🪚Public Policy Analysis Unit 10 – Cost–Benefit Analysis Techniques

What's CBA and Why Do We Care?

• Cost-Benefit Analysis (CBA) evaluates the costs and benefits of a proposed policy, project, or decision to determine its net economic impact
• Compares the total expected costs against the total expected benefits to assess the feasibility and desirability of a project or policy
• Helps policymakers and decision-makers allocate resources efficiently by identifying projects with the greatest net benefits to society
• Provides a systematic and quantitative approach to decision-making, reducing the influence of subjective factors and biases
• Encourages transparency and accountability in the decision-making process by clearly presenting the costs and benefits of a proposed action
• Facilitates the comparison of alternative projects or policies to determine which option yields the highest net benefits
• Enables the identification of potential unintended consequences or externalities associated with a project or policy

Key Concepts and Terms

• Opportunity cost represents the value of the next best alternative foregone when making a decision
• Willingness to pay (WTP) measures the maximum amount an individual is willing to pay for a good or service
• Willingness to accept (WTA) measures the minimum amount an individual is willing to accept as compensation for giving up a good or service
• Present value (PV) is the current value of a future sum of money or stream of cash flows, discounted at a specific rate
• Discount rate is the interest rate used to calculate the present value of future costs and benefits
• Sensitivity analysis assesses how changes in key assumptions or variables affect the outcome of a CBA
• Externalities are the unintended positive or negative effects of a project or policy on third parties not directly involved in the transaction
• Distributional effects refer to the impact of a project or policy on different groups within society, such as income or demographic groups

Steps in Conducting a CBA

1. Define the scope and objectives of the analysis, identifying the problem or opportunity being addressed and the potential solutions
2. Identify and quantify all relevant costs and benefits associated with each alternative, including direct, indirect, and intangible effects
   • Direct costs and benefits are those directly related to the project or policy (materials, labor)
   • Indirect costs and benefits are secondary effects that occur as a result of the project or policy (increased tourism, reduced crime rates)
   • Intangible costs and benefits are difficult to quantify but still relevant (improved quality of life, aesthetic value)
3. Assign monetary values to costs and benefits using appropriate valuation techniques (market prices, WTP, WTA)
4. Discount future costs and benefits to their present value using an appropriate discount rate
5. Calculate the net present value (NPV) for each alternative by subtracting the total present value of costs from the total present value of benefits
6. Perform sensitivity analysis to assess the robustness of the results and identify critical assumptions or variables
7. Consider distributional effects and equity concerns, evaluating how costs and benefits are distributed among different groups in society
8. Make a recommendation based on the results of the analysis, considering any limitations or uncertainties

Measuring Costs and Benefits

• Market prices can be used to value costs and benefits when the goods or services are traded in well-functioning markets
• Revealed preference methods infer the value of non-market goods or services based on observed behavior and market transactions
  • Hedonic pricing estimates the value of environmental attributes by analyzing differences in property values (air quality, proximity to parks)
  • Travel cost method estimates the value of recreational sites based on the costs incurred by visitors to access them (transportation, time, entrance fees)
• Stated preference methods use surveys to elicit individuals' WTP or WTA for non-market goods or services
  • Contingent valuation directly asks respondents their WTP or WTA for a specific good or service
  • Choice experiments present respondents with a series of choices between alternative scenarios with varying attributes and prices
• Benefit transfer involves adapting estimates of costs and benefits from previous studies to a new context, adjusting for differences in population, income, or other relevant factors

Dealing with Time: Discounting

• Discounting adjusts future costs and benefits to their present value to account for time preferences and the opportunity cost of capital
• The discount rate reflects the rate at which society is willing to trade off present consumption for future consumption
• Higher discount rates place less weight on future costs and benefits, while lower discount rates give more importance to long-term effects
• The choice of discount rate can significantly impact the outcome of a CBA, particularly for projects with long time horizons (climate change mitigation, infrastructure investments)
• Constant discount rates assume that time preferences and the opportunity cost of capital remain stable over time
• Declining discount rates account for the possibility that time preferences and the opportunity cost of capital may change in the future, giving more weight to long-term effects
• Hyperbolic discounting suggests that individuals have inconsistent time preferences, discounting the near future more heavily than the distant future

Handling Uncertainty and Risk

• Sensitivity analysis assesses how changes in key assumptions or variables affect the outcome of a CBA, helping to identify critical uncertainties
  • One-way sensitivity analysis varies one parameter at a time while holding others constant
  • Multi-way sensitivity analysis varies multiple parameters simultaneously to explore their combined effect
• Scenario analysis evaluates the costs and benefits under different plausible future scenarios (best-case, worst-case, most likely)
• Monte Carlo simulation generates a large number of random scenarios based on probability distributions for key variables, providing a range of possible outcomes
• Expected value is the probability-weighted average of all possible outcomes, representing the average result if the analysis were repeated many times
• Risk aversion refers to the preference for a certain outcome over an uncertain outcome with the same expected value
• Risk premiums compensate individuals for bearing risk, reflecting the additional value placed on certainty
• Irreversible decisions, such as the destruction of unique ecosystems, may require a higher burden of proof or a precautionary approach in the face of uncertainty

Real-World Applications

• Environmental policy (air pollution regulations, climate change mitigation)
• Transportation infrastructure (highway construction, public transit investments)
• Healthcare interventions (vaccination programs, cancer screening)
• Education initiatives (early childhood development, school choice programs)
• Crime prevention and criminal justice (community policing, drug treatment programs)
• Natural resource management (fisheries quotas, forest conservation)
• Urban planning and development (zoning regulations, affordable housing policies)

Limitations and Ethical Considerations

• CBA relies on the monetization of costs and benefits, which may not fully capture non-market or intangible effects (biodiversity, cultural heritage)
• The distribution of costs and benefits across different groups in society may raise equity concerns, as a project with a positive NPV could disproportionately benefit some while harming others
• The choice of discount rate can have significant ethical implications, particularly for projects with long-term effects (climate change, nuclear waste storage)
• CBA assumes that individuals have well-defined preferences and make rational decisions, which may not always be the case in practice
• The analysis is only as good as the data and assumptions used, highlighting the importance of transparency and sensitivity analysis
• CBA may not adequately address irreversible or catastrophic risks, such as the potential for environmental tipping points or the loss of unique resources
• Ethical considerations, such as the intrinsic value of human life or the rights of future generations, may not be fully captured by a monetary analysis
• Political and institutional factors can influence the conduct and interpretation of CBA, potentially leading to biased or misleading results