Are sunk costs sunk, is salvage value salvageable? A paradox in engineering economics analysis

Salvage value is defined as “The estimated value of an asset at the end of its useful life.”
Sunk cost is defined as “Cost already incurred which cannot be recovered regardless of future events.”
It is often said in economics that “sunk costs are sunk”, meaning they should not be considered a cost in economic analysis, because the money has already been spent.
Now consider two cases
In case 1, we have a road project that costs $10.00 today, and at the end of 10 years has some economic value remaining, let’s say a salvage value of $5.00, which when discounted back to the present is $1.93 (at 10% interest). This value is the residual value of the road. Thus, the total present cost of the project $10.00 – $1.93 = $8.07. Clearly the road cannot be moved. However, its presence makes it easier to build future roads … the land has been acquired and graded, some useful material for aggregate is on-site perhaps, and can be thought of as the amount that it reduces the cost of future generations to build the road. Alternatively, the land could be sold for development if the road is no longer needed, or turned into a park.
Assume the present value of the benefit of the road is $10.00. The benefit/cost ratio is $10.00 over $8.07 or 1.23. If we treat the salvage value as a benefit rather than cost, the benefit is $10.00 + $1.93 = $11.93 and the cost is $10, and the B/C is 1.193.
In 10 years time, the community decides to replace the old worn out road with a new road. This is a new project. The salvage value from the previous project is now the sunk cost of the current project (after all the road is there and could not be moved, and so does not cost the current project anything to exploit). So the cost of the project in 10 years time would be $10.00 – $5.00 = $5.00. Discounting that to the present is $1.93.
The benefit in 10 years time is also $10.00, but the cost in 10 years time was $5.00, and the benefit/cost ratio they perceive is $10.00/$5.00 = 2.00
Aggregating the two projects
the benefits are $10 + $3.86 = $13.86
the costs are $8.07 + $1.93 = $10.00
the collective benefit/cost ratio is 1.386
the NPV is benefits – costs = $3.86
One might argue the salvage value is a benefit, rather than a cost reduction. In that case
the benefits are $10.00 + $1.93 + $3.86 = $15.79
the costs are $10.00 + $1.93 = $11.93
the collective benefit/cost ratio is 1.32
the NPV remains $3.86
Case 2 is an identical road, but now the community has a 20 year time horizon to start.
The initial cost is $10, and the cost in 10 years time is $5.00 (discounted to $1.93). The benefits are $10 now and $10 in 10 years time (discounted to $3.86). There is no salvage value at the end of the first period, nor sunk costs at the end of the second period.
What is the benefit cost ratio?
the costs are $11.93
the benefits are still $13.86
the benefit/cost ratio is 1.16
the NPV is $1.93.
If you are the community, which will you invest in?
Case 1 has an initial B/C of 1.23 (or 1.193), Case 2 has a B/C of 1.16. But the real benefits and real costs of the roads are identical.
The salvage value in this example is, like so much in economics (think Pareto optimality), an accounting fiction. In this case no transaction takes place to realize that salvage value. On the other hand, excluding the salvage value over-estimates the net cost of the project, as it ignores potential future uses of the project.
Time horizons on projects must be comparable to correctly assess relative B/C ratio, yet not all projects do have the same benefit/cost ratio.
This “paradox” was first noted to me by Mark Snyder. I don’t know how widely it is known or understood, but it does affect analysis.

