected with the project 

will not be considered as NED costs. This is a policy 

decision entirely within the discretion of the policy 

makers. It has the effect of separating NED costs from 

opportunity costs in certain situations. Insofar as NED 

costs are purported to be opportunity costs, these policy 

exceptions can confuse analysts and the public. 

NED costs are not defmed on the basis of who 

incurs the cost. For example, NED costs may be 

incurred by the Federal government, any non-Federal 

level of government, by individuals, or society in 

general. The primary contribution made by the P&G 

definition of NED costs is to identify and defme 

specific examples of fixed and variable opportunity 

costs associated with Corps projects. 

The distinctions economists make among 

costs, the subject of preceding sections of this chapter, 

are for the most part unnecessary in discussing NED 

costs. The NED costs are divided into 

implementatitm outlays, associated costs, and other 

direct costs. Examples of these costs are provided in 

terms of the resources used and costs incurred to 

produce a typical Corps project. 

"NED cost" is not an economic concept. The 

definitions of various cost categories presented in the 

P&G are more policy directives than sound economic 

definitions, and in some instances NED costs may not 

be the opportunity costs they profess to be. 

This fundamental confusion in defming costs 

arises from slight differences in determining relevant 

costs for the decision situation. From an economist's 

point of view, opportunity costs are always the relevant 

costs. Policy makers are free to depart from the 
economist's perspective and at times they do so in the 

P&G. 

In some cases, analysts are directed to use 

current bid items and market values. An economist 

would argue that if a monopolist is offering the bid for 

an item or if there is a discrepancy between the market 

price and opportunity cost, then following this guidance 

will yield NED costs that are not opportunity costs. 

P&G's suggestion that actual costs incurred 

for similar activities for similar projects be used as cost 

estimates, could lead to similar divergences between 

NED costs and opportunity costs if market conditions 

change between the time andlor location of the actual 

cost estimate and the project construction under 

consideration26. 

Implementation outlays, as defmed by the 

P&G, are primarily based on market values and 

opportunity costs. Curiously, they appear by title to 

preclude the inclusion of implicit costs which are an 

important part of opportunity costs27. 

Associated costs are a subset of costs over and 

above the "project costs" necessary to realize the 

benefits; they are usually, but not necessarily, nonFederal costs. The distinction between implementation 

outlays and associated costs is rather artificial from an 

economic theory standpoint. From a purely economic 

sense, project implementation costs would include the 

costs of all inputs necessary to produce the project 

outputs or benefits, regardless of by whom they are 

paid. 

26 The spirit of P&G Section XII NED Costs is one of consistency 

with sound economic principles. Whether the fact that the P&G 

directs analysts to adjust some market values when necessary but 

fails to direct this adjustment for all categories is one of simple 

oversight or policy intent is an argument beyond the scope of this 

manuaI. 

27 NED relocation costs associated with the Uniform Relocation 

Assistance and Real Property Acquisition Policies Act of 1970 are to 

include only housing costs for replacement in kind. Costs in excess 

of this are to be tre~d as financial costs for nonproject purposes. 

Thisis a policy exception that conflicts with economic principles. An 

economist wonld argile that the entire cost of the replacement 

housing shonld be included among the economic costs of the project 

and the benefit measured by changes in willingness to pay for the 

improvements, which could well exceed the costs of improvements, 

would constitute a valid benefit. 

42 

The NED distinction between implementation 

outlays and associated costs appears to be based on the 

identity of the party that incurs the cost 

Implementation outlays appear to be the responsibility 

of the Federal government and the non-Federal partner, 

while associated costs frequently, but not always, are 

the responsibility of the non-Federal partner or a third 

party. A Soil Conservation service project necessary 

for the Corps project'S benefits to accrue is an example 

of an associated cost that is a Federal responsibility. 

ER 1105-2-100 indicates that if the associated 

costs of a project can be recovered through user fees or 

other revenues generated by the resources purchased 

through the associated costs, they can be excluded from 

NED costs. For example, associated costs of a 

navigation project may include new docks and 

terminals needed for with but not without-project 

conditions. Often there is a revenue (benefit) stream 

that would accrue to these features. If the revenue 

stream has been incorporated into the benefit analysis, 

NED costs must include the associated costs. If the 

revenue stream is not incorporated, an analysis is 

needed that demonstrates the revenue stream is 

adequate to cover the costs to omit both revenues and 

costs from the NED analysis. 

The NED category "other direct costs" is 

defined more by example than sound economic criteria. 

Other direct costs appear to be comprised primarily of 

implicit costs of a project. Even this interpretation is 

not entirely adequate because some examples include 

explicit costs to others. For example, increased water 

supply treatment costs are explicit costs of the project 

that do not fit neatly into either of the other categories. 

However, from an economic standpoint they are all 

opportunity costs of the project. 

FINANCING THE PROJECT 

No matter how many net NED benefits a 

project produces, the project will not be bnilt unless 

someone is willing and able to fmance project 

construction. The fact that a community has the funds 

to build a project does not mean that it should be built 

On the other hand, that a project produces net benefits 

is no assurance that it will be built. 

Economic analysis answers the questions: 

should the project be built? should it be built this way 
or that? should it be built all at once or in 

stages? when should it be built? etc. 

Financial analysis answers the questions: 

who should pay the project costs? what 

are the payment obligations? can they 

meet the payment obligation? In the 

public's mind, financial analyses that 

address willingness and ability to pay for 

a project are viewed as serving the 

function of economic analysis; they do 

not. While there can be considerable 

overlap in the data, terminology and 

methods of the two types of analysis, they 

are conceptually different. 

Nonetheless, the need to pay for 

a project produces a unique and important 

perspective--that of the project sponsor(s), 

especially the non-Federal partner. In 

order to respond to this newly evolving 

perspective, it has been necessary to 

identify a new taxonomy of cost 

terminology. There are some financial 

cost concepts whose working definitions 

are evolving still. Baseline costs, 

authorized costs, fully-funded costs and 

maximum costs are but a few examples of 

these evolving terms. 

PREVIEW TO CHAPTER 5 

This chapter has provided an 

introduction to many cost concepts 

necessary to understand an NED cost 

analysis and completes the manual's 

presentation on benefits and costs. In 

Chapter 5 the emphasis turns to a few 

specific economic concepts of particular 

interest to Corps analysts and planners. 

These include marginal analysis which is 

the basis for designating the NED plan; 

with- and without-project conditions and 

there role in NED analysis; and, the 

value of time saved, a project effect of 

growing interest. 

L 

(IJ 

a. 

m 

L 

It! 

-

g :-;.iI";";';+-~,-Costs of Land-Side Development 

$3 

Mil lions of Tons of cargo 

43 
44 
Chapter 5: SELECTED TOPICS 

MARGINAL ANALYSIS 

MAXIMIZING NET NED BENEFITS 

The NED plan is described as: 

"A plan that reasonably maximizes 

net national economic development 

benefits, consistent with the Federal 

objective .. " ... Economic and 

Environmental Principles and 

Guidelines for Water and Related 

Land Resources Implementation 

Studies, p. 7, March 1983 

11I!tti~PI@fl'Qt.aXiniizes net benefits, but not 

•• )I~t1tlelllefits ti1aximized are only 

source of frustration and 

non-Federal interests more 

~~l~Illcet.N_~giOinalbenefits than national benefits, 

YtIlMf,gmat analysis is a necessary ste) 

X'~JlID;imiziIlg net NED benefits. 

MARGINAL THINKING 

Consider the following question. Planners 

formulated a flood control plan protecting 1,000 

identical structures at a total cost of $1 million, or an 

average cost of $1,000 per house. Benefits average 

$900 per house. Net benefits are -$100,000 and the 

project is unjustified. The study team economist has 

determined that if 500 more homes are protected, the 

benefits from these homes average $500 each. It is 

impossible to provide protection just to these homes 

because of the topography, i.e., these additional homes 

cannot be protected unless the first 1,000 homes are. 

Should the extra houses be protected? 

On first glance this appears to be a bad deal. 

Thus far, the average cost per house is $1,000 and the 

plan is already unjustified. On an average cost 

calculation, how can the plan be improved by 

protecting houses that yield even less benefits than 

those already protected? Aren't these additional houses 

just going to add -$500 each to net benefits? Not 

necessarily, and that is exactly the point! 

45 

Table 1 shows the relevant information for the 

initial plan formulated. Total costs were $1 million, 

and average costs were $1,000 per house. Missing is 

the most important piece of £Q.§! information. How 

much will the total costs change if we protect these 

500 houses? 

Assume the study team determines that each 

additional house can be protected at a marginal cost of 

$200 per unit. i.e., total costs will increase $200 for 

each house protected. In deciding whether to protect 

the additional houses, the only relevant cost is the 

marginal cost. Average costs are irrelevant. Total 

costs, while they cannot be ignored for long, have no 

place in this decision process. 

Knowing the marginal cost of each house is 

$200, should it be protected? To answer that question 

we need one more piece of information. What are the 

marginal benefits of the house being added--that is, 

how much will total benefits change if we protect one 

more house? Average benefits and total benefits are 

irrelevant to the question of adding 500 houses to the 

protected area. The marginal benefit of each house is 

$500. Add a house to the protected area and it not 

only covers the cost of protecting that house, it yields 

a net marginal benefit of $300 ($500 in marginal 

benefits less $200 in marginal costs) that can be used 

to offset the -$100,000 in net benefits from the Original 

1,000 houses we have conveniently assumed are 

necessary to the larger project. 

Table 2 shows the project benefit summary 

after adding houses with benefits below average costs. 

Total benefits now exceed total costs. The moral of 

the story? Any individual or group, such as a study 

team, that must make economic choices for the use of 

scarce resources should use marginal analysis. 

In any decision to expand an output, whether 

it be from the without-project condition to the smallest 

feasible project or from one level of protection to the 

next, it is always the marginal costs and the marginal 

benefits that are the relevant values. Calculations 

based on average costs and benefits are likely to lead 

decision makers to miss all sorts of opportunities, some 

of them critical. Optimal decisions, identification of 
Table 1 

Initial Plan Formulation 

Total Cost $ 1~000~Ooo.0 

Cost/ Str ucture 

Total Benefits 900~OOo.0 

Benefits/Structure 900.0 

Net Benefits C100~OOO.0) 

BCR 0.9 

Table 2 

Final Plan Formulation 

Total Cost $ 1~100~000.00 

Cost/ Structure 733.00 

Marginal Cost 200.00 

Total Benefits 

Benefits/Structure 767.00 

Marginal Benefits 500.00 

Net Benefits 50~OOo.00 

Marginal Net Benefit 300.00 

BCR 1.05 

46 
the NED plan among them, must use 

marginal analysis. 

RELEVANT COSTS AND 

BENEFITS 

Marginal costs are generally 

considered to be the change in total 

costs that results from increasing the 

output by one more unit. Likewise, 

marginal benefits are the change in 

total benefits by increasing the output 

by one more unit. Corps planners 

rarely have the lUxury of designing 

plans that protect one more structure, 

pass one more ton of cargo, generate 

one more kilowatt of energy or provide 

one more acre-foot of water. Projects 

are more likely to vary by discrete 

jumps in project scale. Levees one 

foot higher, a channel five feet deeper 

or 100 feet wider, etc. 

