Table of Contents
Suggested citation: Arampatzis, S. (2013). Cost-benefit analysis. LIAISE Toolbox. Retrieved date, from http://beta.liaise-toolbox.eu/ia-methods/cost-benefit-analysis.
Cost−benefit analysis (CBA) is an economic technique applied to public decision−making that attempts to quantify and compare the advantages (benefits) and disadvantages (costs) associated with a particular project or policy for society as a whole. The appeal of CBA is that by monetising the benefits of the policy, it is possible to compare and/or aggregate many different categories of benefits with one another, and with the costs of the policy. When the social benefits outweigh the costs, the policy should be implemented.
When a number of alternative policies or programs are being examined, CBA would recommend choosing the one with the largest net benefits, where net benefits are defined as the benefits minus the costs. The estimation of costs and benefits also allows one to determine the socially optimal size of the program or project, i.e., the one that maximises net benefits.
Concerns with respect to the application of CBA include its partially subjective nature, its lack of concern for the distribution of the achieved benefits, its treatment of intergenerational equity, and the difficulty of accurately estimating all social costs and benefits, which might make the actual conduct of a fully comprehensive CBA a very costly business.
Definition & Objectives
A cost−benefit analysis (CBA) can be defined as an economic technique applied to public decision−making that attempts to quantify the advantages (benefits) and disadvantages (costs) associated with a particular project or policy. This technique has been used to analyse policies affecting transportation, urban regeneration, agriculture, public health, criminal justice, defence, education, and the environment. The appeal of CBA is that by monetizing the benefits of the policy, it is possible to compare and/or aggregate many different categories of benefits with one another, and with the costs of the policy.
Process & Method
A policy or project would be deemed acceptable if its benefits outweigh the costs. In this sense, a CBA informs decision−makers of social preferences, and thereby also of the social desirability of a project or policy. Out of a number of alternative programs being examined, CBA would recommend choosing the one with the largest net benefits, where net benefits are defined as the benefits minus the costs. Cost−benefit analysis also allows one to determine the socially optimal size of the program or project, i.e., the one that maximizes net benefits. In ecoomic terms, the marginal benefits of a socially optimum program will be equal to its marginal costs.
The first order of business of a CBA is to identify possible costs and benefits of the proposed policy or project, along with the parties who incur such costs or experience such benefits. Next, the analyst needs to place a monetary value on the various categories of costs and benefits, and aggregate the various categories of monetized costs and benefits into cost and benefit totals. This task is complicated by the fact that many policies entails costs and benefits that are incurred in different time periods—which requires discounting them to compute their present values—and that many categories of benefits are non−market goods, and as such are not bought and sold in regular marketplaces.
Process - categories of costs
When economists estimate the costs of a policy or project for the purpose of conducting a CBA, they refer to the social costs of the policy, which may well be different from the private costs of the policy. Briefly, the total social costs are the sum of all opportunity costs incurred by society because of the new policy. The opportunity costs are the value of the goods and services lost by society resulting from the use of resources to comply with and implement the policy, and from reductions in output (if any). For simplicity, in what follows we place the costs of the policy into five broad categories:
- real−resource costs, including compliance costs,
- government regulatory costs
- social welfare losses
- transitional costs
- indirect costs.
By real−resource cost, we mean all of the resources that are used up to implement the program or policy. By real−resource compliance costs, we mean all of the resources that must be expended for complying with the regulatory aspects of the program. Suppose, for example, that we were considering an environmental policy. In this case, the real−resource compliance costs would be costs associated with purchasing and installing new pollution control equipment, changing the production process by using different inputs or different mixtures of inputs, and capturing the waste products, reusing or re−selling them, or disposing of them in approved landfills or incinerators.
These costs would, therefore, be borne by firms or plants, as well as private citizens. For example, if a mobile source policy required car owners to subject their vehicles to emissions testing, (i) the fee paid to take the test, (ii) the value of the time spent by the car owner to go to and wait at the testing facility, and (iii) the cost of any repairs to the emissions control equipment would be examples of possible real−resource compliance costs incurred by these individuals.
