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Chapter

Cost-Benefit Analysis Concepts and Practice

Cost-Benefit Analysis: Concepts and Practice, Fourth Edition Boardman • Greenberg • Vining • Weimer

FOURTH EDITION

Introduction to

Cost-Benefit Analysis

One

CBA IS A METHOD FOR DETERMINING SOCIAL COSTS AND BENEFITS

Definition

Cost-Benefit Analysis (CBA) is a policy assessment method that quantifies the value of policy consequences (usually called impacts) in monetary terms to all members of society.

A CBA calculates net social benefits (NSB) for each policy alternative: net social benefits equal social benefits (B) minus social costs (C):

NSB = B - C

In CBA, we try to consider all of the costs and benefits to society as a whole – the social costs and the social benefits.

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Two Arguments Against the Use of CBA:

1. Dispute against the fundamental utilitarian assumptions of CBA Some dispute the fundamental assumptions of CBA (i.e. that the sum of individual utility should be maximized and that one can trade off utility gains and losses among people). They argue that there is no theoretical basis for making trade-offs between one person’s benefits and another person’s costs.

2. Public policy participants disagree about specific issues in CBA, such as how to monetize costs and benefits, what impacts are (especially over time), whether an impact is a cost or a benefit, and how to make trade-offs between the present and the future.

THE PURPOSE AND USES OF CBA

Purpose General:

• To help effective social decision making and make it more rational

Specific:

•To have more efficient allocation of society’s resources when markets fail.

• When markets fail and resources are used inefficiently, CBA can be used to clarify which of the potential alternative programs, policies or projects (including the status quo) is the most efficient.

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Types of CBA:

1. Ex ante CBA – conducted prior to the intervention; while the project or policy is under consideration. Useful to show whether resources should be used on a program or project.

2. Ex post CBA – conducted at the end of the intervention – at then end of the project. Provides information about the particular class of intervention.

- All of the costs are “sunk” (already been incurred and cannot be recovered)

- Contributes to “learning”

Types of CBA:

3. In medias res CBA- conducted during the intervention – during the course of the life of a project. Analyses have the potential to influence decision – whether or not to continue the project. -can also provide information to predict costs and benefits in future analyses

4. Comparative CBA – compares the ex ante predictions to ex post results for the same project (very few of these comparisons have been conducted because the clients of ex post analyses are different from the clients of ex ante analyses).

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Project-specific Decision Making

Ex ante analysis is most useful for making resource allocation decisions. In medias res CBA analysis can also be used for this purpose, but ex post analysis is too late to divert resources to alternative uses.

Learning About the Net Social Benefits of a Specific Project

Ex post analysis is the most useful for looking at the efficiency of a particular project, then in medias res, then ex ante. The reason is that more is learned about the actual impacts of the project as time goes by.

Learning About the Potential Benefits of Similar Projects

Ex post analysis also provides information about the probable costs and benefits of similar future interventions. The amount of learning depends on the representativeness of the particular project, i.e., how generalizable the project is to other projects or large-scale projects.

Learning About the Efficacy of CBA

Learning about the efficacy of CBA occurs by comparing ex ante analyses to either in medias res or ex post analyses. These comparisons provide information about the accuracy of ex ante CBAs. These comparisons also help our understanding of prediction error.

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Table 1-1 (continued) Value of Different Classes of CBA

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THE BASIC STEPS OF CBA

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Step 1 -- Specify the set of alternative projects.

• There are usually a huge number of potential alternative projects.

• Minimally, the CBA compares the net social benefits of the project with the net social benefits of a hypothetical project (or specific project if that is what would be displaced) that would be displaced if the project would proceed.

This hypothetical project is called the counter-factual and is usually the status quo (which means there is no change in government policy).

THE BASIC STEPS OF CBA

Step 1 -- Specify the set of alternative projects.

Sometimes the status quo is not a viable alternative. If a project would displace a specific alternative, then it should be evaluated relative to the specific displaced alternative.

Example: committing resources to either a highway project or a rail project, where there is no possibility of maintaining the status quo.

Table 1-3 Coquihalla Highway CBA - Consider two alternative four-lane highways, one with tolls and one without

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Step 2 -- Decide whose benefits and costs count (standing).