The principle of marginal 

analysis remains the same. The 

interpretation is perhaps more familiar 

to Corps planners in tenns of 

"incremental costs and benefits". 

Incremental analysis is the tenn used 

when the changes in project outputs are 

more than marginal, more than 

increases or decreases of one at a time. 

Figures 19, 20 and 21 show 

the relationships among total costs and 

benefits, marginal costs and marginal 

benefits, and marginal net benefits 

using the data from the wheat example 

of Chapter 3 and Figures 6 and 7. 

Each of the figures shows that the 

optimal quantity is 8,000 bushels of 

wheat. 

47 
32 

30 

28 

26 

2<4 

22 

20 

III 18 

la ,. 

a , .. 

12 

10 

3.5 

2.5 

III 

la 

a 1.5 

0.5 

o 

.. 

3 

2 

Ul 

... 0 It! 

a -1 

-2 

-3 

-.. 0 

Flgur-e 19 

Total Costs and Total Bene~lts 

MDlIMIft ""-t. """""tII 01. 

3 .. 6 7 6 10 11 12 13 ,.. 15 16 

QO Q. 

QuantIty 

Flgur-e 20 

Mar-glnal COst and Mar-glnal Bene~lts 

S 6 7 8 9 1[] 11 12 13 1-4 1S 16 

3 .. 

QuantIty 

Flgur-e 21 

Mar-glnal Net Bene~lts 

S 6 7 8 9 10 11 12 13 ,.. 1S 16 

QuantIty 

48 
WITH- AND WITHOUT -PROJECT 

CONDITIONS 

NED benefit estimation in the Corps' planning 

process proceeds by comparing forecasts of economic 

conditions without the project to forecasts of economic 

conditions with the project, a subject taken up again in 

the next chapter. Hence, identification of reasonable 

with- and without-project conditions is a critical step in 

the planning process. With this much we can all agree. 

The problem comes in defining what is "reasonable". 

Economics offers its principle of economic 

rationality to help defme what is reasonable. Pragmatic 

definitions of reasonableness are also dependent upon 

current guidance and policy, a host of formulation 

issues, and considerations unique to each planning 

study. Economics is, nonetheless, an important 

component of the working defmition of reasonableness 

and is the only subject of this section. 

ECONOMIC RATIONALITY 

Economists assume people make choices and 

act in their own self-interest. As individuals they 

maximize their utility. As frrms, they minimize costs 

and maximize profits. In the Corps' planning context, 

it may be convenient to add that planners maximize net 

benefits. Behavior that violates these assumptions is 

economically irrational and should not be part of any 

without or with-project condition forecast. A general 

recognition of the fact of scarcity also implies that 

blatant inefficiencies of any kind are irrational. . : . 

Economic behavior is npt the only kind of 

behavior that people exhibit, however. Laws frequently 

prohibit behavior that certain people would find in their 

personal interest. Restraint of trade and unregulated 

monopoly power are two ways to increase profits that 

have been heavily regulated in the U.S. Thus, there 

may well be valid reasons why ec,onomically irrational 

behavior can be observed in reality. In such cases, it 

is wise to address the rationale for that behavior in 

sufficient detail to convince the critic of its pragmatiC 

rationality. 

49 

WITH AND WITHOUT IN THE LONG RUN 

The Corps' period of analysis frequently 

extends to 100 years. Change is the only constant in 

such a time period. Forecasts of economic variables 

should be made with a long run perspective appropriate 

for such a planning horizon. 

Corps' planners must forecast commodity 

shipments, fleet composition, flood plain conditions, 
and countless other variables when describing the 

without- and with-project conditions. It is inevitable 

that deviations from these forecasts will occur, often 

even before the study is completed. Some of these 

anomalies will be due to errors in the forecasts; others 

will be due to short run deviations from the long run 

trend. 

Stepping back from the content of the study 

and considering the process itself, it makes no 

economic sense to alter the long run forecast for every 

short term aberration in a variable. Before a large 

flood damage survey can even be completed, it is 

almost inevitable that uses for some of the land and 

structures in the survey will have changed. Families 

move, businesses expand, businesses fail, people die, 

conditions change. It is naive to think that individual 

changes in structure use, warrant a new flood damage 

survey. 

From an economic perspective, it is far more 

reasonable to try to place the current level of 

development in some long run perspective than it is to 

worry about whether a building is used as a book store 

or a florist shop, even though the damages may differ 

substantially between the two. For example, a flood 

damage survey conducted during the depths of a 

recession may be unrepresentative of the economic 

conditions that will prevail for the majority of the flood 

plain's next 100 years. If so, it should be adjusted. 

The without- and with-project forecasts should 

be long run forecasts that avoid giving disproportionate 

weight to short run events. 

VALUE OF TIME SAVED 

Time savings are a frequent benefit of water 

resource projects. Flood control projects prevent the 

loss of roads or bridges that could disrupt 

transportation patterns for extended periods of time. 

Navigation projects can shorten delays at locks or 

prevent delays caused by one-way traffic through 

narrower channels. Recreation projects may shorten 

the travel time for users of the project. In these and 

all other cases, the principle to be used is to evaluate 

the saving of travel time as the amount of money that 

the beneficiaries of the saving would be willing to pay 

to obtain the saving. 

50 

Time saving is valuable because it frees time 

for alternative uses. To properly evaluate time saving, 

it is important to specify the alternative use to which 

the time saved will be put. In a broad sense, time 

saved may be spent working or in leisure. 

In a competitive economy, in which firms are 

able to make productive use of the time saved from 

traveling, the value of the time saved is the value of 

the increase in output made possible by the time saving 

or the wage rate. The appropriate wage rate to use is 

the gross wage rate, or before tax wage, since, in a 

competitive economy, that is the value of the marginal 

product of labor. The wage rate is the opportunity cost 

of labor. In many cases, resources other than labor are 

saved as a result of the project. For example, as tows 

are queued to pass through a lock they consume diesel 

fuel and deteriorate their capital equipment as time 

passes. These resource losses may be reduced by a lock 

rehabilitation. In such cases, the value of the resonrce 

losses prevented may be included among the value of 

the time savings. 

Some of the travel time saved may be used to 

increase leisure time. Time saved commuting to and 

from work may be used entirely at home in non-work 

activities. The problem with measuring the value of 

leisure time that replaces travel time is that the value 

of leisure time is not reflected in any market prices. 

The wage rate does not accurately reflect the 

value of leisure time. An individual allocating her 

travel time saved between work and leisure will choose 

work if the value of the wage (in this case, the aftertax wage) plus the benefits of working an hour (for 

many, if not most, people these benefits would be 

negative) exceeds the value of an hour of leisure. 

Let's assume our individual is allocating her 

time at the margin so the benefit of taking more leisure 

time (MBI) just equals its opportunity cost, i.e., the 

foregone wage payment (w) and the foregone benefits 

of working (MBw). In mathematical terms: 

(3) MBI = w + MBw 
Since few people work without jay, we can reasonably 

assume that MBw is negative2 . This being the case, 

we expect the marginal benefit of leisure time to be 

less than the wage. 

For example, suppose the marginal hour is 

time and one half overtime paying $18 per hour. 

Staying another hour has a dis utility of say -$4, i.e., in 

this case MBw = -$4. If the marginal benefit of having 

that hour off is $12, our worker will take the overtime. 

She will continue to take overtime up to the point 

where equation (3) holds. With each additional hour we 

can expect that the disutility of staying longer grows 

more negative and the MBI grows larger. 

Additional complications arise when you 

consider adults who are retired, students, children and 

others for whom equation 3 is not relevant. 

This doesn't quite capture all the opportunity 

cost of savings in commuting time, however. 

Presumably, there is some utility or disutility to the 

actual commute. The value of a reduction in 

commuting time (Rc)' is the value of the leisure time 

(MBl) less the marginal benefits of commuting (MB d 

or: 

Substituting equation (3) for MBI into this 

equation yields: 

Since we expect the marginal benefits of work and the 

marginal benefits of commuting time foregone to be 

negative, we have the wage rate plus a negative value 

minus a negative value. Thus, the right hand terms in 

the above expression are positive, negative, and 

positive, respectively. Rc' the benefit of time savings 

we seek, will be less than the wage rate as long as 

MBc>MBw· 

28 It is entirely possible that MBw is positive. If this were not so 

there would be no volunteer labor. A rational individual who values 

her leisure at all will not willingly work for a zero wage unless the 

work itself provides satisfaction, i.e., MBw > o. 

51 

Thus, the value of leisure time may be more 

or less than the wage rate depending on the 

individual's utility or disutility from her job and 

commute. 

Several attempts have been made to fmd Rc 

indirectly. The usual method is to run regressions 

relating the proportion of trips taken by one of two or 

more alternative modes of transportation to differences 

in time cost, differences in money costs and any other 

differences between the modes considered to be 

significant. 

PREVIEW TO CHAPTER 6 

This chapter has provided discussion on the 

use of economic principles in areas of particuIai: 

interest to planners and analysts involved with NED 

analysis. Chapter 6 draws on the material and concepts 

in the preceding chapters to illustrate examples of NED 

analysis in specific settings familiar to Corps analysts. 

It begins with a look at discrepancies between fmancial 

and economic costs followed by a discussion of land in 

the with-project condition. The chapter continues with 

a look at the importance of long run vs. short run 

analysis followed by drawing some distinctions 

between national and regional economic development. 

The chapter concludes by considering the· economic 

basis for potential GNP benefits. 
Chapter 6: SELECTED 

APPLICATIONS OF NED 

PRINCIPLES 

INTRODUCTION 

In this chapter, the economic concepts 

presented earlier in the manual are applied in several 

Corps-specific settings. The purpose of the chapter is 

to illustrate the use of the concepts. 

FINANCIAL AND ECONOMIC COSTS 

Chapter 4 provides a discussion of financial 

and economic costs built around basic economic 

concepts. In essence, if you have to pay cash or write 

a check for something, it's a fmancial cost. Price is 

the usual measure of financial cost. Economists see 

costs a little differently. Cost has to do with 

comparing options, not with evaluating a single option 

by itself. Cost is that opportunity which must be 

foregone to use resources in a given way. Economic 

costs are opportunity costs and they may include 

explicit and implicit costs. If a resource has no 

alternative uses, it has no cost in use. 

Benefit-cost analysis is based on economic 

costs. Local cooperation agreements and contract 

awards are based on financial costs. Because the two 

costs differ, there is frequently much confusion about 

what "the" costs of a project are. The confusion 

emanates from differences in perspective that the 

various parties of interest fail to recognize. One 

perspective is--is this project an efficient use of scarce 

resources. The second perspective is--what's it going 

to cost to build this project? 

Corps analysts iIte frequently faced with 

sitqations that perplex new analysts and the public. 

Some of these examples are considered in this section. 

53 

NON-NED COSTS 

Some costs are explicitly excluded from 

consideration as costs in the benefit-cost analysis 

though they clearly are economic costs. These costs 

are usually included among financial costs, but they are 

purposely ignored in the economic evaluation as a 

matter of national or agency policy. 

Relocation and evacuation costs are a prime 

example of how policy can override economics. A 

nonstructural flood control project may provide for the 

evacuation (permanent removal) or relocation of 

structures from the flood plain. The Uniform 

Relocation Assistance and Real Property Acquisition 

Policies Act of 1970 (P.L. 91-646) outlines the 

payments that must be made to persons displaced by 

Federal and Federally assisted programs. The 

treatment of these costs is a matter of policy. 