The second category of costs—government regulatory costs—includes the monitoring, administrative, and enforcement costs associated with the policy, especially when the latter has a regulatory aspect. The cost of setting up new markets (e.g., an emissions trading program) would be included in this category of costs. However, any incentives paid out by the government to private firms or individuals to induce them to undertake certain actions (or refrain from undertaking them) are generally not counted among the costs of the policy. Presumably, these are transfers from one group of agents (e.g., taxpayers) to another, and so they would be costs the former and benefits to the latter. To avoid double−counting them, they are thus generally excluded from the cost−benefit calculus.
By social welfare losses, one generally means the consumer and producer losses associated with possible rises in prices or decreases in output that occur as a result of the policy.
Presumably, if the cost of a product were to rise as a result of the policy (consider, for example, a policy that regulates the use of pesticides in agriculture), consumers would have to buy less or switch to a substitute, which would lead to a fall in consumer surplus. The extent of the fall in consumer surplus depends on the market structure, and on the elasticities of demand and supply for this product. Once these are known, it is possible to obtain an estimate of the change in consumer surplus. The task of estimating this category of costs is complicated by the difficulty of estimating the demand and supply for the product, and any structural changes in the market for the good whose price or supply is affected by the policy.
When the US Environmental Protection Agency was called to cancel or allow continued registration of pesticides for use on crops under the Federal Insecticide, Fungicide and Rodenticide Act (FIFRA), the law explicitly instructed the agency to compare the costs and benefits of allowing continued use of the pesticides in questions. Producer and consumer losses due to higher produce prices were calculated and are documented in the Record of Decision that accompany the final outcome for each of the pesticides considered by the Agency (Cropper et al. 1992).
Transitional social costs include the value of all the resources that are displaced by the policy, and the private costs of reallocating these resources. These include, among others, unemployment and firm closings, shifts of resources to other markets (for example, capital might be attracted to other markets if the returns on the presently considered market decline), transaction costs, and any disruptions in productions that occur as a result of the policy.
It should be kept in mind that any job losses associated with the policy might be offset by the additional hires that must be made to ensure compliance with the policy. In addition, when computing the costs due to job losses, it is important to examine the duration of the spell of unemployment, the size of the group of workers affected, and the cost of re−training programs and unemployment benefits.
The remaining category is comprised of indirect costs, such as adverse effects that the policy may have on product quality, factor productivity, innovation, discouraged investment, and changes in markets indirectly affected by the policy. In some cases, some of these effects will already be captured by the losses in producer and consumer welfare. It is, therefore, important to avoid double−counting of these costs.
Combination with other methods
As mentioned, CBA focuses on the aggregate costs and benefits of a policy or programme. One limitation of CBA is that it ignores distributional issues, including whether those who care about the benefits of the policy can actually afford to pay for it. Another problem with CBA is that it must monetize categories of costs and benefits that are experienced at different times. Economists recommend discounting costs and benefits incurred in the future to compute their present value, but doing so requires choosing a discount rate. Present values are very sensitive to the choice of the discount rate and to any assumption about whether the discount rate does or does not stay constant over time.
CBA typically makes use of monetary valuation methods. The benefits of projects or policies will often take the form of improvements in individuals’ welfare that are not traded in markets, and for which there is no market price. Valuation methods are used in CBA to circumvent this problem. Which specific valuation technique is appropriate for one’s benefit estimation exercise depends on the context, on the category of benefits being considered, and on whether the market or individuals’ behaviours are consistent with the assumptions of the method being used. Based on these considerations, it can be concluded that the estimation of the benefits of a policy is generally a difficult task, much more so than the estimation of the costs of a policy.
Types of data needed
In order to determine the net effect of a proposed policy, we must first identify those persons who stand to gain and those who stand to lose from the implementation of the policy, and then estimate their respective gains or losses. For all practical purposes, CBA adopts the principle of a potential Pareto improvement, where winners can potentially compensate the losers. In total the benefits and the costs examined in a CBA are the aggregate gains and losses experienced by the individuals who comprise society.
