Cost-Benefit Analysis

E.J. Mishan, Euston Quah

• Publisher: Routledge
• Year: 2020
• eBook ISBN: 9781351029766
• Topic: Business
• Subtopic: Decision Making
• Index: Business

Cost-benefit analysis (CBA) is the systematic and analytical process of comparing benefits and costs in evaluating the desirability of a project or programme – often of a social nature. It attempts to answer such questions as whether a proposed project is worthwhile, the optimal scale of a proposed project and the relevant constraints. CBA is fundamental to government decision making and is established as a formal technique for making informed decisions on the use of society's scarce resources.

This timely sixth edition of the classic Cost-Benefit Analysis text continues to build on the successful approach of previous editions, with lucid explanation of key ideas, simple but effective expository short chapters and an appendix on various useful statistical and mathematical concepts and derivatives. The book examines important developments in the discipline, with relevant examples and illustrations as well as new and expanded chapters which build upon standard materials on CBA. Highlights include:

• updated historical background of CBA
• extended non-market goods valuation methods
• the impact of uncertainty
• evaluation of programmes and services
• behavioural economics
• decision rules and heuristics
• CBA and regulatory reforms
• CBA in developed and developing countries
• value of household production
• other topics frequently encountered in CBA, such as costs of diseases and air pollution, and value of statistical life.

This book is a valuable source and guide to international funding agencies, governments, interested professional economists and senior undergraduate and graduate students.

The text is fully supported by a companion website, which includes discussion questions and PowerPoint slides for each chapter.

Part I

Scope and method

1 Brief historical background to cost-benefit analysis

1 Cost-benefit analysis (CBA) is currently an established technique that is widely used in both governments and international organizations. Although certain underlying concepts of the technique originated from Europe in the 1840s, the use of CBA in environmental economics is a relatively new occurrence, becoming established only after regulations were set by the US government which made the use of CBA mandatory in certain circumstances in the 1930s.

The two underlying concepts which originated from Europe are the concept of consumer surplus and the concept of externality. These concepts are the main aspects that distinguish CBA from traditional profit-and-loss accounting. The concept of consumer surplus was argued by Jules Dupuit in 1844, when he pointed out that the users of roads and bridges in France enjoyed benefits in excess of the tolls they paid for the usage (Dupuit, 1844). Dupuit named this additional enjoyment ‘relative utility’ which later became known as Alfred Marshall’s consumer surplus. In the 1920s, Pigou (1952: 183–192) effectively developed the concept of externality by arguing that there is a difference between private economic production and public economic product, citing child labour, maternity leave for working mothers, alcohol, war and factory pollution. The key relation of the above two concepts to CBA was that they identified how social welfare could be measured (consumer surplus) and how previously ignored factors could contribute to or subtract from it (externalities).

2 CBA in environmental applications took on a significant role with the enactment of the US Flood Control Act of 1936 which, among other things, stated that any flood control project should be deemed desirable if the benefits to whomsoever they may accrue are in excess of the estimated cost. Although no specific guidelines were given on the implementation of the standard, the Act effectively paved the way for the assessment of projects on the basis of calculating their net benefits and the entire social assessment of the net benefits instead of solely basing it on the financial appraisal, which looks at the interests of only the producers.

Owing to the lack of specific and concrete guidelines, inconsistent sets of standards and procedures were developed and implemented by the various agencies involved in the development of water resources. This gave the impression that each agency’s main objective of the CBA was to justify the projects that each agency wanted to carry out instead of providing critical evaluations of the merits of the projects.

In order to ensure consistent and standardized practices and guidelines across different agencies, an inter-agency group was formed in 1946. Called the US Federal Inter-Agency River Basin Committee’s Subcommittee on Benefits and Costs, it produced the Proposed Practices for Economic Analysis of River Basin Projects (1950; revised 1958) or more commonly known as the Green Book. This publication, together with the Budget Circular A-47 by the Bureau of Budget in 1952, not only attempted to standardize practices among the agencies and bring them in line with economic theories but they also caught and encouraged academic interest.

3 A firm theoretical framework for CBA was finally established with works by three eminent economists (Eckstein, 1958; Krutilla and Eckstein, 1958; McKean, 1958) which methodically utilized neoclassical welfare economics in relation with CBA. The 1960s and 1970s saw the rapid development of CBA as numerous books and papers on the topic appeared, all trying to accomplish the deceptively simple objective of determining whether a proposed project’s benefits exceeded costs and, if so, by how much.

