CHAPTER 1: INTRODUCTION TO COST-BENEFIT ANALYSIS Purpose: To provide a non-technical overview of cost-benefit analysis.
CBA IS A METHOD FOR DETERMINING THE NET SOCIAL BENEFIT OF A POLICY
The broad purpose of cost-benefit analysis (CBA) is to help social decision making and to increase social value or, more technically, to improve allocative efficiency.
CBA is a policy assessment method that quantifies in monetary terms the value of all
consequences (usually called impacts) of a policy to all members of society. A CBA calculates the incremental net social benefit (NSB) for each policy alternative, which equals social benefits (B) minus social costs (C):
NSB = B - C
Net social benefits measure allocative efficiency. In practice we often drop the word “social” and refer to benefits, costs and net benefit rather than social benefits, social costs and net social benefit.
TYPES OF CBA ANALYSES
1) Ex ante (or prospective) CBA – conducted prior to the decision to implement a new policy. Useful for making future resource allocation decisions: can show whether
resources should be used on a particular proposed program or project. It addresses: would this policy be a good idea? Ex ante analysis is most useful
2) Ex post (or retrospective) CBA – conducted at the end of the intervention and all of the effects have been realized. Provides good information about the efficiency of a particular class of intervention because more is learned about the actual impacts of the project as time goes by. It addresses: was this policy a good idea? Should we undertake similar future interventions? The relevance to a new situation depends on their similarity;
projects may not scale well.
3) In medias res CBA- conducted during the intervention—after the decision to proceed, but before all impacts have occurred. It addresses: is continuation of this policy a good idea?
4) Comparative CBA – compares the ex ante analysis to an in medias res or ex post analysis of the same project (very few of these comparisons have been conducted). These
comparisons provide information about the prediction error and the accuracy of ex ante CBAs.
THE BASIC STEPS OF CBA
CBA can be broken out into ten basic steps:
Step 1 – Explain the purpose and broad focus of the CBA
Step 1 requires the analyst to explain why she is conducting the CBA. She should answer the
or government failures that suggest a new policy would increase allocative efficiency in the specific situation?
Step 2 -- Specify the set of alternative projects.
There are usually a huge number of potential alternative projects, for example, n dimensions with k possible values = kn alternatives. At a minimum, CBA compares the net social benefit of a proposed project with the net social benefit of a hypothetical (or actual) project that would be displaced if the proposed project would proceed. This displaced project is called the counter- factual and is usually the status quo, that is, continuation of current policy.
Step 3 -- Decide whose benefits and costs count (specify standing).
Standing determines whose benefits and costs will count. Standing is usually most appropriately specified at the national level. Some favor global standing, especially where there are
international spillovers (e.g., for many environmental issues). For other kinds of projects, some advocate standing at a lower level, such as state/province or local government.
Step 4 – Identify the Impact Categories, Catalogue them and select metrics.
Identify the physical impact categories of the alternatives, catalogue them as benefits or costs and specify the measurement indicator of each impact category. CBA analysts should only include impacts that affect the utility of human beings with standing. Also, there must be a cause and effect relationship between project outcome and the individual’s utility. Beware of impact categories that may be valued oppositely by different individuals (i.e., some individuals view the impact as a cost while others view it as a benefit). In such circumstances, it is often more useful to create two separate impact categories. Also, natural measurement units may not be feasible (i.e. crimes avoided); in such cases, surrogate indicators can be used.
Step 5 -- Predict the impacts quantitatively over the life of the project.
Prediction is difficult. Chapter 8 considers this topic in detail. Supply and demand curves usually aren’t known, which makes it hard to quantify impacts according to the conceptually correct method. In general, it’s more difficult to predict impacts if the project has a long time horizon or if the relationships between variables are complex.
Step 6 -- Monetize (attach dollar values to) all impacts.
In CBA, the value of a benefit is measured in terms of “willingness to pay” (obtained from demand curves). Many impacts are difficult to value in dollar terms because they are not traded in markets (e.g., life). If no individual is willing to pay for an impact, it has a 0 value. Costs are valued in terms of opportunity costs.
Step 7 -- Discount benefits and costs to obtain present values.
The mechanics of discounting are explained in Chapter 9. Impacts are discounted because almost everybody has a preference for consumption now rather than later and because there is an
opportunity cost associated with the funds required for a project. The appropriate social discount rate (SDR) method and the value of the SDR is contentious. It is discussed extensively in
Chapter 10. Often, the rate is mandated by a government agency responsible for financial and budgetary oversight for other government agencies.
