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Hockey Sticks and Sanity Checks

posted Jul 3, 2013, 12:58 PM by Info@ Whitaker   [ updated Jul 3, 2013, 1:05 PM ]

Democrats and Republicans, liberals and conservatives, have some fundamental differences in philosophy, but one thing they usually agree on is that when government spends tax dollars, it should spend those tax dollars wisely. Investment in infrastructure projects such as transportation is one category of expenditure that often achieves bipartisan support. For example, in 2013 Democrats and Republicans in Virginia united to pass legislation that raises taxes in order to pay for new transportation investments.

I know some people who never never to have seen a rail project that they didn’t like, and other people who never seem to have seen a highway project that they didn’t like, though these people never seem to be the same. I believe there are good transportation investments and there are bad transportation investments. How can we tell the good from the bad?

The process of making private sector investments and public sector investments has much in common--identification of alternatives, identification of costs and benefits, application of an appropriate discount rate to calculate net present value, and sensitivity analysis. Significant differences in these two processes include the fact that when evaluating private investments, costs and benefits are considered from the private owner’s perspective, while public sector investments look at costs and benefits from a much wider public perspective.

“Rational” private sector investments are only made in projects whose net present value is positive at the appropriate discount rate. The simple economic reason for this decision rule is that investments in projects with a positive net present value yield returns that can then be reinvested, thereby increasing the value of the organization and the wealth of the owner. For instance, a private investment in an airline that generates sufficient revenue from passengers and freight to pay the airline’s capital and operating expenses can purchase additional airplanes, expand its fleet, and increase in value. An airline that doesn’t generate sufficient revenue will not be able to expand or even continue to operate. A free market is usually, eventually, self-correcting.

Many public sector investments don’t have the same connection between the benefits derived from the investment and the cost of that investment. “Freeways” are a perfect and aptly named example where the benefit from the investment isn’t the revenue--which comes in the form of taxes--that is generated, but rather the benefit is the ability of citizens to travel and for the economy to grow. The difficult part about public sector investment is that the disconnect between the ability to raise taxes for a project and the benefits that arise from such an investment tends to eliminate the self-correcting nature that we find in the private sector. Governments may be able to raise taxes because of their authority and spend those taxes on projects in which the population places no value.

One of the most important things to do when evaluating private and public investments is to perform a simple sanity check not only on the end result but on the underlying inputs and calculations. In transportation, we have learned a lot about elasticities of demand--the change in demand that results from a change in transportation price or the change in travel time--and other factors that affect consumer choice. One of the frequent complaints of business plans is that they often show “hockey stick” revenue and usage growth rate projections where the projected growth rate makes a sharp rise from the historical growth rate. We know that transportation demand will change based on factors such as price and travel time, and there is some evidence that we may have reached “the end of car culture,” but shifts in transportation demand are most likely to take place gradually over time. When evaluating transportation investments, always do the sanity check, and beware the hockey stick.