COST-BENEFIT ANALYSIS
What is it?
Why do it?
How’s it done?
Associate Professor Richard Brown
r.brown@economics.uq.edu.au
Cost-Benefit Analysis
What is CBA?
A method for evaluating projects, policies, programs
More precisely:
A process of identifying, measuring and comparing the social
benefits and costs of an investment project, program or policy
intervention, from a public interest perspective
CBA is used for both prospective (appraisal) and retrospective
(evaluation)
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
What is CBA?
Used primarily but not exclusively in public sector decisionmaking
Some examples:
investment in public infrastructure – roads, schools,
hospitals, dams, universities, R&D
public policies and regulations: health and safety, air
and water quality, smoking, speed limits
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
Why CBA? Why for public sector?
Why not leave all investment decisions to private sector, based
on calculations of financial profitability?
Market failure!
The free market is not always capable of providing the correct
price signals to guide private investment decisions in the ‘right
direction’
Markets can be distorted for various reasons
Price distortions
inefficient outcomes
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
Why CBA? Why for public sector?
Purely market-based decisions by private sector do not always
deliver an outcome that is socially desirable – in the best
interests of the public at large
Private sector unlikely to invest in roads, dams, schools,
hospitals, defence, etc. if left completely to the free market
Why?
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
Three main reasons for market failure:
uncompetititve market structures eg. monopolies,
oligopolies, etc.
government interventions eg. taxes, subsidies, import
duties, price controls, quotas
externalities i.e. costs and benefits arising from a
decision (investment) not born/received by the private
investor making the decision eg. air pollution (external
cost), education (external benefit)
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
Correcting for market failure and price distortions
Aim is to come up with interventions that would bring
investment decision-making more in line with the socially
desirable outcomes
Various means to steer private and public sector decisions
towards more efficient, socially desirable outcomes:
regulations and penalties; eg. fines for speeding,
smoking in public, noise, anti-competitive behaviour
taxes and subsidies to correct for externalities
eg. ‘sin taxes’ on alcohol, tobacco, gambling
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
Correcting for market failure and price distortions:
Tradeable permits - where markets do not exist ‘create’ a
market eg. tradeable permits for carbon trading
Application of CBA - using a different set of prices
‘Shadow Prices’ used in calculation of profitability
‘Shadow Prices’ = ‘Opportunity Cost’
We have two types of shadow prices:
‘adjusted’ market prices - to offset distortions
‘non-market values’ – where prices non-existent
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis
What main economics principle underlies CBA methodology?
Standard CBA methodology requires the application of the core
economics concept of opportunity cost
We have limited resources and unlimited wants or needs
The key economics question is how to make best use of our
limited resources
By using them for the production of a given output will yield
certain benefits. Using them for the production of some other
good (or service) generates other benefits
Which produces the greater benefit to society?
Richard Brown: UQ Economics Schools' Day, July
2015
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Standard CBA Methodology: Opportunity Cost
Figure 1.1: The “With and Without” Approach to Cost-Benefit Analysis
Decision
Undertake
the Project
Scarce Resources
Allocated to the Project
Value of Project
Output
Do not Undertake
the Project
Scarce Resources Allocated
to Alternative Uses
Value of Output from
Resources in Alternative Uses
Project Benefit = $X
Project Opportunity
Cost = $Y
If X>Y, recommend the project
Richard Brown: UQ Economics Schools' Day, July
2015
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Comparing ‘with’ vs ‘without’ Scenarios
$ net
benefit
The ‘with’ project scenario
Measure this –
the difference
NOT THIS!
The ‘without’ project scenario
The ‘before’ project scenario
Project
introduced
Time/years
Richard Brown: UQ Economics Schools' Day, July
2015
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What do we mean by the public interest?
A private or public sector project has implications for:
• Government revenue – taxes, charges
• Government expenditure – provision of services
• Employment
• The Economy
• The Environment
These need to be assessed as part of a CBA before project or
policy approval
Richard Brown: UQ Economics Schools' Day,
July 2015
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Practical Examples: Comparing ‘with’ vs. ‘without’ scenarios
Richard Brown: UQ Economics Schools' Day, July
2015
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Practical Examples: Using Opp. Cost in Place of Market Price
Remember: OC = value in alternative use
Ask:
(i) How would resource otherwise be used? and
(ii) What is value in alternative use?
Example 1: A project generates 100 new jobs for otherwise
unemployed youth, paid say $20
In Private Profitability calculation labour would be costed at
100 x $20 = $2000
In CBA we would first ask “What is value of labour’s output in
alternative use?” Assume they have casual/informal work
equivalent to $5 each
In CBA labour would
be costed at 100 x $5 = $500
Richard Brown: UQ Economics Schools' Day, July
2015
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Practical Examples: Using Opp. Cost in Place of Market Price
So what? How would use of opportunity cost of labour in a CBA
change anything?
By costing labour at lower opportunity cost, projects that
generate relatively more jobs would be ranked higher - prefered
Example 2:
A project requires 100Mwh of electricity per day. The power
company charges $5 per Mwh
In private profitability calculation electricity costed at $500/day
In CBA we need to ask first, where would that additional power
supply come from, and, at what opportunity cost?
