There are two popular narratives about our infrastructure in the United States. The first is that our infrastructure is crumbling. The second is that our infrastructure spending is allocated based on its political value rather than its economic value. Maybe you believe one of these stories. Maybe you believe both. Maybe you believe neither. Regardless, these narratives are indicative of two important questions. How can we efficiently manage our public infrastructure? And how can we ensure that infrastructure investment isn’t used as a political tool? I have a new paper that proposes an answer to both questions. My proposal is to create a rule of law for public infrastructure based on option values. This rule of law would ensure that infrastructure is maintained efficiently and also that politicians would not be able to use infrastructure spending as a political tool.
The standard way to evaluate public infrastructure projects is to figure out the benefits of the infrastructure over its entire lifespan and then compute the present value of those benefits. Then you do the same thing with the costs. When you subtract the present value of the costs from the present value of the benefits you get something call a net present value. Infrastructure investments are evaluated using a positive net present value criterion. In other words, as long as the present discounted value of the benefits exceeds the present discounted value of the costs the project is desirable.
In theory the net present value approach seems like a good idea. Of course we would want the benefits to outweigh the costs. This approach, however, is much different than how a private firm would value their assets. A firm that owns a factory knows that the factory can eventually become outdated. To the firm the value of the factory is the sum of two components. The first component is the value of the factory to the firm if the firm never shuts down the factory or builds a new one. The second component is the value of the option to build a new factory or add to the current factory’s capacity in the future.
The same general concept is true of public infrastructure investment. The value of any existing infrastructure is the value of the infrastructure over its entire lifetime plus the option value of replacing that infrastructure in the future. This option value is associated with a tradeoff. Since infrastructure depreciates over time, the value from existing infrastructure is declining. This means that as time goes by, the opportunity cost of replacing the infrastructure declines and therefore the option value of replacing the infrastructure rises. However, the longer the government waits to replace the infrastructure, the longer society has to wait to receive the benefit of replacement. This reduces the option value. My proposal suggests that the government should choose the value of the current infrastructure that optimally balances this tradeoff. What this ultimately implies is that the government should wait until the value of the current infrastructure is some fraction of the net present value of the proposed replacement project.
The reason that this option approach is preferable to the net present value approach is as follows. First, even though a current project has a positive net present value, this does not necessarily imply that now is the optimal time to undertake the project. Replacing infrastructure entails an opportunity cost associated with the foregone benefit that society would have received from the existing infrastructure. In other words, society might get greater value from the project if the government chooses to wait a little longer before replacing what is currently there. Second, my approach provides a precise moment at which it is optimal to replace the infrastructure. In contrast, the net present value approach says nothing about optimality; it’s simply a cost-benefit analysis. Given the possibility that society could get an even larger benefit in the future, the option approach should be strictly preferred. Third, the option approach provides an explicit way for the government to maintain an infrastructure fund. In my paper I provide a simple formula for computing the amount of money that needs to be in the fund. This formula is simple; it only needs to take into account the cost of each project and the relative distance that project is from its replacement threshold. This sort of fund is important because it would also allow the government to continue funding infrastructure projects at the optimal time even during a recession when infrastructure budgets, especially at the local level, are often cut.
The final and most significant benefit of my approach, however, is that it would provide the means for establishing a rule of law for public infrastructure projects. This rule of law should appeal to people across the ideological spectrum. I say that for the following reasons. First, if the government adopted this option value approach as a rule of law, this would require that the government fund any and all infrastructure projects that had reached their replacement thresholds. This would ensure that the infrastructure in the United States was maintained efficiently. Second, because the only projects that would receive funding would be those that had reached the replacement threshold, politicians would not be able to use infrastructure spending as a tool for reelection or repayment to supporters. As a result, the option approach would provide the means for a rule of law for infrastructure investment that is both transparent and efficient.
Establishing such a rule of law would be difficult. The same politicians that benefit from allocating infrastructure investment for political reasons would be the same ones who would have to vote on the legislation to enact this new rule. Nonetheless, there is evidence that politicians vote in favor of infrastructure projects that benefit their constituents, but vote against aggregate investment. If the group of politicians that benefit most from this state of affairs is small, then the legislation might be easier to pass. In addition, there is nothing to stop departments of transportation at both the state and federal level from calculating option value and making the data available to the public. This greater transparency, while not a rule of law, would at least be a step in the direction of a more efficient management of our public infrastructure.