Corps policy29 provides that costs over and 

above replacement in kind are not considered economic 

costs for purposes of project evaluation. A specific 

policy decision has been made to limit consideration of 

the project's economic costs to a specific subset of the 

total costs. The inferred economic rationale for 

excluding relocation assistance payments is that the 

betterments received have a value at least equal to their 

cost. It has been deemed preferable, from a policy 

perspective, to exclude both the costs and benefits from 

the NED accounting framework. 

Economic concepts can clearly be applied in 

the instance of evacuation and relocation. The 

economic costs are all the opportunity costs of the 

measure, e.g., costs to purchase and raze the structure, 

relocation costs along with the costs of any 

29 As summarized in paragraph 5-7c(2)(f) of the ~' Digest of 

Water Resources Policies and Authorities, 15 February 1989. 
betterment, and site preparation costs. If a bettennent 

is provided, the entire cost of the bettennent is a 

relevant economic cost. Benefits produced by that 

bettennent are likewise relevant for the project. 

Financial costs are clearly the entire money cost of 

implementing the plan. 

In this instance, policy has assured that 

economic and fmancial costs will differ. It is clearly 

within the Corps' purview to make such distinctions. 

Indeed the Corps has gone on to say for flood control 

projects that, "Costs for bettennents are not included in 

the total project cost estimate or economic 

evaluation30. " 

For example, consider the case in which a 

road must be relocated as part of a project. Suppose 

the two-lane road could be replaced at a cost of $5 

million, but is, at the non-Federal partner's discretion, 

replaced by a four-lane road at a cost of $8 million. 

The true economic cost of replacing the road is $8 

million. That someone has elected to improve the road 

at the same time it is being replaced is of no 

consequence when applying economic principles. 

Financial costs are also $8 million; that is what must 

be paid to build the road. 

Corps policy says that only the replacement in 

kind cost of $5 million is an NED cost. At this point, 

NED costs, which purport to be opportunity costs, 

diverge from economic principles. It is entirely proper 

that the agency be allowed to do this, though, as a 

result, NED costs are no longer identically equal 

opportunity costs. When some costs are not included 

for policy rather than economic reasons confusion can 

result. 

The additional $3 million would not even be 

considered as a fmancial cost of the project. The 

Corps would regard this as a . local expenditure that 

non-Federal interests elected to undertake at the time of 

project construction. Because the additional lanes of 

traffic have nothing to do with the Corps' project, there 

is a certain bookkeeping logic to treating it separately. 

In this example, the Corps would consider only $5 

million of the total $8 million cost as economic costs 

for purposes of benefit-cost analysis and would 

likewise consider fmancial costs to be $5 million. The 

30 . Ibid., paragraph 6-5c.(1). 

54 

extra $3 million in fmancial costs would be considered 

a local public works project unrelated to the Corps 

project. 

The project sponsor pays 100 percent of 

bettennents and elements, or project scale increases, 

that are beyond the NED plan. The Federal 

Government just does not take a position on the 

benefits for these add-ons and merely assumes that the 

willingness of the sponsor to pay these costs is a 

sufficient indicator of the benefits. The NED principle 

is invoked to guide the expenditure of Federal monies 

on Federal water resource projects and need not be 

applied to expenditures of a purely local nature. 

In the last example, there is no difference 

between economic and financial costs. If homes were 

being evacuated at a similar cost, i.e., $8 million total, 

$3 million of which is bettennent and excluded from 

the economic costs of the benefits cost analysis, then 

financial costs would be $8 million while economic 

costs are only $5 million. 

The major problem with policies that 

contradict economic theory is that by not considering 

all project costs and benefits, resources may be 

allocated inefficiently, resulting in less-than-maximum 

public welfare improvements. The lesser danger of 

such is that confusion will abound among analysts and 

the public. 

COST OF LAND 

Land is a scarce resource that in all but the 

most extreme cases has alternative uses. Proper 

treatment of land costs is a recurring headache for 

many projects. 

One of the most common problems 

encountered is the case in which lands needed for the 

project are already owned by project sponsors. 

Suppose the non-Federal partner owns land that is 

currently undeveloped bottom land upon which a levee 

is to be constructed. What are the costs of this land? 

There will be no fmancial cost for the land. 

The non-Federal interest will not have to pay anyone 

for a right-of-way or fee simple; they already own the 

land. Is there an economic cost for the land? Almost 

certainly. As long as this land can be used in some 
alternative manner to supporting a levee there is an 

opportunity cost. 

If the land is developable and could be used 

for homes or industry at some point in the future 

(remember the plan has a lOO-year planning horizon), 

commitment of this land to the levee precludes that 

development. Foregoing the opportunity to develop 

this land could have a substantial opportunity cost. 

Though no one will have to write a check, local 

interests are foregoing the opportunity to sell this land 

for a substantial gain at some point in the future. This 

is a very real economic cost 

It is more likely that river bottom land will 

have severely limited options for future use. Zoning 

regulations, topography, an excess supply of land or 

any other number of factors could limit the land's 

alternative uses. Nonetheless, land almost always has 

alternative uses like farming, developed recreation, the 

passive use of an occasional hiker, or use as habitat 

In such cases, the economic cost of the land is likely to 

be modest. 

In these cases there would be a zero fmandaI 

cost but some positive economic cost. This cost is 

used in the benefit-cost analysis to assure that there is 

no misallocation of resources and to capture the cost to 

society of devoting the land to this use. But no one 

will ever have to make a financial payment for this 

cost, 

A second example that has caused some 

confusion was recently encountered in a Corps project. 

Rights of way (ROW) for channel banks and channel 

bottoms already serving as channel banks and bottoms 

had to be purchased. This was clearly a fmancial cost. 

However, based on the argument that this represented 

no change in use of the resource it was not an 

opportunity cost This may not be consistent with the 

economic principle of opportunity cost. 

The Corps' prinCiple of with- and withoutproject analysis is based on good common sense; it is 

not a tenet of economics. That there is no change in 

the use of a resource does not mean there is not an 

opportunity cost. Whether there is an opportunity cost 

Of not hinges more on reasonable with-and withoutproject condition forecasts. If the without-project 

condition allows for alternative uses of the resource 

that the with-project condition precludes then there may 

55 

well be an opportunity cost without an actual change in 

resource use. 

If the ROW permanently commits the land to 

use as channel bank and bottom there is an opportunity 

cost, so long as this land has other potential uses at any 

point in the future. If the ROW entails maintaining the 

land in a different condition, for example, clear of tree 

and brush growth there could be a foregone opportunity 

to use this land as habitat or a shady bank from which 

to fish. Granted, these alternative uses may not be 

intense, but they are alternative uses, presumably with 

some value that can be estimated by application of the 

willingness to pay principle. 

WHEN ECONOMIC COSTS ARE LESS THAN 

FINANCIAL COSTS 

Though relatively rare, there are instances 

where the incurred financial cost exceeds the economic 

cost It is entirely possible that the fmancial cost of 

the ROW in the above example exceeds the economic 

costs of the ROW. The value of a shady bank from 

which to fish may be well below the financial cost of 

a ROW. 

A more familiar example is that of 

unemployed or underemployed labor resources. Corps' 

policy provides that projects in areas designated as 

having "substantial or persistent" unemployment are 

eligible for benefits equal to payments to unemployed 

and underemployed labor resources used in project 

construction. 

Wages are the cost of a worker's time. To 

hire a worker to build a project in an area with other 

employment opportunities entails an opportunity cost 

equal to the wage earned in the next best job. For 

example, one hour of carpenter labor for a project 

means one hour less of carpenter labor for some other 

job. The value of the carpenter's time is the value of 

the production of his hour on the other job. In a 

competitive market this is the wage rate. The 

economic cost of a carpenter hour is the same as its 

financial cost. He's paid $15 per hour and the 

economy loses $15 worth of production on another 

project. 

If the carpenter is unemployed with no 

reasonable alternatives for employment the financial 

cost of an hour of his time on a water resource project 
is still $15. However, the economy is not losing an 

hour of productivity on some other job because he 

would not have been working in the absence of this 

project. If the unemployed carpenter would've used 

the hour as leisure time then all his hour of labor costs 

society is the value of one hour of leisure lost 

Because the unemployed carpenter has an abundance of 

leisure time it's not likely he valued the hour he gives 

up very highly. Thus the economic cost of the 

carpenter's hour is likely to be much less than the $15, 

say $4. The fmancial cost is $15 per hour and the 

economic cost is $4 per hour. 

At present, Corps policy provides that the 

financial and economic costs, though different, be 

presented as equal. The difference between them is 

included as a project benefit. Economists would prefer 

to present the labor costs of a project valued at their 

true opportunity cost, which is less than the financial 

cost. There would be no benefit to offset the 

difference in costs. Presenting the difference between 

financial and economic costs as a benefit rather than a 

lower economic cost can have a distorting effect on the 

benefit-cost ratio. Table 3 illustrates this point with a 

simple example. The only project costs are for labor 

which costs $70. Due to the use of unemployed 

resources the economic cost of this labor is only $60. 

Project benefits for flood control are $80. Labor 

benefits are included in the Corps policy scenario but 

not the other. Labor benefits are the benefits allowed 

for the use of under-employed and unemployed labor 

resources to construct the project. In this example, 

current Corps policy yields a different result. Though 

net benefits are the same, the BCR is slightly less 

under the Corps policy scenario. 

By handling this situation where fmancial 

costs exceed economic costs on the benefit side of the 

ledger, policy contributes to the lingering confusion of 

analysts and the public about what is an economic cost 

and what is a fmancial cost. 

LAND AND FIXED ASSETS IN THE WITHPROJECT CONDITION 

In the economics of water resource projects, 

few concepts are simultaneously as essential and as 

misunderstood as the concept of rent and the value of 

land and other fixed assets. Flood control includes 

inundation reduction, location, intensification, and 

restoration of land value as legitimate benefit 

Table 3 

Labor Costs or Labor Benefits? 

Corps EconomIC 

Polley Pr I nc Iples 

Labor Costs $ 70.00 $ 60.00 

Total Economic Costs 70.00 60.00 

Total Financial Costs 70.00 70.00 

Project Benefits 80.00 80.00 

Labor- Benefits 10.00 0.00 

Total Benefits 90.00 80.00 

BCR 1.29 1.33 

56 
categories. Each is related in some peculiar way to 

land values--how remains a mystery to many planners. 

In this section, we will attempt to unravel some of the 

mystery surrounding land value and its role in benefit 

estimation. 

TIlE BASIS FOR LAND VALUES 

Land is a factor of production. It is the one 

truly indispensable input. No matter what is produced, 

you always have to be somewhere to produce it. Land, 

then, has value because of its location. One piece of 

land can have an advantage over another piece of land 

because of its location in relation to the market for the 

things that are produced on the land. Land in the 

center city has an advantage in commercial uses 

because it is located in an area where large numbers 

of people congregate daily. Land in the closer suburbs 

has an advantage over outlying lands in residential uses 

because it puts people closer to their jobs. 