Mass Transport and Mainframes

A recent post on Jonathan Schwartz’s Weblog : The Glamor in Mass Transit (?) basically talks about the efficiencies of scale. Sun computer, which Schwartz leads, has long argued the network is the computer, and has been trying to move intelligence back from the decentralized desktop into the highly centralized information technology control center.
The comparison between mass vs. private transportation and mass vs. private computing is worth noting. Everyone has a mental image of mass transit, though that image varies by individuals, some who see it is valuable, some as something they would not touch. The perception of course is shaped by their individual experiences, preferences, locations, and so on. Mass transit is efficient in certain specific contexts, but it requires users give up an element of freedom and (in general) spend more time traveling.
The personal computer revolution of the late 1970s and early 1980s enabled individuals to have control over their computing environment, without relying on a third party to provide that service. This provided freedom (I can write my own programs, and run them when I want in real-time, not having to go down to the computer center and load my program on to the Cyber at Rich Hall at Georgia Tech, and wait 20 minutes for the output to be printed (in below zero F temperatures, really, in Atlanta, January 1985, you can look it up .. Reagan’s second innaugural was delayed by the same coldfront) so that I can do a homework problem for Professor Betamax’s Fortran class (the course was videotaped, and was replayed every hour, so we could attend when we wanted). I hear horror stories of people who work in controlled environments like Lotus Notes, where they can’t deal with email conveniently but require using a browser with a sluggish email program behind it.
So as much as we might curse personal computers, or cars, freedom of action is what they provide.
A good mass transit system, like the so-called web 2.0, can provide the same freedom through its ubiquity, and free the user from the need to manage complex systems (automobiles, computers), focusing only on the higher level decision (what I want to do, what I want to say, where I want to go). But it builds in additional dependencies (will the internet be up? will I have to pay to get access in a hotel room to my data? will the bus show up on time? does the bus really go there? what will google do with my data? do I want to see personalized ads based on my research paper on transportation?).
Freedom from and Freedom to are important distinctions. I would much rather have Freedom to act than freedom from cost or risk of acting.
What should be owned and what should be rented or provided as a service is one of those essentially tug-of-wars that shape every aspect of the modern economy. There must be some economies of scale, or we would not see scale, but there must also be diseconomies, and loss of freedom is one of them.

Network Neutrality: Lessons from Transportation

I recently finished an essay/paper on Network Neutrality.

The politically-charged notion of network neutrality came to the fore in 2005 and 2006, using analogy from transportation as one of the key tools in motivating arguments. This paper examines how the various notions around network neutrality (common carriage, regulation, price discrimination) have played out in the transportation sector, and suggests many of the current arguments fail to understand the nuances of how complex networks actually operate to serve the many demands placed on them.

The full document can be downloaded here
It has been published
Levinson, David (2009) Network Neutrality: Lessons from Transportation. Review of Network Economics 8(1) 13-21 [DOWNLOAD]

Thomas, a thinly veiled portrait of rail in England

When I first came to England, I went into the HMV store and my son, trying to find something familiar immediately glommed onto Thomas the Tank Engine (he had a Thomas train in Minnesota, but it really wasn’t a big deal for him then). I bought the DVD which he became obsessed with for a time. Having not seen Thomas in detail before, I was surprised he is thought of as an icon for railfans. Almost every episode has some kind of disaster. I suppose this realistically portrays the state of surface rail in England, but it is hardly a positive spin on things, even if it works out in the end. The 26 episodes on the first season DVD follow, with a brief description of the maladies befalling The Isle of Sodor.
episode issue
1 Thomas and Gordon – Thomas doesn’t get uncoupled soon enough and is pulled by Gordon
2 Edward and Gordon – Edward gets picked to work, but isn’t thanked by Gordon
3 The Sad Story of Henry – Henry refuses to leave tunnel
4 Edward, Gordon and Henry – Gordon blows safety valve, Henry & Thomas save train
5 Thomas’ Train – Thomas leaves train’s coaches behind (as they were not coupled)
6 Thomas and the Trucks – Thomas pulls trucks, trucks willfully push him too fast, bump into each other, and as a consequence overshoots station
7 Thomas and the Breakdown Train – James derailed because trucks push him too fast. Thomas moves broken trucks and rights James. Thomas gets own branch lline
8 James and the Coaches – James steams controllers hat, overshopts stations, bumps coaches, passengers mend the brakepipe with bootlace and newspaper.
9 Troublesome Trucks – James pulls trucks (brakes would stick on or axles run hot) coupling snaps
10 James and the Express – Gordon switched off mainline onto loop, so James pulls
11 Thomas and the Guard – Henry’s system out of order, Thomas leaves guard behind
12 Thomas goes Fishing – Thomas needs water, draws water from river, Thomas gets fish in boiler, blocks pipes
13 Thomas, Terrance, and the Snow – Thomas bangs snowplow attachment, Thomas runs into a snow bank, Terrance the tractor pulls him out.
14 Thomas and Bertie – Thomas and Bertie the Bus get into race. Bertie has better acceleration, but a circuitous route and the railway has Right-of-way, Thomas wins, but racing is officially discouraged.
15 Tenders and Turntables – Turntables spins James around because of wind. Indignation meeting Gordon, James, and Henry
16 Trouble in the Shed – Thomas and Edward pick up slack from still sulking engines. Brings in Percy
17 Percy runs Away – Gordon almost crashes into Percy (Percy was on the wrong track), Percy runs away with no driver to pull brakes, and crashes into an earthbank.
18 Coal – Henry not operating well, bad coal
19 The Flying Kipper – Points frozen, danger sign not set. Crash. Henry derailed and remodeled.
20 Whistles and Sneezes – Gordon’s whistle stuck. Boys on bridge vandalize Henry’s Coaches. Henry “sneezes? ashes at boys.
21 Toby and the Stout Gentleman – Toby, a tram engine, moves trucks from farms to market, business dries up.
22 Thomas in Trouble – Police writes up Thomas for wheel sidings and cowcatchers. James runs into tar trucks.
23 Dirty Objects – James is pushed into tar wagons by his trucks
24 Off the Rails – Gordon’s plan for revenge misfiles and he slides into a ditch
25 Down the Mine – Thomas falls down the mine, is rescued by Gordon
26 Thomas Christmas Party – who knew trains were religious. Was a locomotive risen from the dead 2000 years ago?
The trains clearly have some major sins (the series was written by Reverend Awdry after all, there must be a moral), they seem largely to be a variant of Pride:
* Express is better than Pulling Coaches is better than Pulling Freight is better than Shunting
* Trains get “cheeky? with each other.
* Engines Want shiny coaches, shiny paint.
The system is strangely personified, trucks (freight cars) play tricks, and engines have personalities, yet are subservient to humans, still Drivers and Firemen and Fat Controller must negotiate with engines
Interestingly, the Engines recognizes intelligence is in the tracks (though one says “I seem to know the right line by instinct“)
Apparently later seasons tone down the carnage on the tracks, though it still remains, and Season 5 is quite dark and forboding, an Empire Strikes Back to Season 1’s Star Wars.
More on Thomas here: Thomas and Friends – Season 1 – Wikipedia, the free encyclopedia

