Chapter 1: The Big Picture
After completing this chapter, students should be able to:
Define cost-benefit analysis (CBA).
Describe the purpose of CBA in public and private sector decision-making.
Identify the underlying economic principles used in CBA.
Describe how CBA relates to applied welfare economics.
What is Cost-Benefit Analysis.
Cost-benefit analysis (CBA) is an activity everyone completes 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 more than one potential alternative, 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 or explicit cost-benefit analysis is a systematic tool for identifying, measuring, and comparing benefits and costs from a policy intervention, investment project, program, or government activities. This involves quantifying relevant consequences or 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 effectively observed and measured. For example, tangible impacts capture the inflows and outflows of money associated with construction of a road. Intangible impacts cannot be directly observed and measured, such as increased road safety from the road construction.
Consequently, 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 cost-benefit analysis does not consider only financial cashflows or transactions attributable to a firm. It considers all relevant costs and benefits irrespective of who bears those impacts. Consequently, stakeholders beyond the direct investor in a project or program are considered in a cost-benefit analysis.
Project, program, or policy? These terms are used interchangeably. We use these terms for the evaluation of an investment decision for the private sector and interventions or investments in the public sector.
The Purpose of CBA in the Private and Public Sector.
Using cost-benefit analysis in the private sector provides the framework to formalises the investment process to ensure precise decision-making at the investment level rather than decisions made based on 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 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 changes in policies, programs, or projects may have implications on 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 prioritization of programs and a transparent framework for consistent decision-making.
Key Concept – Scarcity
The economic problem of scarcity involves unlimited wants and limited resources. When faced with limited resources, choices need to be made. When making choices we face trade-offs. These trade-offs are referred to as opportunity costs.
Remember that economics is the study of how individuals or governments make choices under scarcity. For a refresher on scarcity you may consider reviewing the relevant section this external website: Understanding Economics and Scarcity | Microeconomics (lumenlearning.com)
For cost-benefit analysis in the public sector, we often need to consider:
- What outcomes are policymakers seeking from the policy or project?
- 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 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 extensive, clogging the waterway, 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 this decision. Instead, the state government likely weighed up implicit costs and benefits in the decision to ban single use plastics and conducted consultation 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 the transportation can be more costly. Alternatively, paper bags are biodegradable, and can be made from renewable sources of trees. However, paper bags require more resources in the production compared to plastic bags – and are more difficult to re-use. The impact of increased use of glass or paper bags were not formally evaluated as part of the policy. Consideration of policies to encourage the reuse and appropriate recycling 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:
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.
Market failure is a situation when resources are used inefficiently usually due to a market distortion. Essentially, a free market fails to achieve an efficient allocation of resources which results in a loss of economic and social welfare.
There are four key types of market failure:
- Public goods
- Incomplete information
- Uncompetitive market structures
Within the CBA context, the type of market failure is important when identifying social costs and social benefits that need to be accounted for. We will cover various market failure in detail in future chapters.
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 the 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 in 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.
Key Concept – Mutually Exclusive
In cost-benefit analysis, projects are considered mutually exclusive if only one alternative can be selected out of the set of potential options or alternative projects. For example, if a library is considering replacing its library management system it can choose between Opals, Newgenlib, or Evergreen software. In this case only one management system is required.
Alternatively, projects can be non-mutually exclusive. In this case the decision-maker can choose more than one of the projects under consideration. For example, a local council might consider upgrading a new park and may choose to install new park equipment, planting new trees and a recreational barbecue area. The council could install all three upgrades, or any combination of the three upgrades.
Note: We use the terms options and alternatives interchangeably.
Although we can use the 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 there is an increase in 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 the same. This referred to as a potential for Pareto improvement.
Key Concept – Pareto Principles Refresher
Remembering back to first principles, economics is about choice. In the context of CBA, it implies the following:
(1) Pareto Improvement: where the implementation of a policy or project leads to a strict increase in the net benefits, without anyone being made worse off.
(2) Potential for Pareto Improvement: the cost-benefit analysis of a project which indicates the capacity to make an unambiguous improvement in welfare by compensating losers so that no-one is worse off after implementation of the project.
(3) Pareto Efficient (Pareto Optimal): there exists no alternative allocation that can be made to make one person better off without making someone else worse off.
In the context of CBA, when a project or policy identifies an increase in the Net Social Benefit the project provides an opportunity to reallocate resources to improve the wellbeing of society without making any individual person worse off. Positive net social benefits therefore indicate the potential for a Pareto improvement.
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.
Key Concept – Opportunity Cost
The opportunity cost is the value of the next best alternative use. In CBA this would be the next best project.
Opportunity cost plays a crucial role in how CBA analysts evaluate impacts, and is a fundamental concept we will leverage off in future chapters.
The Status Quo and Incremental Cost-Benefit Analysis
Economics often focuses on comparative analysis.
Often when conducting a CBA, we compare the outcome of the policy or project with the proposed change 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 “state of the world” is often referred to as the status quo. 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, and incremental costs and benefits would be evaluated against this baseline. Example 1.1 highlights incremental analysis.
Assume that a government entity responsible for transport infrastructure would like to review a section of a highway that has observed several serious roadside incidents over the past year. As a CBA analyst you were asked to compare two alternative projects against the current road condition. The two projects are:
- (1) Resurfacing the highway;
- (2) Resurfacing and installing new safety barriers.
The information you collected is outlined in Table 1.1. The status quo in this instance is the current state of the project.
The status quo in this instance would be to continue maintenance on the highway. The goal is to assess project (2) and (3) relative to the status quo to identify which project should be undertaken using the net social benefit criterion.
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.
Summary of Learning Objectives
- Cost-benefit analysis (CBA) is a systematic tool for identifying, measuring, and comparing benefits and costs from a policy intervention, investment project, program, or government activities.
- CBA is used in the private sector to identify profitable investments. In the public sector, CBA is used to identify the best use of public funds and ensuring the efficient allocation of scarce resources.
- When undertaking a CBA 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.
- CBA leverages off the principle of potential Pareto improvement. When the NSB is positive there is an opportunity to undertake a project due to the compensation principle.
Sunstein, C. R. (2018). The cost-benefit revolution. MIT Press.
Heijman W.J.M. (1998). Welfare Economics and Cost-Benefit Analysis. In: The Economic Metabolism. Springer, Dordrecht. https://doi.org/10.1007/978-94-011-5038-5_6
- This is often also referred to as the Current policy, Do nothing, or Business as usual scenarios in various applications and textbooks. ↵