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The Difficult Job of Cost-Benefit Analysis and Government Decision Making
By Gary Hadler
This is another in the series of articles I have been writing on decision making. This article gives a brief overview of Cost-Benefit Analysis and why it is difficult to calculate and use as a method of decision making. To read more articles about decision making and a variety of other academic issues visit ITS Tutorial School.
Cost benefit analysis is the method used by governments to decide what is a socially optimal output level of production of a specific good or service. When a project/decision is being considered by the government it needs to consider all the costs and benefits of this project. Cost are made up of private costs and external costs (external costs are costs to third parties not directly involved in the project/decision). There are also private benefits and external benefits of the project/decision. When private plus external cost is added together this is referred to as social cost. When private and external benefit is added together this is referred to as social benefit. The concept of government decision making is than very simple if the social benefit is greater than the social cost the project should proceed, if not, than the project should not proceed. But here lies the problem.
Suppose that the government is considering a public project, such as building a new highway. To judge whether to build the highway, it must compare the total benefits of all those who would use it to the costs of building and maintaining it. To make this decision, the government might hire a team of economists and engi¬neers to conduct a study, called a cost-benefit analysis, the goal of which is to es¬timate the total costs and benefits of the project to society as a whole.
Cost-benefit analysts have a tough job. Because the highway will be available to everyone free of charge, there is no price with which to judge the value of the high¬way. Simply asking people how much they would value the highway is not reli¬able: Quantifying benefits is difficult using the results from a questionnaire, and respondents have little incentive to tell the truth. Those who would use the high¬way have an incentive to exaggerate the benefit they receive to get the highway built. Those who would be harmed by the highway have an incentive to exagger¬ate the costs to them to prevent the highway from being built.
The efficient provision of public goods or other government services is, therefore, intrinsically more difficult than the efficient provision of private goods. Private goods are provided in the market. Buyers of a private good reveal the value they place on it by the prices they are willing to pay. Sellers reveal their costs by the prices they are willing to accept. By contrast, cost-benefit analysts do not observe any price signals when evaluating whether the government should provide a public good. Their findings on the costs and benefits of public projects are, therefore, rough approximations at best.
Therefore it can be concluded that even though a Cost-benefit analysis is meant to be an effective tool for governments to evaluate investment or other decisions, and to consider all social costs and benefits the extremely difficult nature of effective classification of those costs and benefits make the whole process subject to question.
About the Author
Gary Hadler B.Ec, Dip.Ed, MBA Has had over 15 years experience in training in the Business and Management area. To read more articles from Gary please ITS Tutorial School http://www.tuition.com.hk/information.htm
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