Elements of Cost-Benefit Analysis (Routledge Revivals)

E. Mishan, E. J. Mishan

• Publisher: Routledge
• Year: 2015
• Print ISBN: 9781138852471
• eBook ISBN: 9781317528036
• Edition: 1
• Topic: Economics
• Subtopic: Decision Making
• Index: Economics

This book, which was first published in 1972, is not a collection of case-studies in cost-benefit analysis, of which there had been already several in use employing techniques of varying degrees of sophistication. Nor is it a manual of instruction with particular orientation for less developed counties, such as those produced under the auspices of the U.N. and the O.E.C.D. What this volume does attempt is to introduce the student of economics to the logic and the concepts used in cost-benefit analysis.

Part 1. Introductory

Chapter 1
Why Cost-Benefit Analysis?

1. The general question that a cost-benefit analysis sets out to answer is whether a number of investment projects, A, B, C, etc., should be undertaken and, if investible funds are limited, which one two, or more, among these specific projects that would otherwise qualify for admission, should be selected. Another question to which cost-benefit analysis sometimes addresses itself is that of determining the level at which a plant should operate or the combination of outputs it should produce. In this introductory volume, however, we follow custom in confining our attention chiefly to the former question, about the choice of investment projects.

But why bother with cost-benefit analysis at all? What is wrong with deciding whether or not to undertake any specific investment, or to choose among a number of specific investment opportunities, guided simply by proper accounting practices and, therefore, guided ultimately by reference to profitability. The answer is provided by the familiar thesis that what counts as a benefit or a loss to one part of the economy – to one or more persons or groups – does not necessarily count as a benefit or loss to the economy as a whole. And in cost-benefit analysis we are concerned with the economy as a whole, with the welfare of a defined society, and not any smaller part of it.

A private enterprise, or even a public enterprise, comprises only a segment of the economy, often a very small segment. More important, whatever the means it employs in pursuing its objectives whether rules of thumb or more formalized techniques such as mathematical programming or operations research-the private enterprise, at least, is guided by ordinary commercial criteria that require revenues to exceed costs. The fact that its activities are guided by the profit motive, however, is not to deny that it confers benefits on a large number of people other than its shareholders. It also confers benefits on its employees, on consumers, and – through the taxes it pays – on the general public. Yet the benefits enjoyed by these four groups continue to exist only for as long as they coincide with the yielding of profits to the enterprise. If it makes losses the enterprise cannot survive unless it receives a public subsidy. If it is to survive unaided as a private concern and, moreover, to expand the scale of its operations it must, over a period of time, produce profits large enough either to attract investors or to finance its own expansion.

There is, of course, the metaphor of the 'invisible hand', the deus ex machina discovered by Adam Smith that so directs the self-seeking proclivities of the business world that it confers benefits on society as a whole. And one can, indeed, lay down simple and sufficient conditions under which the uncompromising pursuit of profits acts always to serve the public interest. These conditions can be boiled down to two: that all effects relevant to the welfare of all individuals be properly priced on the market, and that perfect competition prevail in all economic activities.

Once we depart from this ideal economic setting, however, the set of outputs and prices to which the economy tends may not serve the public so well as some other set of outputs and prices. In addition to this possible misallocation of resources among the goods being produced, it is also possible that certain goods which can be economically justified are not produced at all, while others that cannot be economically justified continue to be produced. If, for example, technical conditions and the size of the market are such that a number of goods can be produced only under conditions of increasing returns to scale (falling average cost), it is possible that, although some of these goods will be produced by monopolies charging prices above marginal cost, other such goods will not be produced since there is no single price at which the monopolist can make any profit. But the production of these latter goods is not necessarily uneconomic. It may simply be the case that the monopolist who sells each good at a single price cannot transfer enough of the benefits from his potential customers to make the venture worthwhile.

Again, certain goods having beneficial, though unpriced, spillover effects also qualify for production on economic grounds; but they cannot be produced at a profit so long as the beneficial spillovers remain unpriced. The reverse is also true and more significant: profitable commercial activities sometimes produce noxious spillover effects to such an extent that, on a more comprehensive pricing criterion, they would be regarded as uneconomic.

2. The economist engaged in the cost-benefit appraisal of a project is not, in essence then, asking a different sort of question from that being asked by the accountant of a private firm. Rather, the same sort of question is being asked about a wider group of people – who comprise society – and is being asked more searchingly. Instead of asking whether the owners of the enterprise will become better off by the firm's engaging in one activity rather than another, the economist asks whether society as a whole will become better off by undertaking this project rather than not undertaking it, or by undertaking instead any of a number of alternative projects.

Broadly speaking, for the more precise concept of revenue to the private firm, the economist substitutes the less precise yet meaningful concept of social benefit. For the costs of the private firm, the economist substitutes the concept of opportunity cost – the social value foregone when the resources in question are moved away from alternative economic activities into the specific project. For the profit of the firm, the economist substitutes the concept of excess social benefit over cost, or some related concept used in an investment criterion.