Socialised Medicine

We recently had a child in England … a brief summary of the process is below
In England there is no prenatal care, there is antenatal care (which I thought when I first heard it that they were against babies). And you only see the doctor once in the process, the rest is handled by midwives. Socialised medicine is strange in what they do for you.
For instance, patients keep their own records, there doesn’t appear to be a copy at the doctor’s office (though this cannot really be the case it is much too absurd for a bureaucracy not to keep data), much less a digital version (and their project for that, the world’s largest civilian IT program seems to be having difficulties and … more difficulties (and its leader has come under some amusing scrutiny (his mom notes he failed computers in college) though they are still trying).
The fact that it is a centralized 10 year program already shows why it is doomed to fail, and that no lessons from the failure of transportation mega-projects and ITS or the success of the internet have been learned.
However, there are several home visits by the midwives, I suppose so the nanny state can check you out at home. They don’t do ultrasounds either except when something appears to be a problem, those you must acquire privately. And for your blood work they give you Lucozade) rather than a special sugar drink (which I am sure is cheaper). Given the lack of doctors, lack of ultrasounds, lack of drugs, lack of malpractice insurance and lawsuits, lack of billing, kicking you out of the hospital in one day etc., it should be cheaper, one wonders why National Health Service are running a deficit.
The “A team” of doctors is at the hospitals (My wife actually only saw one doctor prior to the day of birth, and that was only to do the birthing plan, and he didn’t even lay hands on). The procedure was only delayed 4 hours, not too bad on the whole. The nursing staff/midwives is largely immigrant, though I guess the US is moving that way as well. The midwives also seem to have less training than US midwives. The doctors seemed quite good (more competent than their US counterparts).
One doesn’t get a private room. There is a ward with about 6 mothers, though there are privacy curtains. This seems to be more for the convenience of the nurses/midwives monitoring everything than to actually save money, the amount of space difference is minimal, and the hospital (Chelsea and Westminster) has plenty of enclosed open space. I don’t know its utilization, it seemed higher than Fairview-Riverside.
Post-natal care involves 3 home visits by midwives, basically to collect data, again they don’t lay hands on or even look closely at the baby unless asked to. They do weigh it once or twice. There is also a health visitor who comes by.
The at-home visits are nice in principle especially for late in pregnancy and just after child-birth when mobility might be constrained. In practice, there didn’t seem to be too much point, the medical system just asking the same questions over and over again without actually treating anything. You get a team of midwives, so you may never see the same midwife twice.
The child-birth was much smoother this time, probably because a planned c-section is much preferrred to an emergency c-section. The lack of billing (or especially the infuriatingly time-wasting and tree-killing “this is not a bill” statements) is fantastic.