Cost-Benefit Analysis

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Cost-benefit analysis (CBA analysis) is a set of practical
procedures for guiding public expenditure decisions.
It 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

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 PURPOSE AND USES
• CBA is most commonly used for public
decisions– policy proposals, programs, and
projects, e.g., dams, bridges, traffic circles,
riverfront parks, libraries, drunk driving
laws, and anything else the government
might fund.

CBA can be used to rank alternative

projects as well as evaluating the social
value of one particular project.
•Cont…
• Testing the feasibility of expansion plans, proposals
and targets.
• Improving the efficiency of resource utilization.
• To help effective social decision making through
efficient allocation of society’s resources when
markets fail (market failure)
• When markets fail and resources are used
inefficiently, CBA can be used to clarify which of the
potential alternative programs, policies or projects is
the most efficient.

•Cont… •4
CBA measures costs and benefits to the
community of adopting a particular course of
action e.g. Constructing a dam etc.

When investment made commensurate with the

benefit derived, it can be said that operation is
positive and viable; but when benefits derived do
not compensate financial investments made, it can
be said that it is financially non-viable and
negative.
•Cont…
 Finally…

Cost Benefit Analysis is used to determine:

whether a solution/project is economically feasible

which of two or more projects provides the best return

on investment

Other issues :

 Is the project worthwhile financially?

 Is it the best option?
 Should it be undertaken at all?
 Cost Benefit and Cost Effectiveness
Analysis
• Cost-benefit analysis and cost effectiveness analysis can help
us in evaluating the alternative uses of resources. The
estimation of a unit cost is necessary, if one has to make a
cost-benefit or cost-effectiveness analysis. In a cost-benefit
analysis, the output is measured in monetary terms, and in
cost-effectiveness analysis, the output is addressed in terms
of the level of achievement of the objectives. Cost benefit
analysis is also known as “rate of return” analysis.
 Cost Benefit Analysis:
MERITS DEMERITS
1. The CBA analysis may be 1. The government is not
completely aware of all the cost
applicable for both the new as and benefits associated with the
well as old projects. program.

2. It is based of accepted social 2. This approach does not clearly

principle that is on individual states that who should bear the
population control cost.
preference.

3. This method encourages 3. The method of collecting data for

development for new techniques this analysis is generally biased.

for the evaluation of social

4. The people will have different
benefits. value system and there will
always be loser in the process.
 Types of CBA:
• Ex ante CBA – conducted prior to the policy intervention. Useful to
show whether resources should be used on a program or project

• Ex post CBA – conducted at the end of the policy intervention.

Provides information about the particular class of intervention

• In medias res CBA- conducted during the policy intervention

• 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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 BASIC STEPS OF CBA
• Step 1 -- Specify the set of alternative projects

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

• Step 3 -- Catalog the impacts and select measurement indicators

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

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

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

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

• Step 8 -- Perform sensitivity analysis

• Step 9 -- Make a recommendation

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 Example
For private decisions, such as taking martial arts
classes or going to a movie on Saturday night, we
are often not aware of any internal process of
consideration of costs and benefits, but behave as
though we do.

An individual will choose an action if:

Benefits (B) > Costs (C)

or
Net Benefits (NB) = B - C > 0.
• Joan will smoke if B > C.

For Joan, B’s are: taste/oral satisfaction, relaxation,

diet control, and improved work performance.

C’s are: expense, health consequences, value of

time spent, discomfort/inconvenience of
“smoking-allowed areas”, and disapproval of
others.

For the continuous choice of how many cigarettes

to smoke, Joan will smoke the number of cigarettes
which yield the greatest net benefits.
 Project evaluation in Present Value
Project evaluation usually requires comparing costs and
benefits from different time periods.
A. Projecting Present Dollars into the Future :
If $R are invested for T years at an interest rate of r, at the end
of T years, it will be worth $R x (1+r)T.

• Where
– R=initial investment amount
– r=rate of return on investment
– T=years of investment
Thus, The future value (FV) of the investment is:

FV  R1  r 
T
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Projecting Present Dollars into the Future

• Suppose you invest $100 today, @ 5% in the bank

– At the end of year 1, it is worth (1+.05)x$100, or $105

– At the end of year 2, it is worth (1+.05)x$105, or

$110.25

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 B. Projecting Future Dollars into the
Present

• The present value of a future amount of money is the

maximum amount you would be willing to pay today for
the right to receive the money in the future.

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 Example

• Suppose someone promises to pay you $100 after one

year from now.

• What is the maximum amount you should be willing to

pay today for such a promise?

• You are forgoing the interest that you could earn on the
money that is being loaned.
Formula for Projecting Future Dollars
into the Present
• Define
– R=amount to be received in future
– r=rate of return on investment
– T=years of investment
• The present value (PV) of the investment is:

R
PV 
1  r  T

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 Projecting Future Dollars into the
Present
• In previous equation, r is often referred to as the
discount rate, and (1+r)-T is the discount factor.

• Finally consider a promise to pay a stream of money,

$R0 today, $R1 one year from now, and so on, for T
years?

R1 R2 RT
PV  R0   ...
1  r  1  r  2
1  r  T

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Projecting Future Dollars into the Present

• Suppose, A $1,000,000 payment 20 years

from now is only worth today:
– $376,889 if r=.05

– $148,644 if r=.10

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Private Sector Project Evaluation
The present value criteria for project evaluation.

• Suppose there are two projects, X and Y

• Each entails certain benefits and costs, denoted as BX,
CX, BY, and CY.
• Need to ask:
– Is the project admissible?
– Is the project preferable?

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Private Sector Project Evaluation
– A project is admissible only if its present value is
positive

– When two projects are mutually exclusive, the

preferred project is the one with the highest present
value.

