Introduction To Cost Benefit Analysis Townley Chapter 1

What is Cost Benefit Analysis? A systematic way of cataloguing benefits and costs of a proposal. Costs and benefits are not for individuals, but for society as a whole. In a cost benefit analysis the goal is to make an assessment that quantifies in monetary terms the value of all policy consequences to all members of society.

The net social benefit measures the value of the policy. – Social Benefits – B – Social Costs – C – Net Social Benefits – NSB = B - C This is the standard approach that is used when cost-benefit analysis is used to evaluate a policy or a project.

Potential Applications Can be used to look at issues such as: – Should a dam be built for flood protection and irrigation? – Should a hospital be closed? – Should a town install meters to monitor water use? – Should a new highway system be built? – Should new tougher guidelines on greenhouse gas emissions be pursued?

The Economic Perspective Economists are concerned primarily with economic aspects of assessments. Economists focus their attention the following questions: – What are the costs and benefits to society of the proposed policy, law or public sector project? – Once identified, how do we measure social costs and benefits; Especially “intangible items” like the quality of life, a life or noise pollution. – If costs and benefits occur at different times, perhaps over decades, how do we compare them? – How can this economic information be used for decision making? What are the implications for individuals and society as a whole? Cost-benefit analysis tries to determine from an economic perspective whether a proposal project will enhance or diminish social well-being.

Measuring Costs and Benefits Costs are measured as opportunity costs. – Should reflect the resource costs to society. Benefits can be measured directly in markets; sometimes benefits can be also be inferred from market behaviour, even though they may not be directly observed.

Some Issues in Cost Benefit Analysis that We Will Address in the Course Dealing with Time: – Construction of a road might take several years. – Benefits from road might last for a long time. – How do we account for this? Markets and Information: – Need to acquire a lot of information to undertake a cost benefit analysis. – Markets can provide a lot of this information, but sometimes it is hard to access. Example: Sometimes the price of good, service, or factor of production reveals its true value to society, other times market prices overstate or understate true social value. – Why? Market failures might distort what we observe.

Measuring Social Well-Being: – How do we measure well-being? – Use willingness-to-pay measures (more on these later). Distortions: – Market prices always convey information about the value of goods, services, and inputs; however, this is not always necessarily social costs and benefits. – If markets are distorted by taxes, subsidies, market power, or quotas, prices will either overstate or understate social values. – However, we can take observed prices and adjust them for account for the distortions present in markets. These adjusted prices are called shadow prices.

Intangibles: – Risk and uncertainty. For example: A lot of projects involve costs and benefits that may stretch over several decades. Not everything is given in world, we don’t have perfect foresight. Only in future will magnitude of costs and benefits become apparent.