Thus, if no individual is made better off by the public program, there are no benefits associated with it. If no one is made worse off by the program, there are no costs.
We also wish to emphasize that benefits and costs, even though they are expressed in monetary terms in CBA, go well beyond changes in individuals' incomes. If someone's well−being is improved because of cleaner air—through a reduction in the physical discomfort or symptoms associated with pollution exposures, for example—this person experiences a benefit even though his or her income has not changed.
Strengths & weaknesses
The appeal of CBA is that by monetizing the benefits of the policy, it is possible to compare and/or aggregate many different categories of benefits with one another, and with the costs of the policy.
The application of CBA in an IA poses a number of questions. First, CBA measures costs and benefits on the basis of (subjective) individual preferences given objective resource constraints and technological possibilities. Whether or not a project or policy that maximises (subjective) individual preferences is preferable is an open question – and should probably be answered on a case−by−case basis.
Second, CBA is often criticised for its apparent insensitivity to issues of intra− and intergenerational equity. With respect to the issue of intra−generational equity, CBA is insensitive as to the distribution of cost and benefits over different individuals, as long the ‘winners’ could, in principle, compensate the ‘losers’ (but CBA does not require that this compensation actually takes place). With respect to intergenerational equity, the correct practice of CBA to discount future costs and benefits to their present values has been criticised on the grounds that it would thus neglect the welfare of future generations. While the critique on discounting in CBA has sometimes been less than rational, it is true that the choice of a particular discount rate (or discount function) will strongly influence the net present value of long−term sustainability policies such as climate change policies. In academics as well as in policy, some consensus seems to be emerging to discount potentially irreversible environmental damages in the very long term (> 100 years) at the lowest possible rates.
Third, in CBA uncertainty and risk are treated in a classical fashion. If certain future effects are uncertain, the correct procedure is to assess the (discounted) expected utility of the effects. In this approach, the probability and the size of the effects play a role, but also the rate of risk aversion of the relevant population. In CBA, future low probability – high impact events are more important for current policy making, the higher the probability of occurrence, the higher their potential damage, the lower the discount rate, and the higher the rate of risk aversion.
Fourth, certain costs and benefits that are in the social and environmental domains of sustainable development may be difficult to quantify and to value in monetary terms. There are observers who object in principle (or on moral grounds) to the notion that every ‘value’ can be traded for a price. But putting these moral objections aside, in the practice of CBA advanced ‘valuation’ tools have been developed that are capable of inferring individuals’ preferences over both market and non−market (e.g. environmental) goods which are introduced in the valuation methods section.
CBAs can be conducted ex ante—before the policy is implemented—or ex post. The US Environmental Protection Agency (1998, 1999) conducted retrospective CBAs of the 1977 Clean Air Act and of the 1990 Clean Air Act Amendments. These analyses concluded that the benefits due to the premature or cancer−related deaths avoided by this environmental statute accounted for over 80% of the total benefits.
We are aware of several pieces of legislation that require the agency in charge to balance the cost and the benefits in setting standards or issuing regulations. In the US, the Federal Insecticide, Fungicide and Rodenticide Act, first passed in 1947 and extensively amended in 1972, when responsibility for its implementation was transferred from the US Department to Agriculture to the US Environmental Protection Agency, requires that pesticides be registered with the EPA before they can manufactured for commercial use. Distribution of any pesticide that is not registered or that is improperly labelled is prohibited. The burden of proof about the safety of a new pesticide is placed on the manufacturer, while the EPA is responsible for gathering evidence from toxicological studies if it wants to reconsider the registration of an existing pesticide.
In determining whether to register a pesticide, the Congress required EPA to consider economic, social, and environmental costs and benefits of use of the pesticide. Information about the benefits and risks of pesticide use are collected and documented within the so−called Records of Decision.
