SOCIAL COST-BENEFIT ANALYSIS

Cost-benefit analysis is a process for evaluating the merits of a particular project or course of action in a systematic and rigorous way. Social cost-benefit analysis refers tocases where the project has a broad impact across society  and, as such, is usually carried out by the government.While the cost and benefits may relate to goods and services that have a simple andtransparent measure in a convenient unit (e.g. their price in money), this is frequentlynot so, especially in the social case. It should therefore be emphasized that the costs andbenefits considered by (social) `cost-benefit’ analysis are not limited to easily quantifiable changes in material goods, but should be construed in their widest sense, measuringchanges in individual `utility’ and total `social welfare’ (though economists frequently ex-press those measures in money-metric terms).In its essence cost-bene_t analysis is extremely, indeed trivially, simple: evaluate costsC and benefits B for the project under consideration and proceed with it if, and only if,benefits match or exeed the costs.

Cost-Benefit Analysis (CBA) estimates and totals up the equivalent money value of the benefits and costs to the community of projects to establish whether they are worthwhile. These projects may be dams and highways or can be training programs and health care systems.

The idea of this economic accounting originated with Jules Dupuit, a French engineer whose 1848 article is still worth reading. The British economist, Alfred Marshall, formulated some of the formal concepts that are at the foundation of CBA. But the practical development of CBA came as a result of the impetus provided by the Federal Navigation Act of 1936. This act required that the U.S. Corps of Engineers carry out projects for the improvement of the waterway system when the total benefits of a project to whomsoever they accrue exceed the costs of that project. Thus, the Corps of Engineers had create systematic methods for measuring such benefits and costs. The engineers of the Corps did this without much, if any, assistance from the economics profession. It wasn’t until about twenty years later in the 1950’s that economists tried to provide a rigorous, consistent set of methods for measuring benefits and costs and deciding whether a project is worthwhile. Some technical issues of CBA have not been wholly resolved even now but the fundamental presented in the following are well established.

Principles of Cost Benefit Analysis

One of the problems of CBA is that the computation of many components of benefits and costs is intuitively obvious but that there are others for which intuition fails to suggest methods of measurement. Therefore some basic principles are needed as a guide.

1)There Must Be a Common Unit of Measurement

In order to reach a conclusion as to the desirability of a project all aspects of the project, positive and negative, must be expressed in terms of a common unit; i.e., there must be a “bottom line.” The most convenient common unit is money. This means that all benefits and costs of a project should be measured in terms of their equivalent money value. A program may provide benefits which are not directly expressed in terms of dollars but there is some amount of money the recipients of the benefits would consider just as good as the project’s benefits. For example, a project may provide for the elderly in an area a free monthly visit to a doctor. The value of that benefit to an elderly recipient is the minimum amount of money that that recipient would take instead of the medical care. This could be less than the market value of the medical care provided. It is assumed that more esoteric benefits such as from preserving open space or historic sites have a finite equivalent money value to the public.

Not only do the benefits and costs of a project have to be expressed in terms of equivalent money value, but they have to be expressed in terms of dollars of a particular time. This is not just due to the differences in the value of dollars at different times because of inflation. A dollar available five years from now is not as good as a dollar available now. This is because a dollar available now can be invested and earn interest for five years and would be worth more than a dollar in five years. If the interest rate is r then a dollar invested for t years will grow to be (1+r)t. Therefore the amount of money that would have to be deposited now so that it would grow to be one dollar t years in the future is (1+r)-t. This called the discounted value or present value of a dollar available t years in the future.

When the dollar value of benefits at some time in the future is multiplied by the discounted value of one dollar at that time in the future the result is discounted present value of that benefit of the project. The same thing applies to costs. The net benefit of the projects is just the sum of the present value of the benefits less the present value of the costs.

The choice of the appropriate interest rate to use for the discounting is a separate issue that will be treated later in this paper.

2) CBA Valuations Should Represent Consumers or Producers
Valuations As Revealed by Their Actual Behavior

The valuation of benefits and costs should reflect preferences revealed by choices which have been made. For example, improvements in transportation frequently involve saving time. The question is how to measure the money value of that time saved. The value should not be merely what transportation planners think time should be worth or even what people say their time is worth. The value of time should be that which the public reveals their time is worth through choices involving tradeoffs between time and money. If people have a choice of parking close to their destination for a fee of 50 cents or parking farther away and spending 5 minutes more walking and they always choose to spend the money and save the time and effort then they have revealed that their time is more valuable to them than 10 cents per minute. If they were indifferent between the two choices they would have revealed that the value of their time to them was exactly 10 cents per minute.

The most challenging part of CBA is finding past choices which reveal the tradeoffs and equivalencies in preferences. For example, the valuation of the benefit of cleaner air could be established by finding how much less people paid for housing in more polluted areas which otherwise was identical in characteristics and location to housing in less polluted areas. Generally the value of cleaner air to people as revealed by the hard market choices seems to be less than their rhetorical valuation of clean air.

3) Benefits Are Usually Measured by Market Choices

When consumers make purchases at market prices they reveal that the things they buy are at least as beneficial to them as the money they relinquish. Consumers will increase their consumption of any commodity up to the point where the benefit of an additional unit (marginal benefit) is equal to the marginal cost to them of that unit, the market price. Therefore for any consumer buying some of a commodity, the marginal benefit is equal to the market price. The marginal benefit will decline with the amount consumed just as the market price has to decline to get consumers to consume a greater quantity of the commodity. The relationship between the market price and the quantity consumed is called the demand schedule. Thus the demand schedule provides the information about marginal benefit that is needed to place a money value on an increase in consumption.

4) Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve

The increase in benefits reulting from an increase in consumption is the sum of the marginal benefit times each incremental increase in consumption. As the incremental increases considered are taken as smaller and smaller the sum goes to the area under the marginal benefit curve. But the marginal benefit curve is the same as the demand curve so the increase in benefits is the area under the demand curve. As shown in Figure  the area is over the range from the lower limit of consumption before the increase to consumption after the increase.When the increase in consumption is small compared to the total consumption the gross benefit is adequately approximated, as is shown in a welfare analysis, by the market value of the increased consumption; i.e., market price times the increase in consumption.

Sources:

1)SOCIAL) COST-BENEFIT ANALYSIS IN A NUTSHELL-RUFUS POLLOC EMMANUEL COLLEGE, UNIVERSITY OF CAMBRIDGE

2) Ecobook-libraria economista

2) sjsu.edu/faculty/watkins/cba.htm

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