Cost Benefit Analysis

Explain the principles behind cost benefit analysis. Is the use of cost benefit analysis essential in the appraisal of public spending? Discuss this in the light of a transport capital expenditure project with which you are familiar. Cost–benefit analysis is often used by governments 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. The aim is to gauge the efficiency of the intervention relative to the present circumstances.

The costs and benefits of the impacts of an intervention are evaluated in terms of the public’s willingness to pay for them (benefits) or willingness to pay to avoid them (costs). Inputs are typically measured in terms of opportunity costs – the value in their best alternative use. The guiding principle is to list all parties affected by an intervention and place a monetary value of the effect it has on their welfare as it would be valued by them. The process involves monetary value of initial and ongoing expenses vs. expected return.

Constructing plausible measures of the costs and benefits of specific actions is often very difficult. In practice, analysts try to estimate costs and benefits either by using survey methods or by drawing inferences from market behavior. For example, a product manager may compare manufacturing and marketing expenses with projected sales for a proposed product and decide to produce it only if he expects the revenues to eventually recoup the costs. Cost–benefit analysis attempts to put all relevant costs and benefits on a common footing.

A discount rate is chosen, which is then used to compute all relevant future costs and benefits in present-value terms. Most commonly, the discount rate used for present-value calculations is an interest rate taken from financial markets. This can be very controversial; for example, a high discount rate implies a very low value on the welfare of future generations, which may have a huge impact on the desirability of interventions to help the environment. Empirical studies suggest that in reality, people’s discount rates do decline over time because cost–benefit analysis aims to measure the public’s true willingness to pay.

During cost–benefit analysis, monetary values may also be assigned to less tangible effects such as the various risks that could contribute to partial or total project failure, such as loss of reputation, market penetration, or long-term enterprise strategy alignments. This is especially true when governments use the technique, for instance to decide whether to introduce business regulation, build a new road, or offer a new drug through the state healthcare system. In this case, a value must be put on human life or the environment, often causing great controversy.

Cost–benefit calculations typically involve using time value of money formulas. This is usually done by converting the future expected streams of costs and benefits into a present value amount. There are several criticisms to the use of CBA for environmental impact assessment: * Problems in attaching valuations to costs and benefits: Some costs are easy to value such as the running costs (e. g. staff costs) + capital costs (new equipment). Other costs are more difficult – not least when a project has a significant impact on the environment.

The value attached to the destruction of a habitat is to some “priceless” and to others “worthless”. Costs are also subject to change over time – I. e. the construction costs of a new bridge over a river or the introduction of electronic road pricing * The CBA may not cover everyone affected (i. e. all third parties) – inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential “stakeholders” who stand to be affected (positively or negatively) by the decision.

CBA cannot hope to include all stakeholders – there is a risk that some groups might be left out of the decision process Future generations – are they included in the analysis? What of “non-human” stakeholders? * Distributional consequences: Costs and benefits mean different things to different income groups – benefits to the poor are usually worth more (or are they? ). Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument. Social welfare is not the same as individual welfare – What we want individually may not be what we want collectively. Do we attach a different value to those who feel “passionately” about something (for example the building of new housing on Greenfield sites) contrasted with those who are more ambivalent? * Valuing the environment: How are we to place a value on public goods such as the environment where there is no market established for the valuation of “property rights” over environmental resources?

How does one value “nuisance” and “aesthetic values”? * Valuing human life: Some measurements of benefits require the valuation of human life – many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project “reducing the risk of death” – and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies. * Attitudes to risk – e. g. cost benefit analysis of the effects of genetically modified foods The debate over whether there should be a fifth terminal at Heathrow airport has been fierce and long-lasting, the official planning enquiry reported after 5 years and having cost many millions of pounds. The rival arguments at the inquiry highlighted many examples of environmental impact (externalities) – noise, air quality, rivers etc. – but concluded that these were not enough to refuse planning permission and that the new terminal project should go ahead. However, Below are points for and against terminal 5.

Case for Terminal 5 * Economic growth: Demand for air travel in south-east England is forecast to double in the next 20 years, making expansion vital – many thousands of jobs and businesses depend on Heathrow airport expanding to provide sufficient supply capacity to meet this growing demand. An increase in the capacity of Heathrow will make best use of airport’s existing infrastructure and land (nearly 3,000 acres). * The economy and trade: The UK will lose airlines and foreign investment to European rivals if it does not meet demand.

The benefits of a world-beating industry would be diminished – many sectors of our aviation industry have a comparative advantage and add huge sums to our balance of payments * Jobs: The terminal 5 project will create or safeguard an estimated 16,500 jobs, as well as creating 6,000 construction jobs during the building phase – this will have multiplier effects on the local / regional and national economy * Transport: The terminal will be the centre of a world-class transport interchange, with new Tube and rail links.

Car traffic would rise only slightly – the social costs of increased traffic congestion have been exaggerated by the environmentalists * Environment: The site earmarked for terminal 5 is currently a disused sludge works, and any displaced wildlife and plant life will be carefully relocated. The noise climate around Heathrow Airport has been improving for many years, even though the number of aircraft movements has increased considerably – partly due to the phasing out of older, nosier aircraft * Noise and night flights: BAA promises no increase in overall noise levels or in night flying.

The number of flights would rise only 8% Objections to Terminal 5 * Growth: British Aviation Authority forecasts are misleading and will lead to uncontrolled expansion, rather than targeting better solutions such as using existing space at other airports. * The economy: Heathrow already has the biggest capacity in Europe, and ambitions to extend its lead are merely “commercial prestige” rather than having long term macroeconomic benefits * Jobs: Only 6,000 jobs will be created – a tiny fraction of all the new jobs in the South East.

Local studies say jobs will increase anyway even without a fifth terminal * Transport: There will be a significant increase in road-widening and car parks to cater for the tens of thousands of extra car journeys to the airport every year * Environment: Air pollution will increase significantly, and hundreds of acres of wildlife and Green Belt land will be lost forever.

Plus the environmental costs of increased traffic congestion * Noise and night flights: More flights will mean more noise under the flight paths, and the pressure for controversial night flights and a third runway will increase – the regulators will be captured by the airlines and airport authorities and will eventually be pressurized into giving way on allowing more night time flights