3. It cannot be too strongly stressed, however, that even the result of an ideally conducted cost-benefit analysis does not, of itself, constitute a prescription for society. Since it simulates the effects of an ideal price-system, the ideal cost-benefit analysis is also subject to its limitations. Any adopted criterion of a cost-benefit analysis, that is, requires inter alia that all benefits exceed costs, and therefore can be vindicated by a social judgment that an economic rearrangement which can make everyone better off is an economic improvement. The reader's attention is drawn to the fact that such a judgment does not require that everyone is actually made better off, or even that nobody is actually worse off. The likelihood – which, in practice, is a virtual certainty – that some people, occasionally most people, will be worse off by introducing the investment project in question is tacitly acknowledged. A project that is adjudged feasible by reference to a cost-benefit analysis is, therefore, quite consistent with an economic arrangement that makes the rich richer and the poor poorer. It is also consistent with manifest inequity, for an enterprise that is an attractive proposition by the lights of a cost-benefit calculation may be one that offers opportunities for greater profits and pleasure to one group, in the pursuit of which substantial damages and suffering may be endured by other groups.

In order, then, for a mooted enterprise to be socially approved, it is not enough that the outcome of an ideal cost-benefit analysis is positive. It must also be shown that the resulting distributional changes are not regressive, and no gross inequities are perpetrated.

Chapter 2
The Pareto Basis of Cost-Benefit Calculations

1. A Pareto improvement is defined as a change in economic organization that makes everyone better off – or, more precisely, that makes one or more members of society better off without making anyone worse off. A potential Pareto improvement is, then, defined as a change which – if costless transfers of goods and/or money among members of society are assumed – can make everyone better off. It is, in other words, a change which produces gains that exceed in value the accompanying losses; a change, therefore, such that gainers can (through costless transfers) fully compensate all the losers and remain themselves better off than before.

It is now asserted that the rationale of existing cost-benefit criteria is ultimately that of a potential Pareto improvement. Ignoring for the present (a) the difficulties of evaluation and (b) the problems that arise when outlays and benefits are expected to appear at different times in the future, the formal requirement of a potential Pareto improvement, and therefore of a cost-benefit criterion, is simple. Let us define a compensating variation, CV, as the sum of money which, if received or paid after the economic change in question, would make the individual no better or worse off than before the change. If, for example, the price of a loaf of bread falls by 10 cents, the CV is the maximum sum a man would pay in order to be allowed to buy bread at this lower price. Per contra, if the loaf rises by 10 cents the CV is the minimum sum the man must receive if he is to continue to feel as well off as he was before the rise in price. Since, in general, some people lose and some people gain following any economic change –which may involve a fall or a rise in several product and/or factor prices (or may involve the introduction of a new good or the withdrawal of an old one) – the CVs of the gainers (the largest sums they are able to pay), which is a positive sum, may be added algebraically to the CVs of the losers (the smallest sum they will accept), which is a negative sum. If the resulting algebraic sum is positive, gainers can more than compensate losers, and the change will realize a potential Pareto improvement. If, on the other hand, this algebraic sum is zero or negative, the economic change contemplated does not realize a potential Pareto improvement. Moverover the magnitude of a positive algebraic sum measures the extent of the potential Pareto improvement, while the magnitude of a negative algebraic sum measures the extent of the potential reduction of welfare.

Although it is seldom made explicit, the reader will do well to bear in mind that all calculations that enter into a cost-benefit analysis, when reduced to a single point of time by acceptable methods, are to be interpreted as contributions, positive or negative, to the magnitude of some resulting potential Pareto improvement. What is to be concluded, then, from a cost-benefit analysis showing, say, an excess gain of $100,000 is not that everyone concerned is made better off in varying degrees; only that it is conceptually possible, by costless redistributions, to make everyone better off, in total by an amount equal to $100,000. And since economists have, from time to time, vented their dissatisfaction with the notion of a potential Pareto improvement as a criterion and a measure of social gain, we can hardly employ cost-benefit techniques with a clear conscience without examining some of the criticisms to which the concept has been subjected.

2. First, the potential Pareto improvement test clearly ignores the resulting change in the distribution of incomes. Not only is it true that not everyone is made better off, it is also possible that those in the community who are made worse off are to be found largely among the lower-income groups. A change which makes the rich better off by $250,000 at the expense of the poor, who are made worse off by $150,000, still produces an excess gain of $100,000 for the community as a whole. As such, however, it is not likely to be accepted by all as an unexceptionable economic change—at least, not unless it. is to be accompanied by redistributive measures which would make the poor no worse off than before, and possibly better off. A cost-benefit calculation may, indeed, be accompanied by observations on the resulting distribution, and even by recommendations in this respect. But the quantitative outcome of a cost-benefit calculation itself carries no distributional weight, it shows that the total of gains exceeds the total of losses, no more.

