Unit 1 Micro: Using the Cost-Benefit Principle

The cost-benefit principle is one of those core ideas that can be brought into so many evaluation discussions both in micro and macroeconomics – you should be using it in your papers!

The cost-benefit principle says that you should take an action if, and only if, the extra benefit from taking it is greater than the extra cost

Here are some examples where the principle might be built into your analysis and evaluation

1. Costs and benefits of government subsidies e.g. the arguments for and against subsidies to incentivise new housebuilding, to part finance environmental improvement schemes or measures to curb deforestation

2. Costs and benefits of indirect taxes e.g. environmental taxes (such as a carbon tax) or taxes designed to curb demand for / consumption of de-merit goods including higher indirect taxes on alcohol, fuels, air transport etc

3. Costs and benefits of the introduction of competition into a market e.g. postal market liberalisation which is eroding the monopoly power of the Royal Mail, liberalising the market for telecommunications

4. Costs and benefits of an increase in government spending on public goods and merit goods such as flood defence schemes, free entry to museums and galleries, spending on new motorways or state-funded wifi infrastructure

5. Costs and benefits of different strategies designed to reduce income and wealth inequality e.g. the national minimum wage, the introduction of a living wage or changes to the top rates of income tax

6. Costs and benefits of the introduction of carbon trading as a way of reducing CO2 emissions

7. Costs and benefits of different government policies designed to reduce unemployment e.g. comparing the effectiveness of investment in training with an employment subsidy for the long term unemployed

8. Costs and benefits of major infrastructural projects such as new motorways, London 2012, CrossRail, infrastructure projects as part of a fiscal stimulus

9. Costs and benefits of a decision by the government to relax planning controls on new house-building

10. Costs and benefits of tougher regulations for different industries e.g. increased fuel efficiency targets for the motor industry or tighter laws on carbon emissions from factories

Key revision points:

• Market failure diagrams are an excellent way of illustrating the ideas here e.g. you can draw / show private and social costs and benefits and also the welfare losses and gains from different policies. So any question on externalities (positive and negative); merit and de-merit goods etc should definitely have a cost-benefit diagram within the answer and some supporting text explaining it and applying it to the question.

• Consider short and longer term costs and benefits - which policies might have the greatest impact over the longer term?

• Whenever you are considering policies from a cost-benefit viewpoint, the hard part is
o Identifying the relevant costs and benefits
o Measuring and valuing them (we don’t have markets and prices in every kind of environmental resource)

o Recognise that individual rational behaviour does not always lead to a socially optimum / desirable outcome
• When governments get their cost-benefit analysis wrong, there is always scope for government failure

• Remember – the best policies are those that are likely to be:
o Most effective in achieving an aim(s)
o Most efficient in not wasting resources or creating secondary problems / disincentive effects
o Are equitable in terms of their impact on different stakeholders

Please try to remember the basics of the cost-benefit principle in your exams this summer!

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