Richard Brown: UQ Economics Schools' Day, July
2015
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Practical Examples: Using Opp. Cost in Place of Market Price
Example 2 (cont.):
Case A: If the power supply system is already operating at full
capacity, we would have to divert it from other users
The opportunity cost would be the loss of output to them
Assume lost output = $8, then opportunity cost = $800
Case B: If there is spare capacity, we would price it at the
marginal cost of producing more output
Assume marginal cost = $3, then opportunity cost = $300
CBA shows higher net benefit when there is spare capacity
Richard Brown: UQ Economics Schools' Day, July
2015
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Practical Examples: Using Opp. Cost Where No Market Price
Example 3:
A proposed coal-fired power project generating additional
electricity is expected to make a profit of $1250
But, the production of power also produces 50 tonnes of carbon
pollution for which the producer is not charged
In CBA we include the cost to society of the carbon pollution
If the economists value this at, say, $30 per tonne the CBA would
recalculate the ‘economic profitability’ at $1250-1500 ($30x50) =
-$250 (ie. from an economic point of view there would be a loss)
The implication is that a less financially profitable project which
produces less or no carbon would appear more profitable in the
CBA and thus preferred from a public interest perspective
Richard Brown: UQ Economics Schools' Day, July
2015
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Practical Examples: Using Opp. Cost Where No Market Price
Example 4:
A proposed health sector project is expected to reduce human
fatalities by 10 persons per annum
As there is no ‘market price’ for an avoided fatality (a saved
human life) a financial profitability calculation would show no $
benefits for this
In CBA we include the value to society of each human life saved
Moral and ethical issues/objections?
A thought experiment using universal speed limit of 10km/hour
which eliminates all road fatalities. For or against?
Richard Brown: UQ Economics Schools' Day, July
2015
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Comparing Costs & Benefits Among Stakeholders
• The underlying principle of CBA is that net benefits should
be positive for a project to be considered worthwhile
– Total Benefits – Total Costs > $0
• BUT… this does not necessarily mean that all stakeholders
gain – some will but others will no doubt lose
• We need to look at the distribution of net benefits among
stakeholders - who gains and who loses, and how much?
• In some instances the project will not succeed if the costs
and benefits are unevenly distributed – complementary
policies might be recommended to compensate the losers
Richard Brown: UQ Economics Schools' Day,
July 2015
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Comparing Costs and Benefits Over Time
• We cannot compare dollar values that accrue at
different points in time
• To compare costs and benefits over time we apply the
concept of “discounting”
• The reason is that $1 today is worth more than $1
tomorrow
WHY?
Richard Brown: UQ Economics Schools' Day,
July 2015
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Comparing Costs and Benefits Over Time
• Inflation – purchasing power of $ declines in real
terms as prices rise
• ‘Opportunity cost’ – you could have earned some
income (eg. interest)
• Risk – some unforeseen event in the future
• ‘Pure time preference’ – more distant objects appear
smaller
Richard Brown: UQ Economics Schools' Day,
July 2015
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Comparing Costs and Benefits Over Time
Year
0
1
2
3
Project A -100 +50 +40 +30
Project B -100 +30 +45 +50
WHICH PROJECT OPTION: A or B ?
Cannot say until we convert all future values into present
day equivalent values – discounting using ‘discount factors’
Richard Brown: UQ Economics Schools' Day,
July 2015
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Cost-Benefit Analysis: Further Thoughts
Decision-support vs. decision-making?
CBA cannot remove from the decision-maker ultimate
responsibility for a decision
In this sense I prefer to think of CBA as a decision-support
rather than a decision-making process: its ultimate purpose is
to better inform the decision-making process rather than
replacing it
In many respects it is also the process of applying the
principles of CBA, using a coherent framework and ‘thinking
like an economist’ that is more important than the numbers
generated by a CBA
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis: Further Thoughts
 I’ve been teaching and practicing CBA for almost 40 years!
 “What’s different today, I am often asked?”
 Two major innovations in recent decades affecting the
practice of CBA - one technological and one
methodological
 invention of the PC and electronic spreadsheet (Excel),
and,
 development of non-market valuation methods and
techniques for valuation of environmental and other
non-market, ‘intangible’ costs and benefits
Richard Brown: UQ Economics Schools' Day,
July 2015
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Cost-Benefit Analysis: Further Thoughts
Do a CBA of a CBA!
Richard Brown: UQ Economics Schools' Day, July
2015
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Cost-Benefit Analysis: Further Thoughts
CBA can be applied to any decision/situation, but beware
... it could get you into trouble if taken too far!
Richard Brown: UQ Economics Schools' Day, July
2015
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PRIMARY REFERENCE
Benefit-Cost Analysis: financial and economic appraisal using
spreadsheets
H.F. Campbell and R.P.C. Brown
Cambridge University Press, 2003
(2ND Edition Routledge, 2015, in press)
Companion website has a number of worked case studies:
www.uq.edu.au/economics/bca
Login to “Other Users” username=user; password=abc2004
My contact: r.brown@economics.uq.edu.au
Richard Brown: UQ Economics Schools' Day, July
2015
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Questions and Comments
Thank you