Moreover, the appeal of such a test is diminished by its hypothetical nature. A Pareto improvement which positively requires that when some are made better off, no one is actually made worse off, is assured of fairly wide acceptance. It does some good to some, and apparently does no harm to others. A potential Pareto improvement, which is consistent with a great many people actually being made worse off, has much less appeal. One factor, however, does make it easier to countenance. The spread over the last century of increasing wealth, and increasing electoral power, has made for egalitarian tendencies. The more progressive the tax structure, and the more intensive the competition, the more likely it is that a potential Pareto improvement will result in an actual Pareto improvement, or something close to it. In the limiting case of a system of taxes and subsidies designed to maintain complete equality of incomes, every potential Pareto improvement (allowing for sufficient divisibilities) is transformed into an actual Pareto improvement. By redistributive transfers, that is, everybody in fact becomes better off.

In the existing world, however, where projects can have distributionally regressive effects, the economist can, as indicated above, say something about the distribution resulting from the introduction of an otherwise feasible project. If the economist has reason to believe that it will be unambiguously regressive, his duty is to mention it. It may, in some cases, be practicable to combine the project with a distributional scheme. More often than not, the distributional effects on society as a whole are not large. Provided no spillover effects are involved, the direct local effects of a number of familiar sorts of project are apt to be progressive. One thinks in this connection of flood-control, electricity generation, irrigation, and the like. Once spillover effects enter the picture, however, the net impact on the local inhabitants can be distinctly regressive. The spillover effects of through-traffic highways, and flyovers, constructed through working-class neighbourhoods, provide a familiar example.

3. Secondly, as a result of the connection between relative prices and the distribution of the collection of goods, it is possible that a movement from one collection of goods, Q₁ to another Q₂, which realizes a potential Pareto improvement, is compatible with the reverse movement, one from Q₂ to Q₁, also realizing a potential Pareto improvement.

This apparent paradox is obviously a disconcerting theoretical possibility. It has to be taken seriously in attempts to prove some general propositions, for instance that some international trade is better for a country than no international trade. The possibility of such a reversal actually occurring in the real world, where there are a large number of goods and people, is much smaller, however, than the impression conveyed by a two-good two-person diagram. Moreover, no matter how likely we rate the possibility, it diminishes as the focus of our analysis narrows, and the effects both of distributional changes on relative product prices and compositional changes on relative factor prices, become smaller. Nearly all cost-benefit calculations can be regarded as exercises in very partial analysis. Thus, all prices, outside those pertaining to the project, may reasonably be assumed constant.

4. At the beginning of this chapter I 'asserted that the rationale of existing cost-benefit criteria is ultimately that of a potential Pareto improvement'. Let me reassure the reader that the assertion is not arbitrary. If he follows the exposition in this chapter carfeully, he will perceive that any criterion requiring that social benefits exceed in value all costs incurred necessarily implies the fulfilment of a potential Pareto improvement. And he may accept it that this criterion has to hold both in the large and the small – for a large change of the sort involved in the introduction of some public project, and also for a marginal change in determining the 'optimal' amount of a product or service produced by the project in question. The extension of the criterion to marginal changes should make it apparent that the interpretation of the potential Pareto criterion – requiring that the economic change under review is to be such as to enable everyone to be made better off – is that which also guides allocative efficiency in general. A person who agrees to apply the principles of allocative efficiency needs no new assumption to extend his agreement to the application of existing cost-benefit analysis. In sum both the principles of economic efficiency and those of cost-benefit analysis derive their inspiration from the potential Pareto criterion, and a person cannot with consistency accept the one and deny the other.

Chapter 3
Consistency in Evaluation

1. Granted that a cost-benefit analysis seeks to establish the presumption of a potential Pareto improvement, measured in principle as the algebraic sum of all CVs, one must pass from the general concept to specific ways of estimating benefits and costs. The transition can be made by following the convention of the market economy, which regards people both as producers and consumers of goods. If qua producers, men are no worse off in consequence of some contemplated economic change but are better off qua consumers then, on the whole, they are better off, and a Pareto improvement is achieved. If they are all no worse off qua consumers, but better off qua producers, a Pareto improvement is also achieved. Similarly, if men are better off qua consumers and producers, there is a Pareto improvement.¹ Moreover, the value of goods and '...

Table of contents

• Cover
• Title
• Copyright
• Original Title
• Original Copyright
• Preface
• Contents
• PART I. INTRODUCTORY
• PART II. ECONOMIC CONCEPTS OF COSTS AND BENEFITS
• PART III. EXTERNAL EFFECTS
• PART IV. INVESTMENT CRITERIA
• PART V. UNCERTAINTY
• Index