Cost-benefit analysis
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Cost-benefit analysis is an important technique for project appraisal in the public sector. In classical microeconomic theory the market system leads to maximum efficiency. In practice, there are many market failures (M. Mulreany 2002). There are various types of market failures: externalities or spillover effects, absence of relevant property rights, monopoly power and taxation, for instance. None of these are generally taken into account in the production of or the demand for market products. The main technique for including these types of market failures is cost-benefit analysis. Since market-driven choices may lead to socially inferior outcomes, the cost-benefit analyst attempts to construct a set of "as if", or shadow prices; these represent the prices which, if they prevailed in the market, would lead enterprises and individuals to make economic choices that correspond to the optimal welfare of all (P. Honohan 2002). Cost-benefit analysis is the process of weighing the total expected costs vs. the total expected benefits of one or more actions in order to choose the best or most profitable option.
Often, this involves monetary calculations of initial expense vs. expected return. For example, a product manager may compare manufacturing and marketing expenses to projected sales for a proposed product, and only decide to produce it if he expects the revenues to eventually recoup the costs. Cost-benefit analysis attempts to put all relevant costs and benefits on a common temporal 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 (R.H. Frank 2000).
During cost-benefit analysis, monetary values may also be assigned to less tangible effects such as risk, loss of reputation, market penetration, long-term strategy alignment, etc. 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 on the state healthcare. In this case, a value must be put on human life or the environment, often causing great controversy. The cost-benefit principle says, for example, that we should install a guardrail on a dangerous stretch of mountain road if the dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and property damage thus prevented (R.H. Frank 2000).
Cost-benefit calculations typically involve using time value of money formula. This is usually done by converting the future expected streams of costs and benefits to a present value amount.
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 behaviour.
See also
- Kaldor-Hicks efficiency - economic principle underlying cost-benefit analysis
- Pareto efficiency - alternative economic principle
- Net present value - a similar type of calculation
- Excess burden of taxation - which should be figured into cost-benefit analyses of publicly funded projects
External links
- [CelsiEval] - Cost-Benefit Analysis Tool
- [link] - The Environmental Valuation & Cost-Benefit Website
- [link] - Environmental Valuation & Cost-Benefit News
- [link] - Guide to Benefit-Cost Analysis
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