By contrast, in the Clean Air Act the EPA is instructed by the law to set national ambient air quality standards that ensure the protection of human health, with a wide margin of safety and without considering the costs of attaining such protection.
Within the EU, the Water Framework Directive contains provisions that may be interpreted to imply that the benefits of the policy be balanced with its costs. Specifically, the Directive requires that all bodies of water be brought to ‘good ecological status’ but allows for derogations to the rule if the costs are disproportionately high.
CBA have been carried out for a number of proposed or actual EU policies. For example, DG−Environment has conducted a CBA of lowering the sulphur contents of gasoline and diesel fuels to less than 10ppm. The benefits of the policy include, among others, reduced consumption of fuel for vehicle of more recent vintages, and reduced mortality and morbidity effects associated with air pollution exposures. Under the “main scenario 2005,” the present value (at a discount rate of 4%) of the net benefits is equal to over €2,673.5 million.
One major criticism that has been brought to CBA is that it assumes that those persons who stand to gain from the policy change compensate the losers. This ignores distributional issues, and the fact that, for example, a wealthy person would be able, and therefore willing, to pay more than a poor person for the same improvement in environmental quality, even though both cared about it with equal intensity. Equity considerations are not sufficiently reflected in CBAs. The argument that projects or policies with the best benefit−cost−ratio are socially desirable rests on the assumptions that the gainers can – in principle – compensate the losers of a project/policy and still be better off. Whether such compensation actually takes place is not part of the information provided by a CBA.
Regarding the fact the individuals with lower incomes may be limited in their ability to pay for the implementation of the program, economists would suggest that the benefit−cost calculus be amended to alter the weights given to the benefits of certain categories of beneficiaries or the burden imposed on certain categories of individuals.
CBA can be expensive and time−consuming, and results are likely to be sensitive to the many assumptions often required to complete the estimation of the benefits and the costs of the proposed policy and program (Moore 1995).
Another difficulty of CBA—and a key factor when performing a CBA within the broader goal of assessing sustainability policies—lies in the fact that many public programs produce streams of costs and benefits over time, rather than in one−shot increments. This requires discounting future benefits and costs to present values. There is considerable disagreement among economists about the interest rate (or rates) at which these future costs and benefits should be discounted, and about whether the choice of interest rates should reflect uncertainty about the costs and benefits of the program. In its impact assessments for planned legislation, the European Commission routinely applies a discount rate of 4%.
Briefly, the present value of a sum, X, to be incurred in the future—T years from now—is:
The quantity d is equation (1) is the discount rate, whereas is the discount factor. If the sum X (which might be the cost or the benefit of a policy or project) is incurred every year for the next T years, the present value of the stream of payments or benefits is:
Equation (2) can be generalized to the situation where the payments or benefits are different every year:
The problem with the choice of the discount rate d is further complicated by the fact that present values are very sensitive to the choice of the interest rate. For example, €1 million in benefits incurred fifty years from now has a present value of only €8,500 when an interest rate of 10 percent is used, €87000 when the interest rate is 5 percent, and €371,500 when the interest rate is 2 percent. This is of concern when CBA is applied to the evaluation of policies with significant intergenerational effects, such as those pertaining to the prevention of global climate change or the disposal of high−level radioactive wastes (which will be lethal for hundreds of thousands of years).
It is generally recognized that the social discount rate need not be equal to the private discount rate. Economists, however, argue that the discount rate should be positive, even in the context of intergenerational decision-making and investments. Treating one euro today as if it were worth as one euro several years from now is counterintuitive, and would result in an excessive sacrifice in current wellbeing, to the point that each successive generation would be impoverished in order to further the wellbeing of the next (OECD 2004).
