31 Cost-Benefit AnalyslsGerald j. Miller and Donijo Robbins

1.1 INTROOUCTION

The cost-benefit anaIyst's pursuit of evidence to support the one most efficient aIlocation of economicresources deserves critical anaIysis. The analyst who uses the cost-benefit approach, we argue,recommends action based on anaIysis following vaguely defined methods. No matter how vague,these methods derive from a distinct belief about social relations and define a good citizen.

Policy analysts seek intuitive, popular appeal for their work when debate widens to includemany trames of reference. A single frame of reference limits participation in determining the vaIueof action for the common good, wide participation being the equivalent to a free market in goodanaIyses. This chapter has two goals: to describe and then to examine critically cost-benefit analysis(CBA) as a single trame of reference for policy analysis.

Policy anaIysis, in the comparing the costs, benefits, risks, and timing of govemment action-policy consequences-can inform decisions. The decisions may algo cause or realize (spawn) a lessdesirable distribution of costs and benefits among individuals. Despite its straightforward, intuiúvenature, cost-benefit analysis Tests on difficult choices about what are costs and what are benefits.Little agreement exists about how to calculate the impact of risk and timing on costs and benefits.

The cost-benefit idea represents a tradeoff between efficiency and equality in social and eco-nomic affairs. Equity guides policies and programs that give to each according to bis needs fromeach according to her abiliúes whereas efficiency advises that public projects should result in at leastone person being better off and no one worse off. Controlling what analyúcal methods to employin making allocation choices has great allure and controversy.

1.2 WHAT CO5T-BENEFIT ANALY515 15 ANO 15 NOT

Cost-benefit analysis refers to the collection and organization of data relevant to a govemmentleader's decision to intervene when markets fail, through public projects, programs, or regula-tory regimes (Kruúlla 1961, 226; Musgrave 1969). Cost-benefit anaIysis is a form of evaluaúonresearch conceming: either continuing or discontinuing a program, program strategy, a technique,or an improvement, or allocating resources among competing programs (GAO 1991; Poister 1978,

8; Weiss 1972, 16-17).Evaluation criteria vary. They include effectiveness of a program's peñormance in light of

specified objectives, efficiency in maximizing value or minimizing cost through technological,economic, or producúvity analysis, adequacy of the program in the degree to which the programeliminates a problem, appropriateness or worth of the program objectives, and prograrn respon-siveness to the needs and desires of its users and clients. Moreover, evaluation research may takeplace in the research and development or even planning stage of a programo any time during theprogram's operaúon as a formative evaluation, or as a full scale evaluaúon in response to a sunsetprovision in the law creating fue program, a summaúve evaluation (Rossi and Wright 1984; Rossi

and Williams 1972; Poister 1978; Scriven 1972; Suchman 1967).

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The net benefit criterion steers government decision makers in pursuing government action.Graham (1981) has defined net-benefit as a norm signaling appropriate government interventionbecause intervention's benefits outweigh its costs. Analysts use the criterion after they discountbenefits and costs with a figure caJled the social discount rate (Baumol 1970; Tullock 1964; Marglin1963; Pigou 1932). Analysts also account for the sensitivity of their discounted costs and benefitsto risk, uncenainty, and price level inflation (Arrow and Lind 1970; Hirschleifer 1958; Hirschleiferand Shapiro 1970).

Cost-benefit analysis differs from two other well-known policy analysis tools, cost-effective-ness anaJysis and risk analysis. Cost-effectiveness analysis collects and arranges data to facilitatea comparison of the costs of achieving a desired public program objective required by variousalternative treatments, interventions, programs or policy designs. The criterion for judging the bestaltemative is either least cost for a given level of eft.ectiveness or greatest effectiveness for a givenlevel of spending. For example, wimin a health rninistry, having a given amount budgeted to spendfrom me treasury or finding alternatives with the same CaSi, the analysts would evaluate altema-tive public healm programs in terms of mortality, morbidity, or quality of life. The analyst would .recommend me aJternative optimizing the combination or perhaps any single effectiveness measure(monality, morbidity, or quality of life). In other decisions, the analyst might compare two or moreways of getting the same results and recommend me cheapest.

Cost-effectiveness has a more specific use than cost-benefit analysis. For example, cost- effec-tiveness analysis addresses the goals of a ministry rather than the general welfare of me populationseNecto While government program effectiveness and general welfare improvement may appearto be distinctions without a difference, the administrative idea of effectiveness may limit me useof effectiveness anaJysis far more than the socially desirable and intuitively appealing concept ofnet-benefit. However, an analyst may have great difficulty finding the amount of actual benefit thatmay result from a program even if costs are known. Missing data make cost-effectiveness analysisthe analytical technique of choice.

Cost-benefit aIso differs with risk analysis or risk-benefit analysis. In the latter, risk becomesa prirnary factor in the analysis rather than a secondary one in cost-benefit analysis. If we definerisk as the probability of an event multiplied by the event's severity, the risk estímate takes theplace casi holds in analysis. The benefit calculation rests on an estímate of society's willingnessto pay to reduce a risk or to forego a benefit (Wilson and Crouch 2001, 137). The discounting andsensitivity analysis are similar in both techniques. The majar difference between a cost-to-benefitand a risk-to-benefit comparison lies in the perception of risk (Miller 2005, 486-487; Tversky andKahneman 1981; 1974; Douglas and Wildavsky 1982).

