cost benefit analysis (CBA)
Cost-benefit analysis (CBA) is a framework for evaluating the social costs and benefits of an investment project.
This involves identifying, measuring and comparing the private costs and negative externalities of a scheme with its private benefits and positive externalities, using money as a measure of value.
Step 1: identify all costs and benefits using the principle of opportunity cost
Step 2: measure the benefits and costs using money as a unit of account
Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)
Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit now is worth more than £1,000 benefit in 10 years time
a) identify all costs and benefits
A firm deciding on an investment project will only take account of its own private costs and benefits e.g. total cost and total revenue. Firms ignore externalities. CBA will take account of both private and external costs and benefits.
Consider a project to build a bridge over a river:
- Private Costs e.g. construction costs, operating costs and maintenance costs
- External Costs i.e. costs incurred by non users (a) monetary e.g. loss of profits to competitors e.g. to ferry owner and (b) non monetary e.g. noise, loss of countryside, inconvenience
- Private benefits (a) direct the amount consumers are prepared to pay e.g. the tolls paid (b) indirect i.e. consumer surplus
- External benefits i.e. benefits to non users e.g. consumer surplus of users; time savings for travelers and fewer accidents
b) Measure the benefits and costs
Height can be measured using feet and inches. Benefits and costs can be valued using money. Private costs and benefits relatively easy to measure in monetary terms
Total costs and total revenue.
Private costs Build the bridge: £5,000, 000 to operate it £200,000 a year, to repair and maintain £ 50,000
Private benefits 1,000,000 users each paying £1
each = £1,000,000 a year
Externalities are more difficult to measure:
- Noise or loss of countryside. What value do people place on these? By how much do those who suffer need to be compensated Ask them using a questionnaire! If 50,000 affected people value the annual loss of countryside at £5 then cost = £250,000
- Time savings. What value do we place on work time saved or leisure time saved? Is the time saved worth the same to everyone? If 100,000 hours re saved and valued at £4 per hour, benefit = £400,000
- Fewer accidents. Economists value human life using money! One life = £750,000. If the bridge saves on life a year, annual benefit is £750,000
c) Likelihood of the cost or benefit
If there is a 50% chance that a life will be saved then the
benefit is
£750,000 x 0.5 = £325,000
d) The timing of the cost
and benefit
The major costs of the project occurs straight away. The benefits occur over the life of the project. The bridge may cost £5m to build but consumers benefit by £1m a year. If the expected life of the bridge is 25 years then how do we value now £1m of benefit in 25 years time?
Economists discount the future benefit to identify the present value.
e) Is a Project worth Undertaking?
Yes if discounted benefits outweigh discounted
costs. If the government has to choose between competing projects then
the ones with the highest positive net present value should be undertaken.
Richard Young
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