• Standing determines whose benefits and costs will count (global, provincial, etc).

• Standing is usually most appropriately specified at the national level.

• There is contention as to when standing should be specified at the global level. Some favor global standing, especially where there are international spillovers (e.g., for many environmental issues).

THE BASIC STEPS OF CBA

Step 2 -- Decide whose benefits and costs count (standing).

For other kinds of projects, some advocate standing at a lower level, such as state/province or local government.

Table 1-3 Coquihalla Highway CBA The analyst’s superiors in the provincial government wanted the CBA to be done from the provincial perspective (benefits and costs that affect British Columbian residents), but asked the analyst to also take a global perspective (benefits and costs that affect everyone).

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Step 3 – Identify the impact categories, catalogue then and select the measurement indicators.

• Impacts include both inputs (required resources) and outputs.

Example: Coquihalla Highway CBA Benefit impact categories: time saved and reduced vehicle operating costs for travelers on the new highway (“Time and Operating Cost Savings” in Table 1-3); the value of highway at the end of the discounting period of 20 years (Horizon Value of Highway); accidents avoided (including lives saved ; “Safety Benefits”); reduced congestion on alternative routes (“Alternative Routes Benefits”); revenues from tolls (“Toll Revenues”); and benefits accruing to new travelers (“New Users”).

•

THE BASIC STEPS OF CBA

Step 3 – Identify the impact categories, catalogue them and select the measurement indicators.

Example: Coquihalla Highway CBA Cost impact categories: construction costs (“Construction”) , additional maintenance and snow removal (“Maintenance”). Toll collection (“Toll Collection”), and toll booth construction and maintenance (Toll Booth Construction”)

Omitted impacts? • Although this list of impact categories appears to be comprehensive, critics might argue that some relevant impacts were omitted: health impacts from automobile emissions, impacts on wildlife population, changes in scenic beauty, the cost of the land…

THE BASIC STEPS OF CBA

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Step 3 – Identify the impact categories, catalogue them and select the measurement indicators.

From a CBA perspective, analysts are interested only in project impacts that affect the utility of individuals with standing.

CBA analysts should only include impacts that affect individual utility of human beings.

In order to treat something as an impact, there must be a cause and effect relationship between project outcome and the individual’s utility –some physical outcome of the project and the utility of human beings with standing.

THE BASIC STEPS OF CBA

Step 3 – Identify the Impact Categories, Catalogue them and select the measurement indicators.

Note: Beware impact categories that may be valued in oppositely by different individuals (i.e., some individuals view the impact as a cost while others view it as a benefit).

Example: Residents of a flood plain generally view floods as a cost because they damage homes, while duck hunters regard them as a benefit because they attract ducks.

In such circumstances, it is often more useful to create two separate impact categories (one for damaged homes and one for recreation benefits).

THE BASIC STEPS OF CBA

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THE BASIC STEPS OF CBA

Step 3 – Identify the Impact Categories, Catalogue them and select the measurement indicators.

Also, natural measurement units may not be feasible (i.e. crimes avoided); in such cases, surrogate indicators can be used. However, all surrogate indicators involve some loss of information.

The choice of measurement indicator depends on data availability and ease of monetization.

Step 4 -- Predict the impacts quantitatively over the life of the project.

Prediction is difficult. Chapter 11 considers this topic in detail. Supply and demand curves usually aren’t known; this makes it hard to quantify impacts according to the conceptually correct method.

In general, it’s more difficult to predict impacts if the project has a long time horizon or if the relationships between variables are complex.

Example: Coquihalla Highway CBA Total vehicle operating costs that users save; number accidents avoided; and the number of lives saved

THE BASIC STEPS OF CBA

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Step 5 -- Monetize (attach dollar values to) all impacts.

Example: Coquihalla Highway CBA

•Leisure time saved per vehicle (25 % of gross wage times the average number of passengers) = $6.68 per vehicle-hour

•Business time saved per vehicle = $12 per vehicle-hour

•Truck drivers’ time saved per vehicle = $14 per vehicle-hour

•Value of life saved = $500,000 per life

These estimates were based on prior studies.

THE BASIC STEPS OF CBA

Step 5 -- Monetize (attach dollar values to) all impacts.

