Fillable Printable Cost and Benefit Analysis- CBArevis

Cost and Benefit Analysis- CBArevis

Cost-Benefit Analysis

By Matthew J. Kotchen

†

When economics is normative—meaning that the objective is to make a policy recommendation—

the evaluative criteria is economic efficiency. The basic idea is that scarce resources should be allo-

cated to their most valued uses. Cost-benefit analysis (CBA) is the primary tool that economists em-

ploy to determine whether a particular policy, or policy proposal, promotes economic efficiency. At

the most general and comprehensive level, CBA is an aggregator of all impacts, to all affected par-

ties, at all points in time. The impacts, both positive and negative, are converted into a common

monetary unit, and the cost-benefit criterion is simply a test of whether the benefits exceed the

costs. If the net benefits are positive, the policy promotes economic efficiency.

CBA for the purpose of analyzing public policy is distinct from financial analysis in the private sec-

tor. CBA accounts for more than just financial costs and benefits in order to evaluate the net effect

of a policy on overall social well-being. For this reason it is often referred as “social cost-benefit

analysis.” The broad scope of CBA, along with its inherent focus on monetization and efficiency,

means that the technique is frequently controversial, especially when applied to environmental pol-

icy. Concerns about CBA tend to mirror more general critiques of economic efficiency as a norma-

tive criteria and the sway it should have on public decision-making, in addition to the technique’s

sometimes controversial reliance on monetization of all costs and benefits. But the analytical rigor

and bottom-line conclusion of CBA makes the approach highly influential—if not required by law—

when it comes to decision-making in a variety of policy domains, ranging from transportation,

health, crime, education, and the environment.

Some Fundamental Concepts

Every CBA is different regarding the appropriate methodologies and required assumptions. There

are nevertheless some fundamental concepts that are common to most applications of CBA, and

anyone interested in environmental management should be familiar with a few in particular.

A CBA of any policy must first determine which costs and benefits should count. Though some-

times a point of controversy, CBA has a utilitarian foundation, whereby costs and benefits are de-

rived solely on the basis of whether impacts make members of society worse- or better-off. CBA is

thus entirely anthropocentric, and the people who count depends on the particular policy in ques-

tion. If a CBA is being conducted to evaluate a policy at the city, state, or national level, then people

corresponding to the policy’s political jurisdiction define the relevant population. While impacts that

spillover to other jurisdictions may be important, they are beyond the scope of a CBA.

A CBA must also specify the planning horizon over which costs and benefits count. Consider a pol-

icy that requires upfront costs with benefits that continue indefinitely or far into the future, as is

This chapter is an invited submission for the Encyclopedia of Climate and Weather 2

Edition, Stephen Schneider

(ed.), New York: Oxford University Press, forthcoming, 2010.

†

Kotchen is an associate professor of environmental economics and policy at Yale University and a research fellow

at the National Bureau of Economic Research. Email: [email protected].

likely the case with policies designed to mitigate the effects of climate change. Practical questions

arise about how far into the future the benefits should count. While disagreement may exist about

the most appropriate planning horizon—50 years, 100 years, 200 years, or more—CBA requires

specification of some duration, and the assumption should be made explicit, as it can significantly

affect study results.

Discounting is another feature of CBA that can significantly affect results. When costs and benefits

occur at different points in time, discounting makes adjustments to facilitate intertemporal compari-

sons. The basic idea is that, after taking account of the time value of resources (i.e., money), future

costs and benefits are worth less today. Discounting, in effect, is the opposite of compounding in-

terest on an investment, and it converts all future costs and benefits into their present value. The

cost-benefit criterion is then a question of whether the present value net benefits are positive.

Both the timing of impacts and the discount rate itself have an important effect on CBA. For in-

stance, with a discount rate of five percent, a benefit (or cost) of one-hundred dollars in ten years

has a present value of approximately sixty-one dollars, and if it occurs in fifty years, the present value

drops to less than nine dollars. With a discount rate of eight percent, the two present values are even

lower, at approximately forty-six dollars and two dollars, respectively. Even these simple examples

demonstrate the significant effect that discounting can have on CBA of policies to address long-

term climate change: benefits that occur far into the future count much less against costs that must

be incurred earlier.

There is general consensus within the economics profession about the need to discount, but the

question of what discount rate to use is often subject to debate. Many economists argue that dis-

count rates should reflect market transactions in which people reveal how they actually make in-

tertemporal tradeoffs. Others argue in favor of lower discount rates that reflect more normative

judgments about how societies ought to place more weight on the future. Such debate about the

most appropriate discount rate is particularly salient in the context of climate change, as discount

rates have such a large influence on the CBA of long-range policies. In practice, discount rates be-

tween four and eight percent are most common in the literature, but recent well-known and contro-

versial analyses have argued that discounting of climate impacts at a planetary scale over long peri-

ods of time should occur at a much lower rate.

A further challenge to the conduct of CBA is the fact that all costs and benefits are not readily trans-

lated into monetary values. The most common way for economists to measure an individual’s value

for something is through the intuitive concept of one’s willingness to pay (WTP). But there are

many things that people value, such as environmental quality, for which they pay nothing, at least

not directly. In order to account for these values, CBA often requires the use of nonmarket valua-

tion techniques, where the aim is to infer WTP (or sometimes willingness to accept) for things that

are not directly traded in markets and for which there are no immediate prices.