The question of whose estimates should prevail captures much of the legitimacy question af-fecting anaJyst use of cost-effectiveness, risk-benefit, and cost-benefit analysis.

1.3 ROOTS OF COST-BENEFITANALYSIS

Cost-benefit analysis developed in practice and application first, then theory followed much later.Persky (2001) credits French engineers, especially Jules Dupuit, with me pioneering use ofcost-benefit anaJysis. Dupuit (in translation; 1952) uses Jean-Baptiste Say (1826) as a vehicle for de-velopment and analysis of public works decisions in which one could find the "power or capacityof an article to satisfy our wants or gratify OUT desires" (p. 87). Utility to Dupuit and Say was "medifference between the sacrifice the purchaser [taxpayer] would be willing to make in arder to get[the project] and me purchase price [tax] he has to pay in exchange" (p. 90). Later, Dupuit definesutility as the power to satisfy or gratify arising from the expenditure of public funds on a project.The power resides in the project's effects-cost savings, inventive new uses for me public project.and competition wim costreduction in competing forms of goods the public project supponed.

Cost-Benefit Analysis 467

Dupuit illustrates with a canal. A town, he explains (1952, 91-96), may use 10,000 tons ofstoneeach year, perhaps delivered by path and ox cart. for house construction and repair. A canal built tocarry the stone reduces the cost of stone production by 25 percent. Moreover, the canal, if longerthan the present ox cart path, opens up new quarries to extraction, increasing competition and thevariety of stone, and thereby reducing costs of production even more. The greater variety of stoneand stone's lower cost may lead to other uses-more durable housing, tile instead of thatch roofs.paved streets, and more durable drainage canals opening more land for cultivation or some othernet positive use. The public expenditure has reduced production costs and has satisfied wants andgratified desires. Did anyone. if asked, agree to pay the canal construction tax with full knowledgeof the canal 's consequences? Perhaps noto Did the canal benefits outweigh the costs? Accordingto Dupuit, they dicto

Watkins (2005) and Porter (1995) credit French engineers with transmission of analysis abroad.especially to the United States through their close relationship with officers in the U.S. Arrny. TheFrench helped found the U.S. Corps of Engineers during the American Revolution as well as theU.S. Military Academy's engineering school, the sole engineering school in the country until theestablishment of one at Renssel.aer Polytechnic Institute in 1824.

Thus, modero uses of cost-benefit analysis in the United States carne with the U.S. Arrny Corpsof Engineers. As the Corps rose as a major force in public works, the U .S. Congress mandated,within its Rivers and Harbors Appropriations Act of 1902, that engineer analysts

shall have in view the amount and character of commerce existing or [a reasonable pros-pect of what will exist] which will be benefited by the improvement, and the relation ofthe ultimate cost of such work, both as to cost of construction and maintenance, to thepublic cornmercial interests involved, and the public necessity for the work and proprietyof its construction, continuance, or maintenance at the expense of the United States (U .S.

Congress 1902,372).

Although general, the 1902 Act outlined a Dupuit-style cost-benefit analysis.Standardization of analytical terms and concepts, as well as federal responsibility for flood

control when analysis justified it, anived with the Flood Control Act of 1936. The Act allowedgoveroment improvement or participation in the improvement of benefits 'Oto whomsrever they mayaccrue" when those benefits exceed estimated costs "and if the lives and social security of peopleare otherwise adversely atfected" (U .S. Congress 1936, 1570). No theory and no generally accepteddefinition of costs and benefits existed. In fact, Key (1940, .1.137) could still ask, "On what basisshall it be decided to allocate x dollars to activity A instead of activity B?" His answer: "impres-sionistic judgment." He argued that few cost standards exist I.eaving analysts to rely on judgmentand administrative surveys.

Neverthe1ess, cost-benefit analysis advocates were everywhere. Pearce (.1998) describes the in-creasing acceptance ofthe analytical approach to include a federal interagency cornmittee on analysisin 1946, a Bureau of the Budget Circular in 1952 forrnalizing concepts and providing guidance, andmajor academic economists' justification for the technique in 1958 (Eckstein, .1958; Krutilla andEckstein 1958; McKean 1958). Moreover, President Lyndon Johnson added cost-benefit analysis asa tool within the Planning, Prograrnming Budgeting System (PPBS) to advance bis Great Societyin .1965. To Johnson cost-benefit analysis was a modero-day management tool. From that point on,all presidents have called for some forrn of economic analysis. For exarnple, Presidents Reagan andClinton issued executive orders (.12291 in .1981 and 12866 in 1993, respectively) requiring federalagencies to prepare cost-benefit analyses for all major federal regulations (Hahn and Dudley. 2004).These RlAs (Regulatory Impact Analysis under Reagan and Regulatory Impact Assessment underClinton) "require agencies to consider all significant costs and benefits" even unquantifiable ones,as we11 as alternatives (Hahn and Dudley 2004, 5).