Location is not the only reason land is 

valuable. One piece of land can have an advantage 

over other pieces of land in terms of its physicalenvironmental properties like soil quality, climate, 

topography, etc. These properties, or "free gifts of 

nature", in combination with locational advantages, 

give value to land to people who want to use it. 

The value of land depends on the number of 

consumers who would like to "hire" its locational and 

physical services and what return they expect from 

using the land. The consumer who succeeds in getting 

the land would, in a world running according to 

economic theory, be the one who expects to get the 

highest return from the land. 

ECONOMIC RENT 

In everyday usage, "rent" refers to the amount 

of money we pay for our apartment or the charge for 

a rental car. In economic analysis, the term has a 

different definition. We'll restrict this discussion to 

consider only land, though the rent concept may apply 

to any factor of production. 

Economic rent is the difference between the 

payment actually received for a piece of land and the 

laIl(llord's reservation price (the minimum amount 

necessary to induce the landowner to permit the land to 

57 

be used). Rent is the producer surplus realized in 

competitive markets for land or any fixed asset 

(described in Chapter 3). 

LOCATION, RENT, AND FLOOD PLAIN LAND 

Flood plain land, by virtue of its fertility, 

flatness and proximity to water transportation has 

historically been among the first land settled. Because 

our modem communities, towns, and cities have grown 

up around these early settlements, flood plain land bas 

acquired significant locational advantages in many 

places. Population pressures and the limited supply of 

developable land have assured that much of today's 

undeveloped flood plain lands remain attractive 

resources for a variety of uses. 

The value of land, or any flXed asset, is based 

on the income stream that the land can produce into the 

future. Consider a piece of flood plain land for sale 

with four possible uses: open-space, agriculture, 

residential, and commercial. The bidder for the openspace is an environmentalist who would enjoy the view 

and the openness of the land, valuing this benefit at 

$500 annually. The farmer could produce crops that 

would net him $1,000 annually. The home developer 

could build and rent houses that would net her $2,000 

annually. The commercial developer fmds it infeasible 

to locate on this land because of the existing flood 

problem. What will each person bid for the land? 

In order to determine a fair price for the land, 

each of these people has to figure out what the future 

stream of income or benefits they will get from the 

land is worth today. This is done by capitalizing the 

annual value31. Using an interest rate of 10 percent 

for simplicity, the maximum each would pay for the 

land is $5,000 by the environmentalist and $10,000 and 

$20,000 by the farmer and home developer, 

respectively. The commercial developer does not bid. 

In such a market, we would expect the developer to 

win the competitive bid. Because he can expect to 

make more money on this piece of land, he can afford 

to offer more for the land. Thus in a competitive 

3 I CapitaHzation involves dividing the annual return from an asset 

by an appropriate return on investment or interest rate to determine 

the equivalent present value of the asset. It is not a simple matter to 

determine an appropriate rate of return. The issues involved are 

beyond the scope of this manual. 
market, the scarce locational and physical 

characteristics of the land are efficiently allocated and 

this land is worth $20,000. 

An annual stream of $2,000 is exactly the 

same as a one-time payment of $20,000 if the interest 

rate is 10 percent. If you had $20,000 to invest, you 

could save it in the form of a certificate of deposit or 

stocks and bonds with an effective yield of 10 percent 

annually. These financial assets would provide you 

with $2,000 per year. Or, you could buy this land and 

earn $2,000 per year by building and renting houses. 

In terms of personal preferences or options available to 

individuals, there may be great differences between the 

two options. In terms of value, there is no difference 

between the two. 

Now that the land has been allocated for 

residential usage, let's take a closer look at how the 

value of this land is determined. The developer incurs 

substantial costs to build and manage the houses he 

counts on for income. There are construction costs, 

finance charges on his loan, operation and maintenance, 

periodic replacement costs for the roof, furnaces, etc., 

a normal rate of return on his investment, and annual 

taxes, among other costs. Again, for simplicity, 

assume the total annual costs are $10,000 per year, 

bearing in mind that this includes explicit and implicit 

costs, and total revenues generated by renting the 

homes are $12,000. The net income is $2,000. 

The Flood Tax 

One of the expenses of renting these homes is 

taxes. Taxes are easily anticipated annual charges 

levied by the government against the property. One of 

the physical-environmental attributes of the land is that 

it is prone to flooding. This can be likened to a tax 

that nature levies on a random basis as payment for the 

land's proximity to water, its fertility, topography, etc. 

Nature's flood tax can be expressed as an 

~xpected annual value that is comparable to any other 

annual expense of operation. Let's assume the flood 

faX is $1,000 8llllually, i.e., on average over a very 

long period of time32, flood damages to the houses 

that must be paid by the landlord average $1,000 per 

year. 

If a flood control project could completely 

eliminate the flood problem, and hence the flood tax, 

58 

the land would become more valuable. There are 

several different ways this could happen; we'll take the 

simple case in which demand for the houses does not 

change simply because the houses are now protected. 

The revenues are still $12,000 annually, while costs 

have now fallen from $10,000 to $9,000 per year as a 

result of the "repeal" of the flood tax. Net income is 

$3,000 instead of $2,000 and the maximum price the 

developer could pay for the land if it is protected is 

$30,000. 

Inundation Reduction Benefits 

The gross benefits of flood control in this case 

are $1,000 annually or $10,000 on a one-time basis. 

These benefits occur simply because physical damages 

to the houses are reduced by an expected $1,000 per 

year. Use of the land does not change at all, i.e., the 

land's output stays the same; it simply becomes less 

costly to produce that same amount of residential 

housing. This is an inundation reduction benefit 

Intensification Benefits 

A second possibility is that the developer is 

unable to rent the below grade garden apartments in 

each building because of the flood problem, rather than 

that the landlord sustained expected annual damages of 

$1,000. The foregone net revenues that could have 

been realized from renting these unused units, i.e., the 

$1,000 damage, represents an implicit cost of the flood 

problem to the developer. If a project eliminates the 

flood problem and the developer can rent the additional 

units, these net revenues will now be realized. Under 

this scenario, the land is still used for residential 

purposes, but it is used more intensively with the 

project than it is without the project. This is an 

intensification benefit. 

32 We do not want to get side-tracked on issues related to the 

estimation of expected annual flood damages here. However. it is 

evident that in most years there would be no flood damage. while in 

some others there could be damages ranging from minor to 

catastrophic. If the houses did not change in any significant respect 

for a few thousand years and we added up all the damages and 

divided by a few thousand, we would have an estimate of the 

average annual damages. Expected annual damage estimates provide 

a statistical estimate of what that average would be without having 

the thousands of years of data. 
Location Benefits 

The third possibility is that the protected land 

rekindles the interest of the commercial developer. 

Now that the property is flood-free, it may be wellsuited for use as a new regional shopping mall. The 

land may be capable of generating $10,000 per year in 

this new use. An offer of $100,000 (neglecting-for 

convenience such issues as the value of the buildings, 

existing leases, etc.) would cause a reallocation of land 

resources from residential to commercial uses. This 

change in land use would yield a location benefit. 

Restoration of Land Market Values 

The P&G (paragraph lV-2.4.13.d, p. 38) 

provides that if the market value of existing structures 

and land is lower because of the flood hazard, the 

restoration of market values represents a quantification 

of otherwise intangible benefits. The commingling of 

economic terminology with policy intent produces 

confusion for analysts in this benefit category. 

Though a more detailed explanation of this 

benefit category is offered in the discussion of short 

run and long run effects below, an intuitive treatment 

is offered here. Prices, i.e., the market value referred 

to by this benefit category, are determined in the 

market by the interaction of differently motivated 

groups of buyers (demand) and sellers (supply). 

In the absence of recent flood events, land in 

a flood plain may be at its long run equilibrium price. 

In the immediate aftermath of a flood, we can expect 

prices of flood plain land to drop precipitously. The 

market is inundated with new information about this 

land. The drama that accompanies a recent flood event 

makes it difficult for buyers and sellers to properly 

evaluate the true nature of the flood risk. The threat of 

flooding may be greatly overestimated by both groups. 

In the short run, there may be a surplus of flood plain 

land as people seeking to leave the flood plain are 

unable to fmd any buyers. 

In extreme cases, there may be no buyers of 

flood plain land at any price. Let us return to our 

hypothetical property for an example. Assume the land 

i$ worth $20,000 prior to a flood event. This value 

~ady reflects the expected annual flood damages of 

$1,000 per year. Now assume a flood, entirely 

consistent with the expected annual damage 

59 

computation, devastates the flood plain in a dramatic 

event. The value of land now drops to $10,000, 

reflecting a sudden drop in buyers' and sellers' 

confidence about the ability of this land to sustain a 

$2,000 income stream into the future. 

What has changed? It is not the actual flood 

damages; they're fixed at $1,000. It is people's 

expectations about the future at this flood plain location 

that have changed. Because of the trauma and 

inconvenience associated with a flood location, buoyed 

by recent experience, market values have fallen to a 

new low. If market values can be restored to the long 

run value that gives appropriate weight to the flood 

risk, most if not all of the reduction in price, 

attributable to the trauma, will be restored. 

Thus, in this example, a project would cause 

land values to rise from $10,000 to $30,000. Ten 

thousand dollars of this rise is due to the elimination of 

damages; the other $10,000 rise in market value is due 

to the elimination of the short tenn effects of trauma in 

the market price. 

SHORT RUN VS. LONG RUN 

Planning horizons for Corps projects typically 

range from 50 to 100 years. Planning for such a long 

time period requires analysts, planners, and decision 

makers to maintain a perspective that does not come 

naturally. It is a perspective that many find impossible 

to keep in pmctice, no matter the obvious logic of the 

position. 

We can defme the long run to coincide with a 

project's planning horizon. Conditions without and 

with a plan, commodity forecasts, development trends, 

climate, public policy, and the project's performance 

are but a few of the things that must be forecast over 

the planning horizon. A long run perspective, then, 

consists of conditions that are reasonably representative 

of the entire planning horizon. It is imperative that 

short run deviations from the long run trend not be 

given too much emphasis. 

For example, a 1979 structure-by-structure 

damage survey of a 25,000+ structure flood plain 

yielded a stage-damage curve used in a project report. 

In 1983-84 an Army Audit Agency (AAA) review of 

the stage-damage data for a selected few of the largest 

industrial firms revealed that at the time of the AAA 
review, damages would be significantly lower than 

previously estimated. AAA concluded that the stagedamage data were flawed and out-of-date. This may 

have more appropriately been a problem of not keeping 

the proper long run perspective. 

The 1983-84 review was conducted as the 

U.S. was beginning to recover from its worst recession 

since the Great Depression of the 1930's. Demand for 

industrial products was significantly reduced during this 

time. As a result the frrms reviewed had fewer 

employees, less raw material, smaller inventories and 

shorter work weeks. This means less damage would 

occur if flooded during a recession than during normal 

times. 

If damages for these firms had been reduced, 

as AAA recommended, to reflect more current 

conditions would this community's stage-damage 

relationship, representative of a 100-year period, have 

been improved? The recession was followed by the 

nation's longest uninterrupted peacetime expansion. 

The frrms reviewed earlier in the decade had recovered 

to their more normal levels of capacity. Some had 

even surpassed those levels. 

It would be more reasonable to document the 

community's economic conditions at the time of a 

stage-damage survey and place this in some sort of 

long run perspective for the decision maker. Stagedamage surveys conducted in the depths of a recession 

or the heights of an economic boom are not likely to 

be as representative of long run conditions as surveys 

conducted during more normal times. 

