Cost Benefit Analysis

Theory

Cost-benefit analysis is often used by governments and others, e.g. businesses, to evaluate the desirability of a given intervention. It is an analysis of the cost effectiveness of different alternatives in order to see whether the benefits outweigh the costs (i.e. whether it is worth intervening at all), and by how much (i.e. which intervention to choose). The aim is to gauge the efficiency of the interventions relative to each other and the status quo.

Valuation

The costs of an intervention are usually financial. The overall benefits of a government intervention are often evaluated in terms of the public's willingness to pay for them, minus their willingness to pay to avoid any adverse effects. The guiding principle of evaluating benefits is to list all parties affected by an intervention and place a value, usually monetary, on the (positive or negative) effect it has on their welfare as it would be valued by them. Putting actual values on these is often difficult; surveys or inferences from market behavior are often used.

One source of controversy is placing a monetary value of human life, e.g. when assessing road safety measures or life-saving medicines. However, this can sometimes be avoided by using the related technique of cost-utility analysis, in which benefits are expressed in non-monetary units such as quality-adjusted life years. For example, road safety can be measured in terms of 'cost per life saved', without placing a financial value on the life itself.

Another controversy is the value of the environment, which in the 21st century is sometimes assessed by valuing it as a provider of services to humans, such as water and pollination. Monetary values may also be assigned to other intangible effects such as loss of business reputation, market penetration, or long-term enterprise strategy alignments.

Time

CBA usually tries to put all relevant costs and benefits on a common temporal footing using time value of money formulas. This is often done by converting the future expected streams of costs and benefits into a present value amount using a suitable discount rate. Empirical studies suggest that in reality, people do discount the future like this.

There is often no consensus on the appropriate discount rate to use - e.g. whether it should be small (thus putting a similar value on future generations as on ourselves) or larger (e.g. a real interest rate or market rate of return, on the basis that there is a theoretical alternative option of investing the cost in financial markets to get a monetary benefit). The rate chosen usually makes a large difference in the assessment of interventions with long-term effects, such as those affecting climate change, and thus is a source of controversy. One