Suppose the government of an ocean-side municipality is trying to determine how to best deal with water pollution along its shoreline. It has hired you to help determine the better of two potential projects. In particular you have been asked to help with the benefit-cost analysis of these two projects. Project 1 involves installing a wastewater treatment facility to treat all residential wastewater prior to releasing it into the ocean. This facility will remove 100% of solid waste and treat 99% of liquid waste prior to releasing the water into the ocean. With the reduction of solid waste and liquid waste, the shoreline would become more attractive and there would be an increase in tourism to this municipality. The value of this increase in tourism is worth $60 million per year. The increase in tourism is dependent on continued operation of this treatment facility. Project 2 involves installing a wastewater treatment facility to treat all residential wastewater prior to releasing it into the ocean. This facility will only remove 80% of solid waste and will treat 70% of liquid waste prior to releasing the water into the ocean. This project would also increase tourism. The value of its increase in tourism is worth $40 million per year. The increase in tourism is dependent on continued operation of this treatment facility.
Project 1: Capital costs = $70 million. The new plant takes one year to build. Once it is constructed, operating costs = $20 million per year, and begin at the end of the first year of operation.
Project 2: Capital costs = $25 million. The new plant takes one year to build. Once it is constructed, operating costs = $10 million per year, and begin at the end of the first year of operation.
Assume that the discount rate is 5%. With either project, the municipality will operate the treatment facility for 5 years and then, conduct a study to see whether to continue operating it as is or modify it.
a) Which project should be undertaken? Give evidence to support your answer
b) Now suppose instead that the discount rate is 1%, all else the same, which project should be undertaken? Give evidence to support your answer.
c) Finally, suppose that with either project, there is a 25 percent chance that no tourism will occur. If the discount rate is 5%, which project should be undertaken? Give evidence to support your answer