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1.4 PROVISION THEORY

Jules Dupuit's ideas have found a place in public finance and government's provision of publicservices. Generally, the problem is to decide how much and what type of goods to provide whenrationing by the market is not feasible or desirable or both. Public policy makers need some mecha-nism for deciding these questions, and luckily, they have not just one but tour mechanisms: basiceconomic feasibility, Pareto optimality, the Kaldor criterion, and democratic voting.

1.4.1 ECONOMIC FEASIBILlTY

Economic feasibility or economic efficiency exists when the benefits from a public program exceedthe costs of that programo Consider the following two programs, each costing society $10,000 butyielding different benefi ts. The first program, program A (see Table 31.1), is not economicallyfeasible; benefits are less than costs. Program B (see Table 31.2) is economicaily feasible becausebenefits to society as a whole, the summation of all individual benefits, exceed societal costs. Policymakers, if only using ibis method, would choose program B. In the end, however, program B doesnot meet productivity standards; that is, economic efficiency and equity may not be realized becauseone person is made worse off in the end.

1.4.2 PARETO CRITERION

Named after the nineteenth-century economist, the Pareto criterion guides selection of a policy. Thecriterion formalizes the definition of economic efficiency by favoring those projects or policies inwhich at least one person is better off and no person is worse off as a resulto The Pareto criteriongres one step further than economic feasibility to allow for more equity.

Consider program B where efficiency is achieved but equity is lacking. Using the Pareto crite-rion, although the majority of individuals are made better off, there is one person, C, whose position

TABLE 31.1Program A

Individual Benefits ($) Costs ($) Surplus (Loss) ($)

A 3.000 2,000 1,000B 2,500 2,000 500C 500 2,000 (1,500)D 500 2,000 (1,500)E 2,000 2,000 OTotal 8,500 10,000 (1,500)

TABLE 31.2

program B

Individual Benefits ($) Costs ($) Surplus (Loss) ($)

A 3,000 2,000 1,000B 3,500 2,000 1,500C 1,000 2,000 (1,000)D 3,000 2,000 1,000E 2,500 2,000 500Total 13,000 10,000 3,000

Cost-Benefit Analysis 469

TABLE 31.3program C

Individual Benefits ($) Costs ($) Surplus (Loss) ($)

A 3,000 2,000 1,000B 3,500 2,000 1,500C 2,000 2,000 OD 3,000 2,000 1,000E 2,500 2,000 500Total 14,000 10,000 4,000

is made worse; the individual costs are more than fue individual benefits, Under this criterion, then,policy makers would not fund program B,

Program C (see Table 31,3), on fue other hand, deserves funding because it is both economicallyfeasible and achieves Fareto optimality; at least one person, here A, B, D, and E, is made better offwithout making anyone worse off,

1.4.3 KALDOR CRITERION

Another method of dealing with general welfare of fue population, fue Kaldor criterion, is slightlyless demanding, This method begs the question: Should we or should we not accept a policy if thosein fue community benefiting from the policy compensate those who lose by fue policy, especiallyif the winners or beneficiaries still have some gain left ayer?

Consider this example, If fue strict private goods only requirement were not relaxed (libertari-anism), we would never get such goods as pristine ocean beaches. One finds it extremely difficultto slice up pieces ofthe ocean in order to allocate maintenance responsibilities to protect fue beach,Moreover, nature's ways in forcing erosion and beach sand movement would make such coercionfolly. Will one person rnaintain the beaches? Not by fue table of benefits, especially when thosebenefits are held down by the inability to divide the resource or exclude others from its use.

But should fue beaches be sustained? If costs equal the expense of maintaining fue beaches andbenefits equal fue sum of everyone's perception of betterment, if economic feasibility occurs, thencornmon sense would tell us yes, For example, fue $10,000 program, program C, provides greaterbenefits to some than to others. The gains range from $500 for E to $1,500 for B.

We might say that fue $10,000 version of beach cleanup is less equitable than it is efficient.Defining performance as a balance between equity and efficiency, analysts want to find the programthat would achieve both. The Kaldor criterion suggests a way to find that programo

Recall fue Kaldor criterion provides for winners compensating Iosers in a given situation. With-out assuming any losers, however, we can still create a Kaldor-like resu1t, as Table 31.4 illustrates.

TABLE 31.4Program C

Individual Benefits ($) Costs ($) Surplus ($)

A 3,000 2,999 1B 3,500 3,500 OC 2,000 2,000 OD 3,000 3,000 OE 2,500 2,500 OTotal 14,000 13,999 1

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To ensure that the winners bear their fair share of the costs and still reap some gain, the maximumproject would have to be $13,999. We can compute this amount by distributing the costs in thesame way as the original surpluses so that one person gains $1 of surplus, whereas all others have

benefits that equal their costs.

The dispersion of benefits and costs underlies the progressive tax structure and distribution

of income programs that have guided the construction and maintenance of the U.S. version of the

welfare state. More to the point of this chapter, however, the Kaldor criterion underlies cost-benefit

analysis. The Kaldor criterion argues that as long as the benefits exceed the costs of a project, the

project should go forward.

