Cost Benefit Approach

  • Cost-benefit analysis (CBA) genuinely attempts to quantify the opportunity cost to society of the various possible outcomes or courses of action. It is therefore a procedure for making long-run decisions where present actions have implications far into the future.
  • Is a method of appraising a major investment project such as a railway line, airport and main road.

The cost-benefit approach differs from private sector methods of appraisal in two main respects. These are :

-It seeks to include all of the costs and benefits, not just private ones.

-It often has to impute shadow prices on costs and benefits where no market price is available. Examples are how to value the degradation of scenic beauty or the loss of agricultural land due to the building of a mall etc.

The problem created by externalities Figure 3.2 Over-production

The framework of cost-benefit analysis

Four stages in the development of Cost Benefit Analysis:

  • Stage 1:

–  To identify all of the relevant costs and benefits arising out of a particular project.

-Systematically, this involves establishing what are the private costs, the private benefits, the external costs and the external benefits.

-Sounds easy enough, but a little more thought is required.

There are problems when determining external costs and benefits; not easy to define and might have far reaching effects on society.

  • Stage 2:

-Putting a monetary value on various costs and benefits.

-Easy to do when market prices are available.

-When market prices are not available it can be linked to opinions or judgements.

-Example. How do you value time? Travel time and savings in travel time.

-How do you value accidents? Serious injuries, loss of life.

-Externalities may be estimated by using questionnaires, considering how much those who suffer have to be compensated and how much people would be prepared to pay for the benefits.

  • Stage 3:

Forecasting future costs and benefits

-Should be discounted (given a lower value), because money paid out in the future is less of a sacrifice than money paid out now, and money received now is more valuable than money received in the future as it can be put to use or can earn interest.

-Applies in situations where projects have longer-term implications which stretch well into the future.

-Here economists have to employ statistical forecasting techniques, sometimes of a very crude nature, to estimate costs and benefits over many year.

-Applies to projects that require massive capital expenditure.

-This stage might not be needed when considering 2 alternatives.

-Calculations have to be adjusted for risk and uncertainty.

-When all these costs and benefits have been added up and compared, the net present value is calculated.

  • Stage 4:

-Decision-making- the interpretation of the results of Cost Benefit Analysis.

-The results of stages 1-3 are drawn together so that the outcome can be presented in a clear manner in order to aid decision making.

-When the value of benefits exceeds the value of costs, then the project is worthwhile.

-When social costs exceed social benefit it is not recommended.

  • The four stages in a cost-benefit analysis provide a coherent framework by which decisions can be made in situations of market failure.
  • According to the Pareto criterion, a project is desirable only if there are gainers and no one is worse off.
  • According to this view, a project would be approved only if the gainers fully compensate the losers, with the gainers still being better off after doing so.
  • The Hicks- Kaldor criterion is more lenient. It suggests a project should be approved if the gainers could, in principle, compensate those who lose and still enjoy a net increase in welfare.

Cost Benefit Analysis advantage:

  • It seeks to make a decision based on the full costs and benefits of a project. This should make it more likely that an allocatively efficient decision will be made.

Cost-benefit analysis; Some difficulties:

1.Which costs and benefits should be included.

2.How to put monetary values on them.

3.Cost Benefit Analysis does not always satisfactorily reflect the distributional consequences of certain decisions particularly where public sector  investment is involved. In the case of a retail development external costs are likely to be highly localized while external benefits, in terms of employment creation are likely to be widely spread.

4.Many public sector projects are very controversial and subject to much local aggravation from pressure groups. Local political issues might result in the most uneconomical project being chosen due to the involvement of certain ministers or stakeholders.

In this case the outcome of the Cost Benefit Analysis is rejected and people’s own personal interest or feeling win.

2 thoughts on “Cost Benefit Approach”

  1. This is an amazing blog! Very comprehensive, as well as helpful. It will help me prepare for my lessons in future. Also love the fact it comes with a video. I look forward to more.

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