Step 8 -- Compute the net present value of each alternative.
The net present value (NPV) of a project equals the present value of benefits minus the present value of costs:
NPV = PV (B) – PV(C)
Choose the alternative with the largest NPV. This alternative at least represents a more efficient allocation of resources. One cannot say it’s the most efficient allocation because not all possible alternatives are necessarily analyzed in the CBA.
Step 9 -- Perform sensitivity analysis.
There is usually considerable uncertainty about both predicted impacts and their appropriate monetary valuation. Sensitivity analysis clarifies for decision makers how these uncertainties affect the CBA results. Just about every variable and assumption can be subjected to sensitivity analysis, but time and resource constraints lead analysts to focus on the most important variables or assumptions. In theory, analysts should estimate the expected NPV. For this purpose, decision trees are useful, which we discuss in Chapter 11. Analysts might also perform Monte Carlo analysis, which provides a better understanding of the distribution of the estimated NPV.
Step 10 -- Make a recommendation.
Normally recommend the alternative with the highest (expected) NPV, but also take into account sensitivity analysis. In general, do not use the internal rate of return or benefit-cost ratio criteria.
BUREAUCRATIC AND POLITICAL “LENSES”
Government employees (and some analysts) have a tendency to see “costs” and “benefits” from an individual self- interested perspective or from an agency-interested perspective. Three archetypal perspectives are those of guardian, spender and analyst. Because the analyst perspective basically corresponds to CBA as described in this book, it is not discussed further here. In practice, government employees may vacillate between a spender and guardian perspective depending on the political and budgetary climate.
Guardians
Guardians view projects from a government revenue-expenditure perspective (i.e. revenue
naïve and impractical and as a tool of spenders to justify government projects. Financial control personnel in line agencies tend to have a guardian perspective.
Some consequences of the guardian perspective are:
• It downplays or ignores non-financial social benefits (time saved, lives, etc.) and costs (time spent, pollution).
• It interprets the meaning of “costs” idiosyncratically (and often incorrectly); e.g., regarding the cost of labor – guardians focus on actual wage remuneration, while CBA focuses on the opportunity cost of the labor.
• Resources owned by government tend to be viewed as free goods (rather than having an opportunity cost).
• It ignores those costs not borne by its own level of government.
• It treats subsidies from other levels of governments as “benefits” (because they are a revenue inflow).
• It wants to use a high social discount rate – similar to a financial market discount rate (usually higher than the social discount rate).
Spenders
The spender perspective is usually found in service or line departments. This often means they support any new project.
Some consequences of the spender perspective are:
• Expenditures on constituents are viewed as “benefits” rather than costs.
• Transfers from a CBA perspective that are received by constituents are viewed as
“benefits.”
• Some costs from a CBA perspective (such as workers’ wages) are viewed as benefits
• Utilized resources that are owned by government are viewed as having no cost.
• Large, capital-intensive projects with big sunk costs are favored. They are harder to cancel later on.
• They tend to view market allocations as inappropriate, and do not accept that project resources are diverted from other productive uses.
• They favor low discount rates (because, generally, this raises the NPV).
THE ORIGINS AND DEMAND FOR CBA
The origin of CBA dates back to Sir William Petty in 1665. He suggested that government should implement a new policy on the basis of his CBA.
Indeed, the primary clients for CBA are governments. The US Army Corps of Engineers was an early user of CBA, starting in the 1930s. Since the 1950s CBA has spread to many countries and is promoted by the World Bank and other multilateral development banks. It is often mandated for the evaluation of new government projects and regulations, and is now a major part of regulatory impact analysis.
In addition, courts of law may require CBA for the assessment of damages and therefore parties appearing before the courts (such as environmental groups) must be prepared to understand it. It is also used in antitrust cases.
Private-sector corporations increasingly are paying attention to sustainability, corporate social responsibility or the “triple bottom line”. As the purpose of these approaches is to improve the welfare of society, they can be considered a form of CBA.
THE COST OF DOING CBA
The cost varies considerably and may be hundreds of thousands of dollars.
READERS OF THIS BOOK
This book is both for those who want to perform CBA and those who want to know how to understand and interpret it; in other words, the various clients of CBA.