In CBA, value is measured in terms of “willingness to pay”(obtained from demand curves). Many impacts are difficult to value in dollar terms because they are not traded in markets (i.e. life, environmental impacts).

If no individual is willing to pay for an impact, it has a 0 value.

Example: If construction of a dam would lead to the extermination of a species of fish but no one with standing is willing to pay a positive amount to save that species, then the extermination of this fish would have a value of zero in a CBA of the dam.

THE BASIC STEPS OF CBA

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Step 6 -- Discount benefits and costs to obtain present values.

Future benefits and costs are discounted relative to present benefits and costs in order to obtain their present values (PV).

The need to discount arises for 2 reasons:

1. There is an opportunity cost to the resources used in the project.

2. Most people prefer to consume now rather than later

THE BASIC STEPS OF CBA

Step 6 -- Discount benefits and costs to obtain present values.

A cost or benefit that occurs in year t is converted to its present value by dividing it by (1 + s)t, where s is the social discount rate.

Equation 1.2

Equation 1.3

The appropriate discount value method and level is contentious. It is discussed extensively in subsequent chapters. Often the rate is mandated by a government agency responsible for financial and budgetary oversight for other government agencies (e.g. the Office of Management and Budget, or the Ministry of Finance, or the Treasury Board).

THE BASIC STEPS OF CBA

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Step 7 -- Compute the net present value of each alternative.

The net present value (NPV) equals the present value of benefits minus the present value of costs:

NPV = PV (B) – PV(C) Equation 1.4

Decision rule: adopt the project if its NPV is positive (relative to the status quo) NPV = PV (B) – PV(C) > 0; that is, if its benefits exceeds its costs:

PV (B) > PV(C)

THE BASIC STEPS OF CBA

Step 7 -- Compute the net present value of each alternative.

When there is more than one alternative to the status quo:

Decision rule: select the project with the largest NPV

The alternative with the largest NPV at least represents a more efficient allocation of resources.

While the NPV criterion results in a more efficient allocation of resources, it does not necessarily recommend the most efficient allocation of resources.

One can’t say it’s the most efficient allocation because not all possible alternatives are necessarily analyzed in the CBA.

THE BASIC STEPS OF CBA

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Figure 1-1 CBA Seeks More Efficient Resource Allocation

THE BASIC STEPS OF CBA

Step 7 -- Compute the net present value of each alternative. In Figure 1-1, the benefits increase as the scale increases, but at a decreasing rate. In contrast, the costs increase at an increasing rate.

A small scale project, (for example, Q1) has positive net benefits relative to the status quo, Q0. As the scale increases, the net benefits increase up to the optimal scale, Q*. As the scale increases beyond Q*, the net benefits decrease. Net benefits are positive as long as the net benefit curve is above the cost curve, they are zero where the curves intersect, and they are negative for larger-scale projects.

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THE BASIC STEPS OF CBA

Step 7 -- Compute the net present value of each alternative.

The optimal output level will not be recommended, however, if it was not among the alternatives (it may not be known or there is budgetary or political constraints).

Therefore, the use of NPV criterion leads to a more efficient outcome than the status quo, not necessarily the most efficient outcome.

Step 8 -- Perform sensitivity analysis.

• There is usually considerable uncertainty about both predicted impacts and their appropriate monetary valuation.

• Sensitivity analysis clarifies for decision makers how these uncertainties affect the CBA results.

• Just about every variable and assumption can be subjected to sensitivity analysis, but time and resource constraints lead analysts to focus on the most important variables or assumptions (Example- global and provincial perspectives).

THE BASIC STEPS OF CBA

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Step 9 -- Make a recommendation.

• Normally recommend the alternative with the highest NPV, but also take into account sensitivity analysis.

• Sensitivity analysis may suggest that the alternative with the largest NPV is not necessarily the best alternative in all circumstances.

THE BASIC STEPS OF CBA

Step 9 -- Make a recommendation.

• Analysts makes recommendations, not decisions. CBA concerns how resources should be allocated, it is normative.

It does not claim to be a positive (i.e. descriptive) theory of how resource allocation decisions are actually made.

• CBA is only one input to the decision process and does not always succeed. Politicians are often reluctant to be persuaded by economic arguments.

