The city of Marietta is currently debating the future of the old Armory building on Front Street. Suppose that the mayor has proceeded with his plans to refurbish the building and use it as a transportation hub and visitor center. The estimated cost to complete the museum was initially $1.6 million. The mayor also believes that the transportation hub will generate an estimated benefit of $2.4 million.The benefit estimate appears to be correct, but costs to date total $2.7 million, and the transportation hub still is not ready. The cost of completing the transportation hub, X, is uncertain.
City Council member Flintstone wants to stop now: "Whatever the value of X, it is clear that the transportation hub will yield negative net benefits." Council member Rubble wants to continue: "If we stop now, we will have wasted $2.7 million."
Comment. How should the decision depend on the value of X?
Congratulations to Kaitlin Huck for being the first of three to submit a correct answer. Using marginal analysis, the decision on whether to continue the project or not hinges on the value of X, the cost of completing the project. The $2.7m costs to date are sunk costs and should not affect the decision to continue or stop the project.
3 comments:
If the value of X exceeds the value of the potential revenue(2.4 million) then the city shouldn't use it as a trasportation hub. The city would lose revenue instead of proffiting.
If the value of X (the cost of completing the transportation hub) is less than $2.4 million, the council should continue to build the transportation hub and visitor center.
Council member Rubble's comment that if we stop now, we will have wasted $2.7 million is irrelevant. Those are sunk costs and marginal analysis dictates that we ignore those costs because we can never get them back.
If the cost of completing the hub is $2.4 million, the city will break even. If it is any less, the hub benefits will outweigh the costs and should be pursued. If any more, the costs will outweigh the benefits and should not be pursued.
Blakely Dye
Part of the issue here is about the timing of the costs and the benefits. In order to make a decision such as this one, council should consider the net present value of all present and future cash flows and compare them to the present and future costs. Assuming that the benefit will not instantaneously appear once the renovation is complete, but, rather, over time (say $500k per year for 10 years), one must consider the discounted (net realizable) value of all those flows. Because of inflation and time preferences, money today is more valuable than money 10 years from now. In discounting the flows, council should consider its time preferences, its cost of capital, and opportunity cost. Even if net benefits exceed net costs counting only interest (paid on a bond issue, loan, or forgone interest) and inflation, it should still consider opportunity cost. Let's say that the city stands to earn a 5% return on its investment, if it could earn 6% on another project, it should not go forward with the transportation hub unless it could somehow quantify the benefit of its citizens having a transportation hub versus a pile of money in the bank.
If the benefits to the city and its citizens accrue immediately, then Blakely's assertion is correct that as long as costs are less than $2.4 million, the city should move forward with the project. This presumes, however, that an alternate investment with a higher return does not exist.
Blakely is also correct in asserting: "Council member Rubble's comment that if we stop now, we will have wasted $2.7 million is irrelevant. Those are sunk costs and marginal analysis dictates that we ignore those costs because we can never get them back."
-Cody Meglio
ECON 371 & 375
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