1.4.4 VOTING

The problem with mathematical approaches to determine public program funding is the quantifi-cation of benefits. especially those that are intangible and immeasurable. In countries where thevalues of individualism and decentralized decision making reign, we assume that each person canjudge a policy alone. The sum of those judgments becomes the public welfare. Referenda votingcan establish the public welfare.

But what vote should be required: Unanimity? Three-fourths? Two-thirds? Fifty percent plusQue? Plurality? The answer lies in the analysis of voting by legislative bodies. Following Buchananand Tullock (1962), the analysis reduces to the interaction of two variables. The first variable isthe loss ofvalue that occurs by not including every individual's vote, every individual' s calculationof benefit from a given project. The second is the cost of the effort to asceftain each individual's

preferences.Voting analysis demands that we know individuals' preferences toward a project. Obviously,

100 percent voting participation resulting in a consensus decision on the project would guide decisionmakers in making a valid decision. The first variable in voting analysis, therefore, is the probabilityof violating the Pareto criterion as we depart from unanimous consent. Such a problem occurs insampling as well as in choosing majority rule over consensus.

Finding an appropriate system of voting involves trading off the cost of exclusion againstthe cost of the election, a calculation easier than it looks. We seldom have a single issue where anindividual has two choices and perfect information about them both. Rather, we have a continuousstream of issues about which individual s have varying levels of intensity of preferences.

Such arrays of preferences yield themselves to vote trading-logrolling-as well as coalitionbuilding. In cases where we have public provision of private goods, we have the conditions for bar-gaining: costly participation, isolated issue salience, and unclear estimates of who benefits throughpolicies and by how mucho These conditions create one of two things: overspending (Buchanan andTullock 1962) and underspending (Downs 1960).

1.5 COST-BEN EFIT ANAL YSIS

The four mechanisms discussed above are the underlying theory of provision and allocation thatguides cost-benefit analysis. With a cost-benefit analysis, at least one project needs to be studied-amicroanalysis approach. In this case, the concept is straightforward: determine benefits and costs; thenfind the ratio of dollar-quantified benefits, at their current value, to dollar-quantified costs, at theircurrent value (B/C). If that ratio is greater than Que, the analysis suggests, because benefits are greaterthan costs, that the project should be considered for inclusion in the government's budget. At themacro level, however, the analysis is more complex. Analysts have to ask, what is happening in the ag-gregate if we do or do not provide this project. For example, if we build a canal, we have to determine

Cost-Benefit Analysis 471

the opportunity cost to society-the cost of giving up something else like a new bridge, a new sewersystem, or higher taxes (and, consequently, lower prívate consumption) to par for the project.

The technical concept includes two major ideas influencing the analysis. First is the notion ofmeasuring benefits and costs. This involves estirnating, forecasting, and costing them, all difficult todo in the public goods sector. The second idea is measuring benefits and costs at their current value.Current value requires the knowledge of social preterences about the time value of money-dis-count-and the impacts of inflation. That these are contested concepts understates the vagueness,the amount of deference given the analyst-the controversy-surrounding them.

1,5.1 UNCERTAINTY ANO THE MEASUREMENT OF BENEFITS ANO COSTS

Measuring benefits and costs involves careful consideration. An analyst must consider both theobvious and not so obvious consequences of a project, forecasting changes that will occur and af-fect these consequences over time, and costing the consequences properly, in both accounting andeconomic terms. Here, we describe the hazards of estirnating, forecasting, and costing. -

The first element of measurement is estimation. Estimation deals with the type of cost orbenefit to be counted and includes benefits and costs that are real or pecuniary types, tangible orintangible, as wel.I. as direct or indirecto First, real benefits and costs are those that have an absoluteconsequence for society as a whole. That is, on balance the benefit or cost to society was not ORe inwhich the cost to ORe group of individual s was offset by the benefit to another group of individuals.The benefit or cost was not merely redistributed-as a pecuniary benefit or cost woul.d describe-butan absolute change in the wel.I.being of society as a whole.

Second, estimates of tangible and intangible benefits and costs describe the difference betweenthose 'that can be priced, or about wh.ich members of society can agree relatively easily on price,and those they cannot. A tangible cost and benefit to many is a project such as a dam, with its mea-surable construction costs and irrigation, flood control, and recreation benefits. An intangible costmight be the value of endangered species that are destroyed as a result of the dam's displacementand destruction of the species' habitat by the construction of the dam.

The last type of benefit and cost that an analyst must confront in estimating the numbers thatfeed the cost-benefit analysis is the direct-indirect contrasto Direct costs are those immediatelyapparent from the project. The dam example, both tangible costs and tangible benefits, illustratesthis idea. The indirect or secondary costs from the dam's construction might include such thingsas poorer or better drainage of Streams and marshes that red the undammed stream; greater air andnoise pol.I.ution as a result of recreational equipment used on reservoirs created by the dam; andeven climate changes that result from large bodies of water replacing water flows.

In each case, the analysis would not be complete without considering the pecuniary, intan-gible, and indirect benefits and costs of a project. Most analyses suggest this to be difficult andcontroversial.

