Cost-Benefit Analysis. Class Notes and Exercises

By Pere Riera

It contains the class notes of a gradute course followed by students of both economics and other backgrounds. At the end of each chapter a problem set is proposed, and the solutions given.

• Language: English
• Publisher: Pere Riera
• Release date: Sep 16, 2019
• ISBN: 9781393338475

Book preview

1  Social Cost-Benefit Analysis

1.1  Introduction

In short, the Social Cost-Benefit Analysis (CBA) of a given change compares the sum of costs to all the affected agents (society) to the sum of all benefits. The change is judged desirable from the social perspective when benefits exceed costs.

In this context, a benefit is a gain of welfare (utility), while a cost reflects a loss of welfare (disutility).

There are numerous textbooks and guides, as well as a great deal of articles and grey literature that can be helpful to introduce the theory and practice of Social Cost-Benefit Analysis. Some are more general, like Boardman et al (2011), and others more sector oriented, like Brent (2003), Gramlich (1998), and U.S. Environmental Protection Agency (2010), among others. Some are more practitioners oriented -e.g. Zerbe Jr. and Bellas (2006)-, and others more theory oriented -see for instance Sugden and Williams (1978), Per-Olov Johansson and Bengt Kriström (2016).

This course examines CBA from both a theoretical and an applied perspective, with more emphasis on the latter.

The class notes are organized in three chapters. The first one is devoted to the economic evaluation by CBA. The second covers the more specialized topic of valuation of non-market goods, probably the most complex and time-consuming task in a standard CBA. Finally, the third chapter provides a short introduction to several economic evaluation alternatives to CBA. It pays particular attention to the Equivalency Analysis, to have a better and more detailed understanding of temporal discounting.  Each chapter ends with a set of exercises. Although the solutions are provided, it is good learning practice not to check them before one confidently believes to have found the right answer.  The notes are intended to facilitate the understanding of the lectures, and the preparation for the exams. Ideally, the student would read the notes before class.

1.2  Valuation and Evaluation

Valuation is just the estimation of a value. It can be seen as a positive topic. Evaluation implies a judgment. The purpose of evaluation is usually normative. Both deal with changes. Without exception, we always value or evaluate a change. For instance, when we value an orange, we value the change from not having the rights to consume the orange to acquiring them; or we can evaluate a hospital project, assessing the change from not developing the hospital, i.e. continuing with business-as-usual, to developing the hospital.

1.3  Terminology

The full label of the main evaluation tool studied in this course is Social Cost-Benefit Analysis, or Economic Cost-Benefit Analysis, depending on the author. However, the name is usually shortened to Cost-Benefit Analysis, but it maintains the perspective of the whole society of affected agents. Alternatively, the acronym CBA is used. In some countries, most noticeably in the USA, the order of the words is often changed to Benefit-Cost Analysis.

1.4  Social vs. Private

When instead of the whole society we take the point of view of the investor or promoter, governmental or non-governmental, we move from Social CBA to a type of Financial Economic Analysis. Otherwise, both instruments are rather similar. As mentioned, the main criterion for a CBA to recommend an action is that the overall social benefits have to exceed the overall costs to society, including both privates and externals. Thus, social benefits are the sum of individual benefits (welfare gains), and social costs are defined as the sum of all the individual costs (welfare losses). This may be an attractive criterion for social decision making, but not without controversy, as will be discussed later.

1.5  Theoretical Foundations

CBA is rooted in mainstream welfare economics –and therefore in microeconomic theory. It is one of the main instruments of applied welfare economics.

It requires to allow for interpersonal comparisons of utility, and cardinality measures of utility. If only ordinality is assumed, a project would typically be socially desirable if there are no losers, and at least one agent is better-off (Pareto criterion, to be discussed later). With cardinality, the interpersonal comparison permits to consider a project socially desirable if the amount of overall utility is not lower than the amount of disutility (Kaldor-Hicks criterion, to be discussed later). Cardinality also opens up the option of introducing weights (e.g., for equity treatment, as will be discussed later).

This course focuses on certain types of CBA applications. They are mostly for small projects, with initial investments (rather than disinvestments), with discrete time (e.g., annual periods) rather than continuous, with no more than one internal rate of return, a constant positive discount rate, and carried as ex ante analyses. This accounts for the most standard cases. Some departures will briefly be explored, but not properly covered. Johansson and Kriström (2016), for example, deals with some of the variants, and gives further references.

1.6  Background and History

The precedents for the theory of CBA can be traced to XIXth Century French economist Jules Dupuit, ( C:\Users\Toshiba\AppData\Local\Microsoft\Windows\INetCache\Content.MSO\FE8042BC.tmp 1804-1866) and to the British economist Alfred Marshall ( C:\Users\Toshiba\AppData\Local\Microsoft\Windows\INetCache\Content.MSO\97E1042A.tmp 1842-1924), in the first decades of the XXth Century. However, the practice of CBA arrived did not start until a bit later. Two United States Acts from the 1930s requested the actual implementation of early forms of CBA, the 1936 Federal Navigation Act, and the Flood Control Act of 1939, thus marrying theory and practice. Another impulse come from the general demand for more efficient governmental expenditures, particularly after the Second World War. In the 1950s and 1960s, practical CBA profited from the theoretical development of welfare economics. It kept gaining adepts within the discipline to become the most recognized formal economic evaluation tool. For a defense of the usefulness of CBA from mainstream economics, see for instance Arrow et al (1996).

Since 1981, CBA is compulsory in the USA for governmental investments over a certain amount, according to an executive order (EO 12291), which requires that major regulations –those with an effect on the economy of $100 million or more, at the time– undergo a regulatory impact analysis (RIA). RIAs often involve a CBA. Some laws explicitly make CBA mandatory (e.g., the 1996 Safe Drinking Water Act Amendments).

In Europe, projects benefiting from Structural Funds, Cohesion Fund and Instruments for Pre-Accession have been examples of investments requiring a formal CBA if they exceed a given budget amount. In some European countries, a CBA is to be included in the Environmental Impact Studies of transport infrastructure; in others it is to be performed separately; but in others it is not mandatory. In the UK (and other countries), there is a strong tradition of CBA applied to trunk road assessment. The British Government provides a computer program, called COBA, to guide practitioners through the analysis and suggest default values for standard costs and benefits (see a [summary], or a [more comprehensive guide]).

International institutions, like the OECD, the World Bank, the Inter-American Development Bank, among others, have contributed a great deal to the