How useful is Cost-Benefit Analysis for public policy decisions?

By Ayan Banerjee

When making any decision for public policy, one must ask the question: which policy will be best for society? Economic development oppurtunities can range from investing in infrastructure to subsidies, all of which have costs and benefits. Economists must therefore use systems in which choices can be made about their effectiveness. However, diverse approaches have different positives and negatives and are further liable to their underlying assumptions. This essay will evaluate all of these factors and attempt to determine which method is most effective.
 
Cost-Benefit Analysis is a decision-making tool in which the benefits of a project or policy are weighed against the costs with regards to society. There are four core steps to carrying out this analysis. Firstly, the project or policy must be defined including its time period and the population it affects. Then identify the physical impacts such as labour man hours or tonnes of landfill. Following this, monetary evaluations of these costs and benefits are made. Finally, future costs and benefits are discounted since it is assumed benefits in the future are worth less than those received sooner. 
 
There are several assumptions made throughout the process of Cost-Benefit analysis which affect its success at maximising societal welfare. 
 
It is often assumed that the benefits and costs in the future are worth less than those that occur sooner. On one hand, there is an inherent time preference of obtaining benefits sooner rather than later. Conversely, it can be argued that the longer a project’s impact lasts, the more valuable it is with regards to sustainability. In future, environmental resources and benefits will naturally be scarcer as we pollute the environment more. Consequently, the supply of clean air, water and other environmental goods would be lower meaning they could be worth more in the future than they would be now. 
 
The model of discounting most commonly used assumes discounting to be exponential[2]. Usually, this system accurately represents markets in evaluating the investment choices of firms, however, it may not be applicable for public choices[3]. The discount rate for public choices is often referred to as the social discount rate and is not straightforwardly observable. Cost-Benefit Analysis is very sensitive to changes in discount rate and since the rate is difficult to determine, discounting will often lead to inaccuracies. 
 
Another perspective is that environmental policy decisions have intergenerational effects[4]. Therefore, we must consider the time preference of not only present-day society but also those of the future meaning discounting solely exponentially would be imprecise. Utilising discounting runs the risk that it may downgrade future damages caused by present day economic activity[5] which would cause major consequences in the future.
 
Conversely, there are benefits from using Cost-Benefit Analysis. Firstly, if the underlying assumptions are correct, it would result in the most efficient allocation of resources to maximise total social welfare. Secondly, this method has the advantage of incorporating a wide variety of factors. Often real-world scenarios involve many variables, making this approach versatile. Finally, impacts can be compared in the same unit – monetary terms. This makes it easy to relate costs to benefits in an understandable medium. However, often the process of quantifying costs and benefits is a difficult task and stated preference methods are liable to inaccuracies[6]. Ecosystems are complex networks that are difficult to isolate and quantify. Therefore, these inaccuracies in monetary valuation are likely to be most prominent with respect to environmental impacts.
 
Alternative approaches include Cost-effectiveness analysis which creates a distinct aim of a policy and then compares different approaches respective to their overall cost. Therefore, the lowest cost approach to achieve the same goal is the best option. The advantage this has over Cost-Benefit analysis is that it avoids monetising the environmental benefits which are difficult to quantify. Although it avoids this negative of Cost-Benefit analysis, it is liable to the other assumptions. Furthermore, in this approach, the degree of implementation must be decided beforehand, therefore, cost effectiveness is maximised which is often not equivalent to total social welfare.
 
Additionally, there is Multi-criteria analysis which uses several metrics instead of placing all costs and benefits in monetary terms. Valuing certain criteria such as population of species can be very difficult and liable to great uncertainty. When involving the environment and ecosystems, using different criteria would reduce these errors and therefore make data more representative of reality. On the other hand, it is harder to compare different metrics than if it were all in monetary terms as in Cost-Benefit Analysis.
 
In conclusion, although Cost-Benefit Analysis is an effective tool, it is inherently flawed by its underlying assumptions and high sensitivity to discount rate. Its alternatives attempt to avoid these faults through either removing variables (Cost-effectiveness analysis) or using different metrics (multi-criteria analysis). However, these new approaches deliver different issues. Therefore, I believe that policy makers should always use multiple approaches and decide on policies that are supported by various analytical methods. This would aid avoiding the negatives of each approach and therefore give a more accurate analysis.


[1] Pg. 114, Kolstad, C.D. (2011), Intermediate Environmental Economics, 2nd edition, Oxford University Press, Oxford
[2] Alberini, Anna and Alan Krupnick, Costof Illness and Willingness to Pay estimates of improved air quality: evidence from Taiwan, 76:37-53 (2000)
[3] Pg. 115, Kolstad, C.D. (2011), Intermediate Environmental Economics, 2nd edition, Oxford University Press, Oxford
[4] Pg. 116, Kolstad, C.D. (2011), Intermediate Environmental Economics, 2nd edition, Oxford University Press, Oxford
[5] Pg. 121, Field, B.C. and Field, M. (2013), Environmental Economics: An Introduction, 6th edition, McGraw-Hill Irwin.
[6] Pg. 145, Field, B.C. and Field, M. (2013), Environmental Economics: An Introduction, 6th edition, McGraw-Hill Irwin.