The second element of measurement is forecasting. The pol.icy problems and consequences offorecasting are often not based on political differences. Rather, they are based on quantitative andqualitative methods using unknown data about the future. Cost-benefit analysts cannot predict thefuture any better than any other analyst, and, instead, must monitor various data sets. Judgmentsmust be made about what to consider important enough to fol.I.ow closely, what is novel, and whatis a trend. For example, forecasters use time-series information on inflation, interest rates, revenue,expenditures, surpluses, and debt to help guide the cost-benefit process. Thus, forecasting has agreat interpretive potential. Likewise a forecase can influence the course of events. If one's view issubstantial.I.y influential, the guidance this forecast provides can influence the expectations of others(Pierce 1971,41). As Kl.ay (1985) has pointed out, what one wants to see can happen; views dobecome self-fulfilling prophecies. Thus, forecasting is often a judgmental process, ORe especial.I.y

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influenced by forecasters' social construction of reality, a process now acknowledged, used, andcalled dynamic forecasting or dynamic scoring (Mankiw and Weinzierl 2004; Auerbach 1996).

Finally, cost-benefit analysts must cope with the assignment of some quantitative value to thestream of benefits and costs. Assignment has special difficulty in the public goods sector, sincemarkets have not "priced" these goods, owing to market failures in either rivalry or divisibility.Specific costing problems that bedevil analysts are estimating shadow prices, final prices, oppor-tunity costs, transfers, and inftation.

First, the cost of a project or the benefit of it may often be estimated by analogy, i.e., shadowprices. Some equivalent market may exist tor a project, somewhere; that equivalent is employedas the basis for costing out the elements of the project for analysis. The problems associated withfinding such a shadow price, or of using the most nearly correct one, still create problems. Woulda roller coaster ticket price shadow a subway fare?

Second, the lack of a shadow price leads to additional problems. That is, most public goodstend to be oriented toward outcomes rather than mere outputs. Therefore determining final pricesbecomes a difficult task. Outcomes are extremely hard to envision much less estima~ in dollar-denominated consequences. For example, street sweeping and cleaning are often touted as popularprograms, even though they have no meaningful outputs (pounds of garbage collected, rayes fromresidents) but they have definite outcomes. "Clean streets" has a meaning all its own and is an end initself. Such an end-in-itself is hard to measure for cost-benefit analysis especially when the outcomemay not have roots in sensible, consequential, and measureable outputs.

Next, a project without a shadow price always carries an opportunity cost that might be measur-able andmeaningfulfor analysis. The opportunity cost of any projectis the benefit and cost of anotherproject foregone to proceed with the present one. The true worth of any project, therefore, is thecost (and benefit) of the mos( obvious substitute. Clean streets may carry the cost of an opportunityforegone, such as a rat amelioration programo The illustration also suggests the problem of lack ofadequate quantifiability in opportunities foregone, the biggest problem in calculating costs.

Fourth, a transfer of payment from one individual to another should not be included in thecalculation of benefits and costs. Transfers are not included because "there are no economic gainsfrom apure transfer payrnent because the benefits to those who receive such a transfer are matchedby the costs borne by fiase who pay tor it" (U.S. Office ofManagement and Budget 1992,5).

Finally, inftation has an impact on the future values of benefits and costs. The U.S. Office ofManagement and Budget suggests that "analysts should avoid having to make an assumption aboutthe general rate of inflation whenever possible" (U .S. Office of Management and Budget 1992, 7).But if a rete is necessary, they recommend that "the rate of increase in the Gross Dornestic Productdeftator from the Administration 's economic assumptions for the period of the analysis."

1.5.2 VALUATION aYER TIME ANO BY DIFFERENT SELECTION CRITERIA

The rnethod of selection of projects through cost-benefit (CB) analysis comes from the concept ofinvestrnent. The investrnent theory utilizes policy or project comparisons between a stream of ben-efits and a stream of costs measured at their current value-discounting future values into today'svalues. Generally, these comparisons are made on the basis of one or the other of two calculations,net present value (NPV) or internal rate of return (IRR).

The NPV measures future streams of benefits and costs by "netting" or subtracting currentvalue costs from current value benefits (benefits minus costs). A variation of this measure is themore popularly known ratio of current value benefits over current costs~ost-benefit ratio (B/C).The criterion for selection in the former is a positive number greater than unity (1).

A second method of selecting a project involves determining the project's internal rete of return(IRR). This calculation suggests projects with current value benefits exceeding their current valuecosts by a given rete, or percentage, are better than fiase that do noto

Cost-Benefit Analysis 473

The difference between NPV and IRR is that the NPU discriminates in favor of larger num-bers. That is, IRR corrects for extremely large differences in scope among projects. IRR is moreappropriately applied at the macrolevel where projects compete against other projects than at themicrolevel where a project's benefits compete against its costs.

Nevertheless, the B/C ratio calculation depends on establishing of current value benefits andcosts. Current value benefits and costs are al so known as discounted elements. Analysts use differ-ent discount cates and time frames for comparison purposes.