In order to infer environmental and resource values, some nonmarket valuation techniques look to

observed behavior in related markets. For example, the travel-cost method, is used to estimate the

benefits of national parks and recreational fishing areas based on the expenditures that visitors make

in traveling to such areas. Another technique, the hedonic-price method, is able to investigate how

environmental quality affects the prices of other goods and services. Differences in housing prices,

for example, can be used to isolate the value of things like a scenic view, local air quality, and prox-

imity to a hazardous waste site. Other possibilities range from looking at insurance markets to value

the costs of more extreme weather events, and looking at agricultural land prices to value differences

in climate. Researchers can also look at adaptation to climate change as an averting expenditure to

estimate particular costs of a changing climate.

Some economic values, known as “nonuse values,” are different because they leave no trace in mar-

ket behavior. Nonuse values arise in the absence of any use of an environmental or natural resource

amenity and, therefore, are based on the satisfaction of simply knowing the amenity exists is a par-

ticular state. Many people, for example, have a WTP to ensure the continued existence of polar

bears, even though they never plan to see one. Estimation of nonuse values requires the use of hy-

pothetical markets, in which a method known as contingent valuation directly questions people

through surveys about their economic value. While nonuse value estimates derived in this way are

widely used in CBA and natural resource damage assessments, questions often arise about the le-

gitimacy of the values themselves and the ability to reliably produce estimates.

When all the elements of a CBA come together, and an initial conclusion is reached about whether

the present value net benefits are positive, sensitivity analysis is an important next step. Sensitivity

analysis is a tool for testing the robustness of findings to inherent uncertainties and the need for as-

sumptions. The idea is to simply replace unknown or uncertain parameters with alternative values

drawn from a plausible distribution. Researchers might, for example, conduct sensitivity analysis

over alternative specifications of the discount rate, dose-response relationships, omitted

costs/benefits, or predictions about future impacts from global climate models. Conclusions of any

CBA should be explicit about whether the qualitative results are sensitive to particular parameters,

especially when they are associated with uncertainty, differences of option, or both.

Some Concerns with CBA

As mentioned previously, concerns about CBA mirror general critiques about the use of economic

efficiency as a normative criteria and about the technique’s reliance on monetization. One source of

controversy is the conceptual foundation of CBA as it relates to distributional equity. Consider a

policy that makes some individuals better-off and no individuals worse-off. Such a policy is said to

produce a “Pareto improvement,” and it would obviously pass the cost-benefit test. Most policies,

however, are likely to produce winners and losers, and CBA requires only that the gains to the win-

ners exceed the loses to the losers. While the winners could compensate the losers to create a Pareto

improvement, the cost-benefit test implements only a “potential Pareto criterion,” meaning that

compensation, while possible, need not take place—and in practice it rarely does. As a result, poli-

cies that make it through a CBA are frequently at odds with concerns about distributional equity.

Measuring costs and benefits with WTP is also objectionable to some because it depends so heavily

on the distribution of income. People with lower incomes have a lower ability to pay and therefore

have less influence on the outcome of a CBA. In principle, CBA can incorporate distributional

weights to address concerns about inequity, but there is no clear guidance about how such weights

should be assigned. Consequently, distributional weights are rarely used in practice. Related argu-

ments are also made out of concern for future generations. Regarding climate change in particular,

critics of the CBA approach argue that discounting poses problems for intergeneration equity be-

cause it down-weights the costs to future generations.

The fact that CBA is based on monetization of all costs and benefits is another source of criticism.

Many things are difficult (or maybe impossible) to monetize, and there are those who feel that some

things are priceless, whereby placing an economic value on them is effectively devaluing. A rights-

based environmentalist, for example, may believe that polar bears are priceless, and protecting the

species is simply the right thing to do, regardless of the costs and benefits. The problem, of course,

is that many people have different priorities and often disagree about the right thing to do, and we

can only do them all under extremely rare circumstances. When tradeoffs are required, CBA pro-

vides a systematic way for evaluating the consequences of choosing a particular alternative. Though

we should keep in mind that the systematic approach is based on economic efficiency, and other

normative criteria (e.g., equity and ecological sustainability) may have an equal stake in the decision-

making process.

Policy Relevance

No technique for analyzing public policy is immune to criticism, and CBA is no exception. Never-

theless, CBA is perhaps the most widely applied and influential method of policy analysis. Many

countries have specific guidelines for the conduct of regulatory impact analysis, and CBA typically

plays a prominent role. In the United States, for example, CBA has been required since 1981 of

most new regulations that impose significant costs or economic impacts. The existing statutory re-

quirement is not that policies necessarily pass the cost-benefit test, but that CBA be used as a gen-

eral accounting framework to highlight the range of impacts of proposed policies. Since 1993, the

specific provision has been that the “benefits justify costs.” In this capacity, CBA plays an important

role in decision-making about environmental quality and public heath at the U.S. Environmental

Protection Agency, along with other regulatory agencies.

In the end, public policies in all areas of governance impose costs and benefits on members of soci-

ety. Prudent decision-making requires a clear and systematic understanding of the different impacts,

and CBA—appropriately applied as a decision tool rather than a decision rule—provides a useful frame-

work to aid in the process. Other analytical techniques, among which CBA is a useful complement,

include cost-effectiveness analysis, multi-criteria analysis, risk assessment, and environmental impact

assessment.

References

Boardman, Anthony, David Greenberg, Aidan Vining, and David Weimer. 2005. Cost Benefit Analysis:

Concepts and Practice (3rd Edition). Prentice Hall.

Pearce, David, Giles Atkinson, and Susana Mourato. 2006. Cost-Benefit Analysis and the Environment:

Recent Developments. Publication of the Organisation for Economic Co-operation and Develop-

ment (OECD).