– To take this decision we need to calculate Benefit-

Cost Ratio.

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 Private Sector Project Evaluation
• The benefit-cost ratio divides the discounted stream
of benefits by the discounted stream of costs. In this
case
• B=stream of benefits and C=stream of costs:

B1 BT
B  B0  ...
1  r   
1  r
T

C1 CT
C  C0  ...
1  r  1  r  T

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 Public sector projects evaluation by the
government
Sensible decision making by the government requires present
value calculations. However, the public sector , should
compute costs, benefits, and discount rates differently than
private sector. The private individuals should reflect the rate of
return available on alternative investments. There are problems
in selecting a public sector discount rate. Public sector discount
rate based on two things .i.e.
1. Rates based on returns in the private sectors.
2. Social discount rate.

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 Rates based on returns in the
private sectors.
• Funds for a given project are collected form a variety of taxes,
each of which has a different effect on consumption and
investment.
• The after tax rate of return measures what an individual
losses when consumption is reduced, dollars that come at the
expense of consumption should be discounted by the after-
tax rate of return.
• Unfortunately, in practice it is hard to determine what the
proportions of sacrificed consumption and investment
actually are for a given government project.

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 Social Rate of Discount
• The rate at which society is willing to trade off
present consumption for future consumption.
• The social discount rate may be lower from market
returns because it:
– Accounts for concern about future generations

– Involves paternalism

– May solve some market inefficiency such as positive

externalities

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 Concern for Future Generations
• The public sector decision makers care not only about the
welfare of current generation but future generations as well,
while the private sector cares only about its own welfare.

 Hence, from social point of view, the private sector dedicates

few resources to saving, which implies too high a discount rate
of future returns. If future generations are expected to benefit
from some projects, the anticipated profitability is high, which
encourages investment today. Private firms plant trees today in
return for profits on wood sales that may not be realized for
many years
Paternalism
•People (even with self-interest) may not be farsighted
enough to consider adequately benefits in the future; they
therefore discount such benefits at too high rate. The
government should use the discount rate that individuals
would use if they knew their own good. This is the
paternalistic argument- government forces citizens to
consume less in the present and in return , they have
more in the future, at which time they probably thank
the govt. for its foresight.

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Market Inefficiency

 Private investments generate positive

externalities that benefit other firms, this leads
to under-provision of investment by private
markets. By applying a discount rate lower than
the market’s, the government can correct this
inefficiency.

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Valuing Public sector Benefits and Costs of a project
The evaluation problem is more complicated for the
government because market prices may not reflect social
benefits and costs.
Evaluating private projects is done by comparing costs
and benefits incurred to the firm and it is
straightforward; benefits are revenues received and costs
are payments for inputs; both are measured at market
prices.
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 Several Ways for measuring the benefits and costs of
public sector projects:
A. Market prices
B. Adjusted Market prices
C. Consumer Surplus.
A. Market Prices
 In well functioning competitive economy, prices reflect the marginal cost
of production and its marginal value to consumers. It would appear that if
the govt. uses inputs and /or produces outputs that are traded in private
markets , then markets prices should be used for valuation. The problem is
that, in reality, markets have imperfections, (e.g. monopoly , externalities
and so on) which makes prices do not necessarily reflect marginal costs
and benefits. •30
B. Adjusted Market Prices

•Prices in imperfect markets do not reflect their marginal

social cost. The shadow price (A shadow price is an
estimated price for something that is not normally priced

or sold in the market). of such a commodity is its

underlying social marginal cost. Although market prices
of goods in imperfect markets diverge from shadow
prices, in some cases the market prices can be used to
estimate the shadow prices.

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C. Consumer Surplus
 In contrast to the small private firms, public
sector projects are relatively large and they may
change market prices.

 In public sector project benefits can be measured

using the consumer's surplus:
“the difference between the amount the consumer is
willing to pay and the amount it actually paid.”
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Games of Cost-Benefit Analysts Play

There are additional common errors committed in cost benefit analysis.

A. The Chain-Reaction Game:

 Advocates of public projects can make them more attractive by counting

secondary profits arising from it as part of the benefits, while ignoring
losses induced by the project.

 Consistency requires counting secondary benefits and losses.

 A problem with chain-reaction game is that it counts as benefits changes

that are merely transfers. For example, Transfers income from gasoline
consumers to gasoline producers, but it does not represent a net benefit of
the project.

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B. The Labor Game

 In case of public projects, count wages paid to

workers as benefits, while in fact they are costs of the
projects not the benefit, side of the calculation.

 Even in an area with high unemployment, it is unlikely

that all project workers would have been unemployed,
or they would have remained so for a long time.

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C. The Double Counting

 If a public project increases the land's value, the

government counts as benefits as (1) it increase the land's
value and (2) the PV of the stream of net income obtained
from farming it.

• Land owner can either sell it or use it, not both. Under
competition, the sale price of the land just equals the PV of
the net income from farming it. Because the farmer cannot do
both simultaneously, counting both (1) and (2) represents a
double counting of the true benefits.
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 Summary of Cost-Benefit Analysis
• Cost-Benefit analysis is used to evaluate potential public sector projects

• Present value of future expected costs and benefits must be calculated in

order to allow correct comparisons

• Choice of the discount rate is critical

• The costs and benefits of public projects can be measured using market

prices in the absence of market failures. Otherwise, shadow prices or

consumer surplus can be used

CONT

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 Summary (cont)
• Quantifying the value of time and life, is
necessary in measuring benefits, but using
earnings as a proxy has limitations

• Whether the distribution of future costs and

benefits on various groups of people should
be included in C-B analysis is under debate

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