Few analysts will welcome the opportunity to 

put their survey work into some sort of long run 

perspective. It is difficult enough to gather the data. 

Budgets and schedules do more to determine when and 

how surveys are conducted than do concerns about 

long run representativeness. Nonetheless, few analysts 

would expect that many of the commerciallindustrial 

structures identified during a damage survey will be 

there on the 100th anniversary of the project. 

It is very difficult to bear in mind, in a 

pragmatic way, that the true goal of a damage survey 

is to describe a reasonable representation of the damage 

potential in the flood plain over the next 100 years. It 

is less important to have a minutely detailed snapshot 

of the damages at a point in time than it is to have a 

reasonably focussed movie of the next 100 years. 

60 

In the short run there will be all sorts of 

perturbations and deviations from the long run trend. 

No analyst, planner or decision maker should give 

unwarranted weight or attention to these short run 

fluctuations. A change in the long run trend, on the 

other hand, warrants reanalysis. 

Planning for a 100-year period in 1990, what 

is the appropriate weight to give to the effect of the 

Persian Gulf crisis on oil prices? If navigation projects 

had been formulated based on suuuner 1990 oil prices 

of about $16 per barrel, transportation costs would 

have been a lot lower than they would have been had 

the project been formulated based on October 1990 

prices which rose as high as $40.40 per barrel. Oil 

prices changed daily with each rumor of impending 

peace and war. By February, 1991 prices were down 

to about $18 per barrel. Clearly, there is much to be 

said in favor of a long run perspective. 

A flood plain savings and loan in 1990 may 

have been taken over by the Resolution Trust 

Corporation and sold to another institution and closed. 

Should the damages be based on the temporarily vacant 

S&L building? 

A proper long run planning perspective 

requires the analyst, planner and decision maker to 

adhere to the secular trend in data and events. The 

temptation is to be unduly influenced by cyclical, 

seasonal or random effects. 

As a pragmatic matter it may be difficult or 

impossible to adhere to a long run trend in rising oil 

prices when a temporary oil glut has caused prices to 

pluuunet Failure to reflect the latest data is, to many, 

the defmition of poor planning. Aud that statement is 

true as far as it goes. It just does not go far enough. 

The latest data should be used but it should be the 

latest data relevant for a 50- or 100-year planning 

horizon, not simply the latest market data. 

SUPPLY AND DEMAND IN THE LONG RUN 

In Chapter 3 project benefits are presented in 

terms of areas under supply and demand curves. Only 

the rudiments of supply and demand were presented. 

Missing from the explanation to this point has been the 

ceteris paribus, or "all other things equal" condition. 
The supply and demand curves presented 

in Chapter 3 are all perfectly reasonable but only 

under a very narrow set of circumstances. Let's 

illustrate with some intuition from a personal 

example. You walk into a convenience store and 

see a popular soft drink on sale. How many will 

you buy? Your answer should begin with "it 

depends". Do you even like this soft drink? How 

much money do you have on you? Are you 

walking or driving? How many do they have? How 

many people are you buying for? On and on the 

questions go. Once each of those questions has 

been answered for you, you can say with 

reasonable certainty how many sodas you would 

buy. Then we could ask you how many sodas you 

would buy if the price is lowered another 10 

percent, all other things equal; meaning your tastes 

are the same, the same amount of money in your 

pocket, etc. 

Thus, your demand for sodas depends on 

a lot of things other than price. In order to 

consider only the relationship between price and 

quantity purchased we must determine values for 

all the those other things and hold them 

constant33. Change the amount of money in your 

pocket from $100 to $0.50 and your answers are 

obviously going to be different. 

The same reasoning applies to project 

outputs. The demand for navigation transportation 

depends on many things. It may depend on the 

cost of alternative transportation modes, the origindestination of movements, the type of commodity, 

market size for the commodity, time of year, 

international events, weather, consumer tastes, 

availability of substitutes for the goods moved, etc. 

Once the planner answers (explicitly or implicitly) 

all of these questions a demand curve can, 

conceptually if not actually, be drawn. That 

demand curve is good only as long as all other 

things are equal. 

33 This may appear to be a daunting process. It need not be. IT 

we are empirically estimating demand curves we must have 

precise measurements of all those things we are going to hold 

equal. Otherwise, it is often sufficient to assume that whatever 

the values of those other things are, they are not changing. 

61 
Figure 22 

Secular and eycl ical Trends 

Do I lars 

Trend 

Secular Trend 

Time 

Figure 23 

Seasonal Trend and Random Influences 

Do I lars 

Seasonal 

Time 

62 
In the short run there can be many 

demand curves because all other things are not 

equal, things change constantly. In the long run 

demand is more stable because short run deviations 

among all the other things held equal even out and 

are ignored. Long run average values for these 

variables permit estimation and use of a long run 

demand. 

Supply curves are likewise dependant 

upon the assumption that all other things are held 

equal. The supply of developable land34 in a 

community depends on many things; the price of 

land, zoning, technology for preparing sites, the 

price of land for undeveloped uses, etc. Sl in 

Figure 25, represents the without-project supply of 

land in a community. S2 represents the withproject supply of land in a community where flood 

protection lowers the cost of occupying land 

making it more attractive under the new 

conditions. The condition that has changed, i.e., 

the "other thing equal" that is no longer equal is 

flood control. Supply curves can shift about as 

conditions unrelated to price change. 

In Chapter 3 single and stationary supply 

and demand curves allowed us to demonstrate the 

NED benefit principle quite nicely. In reality, 

things other than price are changing all the time 

causing the supply and demand curves to shift 

about constantly in the short run. The best hope 

in such cases is to approximate some stable long 

run supply and demand relationships. 

34 III the current context supply does not refer to the fixed 

amount of land available. Instead, it refers to economic supply; 

i.e., the amount of land people are willing and able to offer for 

development at various prices. Thus, for example, there may 

be existing land that is not available for development because 

the cost of preparing it for development exceeds the price it 

would bring on the market. 

(II 

u 

tr. 

63 

Flgu ... e 24 

Changes In Demand 

o 

2 (Clet. .gO) 

• (Dec. ·90) 

L-____________________________ ~~ o 1 (.July ·90) 

Ba ...... els of all 
Figure 25 

Changes in Supply 

51 

W/O CondItIon 

52 

W/ Cond I t I on 

Acres of Land 

Figure 26 shows the equilibrium condition for 

flood plain land, all other things equal. It has been 20 

years since the last flood. As a result of a flood 

consumer tastes for flood plain land drops drastically. 

Figure 27 reflects this change in a demand curve that 

has dropped dramatically. At the original pre-flood 

equilibrium price of PI there is now a surplus of land. 

More people are willing to sell their land at that price 

than are willing to buy it. The only way that people 

with land for sale will be able to move it is to drop the 

price. Price will eventnally fall to P2. 

Corps analysts who initiate a study in the 

aftermath of a flood have often used market values as 

the basis for damage estimates or other flood control 

benefits. A price depressed by short run changes in 

market conditions could be devastating to a project's 

feasibility. Given a 100-year planning horizon it makes 

more sense to use a market value that is likely to 

prevail for most of that period, this would be the long 

run value which may be much closer to PI than P2; 

The effect described in Figures 26 and 27 is 

so commonplace that current Corps policy steers 

analysts away from using market values. While it is 

easy to argue that long run values should be used in 

64 

economic evaluations it can be much more difficult to 

actually estimate and agree upon such values. Rather 

than take the path of least resistance and use the most 

current data, that may be woefully distorted by short 

run considerations, it is much more advisable to at a 

minimum use risk and uncertainty analysis to address 

the long run value issue. 

WITH AND WITHOUT CONDITION 

During development of this manual, the withand without-project conditions were identified as the 

most important issue for project formulation more 

frequently than any other. Identifying reasonable withand without-project conditions is a chronic problem for 

Corps analysts. The majority of the concerns expressed 

were at best policy issues (e.g., why can real oil price 

increases be accounted for in estimating hydropower 

benefits but not navigation benefits) and at worst 

questions without answers (e.g., how much support for 

a with- or without-project condition is enough?). The 

NED principle shines little light on either of these 

areas. Economic analysis, on which the NED objective 

is based, provides some very general, but perhaps 

useful insight into the with- and without-project 

conditions. 
Price 

Price 

P 

1 

P 

2 

Figure 26 

Long Run Equi I ibrium Price 

Flood Plain Land 

Figure 27 

Short R~n Equi I ibria Prices 

Flood Plain Land 

65 
How much is enough? What is reasonable? 

These are two critical questions that deal with defining 

with- and without-project conditions that are beyond 

the scope of economics. Economic analysis can offer 

the analyst some help in answering these questions, 

however. 

Rational behavior is an assumption that 

underlies all economic theory. The assumption is that 

people and firms act as if they are trying to maximize 

their utility or profits or to minimize their costs. 

Rational behavior should be assumed when defining the 

with-project and without-project conditions. Use this 

basic concept, but do not take it to the extreme of 

assuming that under the without-project condition 

parties will automatically act together as if, in the 

absence of federal participation, they are a single 

beneficiary or single owner. 

For example, consider a hypothetical 

streambank erosion problem. The without-project 

conditon assumes streambank erosion will eventually 

destroy a section of public road. As a result, people 

will sustain $125,000 of increased costs each year until 

the road is fixed, due to longer commutes, etc. In 

other words, they would be willing to pay $125,00) 

annually to avoid the increased transportation cost. A 

bank stabilization plan, costing $250,000 would prevent 

the loss of the road and the forecast increase in 

communiting costs. With a 10 percent interest rate and 

a 25-year project life, the annual project costs are 

$25,000. 

Theoretically those benefited would be willing 

to pay for the bank stabilization project to prevent loss 

of the road. In our example, however, the beneficiaries 

include a mix of vactioners, cross-country delivery 

companies, one-time visitors, occasional users, local 

residents, emergency vehicles, meter readers, 

newspaper delivery cars, mail people, a boy scout 

troop, farm trucks and equipment, the dairy tanker, the 

school bus, a regional bus line, some commuters that 

transit the area from far away to jobs in the city, offpost troops at an Army Reserve Unit, and workers at a 

local fish hatchery. 

The $125,000 benefit appears to be widespread 

so a federal interest in the improvement seems to be 

present. If the benefits were of a windfall nature, 

benefitting only a few individuals or companies and not 

widespread, the federal interest would be less clear and 

the beneficiaries might be expected to take a rational 

66 

action and fix it themselves. No matter who fixes it 

though, our assumption is that a rational decision will 

be made based on the transportation savings that can be 

realized. So in either case, it is the without-condition 

that drives the economic evaluation. 

When the without-condition is realistically 

identified, alternative or incremental improvements can 

be evaluated. If the without-condition is not 

realistically identified, however, the benefit evaluation 

for any alternative is questionable since benefits are 

basically quantified on the basis of the difference 

between the with-versus the without-project condition. 

The NED evaluation does not detennine who 

will take action, it merely evaluates alternatives from 

the NED point-of-view by comparing them against a 

without-project condition. There is considerable 

judgement needed in identification of the withoutproject condition, but there is no tolerance for 

promoting a without-condition merely because it will 

enhance justification. Good judgement will most likely 

result in developing a without-condition that will pass 

the test of fitting the description of a "most likely" 

future, and will also be supportable by consensus of the 

planning team. Risk analysis should be used when the 

"most likely" future is a range of possibilities. 

