What is Cost-Benefit Analysis?

Cost-benefit analysis (CBA) is an activity everyone does implicitly everyday throughout their lives. Whenever you make a decision, people consider the consequences and impacts of their choices by identifying the advantages and disadvantages. When you need to choose between multiple alternatives, you will choose the option that gives the largest benefit at the smallest cost. So, while you may not have had formal training in cost-benefit analysis, all students undertaking their first CBA course can intuitively understand the framework that we will utilise.

Formal (explicit) cost-benefit analysis is a systematic tool for identifying, measuring, and comparing the benefits and costs of a policy intervention, investment project, program, or government activities. This involves quantifying the direct impacts in monetary terms. When you conduct a formal social cost-benefit analysis, you take this concept one step further and quantify all consequences of a policy or project – considering both tangible and intangible impacts.

Tangible impacts are those that can be directly observed and measured due to having a physical form. For example, tangible impacts capture the inflows and outflows of money associated with construction of a new road, including construction costs, operating expenses, potential revenues or other budgetary outlays. Intangible impacts cannot be directly observed and measured. Intangible impacts lack a physical form, such as  improved road safety that results from the construction of a new road. Other common examples of intangible impacts in CBA include changes to wellbeing, environmental degradation, improved educational outcomes as a result of a policy, program, or project.

Having identified tangible and intangible impacts, it is also important to distinguish monetary and non-monetary impacts, as both play a crucial role in a comprehensive CBA.  Monetary impacts are those that can be expressed in dollar terms using market prices. Non-monetary impacts do not occur in markets and therefore have no observed market price, but with appropriate evaluation techniques they can be converted into monetary terms for use in a CBA.

From a CBA perspective, tangible and intangible impacts describe whether an effect has a physical form or not, while monetary and non-monetary impacts describe whether that impact can be expressed in dollar terms directly. Tangible impacts are always monetary by nature as they represent direct financial expenditures. Many intangible impacts are initially non-monetary, but are potentially monetisable using an appropriate non-monetary valuation technique. Therefore, in a CBA, the absence of a market price does not imply the absence of economic value. Including these non-market impacts is essential for capturing the full social costs and benefits of a policy, program, or project.

Once these tangible and intangible impacts have been identified and monetised where possible, these form the basis for comparing social benefits and social costs in the analysis. Consequently, social cost-benefit analysis follows a structured decision process – if the social benefits are higher than the social costs then you should accept or undertake the project you are evaluating. This is known as a decision rule.

To evaluate if the social benefit exceeds the social cost, we apply techniques that are similar to those found in financial appraisals. However, the key difference is that social cost-benefit analysis does not consider only financial cashflows or transactions attributable to a firm. It considers all relevant costs and benefits regardless of who bears those impacts. Consequently, stakeholders beyond the direct investor in a project or program are also considered in a social cost-benefit analysis.

The Purpose of CBA in the Private and Public Sector

Private sector CBA

Cost-benefit analysis is used in the private sector as a framework to formalise the investment process to ensure precise decision-making at the investment level; it is not used to make decisions about everyday activities. While private firms are driven by profits, cost-benefit analysis allows firms to analyse the wider impacts of an investment decision. In recent times, this also involves capturing benefits such as identifying opportunities for commercial profitability through cash inflows (benefits), or evaluating risks to a firm’s reputation or branding derived from harmful activities (costs). Therefore, in comparison to financial appraisal in the private sector, a private cost-benefit analysis should capture any external effects that may be harmful or beneficial to a company or firm directly.

Public sector CBA

Public sector decision-making can be complex by nature. Views on what policies governments should implement as part of their roles and responsibilities vary widely. Consider childcare policies, such as a government subsidy, as an example. Those people who have young children may view a childcare subsidy differently to those who have school aged children. Similarly, people without children may view childcare policies as unnecessary. However, we know any changes to childcare policies would have implications for employment, the economy, and provision of other government services due to spending trade-offs.

