I'm doing an online MBA at Cardean University, and part of the class consists of discussions and responses to various questions. Here are some of my posts:.

Question

"It is sometimes argued that the NPV criterion is appropriate for corporations but not for governments. First, governments must consider the time preferences of a community as a whole rather than those of a few wealthy investors. Second, governments must have a longer horizon than individuals, for governments are the guardians of future generations. What do you think?"

(Note that NPV, or Net Present Value, is a method for determining the return from a project. It says that we take all the cash flows from the project, discount them according to interest, inflation, risk, and the future time in which they occur, and add them up. If the result is positive, the project is worth doing. It reflects the fact that as an alternative to any project, we can always invest the capital in securities of equivalent risk and achieve a market rate of return. Thus money we receive in the future is valued at less than nominal value.)

I see three differences, two bad and one good, between public and private projects.

The good is that public projects can take into account externalities (both + and -) that private projects do not. Private projects only measure cash flows to and from the firm.

One bad is that public projects can be undertaken with negative NPV, because its the taxpayers money. There is not the same level of financial accountability. Government departments aren't expected to show a profit, they are expected to spend money. Thus they are free to spend money on things which create less happiness for the public than if they had just given them the money.

Another bad is that public projects are unlikely to use rational NPV calculations because of concentrated vs. dispersed interests, publicity, and other factors. Illustrations:

1) a project that costs $10M, and gives 1.20$ (NPV) in benefits to each of 10 million people, which they probably won't notice. This is a $2M profit.

2) a project that costs $10M, and gives $20 (NPV) to each of 500,000 people, which is enough that they'll notice. This is a $0 profit.

3) a project that costs $10M, and gives $800K (NPV) to each of 10 people for a loss of $2M.

#1 is the most beneficial, but people won't notice it so the real (as opposed to ideal) government agency may well not do it.

#2 is break-even, but it produces visible gain to a lot of people (voters!), so its more attractive to the government agency than #1.

#3 is a loss, but since the beneficiaries are a small number of people with a big gain, they have a large incentive to work hard to get it to happen, through licit or illicit means.

I'd bet on #3 in this field any day. I'd even give 2:1 odds against someone taking #1.

Another student said:

"The issue is that the success of government is often defined differently then the success of a corporation. For example government can be measured by the quality of life factors such as security, quality of health services etc.

In summary, goverment is measured differently and cannot be measured using the same formula as simple as NPV. Some examples are : consumer confidence, GDP etc. "

Economists think you can measure those "quality of life" factors using money, by giving them a value equal to what someone would pay for them. Thus you can try to evaluate all the costs and benefits in a common unit and do an NPV calculation.

This NPV calculation represents the fundamental fact that there are two ways to make someone happy: give them resources now, or invest those resources to make new resources, and give those new resources to the person later.

Even if you don't buy that money can measure everything, its still true that the government can spend taxes on health services now, or invest that money and provide even more health services in the future. We're comparing health services against health services, so whatever units you want to measure them in, we can still compare these two strategies.

Of course, if you are a politician, health services now make the public happy now which makes them vote for you in the next election. Health services when you're no longer in office do you no good at all.

This is less of a problem in the private sector (although still has some effect). While managers care the most about how the company does while they are with it, the companies stock price should include the NPV of its projects out as far as that can be predicted. So changes they make that have effects after they'll be gone still increase shareholder value.

The difference is that in the private sector, the people analyzing (and thus setting via the market) share price are using rigorous methods like NPV and rational evaluation. In the public sector, voters are not evaluating potential programs rigorously. (Even if they had the knowledge & ability, it would not be worth their time due to the