What is Cost Benefit Analysis (CBA)?
This article explains that Cost Benefit Analysis (CBA) is a method which attempts to evaluate the social costs and benefits of a proposed economic activity.
Cost Benefit Analysis (CBA) exists because there are problems with externalities as it is difficult to place a specific monetary value on externalities.
What is Cost Benefit Analysis (CBA)?
Cost Benefit Analysis (CBA) is a process which is often used by governments to make a decision about investment projects. The affects that are taken into account are the social costs and benefits of the project. Cost Benefit Analysis (CBA) is rarely carried out by private firms as they seldom have interests beyond their own private costs and benefits.
Cost Benefit Analysis (CBA) actually attempts to put a value on social costs and benefits. In free market economies or the private sector of mixed economies, private costs and benefits are constantly calculated. However, these private costs and benefits make no consideration of externalities that are caused by any activity. Cost Benefit Analysis (CBA) goes beyond that idea and takes all the costs and benefits of an economic activity into account.
Governments are the managers of the economy. It is their job to oversee the way resources are distributed throughout the economy. They are also interested in the provision of needs and merit goods, which are beneficial to society. Therefore, Cost Benefit Analysis (CBA) is a great tool for governments wanting to assess the implications of an investment project of their own or a private business.
In the most basic form Cost Benefit Analysis (CBA) is carried out as such:
Social benefits > Social costs = The project will be carried out.
Social benefits < Social costs = The project will be denied.
Examples of Cost Benefit Analysis (CBA)
Imagine the government wishes to create greater access between Suzhou and Nanjing in China, so they propose a new project. This project is to build a motorway which will have tollgates. If this project was to be carried out by a private company, they would calculate private costs and benefits.
The costs are the actual costs associated with building the motorway, including materials, labor and any capital investment required. The private benefits come in the form of revenue generated from the tollgates.
If, after calculations, the company felt that private costs were greater than the benefits, they wouldn’t build the road as they would be unable to profit and vice versa. The government however, would go a step further. If the social benefits were greater than the social costs, the new motorway would be considered a good investment.
Sample Cost Benefit Analysis (CBA) of the new Suzhou/Nanjing motorway can look as follows:
SOCIAL COSTS:
1. Air pollution.
2. Noise pollution.
3. Destruction of countryside.
4. Destruction of wildlife habitat.
5. Destruction of some historic sites.
SOCIAL BENEFITS:
1. Create job opportunities.
2. Local shops will have more business.
3. Save travel time.
4. Reduce congestion on other roads.
5. Create transport links.
Note: These two lists are potential social costs and benefits. The government would need to give each factor a monetary value.
Problems with externalities
It can be very difficult to put a true value on an externality. For example, how much is an acre of countryside worth? How can you actually put a monetary value on such a thing that could be considered priceless by many? What is the true value of noise pollution, £1 or £1million per square kilometer? This is one major problem that Cost Benefit Analysis (CBA) has, but it must be overcome by the investigators.
A motorway initiative presents one of the major challenges of Cost Benefit Analysis (CBA) – human life as an externality. Social costs of building a motorway must factor loss of life through accidents. There will be an expectation of a number of accidents along a new motorway, some of them fatal. If the road is expected to have seven deaths a year, how do you put a value on those lives?
Some suggest that the value placed should be related to earnings, so perhaps the average earnings of the region. However, this practice is suggesting that some lives are worth more than others. This has clear moral implications and many would feel that it is too cold to ‘economically’ decide how valuable an individual may be.
Strengths of Cost Benefit Analysis (CBA)
Cost Benefit Analysis (CBA) calculates all the costs associated with a project, not just those of the individual. Monetary values placed on costs and benefits allow easy comparisons to be made. Governments can use it to approve investment projects in an efficient way, which is beneficial to society.
Governments may use it in situations where it is believed market failure exists in order to help bring efficiency and balance back to the economy.
Weaknesses of Cost Benefit Analysis (CBA)
The values placed upon certain costs and benefits may be difficult to determine, imprecise or viewed very differently by different people. Externalities in particular are difficult to value.
It can be difficult to determine costs and benefits over time. A benefit of RMB1,000 now may be worth much more or less in 10 years’ time.
Summary of Cost Benefit Analysis (CBA)
Cost Benefit Analysis (CBA) is a tool used to help determine the implications of an investment within society. It considers all social costs and benefits. Each factor is given a value in determining whether a project idea is valid, but certain variables such as externalities are difficult to put the number on.
