Cost-Benefit Analysis Definition

  • Definition: Cost-Benefit Analysis is a technique designed to determine whether a project should go ahead -Do the benefits outweigh the costs?
  • Cost-Benefit Analysis not only include the private monetary costs but also EXTERNALITIES and NON-MONETARY costs

Procedure of Cost Benefit Analysis

  1. All costs and benefits are identified. These include external and non-monetary
  2. A monetary value is assigned to each cost and benefit. A common value must be used, this is difficult for putting a value on noise, pollution
  3. Account is taken of future costs and benefits; these will also be discounted, for example, £100 now is worth more than £100 in the future
  4. Some costs may have a probability of occurring, e.g. accident has a 10% chance of occurring but would cost £6,000. Therefore the cost is 0.1 * £6,000 = £600

Whether the project should occur

  1. The simplest method is whether total benefits > total costs
  2. Pareto approach. This means that everybody has to benefit from the project. It is possible that originally some people will lose out, but these could be compensated by those who gain
  3. Allow the project to go ahead with regulation

Identifying the COSTS and BENEFITS

Private COSTS

  • Direct (private) monetary costs

External costs

  • Monetary, e.g. a new road may mean less money for train companies
  • Non- monetary e.g. poll, spoiling landscape, noise

These are hard to measure you could:

1. Ask a questionnaire as to how much people wanted to be compensated but there  are problems

  • Ignorance
  • Dishonesty

You could ask people who already have suffered

What is the cost of overcoming it?

  • e.g. cost of double-glazing but this can not be done with landscape
  • What price a human life: one could give a monetary value to a human life but this is not satisfactory

BENEFITS

  1. Direct benefits, this is revenue from firm operating. However these may fluctuate. It is also difficult to forecast demand in the future
  2. Consumer surplus
  3. Time saved from a new road could be given a value from an hourly rate

Discounting in cost-benefit analysis

    • Work out costs and benefits for each year of the project
    • Subtract costs from the benefits for each year to give a net benefit for each year
    • Discount each year’s net benefit to give it a present value
    • Add all these up to give a Net Present Value (NPV)
    • Choose the discount rate, This will reflect society’s preference for present benefits over future ones

Q. What are the problems with using a Cost-Benefit Analysis?

  1. Converting into commensurates (measurable values, such as £)
  2. Agreeing on the benefits of landscape, noise, cost of human life.
  3. The Unpredictable, e.g. Chernobyl
  4. Planning takes a long time benefits and costs may change frequently e.g. Wembley stadium now £1 billion
  5. Choosing a discount rate for future benefits and costs
  6. Deciding on distributional effects

Example

 

By on November 28th, 2016 in