While the valuation theories and techniques were still undergoing refinement in the 1970s, the criterion by which proposed projects might pass was well established by the 1930s. Nowadays known as the Kaldor–Hicks criterion¹ it required the net money measure of gains, from a proposed project, to be positive, regardless of the effects of distribution. Otherwise known as a potential Pareto improvement, the criterion was developed after a prolonged debate amongst welfare economists about the viability of inter-personal comparisons of utility triggered by the repealing of the Corn Laws and in recognition of the impossibility (or at least, great unlikelihood) of achieving Pareto improvements (Mishan, 1981).

4 Use of CBA became more institutionalized and widespread from 1960 onwards, as governments in the US, Canada and the UK required formal CBA before the commencement of certain policies and projects. In the US, President Lyndon Johnson implemented a planning-program-budget system (PPBS) throughout the federal government in 1965 which contributed to the widespread use of CBA. In Canada, Sewell et al.’s Guide to Benefit–Cost Analysis (1965) and the implementation of a PPBS system in 1967 led to popular use of CBA. In the UK, the institutionalization of CBA took place after the release of the 1967 Government White Paper, and CBA was used for the M1 motorway project, the 1970s Channel Tunnel Proposals and the Third London Airport, among many other projects. The academic contributions by Mishan (1971a, 1971b) on CBA and normative economics (1980a, 1980b) added significantly to the growing literature.

In addition to being used by governments, CBA was also formally adopted by several international organizations – the OECD in 1969, the UN in 1972 and the World Bank in 1975 (Squire and van der Tak, 1975). At the Earth Summit in Rio de Janeiro in 1992, it was agreed that country application of financial support for public sector projects be subjected to passing the cost-benefit test as far as possible.

In 1980, US President Ronald Reagan signed Executive Order 12291, in which the efficiency criterion was explicitly required in the preparation of Regulatory Impact Analysis for regulations that are expected to have an annual effect of $100 million or more on the economy. This executive order was replaced by Executive Order 12866, signed by President Clinton in 1993. This new order is similar to the former, requiring that all the costs and benefits of available regulatory alternatives be considered in the process of deciding whether to proceed with certain regulations. This order has continued to remain relevant and in force. Additions to Executive Order 12866 such as Executive Orders 13422 and 13563 have been made by both President Bush and Obama respectively. President Bush’s presidency was focused on cost reduction by removing burdensome government regulations that ‘impede’ economic growth but few amendments of Executive Order 12866 were done with the benefit–cost analysis framework mostly left in place. Under President Obama, Executive Order 13563 places greater emphasis on equity and distributive impacts in conducting cost-benefit analysis and more attention to ‘material failures of private markets’. In President Trump’s presidency, Executive Order 13771 emphasized reducing regulatory costs, meaning that for one new regulation to be imposed two other costly and ineffective regulations must be cancelled. This dramatic shift of attention from benefits to costs may either decrease possible overregulation, refine analytical tools for government agencies or result in even more methodological challenges in the long run. In implementing his regulatory rollbacks, President Trump used controversial calculations in CBA. For example, in calculating the cost of greenhouse gas emissions, President Trump included only the environmental cost to the USA, rather than the global impact. Critics have argued that this is inadequate as global warming is a global, multigenerational issue. This highlights the difficulty in defining not just the scope of CBA but also the usage of different valuation methodology in real-world applications.

In recent times, as more organizations adopt a triple bottom line² approach, cost, not just benefit, analysis has become more pervasive, especially in the corporate sphere. In addition, after the financial crisis of 2007, there have also been calls to extend the requirements of CBA to financial regulators to increase accountability.

5 In more recent history, two developments that could have potentially far-reaching effects on CBA have emerged. The first is the growing number of valuation databases; the second is the development of a new branch of economics – behavioural economics.

The establishment of valuation databases, where the results of valuation studies are meticulously recorded, has thus far been limited to valuation studies of environmental goods. At present, there appear to be at least four databases of this sort, the most comprehensive being the Environmental Valuation Reference Inventory (EVRI) which was established in the late 1990s. Other databases also seem to have been established around this period or later.