The notion of social discount rate is usually presented in the form of the following equation, known as the Ramsey equation:
where d is the social discount rate, r is the ‘pure’ rate of time preference, which reflects people’s impatience, g is the growth rate of future per capita consumption, and m is the elasticity of the marginal utility of consumption. The quantity m is therefore the percentage change in welfare derived from a percentage change in consumption (or income), and its intuitive interpretation is that it expresses individuals’ aversion to fluctuations in income levels. Because people expect to be richer, which means that the marginal utility of a euro in the future is lower than the marginal utility of a euro now, (µ • g) measures the portion of the discount rate due to the fact that future people will be richer than people today.
What are, then, reasonable values for the social discount rate d? Recent literature reviews suggest that m should be equal to one (Cowell and Gardiner 1999), and that the pure rate of time preference should be at most 0.5% (Pearce and Ulph 1999). This implies that for an economy growing at, for example, 2% per annum, the social discount rate should about 2.5%. Indeed, social discount rates developed using equation (4) generally range between 0.5% and 3% (US EPA, 2000).
Is the social discount rate constant over time? Gollier (2002) examines how equation (4) should be amended when there is uncertainty about future income. Precautionary saving—the prudence effect—lowers the social discount rate. By contrast, the social discount rate increases with m. The net effect on the social discount rate, therefore, depends on which of these two factors is stronger. Expectations about the rate of growth of the economy over time are an important determinant as to whether the social discount rate stays the same or changes over time. Even if people expect the economy to continue growing at the same rate across time periods, the social discount rate may be declining over time if people exhibit decreasing relative risk aversion to risk as wealth increases. Weitzman (1998, 1999) discusses another rationale for time−declining discount rates, which are driven by uncertainty about future discount rates. As time goes by, the discount rate converges to the lowest possible discount rate.
Chichilnisky (1997) considers current−day decision-makers whose objective is to maximize the discounted net benefits under a sustainability requirement (effectively, future generations’ well−being). A declining discount rate over time is consistent with the requirement that current generations must always take into account the wellbeing of future generations.
Li and Lofgren (2000) obtain social discount rates that decline over time if society is comprised of two individuals, a conservationist and a utilitarian, where the former has a lower discount rate than the latter. Depending on the weights attached to the conservationist and the utilitarian individuals in final decision-making, the discount rate may well decline over time, tending to lowest possible discount rate (that of the conservationist).
Weitzman (2001) surveys 2600 professional economists, asking them “what real interest rate […] should be used to discount over time the (expected) benefits and (expected) costs of projects being proposed to mitigate the possible effects of global climate change.” The survey data indicate that over the next 1−5 years, the average discount rate is 4 percent; for the 6−25 year horizon, 3 percent; for 26−75 years, 2 percent; for 76 to 300 years, 1 percent, and for more than 300 years, 0 percent.
Empirical evidence based on individual behaviours and data does support the notion that people’s private discount rates may be declining, rather than staying constant, over time. It is sometimes suggested that individuals apply hyperbolic—rather than constant exponential—discounting. Under hyperbolic discounting, the discount factor is higher than that implied by constant exponential discounting for sums of money that are incurred in the near future, but lower when the sum X is incurred at a later time. Figure 2 below summarizes this concept.
Assuming exponential discounting with discount rates that are constant over time, researchers have inferred individual discount rates from behaviours or hypothetical choice questions. Interestingly, the discount rates exhibited by individuals vary considerably across contexts, e.g., when making money−versus−money tradeoffs, risk−versus−money tradeoffs, and employment decisions. For example, by observing the acceptance or rejection of retirement packages in the military, Warner and Pleeter (2001) estimate that discount rates range between 35 and 54% among enlisted personnel, and 10 to 19% among officers. Harrison et al. (2002) estimate the discount rates implicit in the choice to accept money now or later to be 28% for a sample of Danes participating in a laboratory experiment. Moore and Viscusi (1990) estimate the discount rates of workers facing mortality risks associated with workplace exposures, while Horowitz (1990) administers a questionnaire involving hypothetical tradeoffs between immediate and future risks, and Alberini et al. (2004) ask respondents to report their willingness to pay for immediate and future mortality risk reductions. In the money v. mortality risk tradeoff context, the discount rates range between 2 and 14%.
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