Public Policy Analysis MPA 404 Lecture 21

Previous Lecture Distribution of resources as a rationale for policy interventions The Social Welfare Function and Institutional Arrangements for making allocations. Their attributes and their functioning. Measures of welfare; Micro and macro

Cost-Benefit Analysis Its an analysis that takes into account the perceived benefits and costs of a government policy in lieu of a market shortcoming. This kind of analysis encompasses all kinds of government interventions, be it regulatory or project related decisions. It depends upon the decision maker to use this kind of analysis for a specific purpose. There may be a need to evaluate a policy based on social preferences, to reduce the costs of a program or a project, evaluate it in order to decide whether it needs continuation or a closure, etc. The policy maker’s decision in terms of government intervention is guided by the arriving at a benefit figure (like net benefit). The benefit and cost figures are usually arrived at by discounting benefits and costs through a benchmark rate (like the social discount rate). Analysts try their best to figure in variables like uncertainty, inflation and risk, etc.

Cost-Benefit analysis differs from cost-effectiveness analysis and risk- analysis. The cost-effectiveness analysis is exclusively focused on comparisons of only costs in order to arrive at a decision rather than general welfare criterion. The risk-analysis, similarly, is exclusively centered on risks in terms of the costs posed to the society by these kinds of risks. The method of choice amongst these three rests upon the preferences of the decision maker and the nature of the program. For instance, if the nature of the project revolves around a community’s exposure to risk (like floods and droughts) and government’s efforts at tackling them, then risk-analysis would perhaps be a better tool. The theoretical foundations of cost-benefit analysis have a long history. They beginnings are traced to the famous French economist, J.B. Say, who commented that public works as the “power or capacity of an article to satisfy our wants or gratify our desires”. It was later expanded as a concept and application by Jean Dupuit, a French engineer. He was also of the view that public works have the power to satisfy public’s wants (or utility). Therefore, there was purpose to public works.

DuPuit gave the example of a town which produces a certain amount of a certain stone that is used in a lot of applications. But there was no proper road or canal to carry it. Therefore, it was expensive to ship it out of town. so if the government steps in and builds a proper road or canal network, it will result in many benefits, including those that the government did not realize. For example, the increase in production and ease of taking it out of town will not only result in reduction in cost of doing business, but also lure firms to come in and increase production. These, in turn will result in new investment and job opportunities. Jules Dupuit’s ideas are relevant to public finance and government’s provision of public services. In generally, the primary problem is to decide how much and what type of goods to provide given that private markets would not provide that facility. There are a few criteria's to arrive at the decision, which are as follows: a) Economic Feasibility: This criterion involves the calculation (in money amount) of costs and benefits per individual. Costs are subtracted from benefits to arrive at a number. If the number is positive, then the project or proposal is considered feasible. But this method leaves open the

possibility that somebody will be worst off (his surplus will be negative since costs are more than benefits to him). Thus, somebody is worse off. But that problem is set aside because we are considering the total number, not the individual ones. b) Pareto Criterion: We’ve already gone through it. It takes care of the above problem of somebody remaining worse off. c) Kaldor Criterion: tries to strike a balance between efficiency and equity by suggesting that winners compensate losers in some way. This philosophy or idea underlies the method and use of progressive tax culture, at least in the US. In general, the criteria for going ahead with a project is the same: if benefits exceed costs, then project should go ahead. d) Voting: Put simply, it gets around the problem that welfare from a government’s perspective is not the same as from peoples’ perspective. Therefore, why not ask people to let the government know? And what better way is there than voting. Note of caution though: we have to assume that people have perfect information and are not influenced by somebody else.

The calculations in CBA involves two levels. One is the micro level and the other is the macro level. The micro level calculations involve finding the ratio of benefits and costs (in money terms). If the ratio comes up more than one, then the project is good to go ahead. The macro level analysis involves estimation of opportunity cost (the cost of next best alternative) in terms of other proposed projects. In other words, is the proposed project ok or are there better alternatives that we are ignoring? For a person who is analyzing the proposed project, it is imperative that he needs to figure in those factors that are not so visible in the calculations. These relate to estimations, forecasting and costing. All of these are not so easy to estimate and put in calculations since the world around us is very complex. However, what is required is a determined and careful effort on part of the investigator to try his best to include these calculations. This should include a historical analysis of the data that may point towards certain trends.

In terms of CBA, either the criterion of cost-benefit ratio or IRR can be applied separately in order to gauge the efficacy of a project. The cost- benefit ratio is considered more appropriate for micro level or small scale projects, whereas the IRR is considered more suitable for large scale projects where there is competition between various project designs/proposals. Let’s try to make a comparison here between two programs in terms of Benefit-Cost ratio and the discounted costs and benefits in order to understand the process. We take the discount rate as 7 percent, which itself is discounted for every year. Then we discount the costs and benefits through that number. In the last, we add up all the numbers for costs and benefits, and divide total benefits by total costs in order to get a ratio. Note one important distinction: real discount rate and nominal discount rate. If costs and benefits are given in present money terms, then we use the nominal discount rate. If they are given in inflation adjusted terms, then the discount rate should also be inflation adjusted (real discount rate).

YearBenefitsCostsDiscount %Disc benef’sDisc costs 150,0001,000, ,000500, ,00060,000