Consequently, implementing cost-benefit analysis from the perspective of the public sector is complex. As any change in policies, programs, or projects may have implications for a multitude of stakeholders relevant to a government decision-maker, it is important that these implications are assessed before a policy or project is approved. Particularly for government policy – we can ask clearly ‘What are the good and bad effects?’  when evaluating any policy or intervention a government may intend to implement (Sunstein, 2018). Cost-benefit analysis allows decision-makers to move away from political decision-making into a formalised framework that effectively identifies a good decision from a bad decision.

Additionally, CBA has become an established tool used by governments for making social and economic decisions. It provides a framework that allows governments to effectively allocate their scarce resources. CBA also outlines a clear process for prioritising programs and a transparent framework for consistent decision-making.

For cost-benefit analysis in the public sector, we often need to consider:

1. What outcomes are policymakers seeking from the policy or project?
2. What is the role of the government in achieving these outcomes?

The purpose of CBA in the public sector is to ensure resources are allocated efficiently to the competing priorities of the relevant governments. CBA provides a framework for evaluating these implications to ensure an efficient allocation of public sector resources.

Social Cost-Benefit Analysis – in Detail

Regardless of whether we are taking a private or public sector approach to CBA, economists understand the importance of evaluating all impacts of a policy, program, or project. By doing so, we are implementing a social cost-benefit analysis. Therefore, it is essential to understand that many of the effects caused by a policy, program, or project may be non-monetary in nature. These non-monetary impacts are more likely to be observed in a public CBA where there exists market failure. Market failure is often not considered in private sector CBA. This implies that public sector CBA will naturally be more challenging than private sector CBA. This is driven by impacts that may not be considered the responsibility of the private sector and therefore fall on the public sector. One good example of this issue is related to externalities.

Consequently, this is how cost-benefit analysis differs from financial appraisal methods. This is highlighted in the slideshow below (note: you can use the arrow or click on the rectangles to scroll through the slideshow).

Case study example – A ban on plastic straws: an informal CBA approach

In September 2021, the Queensland State Government implemented a ban on single use plastics.

Many cost-benefit analyses have been conducted on the impacts of plastics on the environment. Negative externalities associated with plastic drinking straws, single-use plastic bags and even disposable plastic utensils are numerous as these plastics enter waterways, oceans, and waste facilities leading to environmental damage and pollution.

This issue has been in the forefront of the social sphere over the past 10 years. As consumer preferences successfully shifted away from single-use plastics bags, all single-use plastics were subsequently banned in Queensland. The state government did not take a formal cost-benefit approach to make this decision. Instead, the state government likely weighed up implicit costs and benefits in the decision to ban single-use plastics and conducted consultations with the general public.

However, as no formal CBA was conducted, there may be costs and benefits that were not considered. For example, glass bottles are much heavier than plastic which can mean transportation might be more costly. Alternatively, paper bags are biodegradable, and can be made from renewable sources of trees. However, paper bags require more resources in their production compared to plastic bags – and are more difficult to re-use. The impact of increased use of glass or paper bags was not formally evaluated as part of the policy. Policies to encourage the re-use and appropriate recycling of plastics could be potentially more effective, such as container deposit schemes. For more information on the use of deposit schemes to reduce plastic littering, check out this Conversation article.

Net social benefit

As cost-benefit analysis exists as a method of quantifying the decision-making process to ensure an efficient allocation of resources, we require an analytical measure to help quantify the decision-making process.

We calculate the net social benefit to identify the increase (or decrease) in the welfare to society that is derived from alternative policies, programs, or projects. For a single period we can define the net social benefit as:

(1)  

In this instance we consider the benefits and costs for market and non-market goods related to the project or policy we are evaluating. The total social benefit is the benefit to society from the policy or project including both the private benefits plus any external benefits.  If a project has significant external benefits, then the social benefit will be greater than the private benefit. Similarly, the total social cost is the cost to society from the policy or project including both the private costs plus any external costs. If a project has significant external costs, then the social costs will be greater than the private costs. In the absences of market failure, net social benefit will be the same as the net private benefit.

Net social benefit is a simple decision-making tool, however the process of expressing all social costs and social benefits to calculate the net social benefit can be challenging, especially when faced with external impacts that require evaluation.