NEDVSRED 

You paint your house and can sell it for 

$3,000 more than you could before it was painted. 

You paint your house and your neighbor gets $5,000 

more than he could get, now that his home is no longer 

next to a house badly in need of paint. The paint 

produces $8,000 in benefits. How much of those 

benefits are relevant to you when making the decision 

to paint or not? Obviously, you are concerned only 

with the $3,000 benefit that accrues to you. It's a 

matter of perspective. 

And so it is with National Economic 

Development and Regional Economic Development; 

it's a matter of perspective. There should be no doubt 

that RED benefits are real and legitimate benefits. As 

pointed out in Chapter 3, these benefits are often offset 

by RED costs in other regions. National policy has 

directed that the proper perspective for Federal water 

resource project evaluations is an NED perspective. 

Examples of NED and RED effects are presented here 

to illustrate the difference in perspective. 
Recreation is a major output of many regions 

in the U.S. Slackwater recrea.tional opportunities for 

fishing, boating and bathing comprise major 

components of some local economies. Recreation that 

attracts new participants is clearly an increase in the 

nation's recreation output and is an NED benefit In 

other cases people stop visiting one site in favor of a 

new one. 

Consider the hypothetical Lake Liter at a 

newly built reservoir. The non-Federal partner favors 

the lake because, among other things, it will attract an 

estimated 150,000 out-of-state visitors annually. These 

people will spend an estimated $50 each adding 7.5 

million much needed dollars to the local economy. 

The money will be spent on licenses, food, supplies, 

gasoline, lodging, etc. This spending by visitors will 

become the income of local residents. These local 

residents will in turn spend this money in local barber 

shops, taverns, furniture and clothing stores, etc. 

creating income for these shop owners. And so it goes 

until the money introduced to the economy leaks out 

through taxes, savings and purchases outside the 

region. The $7.5 million brought into the region by 

visitors will represent an increase in local income that 

will greatly exceed $7.5 million before these multiplie:t 

effects diminish. 

It is because these multiplier effects can be so 

large relative to the size of the local economy that they 

are so important to local people. These are major 

economic effects. They are often the real effects for 

which non-Federal interests are paying. It is not 

difficult to understand why they are often stunned to 

learn that these very real and important effects are not 

considered project benefits. 

To see why RED benefits are not considered 

project benefits we must consider the effects of Lake 

Liter on other regions of the country. This is not the 

responsibility of the Lake Liter region's officials but it 

has been judged to be the responsibility of the Federal 

government. 

For simplicity assume that all the people who 

visit Lake Liter come from the Lake Heavy region in 

a distant state. The $7.5 million spent at Lake Liter 

was once spent at Lake Heavy. With the completion 

pf Lake Liter, spending at Lake Heavy decreases $7.5 

JIlillion. The lodge, gas station, souvenir stand, food 

store and other shop owners at Lake Heavy realize a 

$7.5 million decrease in spending in their stores as 

67 

people take their money to the new lake. These 

shopowners suffer a $7.5 million decrease in income 

that means they will have less to spend in the barber 

shops, taverns, etc. in the Lake Heavy region. The 

barbers and bartenders, etc. will in turn have less 

income and so the effect continues. The loss to the 

Lake Heavy region is a very real and important one. 

Lake Liter's gain is Lake Heavy's loss. A 

RED perspective can ignore this, an NED perspective 

cannot. 

There are many such examples in water 

resource projects. Navigation improvements for 

channels and harbors are often extremely successful for 

regional development. Harbor improvements along the 

Gulf Coast may attract many new workboats and 

thousands of tons of catch. As a result marina owners, 

suppliers, dry dock operations and local shopowners 

may realize tremendous increases in income. If the 

increased activity is simply a transfer from another 

harbor, i.e., shrimp that was once landed at Port East 

is now landed at Port West, there is no real benefit to 

the nation35. The multi port emphasis in navigation 

project analysis arises largely from this concern that 

projects could do nothing but continuously reslice the 

same pie instead of increasing the size of the pie, if 

careful planning and analysis are not used. 

Many local officials feel that NED benefits are 

irrelevant to them, and in many cases they are. 

Bridging the gap between NED and RED effects is not 

a matter of finding some new or clever way of 

analyzing benefits. That will never happen. The 

effects are fundamentally different because each 

assumes a different perspective on project effects. This 

is a value-based policy judgment that cannot be 

reconciled through theory or analysis. It is simply a 

fact that NED is often irrelevant to local interests and 

RED is irrelevant to Federal interests. 

As reanalysis of existing projects becomes a 

more important part of the Corps' program, more and 

more RED analysis will be required, regardless of its 

relevance. Though the P&G neither impose nor restrict 

35 To say there is no real benefit to the nation is not likely to be 

strictly true. Assuming rational behavior by the fishermen, there must 

be some advantage or the move would not be made. However, only 

the net increase in consumer/producer sw:plus should be counted. 

Local residents will see all the new business as an increase and will 

not net out the loss to the previous location. 
requirements for RED analysis it can be reasonably 

anticipated that non-Federal sponsors are going to want 

to know what the projects they are financing are going 

to do for them, i.e., what are the RED effects. RED 

analysis would appear to be a fundamental necessity 

for garnering local support and enthusiasm for Corps 

projects. 

As there is a fundamental difference in 

approach to benefit estimation between NED and RED 

perspectives, analysts should rest assured they are not 

failing if they cannot reconcile NED and RED effects. 

They are different. At the same time Corps analysts 

should consider the wisdom of including RED benefits 

in all their studies. 

NEDVS GNP 

In an effort to look creatively at project 

effects, a number of Corps offices have experimented 

with increases in Gross National Product (GNP) as 

an NED benefit category. GNP and NED are two 

entirely different concepts created to serve different 

purposes. GNP is a measure of the economy's 

performance. NED is a Federal objective for water 

resource projects. NED benefits cannot be adequately 

defined as increases in GNP. Some NED benefits are 

increases in GNP but others are not included in GNP 

at all. 

GNP 

Gross National Product is the most widely 

used measure of our nation's economic performance. 

GNP is defmed as the market value of all final goods 

and services produced by the economy during a year . 

. There are two ways of measuring GNP, the expenditure 

approach and the income/cost approach. The former 

counts the money we spent on final goods and services, 

the latter the cost of producing it which produces our 

income. 

The expenditllfe approach sums the 

expenditures of each sector of the economy on final 

goods and services. The four major sectors of the 

economy are households (personal consumption 

expenditures), businesses (gross private. investment 

expenditures), government (government purchases of 

goods and services by all levels. ofgovenunent), and 

the international sector (exports of goods ana services 

less imports of goods and se~lces). The income/cost 

68 

approach sums the flow of costs incurred in the 

production of goods and services. These costs include 

wages, self-employment income, rents, profits, interest, 

indirect business taxes and depreciation. Both 

approaches lead to the same estimate of GNP. 

GNP is not a perfect measure of economic 

performance. There are many items that are clearly 

productive activity that are not included in GNP. GNP 

only includes the value of goods and services that pass 

through the market If you repair your own car, sew 

your own clothes, mow your own grass, or paint your 

own house there is no market transaction so your 

activity adds nothing to GNP. If you pay someone to 

perform any of these services, however, they are part 

of GNP. 

On the other side of the ledger, GNP makes 

no adjustment for harmful side effects that can arise 

from production, consumption and the events of nature. 

GNP makes no allowance for pollution caused in the 

course of production. Nor does it include the value of 

timber and habitat lost in forest fires each year. To 

further complicate matters, GNP makes no distinction 

between the production of new goods and services and 

clean-up and recovery in the aftermath of a flood. 

It is not difficult to see that GNP and NED 

benefits are not well-matched concepts. When a 

homeowner spends time in flood fighting or cleaningup after a flood, this effort is not measured by GNP 

though the homeowner will surely be willing to pay 

some amount of money to be relieved of this necessity. 

A great deal of flood damages do not involve market 

transactions. So, some NED benefits are not part of 

GNP. On the other hand, GNP makes no distinction 

between NED and RED production, hence it includes 

much that the NED concept does not. 

RELATED INCOME MEASURES 

GNP has been defmed as the broadest measure 

of our economic performance. It is not the only 

measure, as can be seen in Figure 28. Net National 

Product (NNP) is GNP less a depreciation allowance 

for the wearing out of machines and buildings during 

the year. Subtracting indirect business taxes from 

NNP, we obtain National Income (NI). NI represents 

the income payments to all factors of production. 

Personal Income (PI) is the total of all income received 

by individuals. PI is obtained by subtracting corporate 
profits and social security taxes from NI while adding 

transfer payments, net interest, and dividends back in. 

Once personal taxes are subtracted from personal 

income, we are left with Disposable Income (01). 

The P&G describe contributions to NED as 

" ... increases in the net value of the national output of 

goods and services ... ". GNP is a gross output measure, 

NNP provides a net measure of output. 

GNP BENEFITS? 

A navigation project in the southwest brings 

iron ingots from Brazil bound for Mexico into the U.S. 

for trans-shipment. While in the U.S., $12 million is 

spent The District argues that since this is foreign 

income attracted to the U.S., it is a change in net 

income that should be an NED benefit. 

A navigation project in the northwest results 

in an increase in the number of Japanese tourists 

visiting the project area. The District argues that the 

tourists' expenditures are NED benefits. 

To understand the relationship between GNP 

and NED, we need to consider a subtle point that is 

well beyond the scope of this manual. Nonetheless, the 

following section provides an intuitive introduction to 

the critical link in the thought process necessary to 

respond to the Disti"icts' concerns. 

The Real Income-Real Output Link 

National income accounting methods illustrate 

that the flow of real goods and services to households, 

business, government and foreign sectors must equal 

the flow of income from finns to the suppliers of the 

resources. In other words, the actual supply of goods 

and services or aggregate output must be equal to the 

actual total income or aggregate income. Since 

aggregate output and aggregate income must be equal, 

it is impossible to change one without changing the 

other. 

Figure 28 

GNP 

Five Alternative Measures of Income 

---------1 

:DepreclatlOrl 1 

NNP 

r l nd I r-;'ct -bUS-I nJss 

1 Ta)(es 1 

NI 

69 

Net 01' 

Trans1'ers a. TEl 

PI 

r - - - - - - --1 

1 Persona I 1 

Taxes 

DI 
The only way a nation can increase its real 

income36 is to increase its real output Unless the 

production of goods and services increases, there will 

not be an increase in the nation's real income. Growth 

in real income is entirely dependent upon growth in 

real output 

When evaluating planning alternatives 

designed to stimulate the growth of income, one must 

focus clearly on this link between income and output 

Proposals such as those above are purported to lead to 

a higher level of income. The careful analyst will 

identify how the project will affect output. Unless 

there is good reason to believe the project will 

stimulate the production of desired goods and services, 

it will clearly not increase income. If the project does 

increase output, it surely would meet the definition of 

an NED effect as quoted above. 

