Cost-Benefit Analysis Essay

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Cost-Benef it Analysis (C BA) is an economic technique for assessing the efficiency of a given project, whether it is a policy, construction, or other activity. The general CBA methodology involves identifying all costs of implementing the project and all benefits that will arise from the project and making a comparison. CBA is widely used by business and government to assess whether or not a project should be undertaken or to select the best choice or priority ranking among a group of options.

The initial step involves identifying a baseline from which to measure costs and benefits. The baseline might be the conditions if no project is undertaken or the conditions if the best project assessed-to-date is undertaken. Next, the affected parties and region of concern must be identified. These are the stakeholders that will bear the costs and/or experience the benefits of the project. A time frame over which costs and benefits accrue is necessary to identify the full stream of costs and benefits into the future. Future costs and benefits are not equivalent in value to present costs and benefits, necessitating choice of a discount rate for calculating the present value of future costs and benefits. The U.S. Office of Management and Budget sets a discount rate of 5 percent for federal projects, but some argue that the discount rate should be lower than this for resources that are not easily replaced such as natural resources. High discount rates can make the value of resources in the future low, raising equity issues with future generations.

Once all necessary information has been gathered, each category of costs and benefits should be summed following proper discounting. If the net benefits of the next best option are known, they should be included as a cost, the opportunity cost of the project. Opportunity costs can also be considered the net benefits of how funds would be spent if the project is not undertaken. The present value of all costs should be subtracted from the present value of all benefits, giving the net present value of the project. If the result is positive, the project is economically efficient. For easier assessment across projects, a benefit-to-cost ratio can be calculated. A related technique, cost-effectiveness analysis, involves comparing costs across options for a given quantity of benefits. Cost-effectiveness analysis is used particularly when benefits are difficult to quantify but have been deemed desirable and justify costs.

Growing Use

CBA has grown in application since the 1930s when it was introduced by the U.S. federal government for assessing proposed flood control and water projects. A wide range of state and federal legislation requires that projects meet CBA efficiency tests, including the Toxic Substances Control Act and the Federal Insecticide, Fungicide, and Rodenticide Act. The U.S. executive branch has issued orders that federal agencies must conduct cost-benefit analyses of rules to be issued, although the particular implementation of this order is controlled by the current president. Additionally, though, several pieces of federal legislation regarding environmental policy explicitly disallow the use of CBA, such as sections of the Clean Water Act, the Clean Air Act, the Endangered Species Act, and the Resource Conservation and Recovery Act. This is typically because the costs of inaction are deemed unacceptable.

While CBA is a straightforward and typical initial step in economic assessment, critiques exist. Certain shortcomings of the technique demand additional consideration or analysis, particularly when assessing environmental and social factors. The full range and extent of consequences of a project with environmental impacts are not easy to predict. Environmental and human health benefits are typically difficult and controversial to quantify in monetary terms. It is often hard to determine the full range and extent of environmental and social impacts. Furthermore, most environmental and social costs and benefits do not have readily accepted values. Therefore there is a tendency to underestimate, including only the readily identifiable values, and values employed are more difficult to justify and verify than those with documented marketdetermined values.

A variety of techniques have been developed by economists to determine values of environmental impacts. These include stated preference techniques such as conjoint analysis and contingent valuation that directly ask individuals questions designed to elicit preferences and willingness to pay for benefits. Travel cost and hedonic pricing techniques use revealed preferences via market expenditures to determine the values that individuals hold for various environmental amenities. Examples for estimating a park’s value would include respectively determining the amount spent to visit the park and real estate price differences.

Environmental and social impacts also face problems of short planning horizons and future value discounting. When benefits are likely to accrue to future generations, such as under projects to slow climate change, discounting might lead to large future benefits assessed as low values at the present. Also, when projects permanently remove an environmental amenity, such as dams and downstream river recreation, the long-term future stream of costs to society carry little weight.

The distribution of costs and benefits and associated equity considerations do not garner explicit measurement in CBA. Therefore, costs might largely fall on one segment of the population, while benefits accrue to another. One project might provide a high net financial benefit, while a separate project provides less overall benefit but a much larger swath of society experiences some benefit. Various theories on taxation on market forces might dictate allocating all benefits to a certain segment of the population for financial return purposes. The same benefit allocated to different individuals might have different total welfare benefits. For example, based on marginal analysis and diminishing returns, one might expect that someone who already has a large amount of a given resource will not benefit as much from an additional unit of that resource as would someone who has very little of it.

Bibliography:

  1. Diana Fuguitt and Shanton Wilcox, Cost-Benefit Analysis for Public Sector Decision Makers (Quorum/Greenwood Publishing, 1999);
  2. Nick Hanley and Clive Spash, Cost-Benefit Analysis and the Environment (Edward Elgar Publishing, 1993);
  3. Per-Olov Johansson, Cost-Benefit Analysis of Environmental Change (Cambridge University Press, 1993);
  4. Richard Layard and Stephen Glais, eds., Cost-Benefit Analysis (Cambridge University Press, 1994).

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