THE BASIC STEPS OF CBA

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BUREAUCRATIC AND POLITICAL “LENSES”

Government employees have a tendency to see “costs” and “benefits” from an individual self- interested perspective or from a variety of agency-interested perspectives.

The agency perspectives are based on the specific organizational role of the government employee.

The three archetypal perspectives are those of guardian, spender and analyst.

Because the analyst perspective basically corresponds to CBA as described in this book, it is not discussed further here.

Guardians (revenue-expenditure analysis)

• They are often found in central budgetary agencies and in accounting functions.

• Guardians view projects from a revenue-expenditure perspective (i.e. revenue inflows = “benefits”; expenditure outflows = “costs”).

• They have a tendency to regard CBA as naive and impractical and as a tool whereby spenders can justify what they want to do.

• Personnel in line agencies may vacillate between a spender and guardian perspective depending on the political and budgetary climate. Financial control personnel in line agencies tend to have a guardian perspective.

BUREAUCRATIC AND POLITICAL “LENSES”

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Some consequences of the guardian perspective:

(1) It downplays or ignores non-financial social benefits (time saved, lives, etc.) and costs (time spent, pollution).

(2) It interprets the meaning of “costs” idiosyncratically (and incorrectly!); e.g., regarding the cost of labor – guardians focus on actual wage remuneration, while CBA focuses on the opportunity cost of the labor).

Resources owned by government tend to be viewed as free goods (rather than having an opportunity cost).

BUREAUCRATIC AND POLITICAL “LENSES”

Guardians

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Guardians

Some consequences of the guardian perspective:

(3) It ignores those costs not borne by its own level of government. (Example: they ignore loss suffered by British Columbians from paying tolls and treat all toll revenues as a benefit).

(4) It treats subsidies from other levels of governments as “benefits” (they are a revenue inflow).

(5) It wants to use a high social discount rate – similar to a financial market discount rate (usually higher than the social discount rate). They know that using a high discount rate will make it more difficult to justify most projects because costs usually occur before benefits.

BUREAUCRATIC AND POLITICAL “LENSES”

Spenders (constituency-support analysis)

The spender perspective is usually found in service or line departments.

Some consequences of the spender perspective are:

Expenditures on constituents are viewed as “benefits” rather than costs.

Transfers (from a CBA perspective) received by constituents are viewed as “benefits.”

Some costs (such as workers’ wages) are viewed as benefits, this often means support for any project rather than a “do nothing” status quo.

BUREAUCRATIC AND POLITICAL “LENSES”

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Spenders

• They treat social benefits and monetary payments received by their constituents as benefits. However, they also treat wages received by construction workers who build the highway (for example) as a benefit.

• They tend to support any alternative rather than the status quo (no project).

BUREAUCRATIC AND POLITICAL “LENSES”

Spenders

• Utilized resources that are owned by government are viewed as having no cost.

• Large, capital-intensive projects with big sunk costs are favored. They are harder to cancel later on.

• They favor low discount rates (because, holding everything else constant, this raises the NPV).

BUREAUCRATIC AND POLITICAL “LENSES”

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THE DEMAND FOR CBA

CBA is used different contexts for many different purposes. The primary clients for CBA are governments. However, the courts may also require CBA for the assessment of damages and therefore parties appearing before the courts (such as environmental groups) must also be prepared to understand it.

Governments

Many countries now mandate CBAs (or related techniques) prior to the enactment of various programs or regulations. In the U.S., for example, various executive orders and acts require a CBA to be conducted prior to new regulations. The UK requires project appraisal.

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The Courts

The courts use CBA to help assess appropriate damages.

Environmental and Other Progressive Groups

As governments consider CBAs in making policy and as the courts use CBA to determine liability and to award damages, environment groups will increasingly need to use it to make their arguments.

THE DEMAND FOR CBA

CBA, Sustainability, Corporate Social Responsibility, and the Triple Bottom Line

Private-sector corporations increasingly are paying attention to sustainability, corporate social responsibility or the “triple bottom line.”

As the purpose of these approaches is to improve the welfare of society, they can be considered a form of CBA.

THE DEMAND FOR CBA

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THE COST OF DOING CBA

The process of cost-benefit analysis takes many resources: analytic time (opportunity cost), skilled human capital (opportunity cost), and money (which represents the opportunity cost of other scarce inputs to the analytic process).

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