The focus, then, must clearly be on output. If 

a tourist rents a hotel room, this is clearly part of the 

GNP. If that hotel room would have been rented by 

someone else anyway, there is no increase in output, no 

increase in income and no NED benefit. If a project 

causes output to increase, then there is no reason this 

increase in output cannot be considered a project output 

analogous, if you will, to increased agricultural outputs 

from irrigation projects. 

NED ANALYSIS HERE TO STAY 

NED analysis of water resource projects is not 

going to go away. History shows that the emphasis on 

economic analysis has only grown stronger and more 

focussed with the passage of time. As we as a society 

become increasingly aware of the limitations of our 

resources, the role of solid economic analysis will only 

be increased. 

This manual has introduced some basic 

economic concepts essential to understanding the NED 

analysis of Federal water resource projects. There is 

much more to the economic theory and its application 

than could ever be presented in a manual and the 

36 We have introduced the concept of "real income" because 

changes in price levels can cast the arguments we offer here in a 

different light for reasons well beyond the scope of this manual. Real 

income is a measure of income that has been adjnsted for changes in 

tile general price level. 

70 

reader is reminded that they have been provided with 

only an introduction to a complex field of study. The 

manual has likewise presented examples, that have 

conveniently always worked out just right. The world 

in which the Corps operates is not nearly as tidy as the 

figures and examples herein suggest. 

Nonetheless, the concepts presented and the 

intuition developed in this manual can serve most noneconomists well as an introduction to understanding 

NED principles and their role in plan formulation and 

evaluation. 
INDEX 

71 
INDEX 

associated costs 37, 41, 42, 44 

average cost 8, 45 

benefit-cost analysis 1, 7, 8, 23, 35, 

53-55 

benefit-cost ratio 2, 7, 8,28, 56 

bequeathment value 13 

betterment 54 

capitalization 57 

ceteris paribus 60 

change in relative prices 25 

compensating variation 9 

compensation principle 6, 7, 36 

compounding 27 

consumer surplus 11, 13, 14, 19,30,32,44 

cost analysis 1, 7, 8, 23, 35, 37, 43, 

53-55 

explicit costs 39, 42 

implicit costs 39, 41, 42, 53, 58 

incremental costs 40,47 

marginal costs 17, 26, 37, 40, 41, 

45-47 

relevant costs 38-41, 47 

sunk costs 40 

cost minimization 10, 14 

cutoff period 6 

cyclical variations 61 

demand 3, 9, 11-14, 16-20, 22, 29, 30, 32, 

36, 44, 46, 58-61, 63, 64 

disbenefits 39 

discount rate 27-29 

discounting 7, 27 

economic costs 39, 41, 42, 51, 53-56 

economic rationality 3, 49 

economic rent 57 

environmental mitigation 15 

equilibrium price 12, 19,20,59,64 

equivalent variation 10 

existence value 13 

expected annual damages 25, 26, 30, 58 

external economies 9, 22 

externalities 22,23 

financial costs 39, 42, 53-56 

73 

flood control 9-11, 15, 16, 22, 23, 25, 26, 

28, 30, 35, 40, 45, 50, 53, 

54, 56, 58, 63, 64 

full employment 25 

GNP 27, 51, 68-70 

GNP benefits 51,69 

gross national product 27, 68 

hydropower 5,29,30,32,64 

implementation outlays 41,42 

intensification benefits 30, 58 

interest rates 8, 26-28 

internal rate of return 7 

inundation reduction benefits 26, 58 

land costs 54 

land values 57, 59 

Law of Demand 12 

leisure time 50, 51, 56 

location benefits 30, 59 

long run 26, 44, 49-51, 59-61, 63, 64 

low-priority outputs 26 

marginal benefits 45-48, 51 

market equilibrium 18, 22 

market failure 22 

most likely alternative 20, 29, 32 

national economic development 1,2,35,45, 

66 

navigation 30,32,35,42,50,60,61,64,67, 

69 

NED 1-3, 5, 6, 8,9, 11, 18,22,23,25, 29, 

35,36-38,41-43,45-49,51, 

53, 54, 63, 64, 66-70 

NED benefits 3, 6, 8, 9, 11, 22, 36, 42, 45, 

46,67-69 

NED costs 3,36-38,41,42,46,53,54 

NED Plan 2, 3, 43, 45-48, 54 

negative externalities 22, 23 

net benefits 1, 7, 8, 14, 15, 18-20, 22, 28, 

29,42,44-49,56 

net present value 6-8 

Nominal values 27 

non-Federal partner 35, 36, 38, 39, 42, 43, 

54,67 

Opportunity cost 5 

option value 13 
otber direct costs 41,42 

overproduction 20, 23 

Pareto principle 6 

pay-back period 6, 7 

period of analysis 26, 49 

positive externalities 22 

price level changes 25 

producer surplus 11, 17, 19, 30, 32, 36, 57, 

67 

profit 10, 14, 15, 18,25,27, 38, 39 

profit maximization 10, 14 

public goods 22, 23 

random influences 61 

rationality 3, 10, 49 

real values 27 

reallocation studies 16 

RED 35, 36, 66-68 

regional economic development 35,51,66 

relevant cost 38, 45 

relocation costs 42, 53 

remaining benefits 40 

remaining costs 40 

restoration of land market values 59 

risk attitudes 25 

risk averse 25,26 

risk neutral 26 

risk-seeking 26 

Scarcity 5 

seasonal variation 61 

secular trend 61, 62 

short run 50, 51, 59, 60, 63, 64 

supply 3, 5, 9, 11, 12, 14-20, 22, 23, 25, 29, 

30, 32, 36, 38, 42, 44, 46, 

55, 57, 59-61, 63, 69 

total costs 7, 8, 10, 14,40,44-47, 53 

total revenues 10, 14, 17, 58 

travel time 50 

underemployed labor resources 40, 55 

underproduction 20, 22 

unemployed labor resources 25, 56 

utility 6, 9-11, 13, 14,22,27, 35, 49, 51, 66 

utility maximization 11 

value of time saved 43,50 

time savings 50,51 

variable costs 26, 40,41,44 

wage rate 50, 51, 55 

water supply 5, 14-16,29,30,32,42 

welfare economics 6, 11 

74 

willingness to pay 2,7,9, 11-14, 16, 17, 19, 

20, 25, 26, 29, 30, 32, 35, 

42,44,55 

witb-project condition 9-11,49, 51, 55 

witbout-project condition 9-11, 30, 32, 45, 

55,64,66 
Appendix 1: SUGGESTIONS FOR 

FURTHER READING 

75 
Appendix 1: SUGGESTIONS FOR FURTHER 

READING 

Baumol, William J. and Alan S. Blinder. Economics 

Principles and Policy. San Diego: Harcourt Brace 

Jovanovich, 1991, 5th ed. 

One of many economics principles texts that provides 

an introduction to many of the concepts presented in 

this manual, with a good introduction to utility and 

profit maximizing behaviors, supply, demand and price 

determination. This edition should be accessible to 

most college-level readers. 

Conrad, Jon M. and Colin Clark. Natural Resource 

Economics, Notes and Problems. Cambridge: The 

Cambridge University Press, 1987. 

This recent work is a graduate level mathematical 

treatment of resource allocation problems ill 

environmental and natural resource contexts. It 

provides the rigor missing from many other texts on 

the subject and provides a treatment of dynamic 

equilibrium issues that are well beyond the scope ·:>f 

this manual. 

Davis, Stuart A., Editor. National Economic 

Development Procedures Manual--Urban Flood 

Damage. U.S. Army Corps of Engineers, Water 

Resources Support Center, Institute for Water 

Resources Report 88-R-2, Fort Belvoir, Virginia, 1987. 

Dolan, Edwin G. and David E. Lindsey. 

Microeconomics. Chicago: The Dryden Press, 1988, 

5th ed. 

One of many economics principles texts that provides 

an introduction to many of the concepts presented in 

this manual, with a good introduction to supply, 

demand and price determination. This edition should 

be accessible to most college-level readers. 

Freeman, A. Myrick. The Benefits of Environmental 

Improvement, Theory and Practice. Baltimore: Johns 

Hopkins University Press, 1979. 

One of the frrst texts to address much of the material 

presented in this manual in an environmental context it 

is still one of the best. The book is oriented toward 

identifying and addressing issues associated with 

benefit estimation. 

77 

Gwartney, James D. and Richard L. Stroup. 

Economics Private and Public Choice. San Diego: 

Harcourt Brace Jovanovich, 1990, 5th ed. 

One of many economics principles texts that provides 

an introduction to many of the concepts presented in 

this manual with a good introduction to supply, demand 

and price determination. This edition should be 

accessible to most college-level readers. 

Hansen, William J. et. al. National Economic 

Development Procedures Manual--Recreation, Volume 

III: A Case Study Application of Contingent Value 

Method for Estimating Urban Recreation Use and 

Benefits. U.S. Army Corps of Engineers, Water 

Resources Support Center, Institute for Water 

Resources Report 90-R-ll, Fort Belvoir, Virginia, 

1990. 

Hansen, William J., Editor. National Economic 

Development Procedures Manual--Agricultural Flood 

Damage. U.S. Army Corps of Engineers, Water 

Resources Support Center, Institute for Water 

Resources Report 87-R-1O, Fort Belvoir, Virginia, 

1987. 

Hartwick, John M. and Nancy D. Olewiler. The 

Economics of Natural Resource Use. New York: 

Harper & Row, 1986. 

This is a modern treatment of general resource 

economics and issues that is suitable for practicing 

economists, advanced undergraduates and graduate 

students. A well written text makes it possible for 

readers to glean the salient points of the theory without 

requiring him to follow all of the mathematical 

treatments. 

Henderson, James M. and Richard E. Quandt. 

Microeconomic Theory a Mathematical Approach. 

New York: McGraw-Hill, 1980, 3rd ed. 

This is an advanced text providing a calculus approach 

to rational economic behavior. It provides excellent 

coverage of classical economic theory including 

relatively recent extensions in duality theory. 
Hirsch, Werner and Anthony M. Rufolo. Public 

Finance and Expenditure in a Federal System. San 

Diego: Harcourt Brace Jovanovich, 1990. 

A public finance text that provides a concise and lucid 

introduction to benefit-cost analysis, consumer and 

producer surplus and related concepts. 

Holmes, Beatrice Hort. History of Federal Water 

Resources Programs and Policies, 1961-70. 

Washington: U. S. Government Printing Office, 1979. 

This and her frnt volume that covered the years prior 

to 1961 are the best source documents available for the 

student of water resource policy. Though they do not 

provide details on the Corps own policy development 

they provide sufficient detail on National policies, 

interests, and politics to be must reading for all 

students of water policy. 

Hyman, David. Public Finance a Contemporary 

Application of Theory to Policy. Chicago: The Dryden 

Press, 1990. 

One of many public finance texts presenting an 

introduction to benefit-cost analysis. 

James, L. Douglas and Robert R. Lee. Economics of 

Water Resources Planning. New York: McGraw-Hill, 

1971. 

Somewhat dated, but still the most comprehensive 

treatment of water resources economics with a 

treatment of benefit-cost analysis. Suitable for all 

Corps employees. 

Just, Richard E., Darrell Hueth and Andrew Schmitz. 

Applied Welfare Economics and Public Policy. 

Englewood Cliffs, NJ: Prentice Hall, 1982. 

