Costs and benefits

Weighing the two

1. A rational decision maker compares the costs of an action against its benefits before acting.
2. A decision improves welfare when its total benefits exceed its total costs, so that net benefit is positive.
   1. The net gain is simply the amount by which benefits exceed costs.
3. If costs exceed benefits, carrying out the action would lower overall welfare.

Private versus social

1. Private agents such as firms and consumers tend to weigh only their private costs and private benefits, the costs and benefits that fall directly on the decision maker.
2. By contrast, social costs and social benefits also count the external effects that fall on third parties.
   1. These spillover effects are the externalities that private agents leave out of their own calculations, so social cost = private cost + external cost.
3. Because private agents overlook externalities, their decisions can lead to a misallocation of resources.
4. A decision maker weighing only private costs and benefits will often reach a different verdict from one weighing the full social costs and benefits.

Cost-benefit analysis

1. CBA values and compares the full social costs and social benefits of a project or policy, and is often carried out by government.
2. Unlike private appraisal, CBA deliberately includes external costs and external benefits, not just the private ones.
3. The first step is to identify all relevant costs and benefits, both private and external.
4. The second step is to put a monetary value on each cost and benefit wherever possible.
   1. Effects such as time saved or lives protected must be estimated in money terms so they can be compared.
5. The third step is to compare total social benefit against total social cost.
6. The project should go ahead only if total social benefit exceeds total social cost.

Where CBA is used

1. Governments use CBA to appraise large public projects such as a new road, airport, railway, dam or hospital.
2. It is also used for policy choices where third-party effects matter, such as pollution controls or vaccination programmes.
3. A new airport, for example, brings benefits like extra travel and jobs alongside external costs like noise and emissions.
   1. Counting only the private revenue would overstate the case for building it.

Limitations

1. Many effects are intangible and hard to value, such as health, clean air or peace and quiet.
2. Forecasts of future costs and benefits are uncertain and may turn out to be wrong.
3. CBA can hide distributional effects, because the people who gain are often not the people who lose.
   1. A project can raise total welfare yet still leave some groups worse off.
4. The estimates can be biased if figures are chosen to justify a favoured decision.
5. How useful CBA is therefore depends on the quality of the valuations; even so, it gives a fuller and more transparent basis for decisions than private appraisal alone.

How useful is cost-benefit analysis?

1. CBA is more complete than private appraisal because it forces external costs and benefits into the decision and puts everything in a common money unit, making the reasoning explicit and open to scrutiny.
2. However, the result is only as good as the valuations. Intangibles such as health, noise or a lost habitat must be estimated in £, so the figures are uncertain and can be chosen to justify a favoured outcome.
3. It also hides who wins and who loses, so a scheme can pass on total welfare yet leave some groups worse off; its value therefore depends on the quality of the data and on whether distribution is weighed alongside the totals.
4. On balance, CBA is a valuable framework for large public projects with big external effects, but it should guide rather than dictate the decision. How much weight it deserves depends on how reliably the key costs and benefits can be valued in money.