Discounting is based on a preference for the time value of money. For example, if given thechoice between $100 now and $100 ayear from now, most people would prefer to have the $100now. If torced to wait, people would want the year-from-now choice to be equal in value to the$100 received today. The amount that would make the $100 ayear from now equivalent in valueto the $100 received today is a person's, or a society's, willingness to wait to receive some benefit.The benefit and its magnitude inftuence a person in a societies a time value ofmoney. Under somecircumstances, some would prefer more money than others. To illustrate: The delay in getting the$100, such as when parents lend money to a college student daughter or son to buy an automobilein return for the promise to repay it, the parents might want compensation for the delay. Whatwould the value and time preference be? Would the value and time preference be the same whenthe student wanted to buy a house or summer on the beach in Xanadu?

1.5.3 AN EXAMPlE

For cost-benefit analysis we begin with future values over multiple years but must convert thesefuture values (FV) into present values (PV) so we can compare all costs and all benefit. For ex-ample, $100 two years from now has a different present value than $100 three years from now.To find the present value, the roture value is discounted based on the interest or discount cate (i)and the timeframe (t). Mathematically, the present value formula is presented as follows: PV = FV[1/( 1 +i)']. The portion ofthe equation in brackets is called the discount factor. Assuming a 7 percentdiscount rate, the present value of $100 two years from now is $87.34. The present value of $100three years from now is $81.63. The longer the period of time before a roture value appears, thesmaller the present value. The same is true with different discount rates. The larger the discountrate, the smaller the present values over time.

This logic applies to cost-benefit projects. The B/C ratio is calculated by adding up the dis-counted benefits and dividing by the total value of all discounted costs. Consider the simplisticPrograms D and E presented in Table 31.5. Each project has a stream of benefits and a stream ofcosts; all are future values. Each value must be discounted for its respective time period assumingthe same discount rate for all time periods. Using a 7 percent discount rate, the discount factor isdeterrnined for each year. The discount factor for each year is then multiplied by the respectivefuture va1ue of each benefit and costo For example, for program D the present value of $300,000three years from now is $244,889. Next discounted benefits are added, yielding a present valuetotal of $1,248,984, and divided by the total discounted costs of$l,621,096. The B/C ratio is 0.77.This ratio is less than unity suggesting costs are greater than benefits. For Program E, the B/C ratiois 1.01; indicating benefi ts are greater than costs.

By adding discount rate sensitivity to these two programs, different B/C ratios are calculated.For example, Table 31.6 presents the same process but with a 6 percent discount rateo Both B/Cratios are larger than with a 7 percent discount rateo Why? Because in both programs the benefitsare much larger than costs, making the magnitude of change (in dollar value) greater. That is, thedollar value of 5 percent of $100 is less than 5 percent of $1000.

Using the 7 percent discount rate as our comparison (Table 31 .5), increasing the rate 1 percentto 8 percent decreases the B/C ratio for both Programs (see Table 31.7). In fact, Program E where

Cost-Benefit Analysis 475

TABLE 31.7Cost-benefit Analysis for Two programs Using Eight Percent Discount Rate

Program D al 8 peocenlDiscount Discounted Discounted

Year Benefits ($) Costs ($) Rate (8%) Benefits ($) Costs ($)

1 O 1,000,000 0.9259 O 925,9262 O 500,000 0.8573 O 428,6693 300,000 60,000 0.7938 238,150 47,6304 300,000 60,000 0.7350 220,509 44,1025 300,000 60,000 0.6806 204,175 40,8356 300,000 60,000 0.6302 189,051 37,8107 300.000 60,000 0.5835 175,047 35,0098 300,000 60,000 0.5403 162,081 32,416

T

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1.6 POllCY ANAlYSIS ANO COST-BENEFIT ANAlYSIS

Where is cost-benefit analysis's place in policy analysis? It depends on whom you ask. AmartyaSeo maintains it is a daydream; Henry Richardson declares it stupid. Yet cost-benefit analysis was amodem-day marvel to President Johnson (Wolfson 200 1). In the end, cost-benefit analysis can serveas a management tool, where applicable, to help guide, fue decision-making process because not allcost-benefit analyses are useful or even conducted properly. For example, Hahn and Dudley (2004,11) evaluated cost-benefit analyses (RlAs) from the Reagan, Bush, and Clinton Administrations.They found fue overall quality of fue RIAs to be low. Costs and benefits often went unreported.Where they were reported, they were not analyzed together. Seventy-one percent of fue RIAs didnot report net benefit infonnation. In addition, where data were available and quantified, cost-benefitcomparisons were not presento

One difficult and controversial approach to estimation comes from "structured conversations"about hypothetical choices. The choices involve individual preferences for the hypotheticaf exis-tence and value of projects and courses of action (Larson 1992). Measuring benefits contingentlyrequires an analyst to ask individuals to "vote" a willingness to pay for or accept compensation forfue los s of a project, program, or policy despite no direct, active consumption of fue fruits of fuepolicy change. Voting-responding to survey research questions-aUows the membersofthe groupto estimate an option value or "an amount someone is willing to pay to keep available the optionfor future consumption of fue good" or fue amount "one might be willing to pay. .. to preserve awildemess that one anticipates possibly visiting some time in fue future" (Weimer 2005,74-75).The willingness to accept compensation-what fue respondent would be wiUing to give up-mayinvolve higher poUution levels, greater use of a park or beach, greater police efforts to constrainmovement, or releasing drug offenders serving a mandated prison sentence (Kahneman and Knetch1992, 69; Brown 2004).