The databases were set up to facilitate a valuation method known as benefit transfer that rose to prominence, not coincidentally, in the early 1990s. Benefit transfer is, in essence, the practice of assigning a value to an item based on the established value of another similar item. The exact methodology and associated issues are covered in the later chapter on benefit transfers.

Nonetheless, from the brief description, it should be clear that the method required an origin from which values could be ‘transferred’. That is where the databases entered the picture. The databases provided a ready source from which CBA practitioners could derive values for items in their studies without employing any of the conventional methods.

Most experts still agree that the conventional methods yield more accurate value estimates. However, with the increased ease of obtaining transferred values, one can reasonably expect that future CBAs will utilize fewer conventional methods and more benefit transfers. As such, it is not improbable that future CBA developments will occur along the lines of developing more accurate transfer techniques as opposed to further refinement of the conventional methods. Increasingly too, there have been calls for concern over the use of cost-benefit analysis in less developed countries, that the method may require some adjustments to accommodate and recognize differences between these countries and developed countries (Quah, 2013). A new chapter has been added in this edition dealing with this issue (see Chapter 45).

The other recent development that has had an impact on CBA is the growth in the relatively young branch of behavioural economics. Studies in behavioural economics have sparked off new controversies regarding the validity of certain CBA techniques, with valuation methods being the most readily debated topic. The more technical nature of the issue will be further explored in Chapter 10, which discusses behavioural economics and CBA. Suffice to say, such challenges will provide an impetus for the further development and refinement of methods and techniques that account for behavioural biases and, more importantly, answer the central and seemingly innocuous question at the heart of all CBA – do the benefits of a proposed project outweigh its cost and if so, by how much would society benefit?

Notes

1 The term was coined in the late 1930s from the writings of two eminent welfare economists, Sir John Hicks (1939) and Nicholas Kaldor (1939).

2 The triple bottom line approach involves the consideration of social and environmental performance in addition to the traditional financial performance.

2 What is cost-benefit analysis?

1 Let us be clear from the start that the sort of question a CBA sets out to answer is whether one or a number of projects or programmes should be undertaken and, if investable funds are limited, which one, two or more among these specific projects that would otherwise qualify for admission should be selected. Another question that CBA sometimes addresses 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 CBA at all? What is wrong with deciding whether 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 benefits (or profits) and costs to personnel engaged in the activity of a particular segment of the economy – be it a firm, an industry or any private or public organization – does not necessarily coincide with, indeed, is unlikely to coincide with, all the benefits and costs experienced by the individuals residing within an area subject to a CBA. The economy of a whole country or nation state should often be analysed. However, it can also be a region that encompasses a number of contiguous countries or, alternatively, one or more provinces of a country or even a single town or city. This problem is called the accounting stance. In order to avoid unnecessary verbiage, however, we shall assume henceforth that the area in question is that of the whole country and therefore speak of ‘the economy as a whole’ or ‘society as a whole’.

A private enterprise, or even a public enterprise, comprises only a segment of the economy, often a very small segment. More importantly, 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 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 to expand the scale of its operations, it must 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. Moreover, 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 prevails in all economic activities.

2 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 as 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 that 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...

Table of contents

• Cover
• Half Title
• Endorsements
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Preface to the sixth edition
• Acknowledgements
• PART I: Scope and method
• PART II: Basic concepts of benefits and costs
• PART III: Shadow prices and transfer payments
• PART IV: External effects
• PART V: Investment criteria
• PART VI: Uncertainty
• PART VII: Topics frequently encountered in cost-benefit analysis
• PART VIII: Further notes and advanced materials
• Appendix 1: Cost-effectiveness analysis
• Appendix 2: The alleged contradiction of the Kaldor–Hicks criterion
• Appendix 3: The problem of second-best
• Appendix 4: Origins of the Hicksian measures of consumer surplus
• Appendix 5: Marginal curve measures of consumer surplus
• Appendix 6: The concept and measure of rent
• Appendix 7: Marginal curve measures of rent
• Appendix 8: The limited applicability of property rights
• Appendix 9: Deadweight loss or love’s labour lost
• Appendix 10: The value of human life
• Appendix 11: The rate of time preference
• Appendix 12: Selecting a set of investment projects for given political objectives
• Appendix 13: Why cost-benefit analysis is useful for regulatory reform
• Appendix 14: Valuing household production
• Bibliography and further reading
• Index