The Economic Concepts that Underpin CBA

There is a clear link between cost-benefit analysis and welfare economics. As mentioned previously, cost-benefit analysis is often used to ensure that resources are allocated efficiently between competing uses. We can use net social benefit to determine which projects to undertake. If social benefits exceed social costs, then the policy, program, or project improves total social welfare. At the same time, we can use net social benefit to identify allocative efficiency. Allocative efficiency is where resources are utilised for their best use within the economy. Therefore, net social benefit measures relative allocative efficiency in a cost-benefit analysis framework.

We can use net social benefit as a measure of allocative efficiency when considering whether a policy or project is worthwhile. Net social benefit identifies the most efficient allocation of resources from our set of available options. Essentially, the largest net social benefit from the options considered in a CBA represents a more allocatively efficient decision (assuming that the projects are mutually exclusive). Therefore, when considering projects that are mutually exclusive – you should undertake the project with the largest net social benefit.

Although we can use net social benefit to identify a more allocatively efficient outcome, we cannot identify the most efficient allocation of resources i.e., we cannot identify the Pareto efficient outcome. This is because we do not necessarily know the set of all possible alternative projects that our scarce resources could be used for. Following this, we can conclude that CBA is a useful tool for identifying relative allocative efficiency but cannot be used to identify Pareto efficiency. However, this does not mean that CBA is not useful – we can use CBA techniques to identify relative efficiencies between alternative policies or projects.

If the net social benefit from an intervention is greater than zero it directly implies that this intervention would increase the total social welfare for society. Therefore, if the net social benefit is greater than zero, a policy, program, or project should be undertaken as it can be considered a Pareto improvement (as seen in equation (1) ). By adopting this approach, we are essentially utilising a strict Pareto efficiency rule for project evaluation. This implies that policies are only adopted if they yield positive benefits (Heijman, 1998). However, this does not mean that the distribution of the costs and benefits should be ignored.

When considering a policy or program as a government decision-maker we need to consider the distribution of the benefits and costs used in (1) based on who gains and who loses from a program. We know that society gains when total social benefits are greater than total social costs resulting in a positive net social benefit (). Consequently, this condition implies that from a given policy, the winners receive more gains than the losers lose. Hence, if the net social benefit is greater than zero, there is a clear opportunity for those who gain from the implementation of a policy or program to compensate those who lose from its implementation. This referred to as a potential for Pareto improvement.

Opportunity costs

So far, we determined that cost-benefit analysis is clearly linked to allocative efficiency through the evaluation of the net social benefit of a policy, program, or project. At this stage we also revisit the concept of opportunity cost. Opportunity cost arises from scarcity – we have unlimited wants or needs and limited resources to satisfy them. Cost-benefit analysis already allows an analyst to assess how we can make best use of our limited resources given a set of potential projects. If we are not using our resources in one project, we would use them in an alternative project. Therefore, there is an opportunity cost in the form of alternative benefits that could have been realized when choosing one alternative project over another.

Opportunity cost plays a crucial role in how CBA analysts evaluate impacts, and is a fundamental concept we will utilise in future chapters.

The status quo and incremental cost-benefit analysis

Economics often focuses on comparative analysis.

When conducting a CBA, we often compare the outcome of the proposed policy or project against the outcome that would occur without the change. Therefore, we are effectively comparing the current “state of the world” against the proposed use of the resources in the project we are evaluating. The current “state of the world” is often referred to as the status quo.^[1] This assumes that the resources utilised in the project would be put to their next best alternative use. As economists think at the margin, we are interested in the incremental costs or benefits of each alternative project relative to the status quo. By utilising an incremental analysis, only costs and benefits that would not have occurred in the status quo scenario should be included in the CBA. Alternatively, a policy or project can be compared to a base case scenario. A base case scenario is used when the policy or project must be undertaken in some form, implying a change must occur. In this case, incremental costs and benefits would be evaluated against this baseline. Example 1.1 highlights incremental analysis.

As can be seen in Example 1.1, project (2) has the highest net social benefit and should be undertaken in this instance based on the incremental analysis.

References 

Heijman W.J.M. (1998). Welfare Economics and Cost-Benefit Analysis. In: The Economic Metabolism (pp. 51–60). Springer Netherlands https://doi.org/10.1007/978-94-011-5038-5_6