Milgrom (1993, 417-422) critiques the theory of contingent valuation on the basis of itsviolation of fue utilitarian philosophy from which cost-benefit analysis developed. He argues thatexistence value in any standard economic approach must be pecuniary value to fue individuals, avalue realized only through their "own personal economic motives" (p. 431). He calls fue contingentvaluation supporters optimistic. They believe that aU factors that shape individual perceptions oftheworld may yield estimates of value. They also believe that individual perceptions alone can drivevaluations. Valuations, in fact, may lead to unacceptable conclusions, perhaps that "the secret [ornatural] destruction ora [wi.ldemess] does no damage... the real damage is wrought by thejournal-ist who first publicizes fue destruction" (p. 419). He caUs for cost-benefit analysis to use on1y fuemost complete and undistorted infonnation about what individual s prefer expressed in economicterms-what they would actually pay or accept-if given fue opportunity in a market and only whatpeople can think of paying or accepting in strict economic tenns.

Feelings, knowledge, and values are some of fue noneconomic factors that sway responses tosurveys valuing existence of some economic resource. Whether individuals feel that policy shoulddictate preservation of a wildemess, whether a person knows fue extent of fue risk the wildemessfaces, and whether someone can value fue wildemess if never seen, directly used, or thought about ineconomic tenns are not likely candidates for strict measurement of economic preferences, Mi.lgromsays. Instead, wildemess will exist because there is some other reason, one that cannot be tradedoff against economic values; environmental preservation is a deep-seated concem, possibly even abelief held by individuals on which public policy develops.

Altruism also violates the principIes of cost-benefit analysis. A survey asking fue value offue continued existence of a wilderness may elicit a response based on fue moral satisfaction ofincreasing fue supply of public goods, with the respondent thinking that more public goods willmake everyone better off. Does fue altruism actually make everyone better off economically?Milgrom asks (p. 419-420). No, he says, altruism is not consistent with fue idea that each person

Cost-Benefit Analysis 477

is independent of every other and that personal value "is treated as a purely personal matter that isrelated to the personal benefits each individual receives from the project" (p. 420). Altruism leadsto double-counting of the individual valuator's benefits.

Valuing the distribution of benefits also runs atoul of strict economic analysis through themeasurement and comparison of costs and benefits. For example, individual survey respondentsmay report that preserving jobs is worth the cost of opposing free trade, that "it is more efficientto protect the habitat of spotted owls [than] the jobs of Oregonian lumberjacks" (p. 421). Someindividuals, he says, would report being willing to pay to en force "racially or ethnically homo-geneous neighborhoods" (p. 421). He asks whether any policy analysts facing such problems usecontingent valuation.

Valuing outcomes presents unique problems. Valuing an outcome can attribute cause and statusto those who are responsible for the change in existence, nature or people. Cause and status defini-tions of the situation can have unwarranted consequences in surveys. Willingness to pay (WTP) oraccept (WTA) in a national park tire situation illustrates the process. Asked in a survey, an individualmight answer in one way to the WTP or WTA in firefighting for those events caused by lightningand in another way to those events caused by careless campers and in still another way, tires setby foresters to reduce undergrowth and prevent future wildfires. Milgrom argues that the surveyrespondent must be consistent irrespective of the method the policy used to mitigate the publicproblem. He also states the obvious in that cost-benefit analysis should not cope with individualvaluations made without adequate informarían.

Valuing from rights and obligations confuses the cost-benefit analysis as well. The environ-mental debate and the debates about almost all policy issues have elements of rights extensionsand exclusions-perhaps a/ right an animal has to be kept free from harm in laboratory experi-ments or the rights of animals not to be used tor food, clothing, or shelter. The debates also haveelements involving obligations, especially ecosystem preservation, for its own sake or for futuregenerations or for the preservationof animals and plant species. A right is a right, irrespective ofeconomic value, Milgrom states. An obligation is a teeling a respondent has, one often affected bythe feeling about those to whom the person might owe the obligation. For example, an obligationto preserve the rainforest in Brazil may fatI on respondents' obligations owed scale according to afeeling about Brazilians.

Political leaders willing to read iuto cost-benefit analysis any of these concepts go beyondthe theory of cost-benefit analysis and, some say, mis use the analysis or use an invalid one. Theseleaders simply read into the substance and process of median valer models-majority rule-theutilitarian model of moral philosophy. The good citizen is one who accepts the benevolence of po-liticalleaders as well. as the leaders' choice of the moments to bestow their recognition offeelings.knowledge, altruism, equity. responsibility, rights, and obligations.