One of the most complete treatments of welfare 

economics available, this is a text for advanced 

undergraduate and graduate students of economics. It 

has both calculus and non-calculus developments of 

consumer and producer surplus. This text is highly 

recommended for practicing Corps economists. 

Kohler, Heinz. Intermediate Microeconomics Theory 

and Applications. New Yorlc: Scott, Foresman and 

Company, 1990, 3rd ed. 

A text for a second course in microeconomics, this 

book provides a good treatment of many of the themes 

of this manual. 

Layard, P .R.G. and A.A. Walters. Microeconomic 

Theory. New York: McGraw-Hill. 1978. 

78 

This text provides an advanced undergraduate and 

graduate introduction to the rudiments of welfare 

theory. 

Maddala, G. S. and Ellen Miller. Microeconomics: 

Theory and Applications. New York: McGraw-Hill, 

1989. 

A text for a second course in economics, this book 

provides a good treatment of many of the themes of 

this manual. 

Moser, David A. and C. Mark Dunning. National 

Economic Development Procedures Manual--

Recreation, Volume II: A Guide for Using the 

Contingent Value Methodology in Recreation Studies. 

U.S. Army Corps of Engineers, Water Resources 

Support Center Institute for Water Resources, Report 

86-R-5, Fort Belvoir, Virginia, 1986. 

Newman, Donald G. Engineering Economic Analysis. 

San Jose, CA: Engineering Press, Inc., 1980. 

One of many texts addressing the discounting 

procedures used in evaluating public works projects. 

Sassone, Peter G. and William A. Schaffer. CostBenefit Analysis: a Handbook. New York: Academic 

Press, 1978. 

A good introduction to many of the most commonly 

used decision criterion is provided for readers 

comfortable with some basic mathematical notation. 

Smith, Gerald W. Engineering Economy: Analysis of 

Capital Expenditures. Iowa State University Press, 

1981. 

U. S. Department of Commerce, National Oceanic and 

Atmospheric Administration. The Use of Economic 

Analysis in Valuing Natural Resource Damages. 

Washington, 1984. 

This monograph provides an excellent review of a wide 

variety of issues that arise in evaluating damages to 

natural resources. 

Vincent, Mary K., David A. Moser and 

William J. Hansen. National Economic Development 

Procedures Manual--Recreation, Volume I: Recreation 

Use and Benefit Estimation Techniques. U.S. Army 

Corps of Engineers Water Resources Support Center, 

Institute for Water Resources, Report 86-R-4, Fort 

Belvoir, Virginia, 1986. 
Appendix 2: NED BACKGROUND 

79 
Appendix 2: NED BACKGROUND 

The Nation's economic development is not a 

new concern of water resource development, quite the 

contrary. The frrst public works project undertaken by 

the Federal government was the construction of a 

lighthouse at Cape Henry, Virginia, authorized on 

August 7, 1789 in recognition of the fact that coastal 

and foreign shipping was the lifeblood of the nation's 

economy. In 1808, Treasury Secretary Albert Gallatin 

presented a foresighted summary guide to future 

development of a system of roads and inland water 

routes that would unite the states and provide access to 

the nation's interior. Economic development of the 

West, i.e., west of the Appalachian mountains at the 

time, was one of the principal motivations for the 

report. 

The history of the Corps, and indeed the 

Nation, is replete with examples of legislation and 

committee reports providing for the economic 

development of our Nation. Interest in the nation's 

economic development is as old as the Nation itself. 

The requirement to evaluate the economic effects of a 

project dates back over 50 years to the Flood Control 

Act of 1936. What is relatively new IS the 

requirement to explicitly evaluate and quantify these 

effects according to a specific set of standards and 

procedures and the emphasis this work receives. 

Early enabling legislation of the water 

resource development agencies consistently required 

that reports demonstrate the economic value of the 

projects. Widespread use of benefit-cost analysis as a 

test of a project's economic worth is generally 

considered to have grown out of section I of the Flood 

Control Act of 1936. This section provided that: 

" ... the Federal Government should 

provide or participate in the 

improvement of navigable waters or 

their tributaries including watersheds 

thereof, for flood control purposes if 

the benefits to whomsoever they may 

accrue are in excess of the estimated 

costs ... Section I, 49 Stat. 1570, 33 

U.S.C. 701a." 

81 

Benefit-cost analysis did not become the 

principal basis for agency project recommendations 

until the post-World War II period. The directive to 

estimate the benefits and costs of flood control projects 

was soon extended to all water resource development 

purposes. 

A 1941 report of the National Resources 

Planning Board recommended the development of 

"standard methods of social accounting" to provide a 

dollar basis on which to evaluate such benefits. That 

same report recognized the responsibility for costs and 

the willingness to pay criteria as follows: 

"As a general principle costs should 

be repaid as far as practicable by the 

beneficiaries, with due consideration 

for the amount of benefits received." 

After the demise of the National Resources 

Planning Board, Congress and the Bureau of the 

Budget (precursor to the Office of Management of 

Budget) insisted that all projects must at least pass a 

test of economic feasibility. Agencies continued to use 

estimation methods that varied widely among agencies. 

For example, the Subcommittee on Evaluation 

Standards of the Inter-Agency Committee on Water 

Resources prepared the following reports describing the 

economic practices of water agencies: 1) Qualitative 

Aspects of Benefit-Cost Practices-1947, 2) 

Measurement Aspects of Benefit-Cost Practices-1948, 

3) Allocation of Costs of Federal Multiple-Purpose 

Projects-1949, and 4) Proposed Practices for Economic 

Analysis of River Basin Projects. 

In December, 1952 the Bureau of the Budget 

issued Circular A-47 to agency heads to inform them 

of the standards it intended to use to accept or reject 

agency evaluations of water projects. It is of some 

historical interest to note that Circular A-47 addressed 

issues such as incremental justification (of project 

purposes), land enhancement of flood protection, and 

what should be included in project costs among other 

issues. 

Each water resource agency adopted different 

and often inconsistent criteria for estimating benefits 
and costs. As benefit-cost analysis developed during 

the 1950s, the Water Resources Committee, a 

committee of the National Resources Committee 

fOlmed in 1935, became concerned that adequate 

attention be given to: 

"social benefits as well as economic 

benefits, general benefits as well as 

special benefits, potential benefits as 

well as existing benefits." 

In May 1958, "Proposed Practices for 

Economic Analysis of River Basin Projects", originally 

issued in May 1950 by the Subcommittee on 

Evaluation Standards, was revised. This document was 

to become known by its cover as the "Green Book". 

The Green Book states that the objective of economic 

analysis is: 

" ... to provide a guide for effective 

use of the required economic 

resources ... " 

The Green Book viewpoint for economic 

analysis is a barely discernible embryoniC version of 

the NED objective that states: 

is: 

"For Federal projects, a 

comprehensive public viewpoint 

should be taken." 

The general objective of project formulation 

" ... to maximize net econOtnic returns 

and human satisfactions from the 

economic resources used in the 

project." 

The Green Book addresses regional effects, 

formulation issues, benefit and cost evaluation, among 

other topics. The genesis of much of the Corps current 

economic guidance can be found in the pages of the 

Green Book. 

In May, 1962 the Water Resources Council 

issued its "Policies, Standards and Procedures in the 

Formulation, Evaluation, and Review of Plans for Use 

and Development of Water and Related Land 

Resources". Better knowq as Sellate Document 97, this 

docUment replaced the superseded Budget :pureau 

Circular A-47. SD 97 provides that the l>asic objective 

82 

of plan fmmulation is to provide for the best use of 

resources. It appears to provide the fust mention of 

the term "national economic development". In pursuit 

of this objective, full consideration is to be given to the 

objectives of Development, Preservation and WellBeing of People. Development was described, in part, 

as follows: 

"National economic development, 

and the development of each region 

within the country, is essential to the 

maintenance of national strength and 

the achievement of satisfactory levels 

of living." 

At this time, this guidance still referred to the 

preeminence of a "comprehensive public viewpoint" 

that needs to be applied in formulation and evaluation. 

Nonetheless, it did provide for the consideration of all 

viewpoints--national, regional, state and local. 

The Water Resources Planning Act of 1965 

(P.L. 89-80) required the newly created Water 

Resources Council (WRC) to establish principles, 

standards and procedures for Federal water resources 

planning. In September, 1973 the WRC established the 

"Principles and Standards for Planning Water and 

Related Land Resources" (P&S). The P&S, as they 

came to be called, followed the December 21, 1971 

publication of the proposed P&S. For the frrst time, 

National Economic Development (NED) is mentioned 

explicitly as one of two overall purposes of water 

resource planning, the other being environmental 

quality.. The P&S said: 

" The overall purpose of water 

and resource planning is to prOtnote 

the quality of life , by reflecting 

society's preferences for attainment 

of the objectives defined below: 

A. to enhance national economic 

development by increasing the value 

of the Nation's output of goods and 

services and improving national 

economic efficiency .... " 

The P&S frrst defined NED effects. 

Beneficial effects in the NED account are: 

" ... increases in the value of the 

output of goods and services and 

improvements in national economic 
efficiency resulting from a plan. 

These include: a. The value to users 

of increased outputs of goods and 

services; and b. The value of output 

resulting from external economies." 

The adverse effects on NED are described as: 

"a. The value of resources required 

for or displaced by a plan; and b. 

Losses in output resulting from 

external diseconomies." 

Corps of Engineers guidance began to 

explicitly address the NED objective; most significantly 

with the June, 1975 publication of ER 1105-2-351, 

"Evaluation of Beneficial Contributions to National 

Economic Development for Flood Plain Management 

Plans". 

The Standards were slightly amended in 

August, 1974 and WRC, in response to the President's 

June 1978 direction, developed a single set of 

procedures to ensure benefits and costs are estimated 

using the best current techniques. "Procedures for 

Evaluation of National Economic Development (NED) 

Benefits and Costs in Water Resources Planning (Level 

C)" were published in December, 1979. These 

Procedures are the step-by-step procedures for 

evaluating benefits for M&I water supply, urban flood 

damage, etc., well-known by Corps planners. This was 

the first systematic description of the NED benefit and 

cost evaluation procedures formally presented. 

In September, 1980 the P&S were revised and 

procedures for evaluating deep draft navigation and 

commercial fishing were added to the NED evaluation 

procedures. In September, 1982 the P&S were 

repealed and replaced in March, 1983 by the 

"Economic and Environmental Principles and 

Guidelines for Water and Related Land Resources 

Implementation Studies" (P&G). 

P&G firmly established NED as the Federal 

objective saying, in part 

"The Federal objective of water and 

related land resources project 

planning is to contribute to national 

economic development consistent 

with protecting . the Nation's 

83 

environment, pursuant to national 

environmental statutes, applicable 

executive orders, and other Federal 

planning requirements." 

The operational definition of NED, presented in Section 

II of Chapter I-Standards, is: 

"Contributions to national economic 

development (NED) are increases in 

the net value of the national output 

of goods and services, expressed in 

monetary units. Contributions to 

NED are the direct net benefits that 

accrue in the planning area and the 

rest of the nation. Contributions to 

NED include increases in the net 

value of those goods and services 

that are marketed, and also of those 

that may not be marketed." 

From "economic lifeblood" in 1789 to what 

many planners consider the be-all and end-all of water 

resources planning 200 years later, economics has been 

and remains a critical component of water resource 

development in the United States. 
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