1.7 ECONOMIC REASONINC IN COVERNMENT FINANCIAL MANACEMENTRATHERTHAN POLICY ANALYSIS

We now place cost-benefit analysis within the even larger body of literature characterizing economicreasoning in government. This review forms a critique and supports the literature of the previoussection, and suggests the larger sources and consequences of the cost-benefit analysis approachfor choice.

Economic decision making tends to be deductive. Because of that, economics has an elegantand mathematics-based precision in detailing "proof." Economics also provides a sense of practicalworldliness. Having based microeconomics, or the theory of the firm, on the idea that firm ownersmaximized, economic theory asserts something called optirnal, public decisions.

The fundamental principIe of economic reasoning applied to the public sector states that "bu-

478 Handbook of Public Policy Analysis

reaucratic officials, like all other agents in society, are motivaled by Iheir own self interests at leastpart of the time" (Downs 1957, 2). That is. political actors seek advantage tor both themselves andIheir constituents and tend to maximize gain and minimize loss. Both bureaucratic and political actorsreach their targels through a maze of rules, communication and coordinalion rules for bureaucraticofficials and voting roles for political actors. The world within which behavior bends around rolesis an unpredictable one. The actors, therefore, constantly calculale what is literally a risk-retumrelationship, given their original preferences for different kinds of advantages.

The CBA approach has its limits in govemment decision-making. That ¡s, CBA is often used tojustity ex pOSI lacIo a position already taken; the most significant factor in CBA is often its sponsor,as was President Lyndon Johnson in the Greal Society and the institution of PPBS. COSI-benefitanalysis tends to neglect the distributional consequences of a choice. The method, logically andsystematically, undervalues projecls thal even the distribution of wealth and overvalues projects thatexacerbate economic inequality. In the Kaldor terminology, cost-benefit analysis wouId recommenda course of action that could potentially allow the winners to compensate the losers so that no oneis worse off, but the method does nol guarantee Ihal the winners will compensate the losers.

ayer and above the operational problems with CBA, and by extension economic reasoningin govemment, there are intangibles of fundamental importance Ihal CBA cannot conceive. Forexample, a moral significance in Ihe duties and rights of individuals to each other and of govern-ment to all individual s is not comprehended in the measurement of consequences alone. Withcost-benefit analysis, certain rights such as due process of the law or broad public participationand discourse, cannot be conceived simply because they are processes valued for themselves rather

than outcomes.Cost-benefit analysis hj1s been blamed for damaging the political system. Some argue that

politics is superior to analysis because of the wider scope of ideas and concepts the people prac-ticing poIitics can fathom. Others argue thal analysis entranchises unelected policy analysts anddisenfranchises those who do not understand, do not believe, or cannot use anaIysis to make theirarguments to government. Such a situation creates a loss of confidence in govemment institutions,at the very least, and, more fundamentally, subverts democratic government.

To retum to CBA's basis in economics, others argue that the basis insofar as it describes orprescribes government action has flaws. That is, CBA assumes that there can be no market failure.There are always opportunity costs and shadow prices with which public sector goods and services. can be valued. Research on markets suggests that markets are not perfectly competitive, that thelack of competition leads inevitably to tailure, and that public goods are produced to remedy thatfailure. Without a way to value public goods and services, therefore, cost-benefit analysis fails to

inform the decision-making process.Another economic idea-that any altemative mustbe judged in terms of other altematives-

lends support to analysis. These proponents of CBA argue that there is no altemative to CBA, noneas explicit or systematic. In fact, CBA analysts' formalized, explicit nature allows the public tohold its public officials accountable to a larger extent than under normal politics and management.Systematic analysis is less likely to overlook an important fact or consideration which when placedin an adversarial process such as politics, may lead to the determination of the public interest far

sooner than mece impressionistic surmise.However, opponents of cost-benefit analysis argue about what it systematically reveals. They

say that it reveals only values related to conserving resources to the exclusion of all others; theoverriding value, in fact, is economic efficiency rather than others that are possible: those associ-ated with justice, domestic tranquility, the general welfare, and the blessings of liberty. As Dryzek(1993,222) points out, "[A]ll that matters is how much ofthe target value [efficiency] is achieved."Moreover, cost-benefit analysis never questions the existing resource constraints, a matter that is

questioned in political debate.The controversy over the use, misuse, or lack of use of analysis often pits those who believe in

Cost-Benefit Analysis 479

govemment against those who see the market as the predominantly positive force in society. 1'ypi-cally, what CBA overlooks is what most pro-government action proponents find govemment mostuseful in providing-equity-and to an even larger extent broad participation in self-govemment.Pro-market proponents argue that government intervenes for spurious reasons and, in doing so, cre-ates more problems than it sol ves, certainly leading to less rather than more economic efficiency.

1,8 CONClUSION

This chapter described and examined cost-benefit analysis. Cost-benefit analysis has had a briefand controversial history. Policy analysts, decision makers, and politicians alike find themselvesarguing over its purpose, theory, and application. Understandably, difterences arise where costs andbenefits are difficult, and sometimes impossible to measure. Used correctly, however, cost-benefitanalysis can lend itself to the decision-making process not as the deciding factor but as a techniqueto identify economically efficient policies, one of many quantitative and qualitative factors in po-litical decision making.

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